COST OF CAPITAL AND CAPITAL BUDGETING

Globalizing the Cost of Capital and Capital Budgeting at AES



Table of Contents

Introduction to the Case Study4

Background of the Study4

Statement of the problem4

Research Aims and Objectives5

Structure of the rest of the Report5

Case Brief7

About the Company7

SWOT Analysis7

Strengths7

Weaknesses7

Opportunities8

Threats8

Description of the problem8

Risk Management9

Currency Devaluations9

Regulatory Environment10

Problem Statement, Plan of Analysis11

Statement of the problems in the case11

Relevant Literature Review12

Cost of Capital12

Factors affecting Cost of Capital for MNCs12

Size of Company13

Access to Global Capital Markets13

International diversification13

Exchange Rate Exposure14

Country Risk14

Weighted Average Cost of Capital15

Capital Asset Pricing Model15

Formula16

Assumptions16

International Capital Asset Pricing Model16

ICAPM Formula17

Risks17

Firm Specific risk17

Systematic Risk18

Foreign Currency Exposure18

Translation Exposure19

Transaction Exposure19

Economic Exposure20

Empirical Studies20

Cost of Capital and MNCs21

Exchange Rate Exposure and MNCs22

Proposed Plan of Analysis23

Sources of Data23

Analysis and Findings24

An Assessment of the Current position24

Valuation of Lal Pir Project, Pakistan25

Valuation of US Company27

Proposed Solution to Problem28

Integrated Assessment of the Analysis28

Adjusted Cost of Capital and Probabilities of Real Events in Pakistan28

Discount Rate Adjustment: USA v/s Pakistan28

Recommendations34

Proposed Plan of Action34

Limitations of the Study, Scope for further research34

Application of the Learning To Another Organization In Any Industry38

References41

Appendix43

Financial Ratios43

Case Study: Globalizing Cost of Capital and Capital Budgeting at AES

Introduction to the Case Study

Background of the Study

AES is a global power company with electricity generation and distribution operations spread across 28 countries on five continents. The company has undergone major expansion in a relatively short spam of time and has foreign subsidiaries in almost 28 counties. Over the years, the company has grown in a way that majority of its revenue was being generated from its units across the world out of which one third is generated from South American operations alone. On one side, it has resulted in phenomenal growth. On the other hand, the management failed to introduce superior methods for dealing all the financial matters and continued to follow a standard approach across all its projects irrespective of its locations and relevant risks. The company could not sustain the environment for a long period of time. Going international exposed the company to exchange rate fluctuations. This had an unfavorable effect on its debt servