Evaluating the Historical Capital Budgeting Method Essay

currently AES employs pop the question Finance Framework. Project finance tends to be used in purports with tangible assets with predictable notes flows in which construction and operating targets can be easily schematic through explicit contract. The key to AES projects financing lies with the precise forecasting of coin flows. In effect, the possibility of estimating cash flows with an acceptable level of uncertainty allows for tryst of happens among various interested parties. The ensuing certainty in cash flows allows for tall level of leverage and enables project assets to be sepa treadd from the rise up company. allow us now take a closer look at the pros and cons of the Capital Budgeting System currently in place. Principal Advantages Non-Recourse The separation of the p arnt company is structured through the creation of a Special draw a bead on Vehicle (SPV). This SPV is the formal borrower under all loan documents so that in event of default or bankruptcy AES is n ot directly credi dickensrthy before fiscal creditors. Instead, their legal claims are against the SPV assets. Maximize Leverage Currently AES inflictks to finance the be of development and construction of the project on extremely leveraged basis.High leveraged in non-recourse project financing permits AES to put less in capital to put at risk permits AES to finance the project with issue diluting its candour investment in the project. Off-Balance Sheet Treatment AES may not be required to report any of the project debt on its balance pall because such debt is non-recourse. Off balance sheet treatment can turn in the added practical benefit of helping the AES comply with covenants and restriction relating to borrowing notes contained in loan agreements to which AES is correspondently a party.Agency Cost The dominance costs of free cash flow are reduced. Management incentives are to project performance. Most eventfully close monitoring by investors is facilitated. two-wa y Financial Institutions One of the four constituents that boast contractual arrangement with the SPV in a typical project are the banks (an integral part free radical of financiers that include share holders, insurers, equipment manufacturers, export credit agencies and funds). Among these banks t here are bipartite financial institutions ( worry IFC, CAF and etc).Presence of these institutions as financiers helps in raising capital from these institutes at lower cost and secondly it is also read as a positive sign by commercial banks. Drawbacks Projects V/S discussion section The company is not only expanding its geographic boundaries, but it is also diversifying its task through backward and forward integration. The current financial model does not provide the AES with the big picture, which now constitutes more number of variables that are cosmos influenced by multiple factors overdue to the increase in depth and fullness of the organization. ComplexityFinancing of proje cts requires involvement of a number of parties. They can be quite complex and can be expensive to arrange. Secondly it demands great amount of management time. Macroeconomic Risk The current methodology sedulous by AES for capital budgeting does not take into account the exchange rate risk. This risk will be of higher magnitude in the exploitation countries because of their unstable monetary and fiscal policies2. As we gravel contriven that fluctuation in exchange rate has greatly hurt the AES telephone circuit and they were unable to abate this risk as they put one overnt anticipated it.This risk becomes important when the exchange rate fluctuation affects balance sheet items unequally. Thus tutelage check on the foreign exchange rate requires timely limiting of two the items of revenue and expenditure, and those of assets and liabilities in different currencies. Political Risk This is other important factor which the current financial management system does not take i nto account. This will be of significant importance when it comes to investing in developing countries where frequent changes in government policies occur. Does this system make consciousness?The financial strategy employed by AES was historically based on project finance. This approach solely took into account those factors that minimized AES exposure to the project and achieved the most beneficial regulatory treatment gum olibanum ensuring availability of financial resources to complete the project. The model worked hygienic for the domestic market as well as for the world(prenominal) operations, provided the opportunities undertook by AES were either in the sector of construct and running a power plant or simply acquire an existing facility and upgrading it and then operating.The underlying assumption over here was that the symmetrical and asymmetrical risks faced by the project were more or less same irrespective of its geographical location (Refer to Exhibit 3). even so when AES started diversifying the breadth of its operations by incorporating other offshoots of energy related business and transforming from a cogeneration to a more utility organization with majority of elaboration occurring in developing economies.This diversification of business increased the symmetrical risks like business risk, a classic example of which we see in brazil-nut tree where AES experience shortfall in demand /sales volume due to Energy Conservation Policy of Brazilian government and this had a mountain range effect on debt servicing capacity of the SPV as well the business price of the parent company. Other factor that current model was not able to include was the risk of devaluation of property in developing economies which resulted in significant losses due to the inability of the company to survive its international debt obligations.Expansion in developing economies also exposed the business to policy-making risk where the policies change erratically with changes in government. Hence we see that the geographical diversification of business causes asymmetrical risk to increase causing bimodal behavior in the result. Project financing becomes less recommendable as a symmetrical risk becomes more manifest. This constitutes a problem for emerging countries where these risks tends to be at the forefront. Lal Pir Project Valuation Scenario 1 PakistanIn order to expect the value of project for the Lal Pir project in Pakistan, we first postulate to code the Weighted Average Cost of Capital (WACC) using the new proposed methodology. For this we curb followed the approach wedded in exhibit 8 of the case. The first measurement is to maneuver the value of levered ? using the formula and training given in the case3. The value of the levered ? comes reveal to be 0. 3852 or 38. 52%, which essentially sum that our project is not very highly correlated to the market requite. utilise this value of ? we now calculate the cost of Equity (ref er Exhibit 4A). We have used the return on U. S. Treasury Bond (i. e. 4. 5%) as the risk free return in calculating the cost of equity. The cost of equity comes push through to be 0. 072 and similarly, using the risk free return and the default spread (given in exhibit 7a of case) we calculate the cost of debt which comes out to be 0. 0807. It is important to note that the cost of debt and the cost of equity also need to be placeed for the sovereign spread (0.0990 for Pakistan). Once we have the set costs of equity and capital we can now calculate the WACC for the project using the formula given in case where we essentially multiply equity and debt ratio with the limited costs of equity and debt respectively4. The WACC in this scenario comes out to be 0. 1595 or 15. 95%. However, now we need to adjust this WACC for the risks associated with doing the project in Pakistan and we do this by using Table A given in the case. We know that the total Risk Score for Pakistan is 1.425 and since at that place is a running(a) relationship between business specific risk tallys and cost of capital5 we need to adjust our WACC by 7. 125% thus making our final WACC 23. 075%, using which we calculate our NPV (refer to Exhibit 6) from the year 2004 to 2023, and it comes out to be negative $234. 34 zillion. Scenario 2 USA For USA similar calculations are made to calculate the WACC (Exhibit 4B). However there are two things that are different. First we see the sovereign spread is equal to zero. Secondly, in this case we would need to calculate the business risk using the information given in exhibit 7a of the case (refer to Exhibit 5).This score comes out to be 0. 64 and using this score, our business risk comes out to be 3. 23% and adding it to our calculated value of WACC, we get our final WACC of 9. 64%. victimization this we calculate our NPV for USA which comes out to be negative $ 35. 92 million (refer to Exhibit 7). Adjusted Cost of Capital and Probabilities of Real Events in Pakistan In calculating the adjusted cost of capital for Pakistan the WACC is adjusted for six super C types of risks Operational, Counterparty, Regulatory, Construction, Commodity, Currency and Legal.We can clearly see from table A given in the case that besides construction there is a chance of all these risks actually effecting the project in Pakistan. In these, the highest probability is that of currency risk and the legal risk. The adjusted cost that we have calculated is adjusted by the total risk score for Pakistan. There is a linear relationship between the total risk score and adjustment to the cost of capital, i. e. a score of 1 leads to an adjustment of 500 basis points in the WACC.When we calculate the WACC for Pakistan through traditional formula it comes out to be 15. 95%, however in order to incorporate the risk factor associated with Pakistan we need to adjust it for the Total Risk Score, which in this case is 1. 425. So we simply multiply this by 500 an d we find out that we need to adjust our WACC 23. 075%. Since this 23. 075% is adjusted using the total risk score we can safely assume that it incorporates for the probability of the afro-mentioned six types of risks in WACC with respect to Pakistan.Discount rove Adjustment USA v/s Pakistan As mentioned earlier the send packing rate is adjusted based on the total risk score of the soil. This total risk score is compiled from 6 main types of risks, the probability of which varies from country to country. If we simply compare the risk scores for USA and Pakistan6, we can see that there is a major difference between the risk profiles of both the countries. For instance, while currency, regulatory and legal risks are significantly high in Pakistan, they do not exist in the USA at all.to a fault we see that operational, counterparty and commodity risks are higher in USA as compared to Pakistan. Similarly when the respective WACCs of the two countries are adjusted for their risk we se e that the adjusted WACC for Pakistan (23. 075%) is much higher as opposed to that of USA (9. 64%), which essentially implies that Pakistan is inherently a riskier country to invest in as opposed to the USA and any investments made in this region would have to cross a higher hurdle rate than if they were made in the US region.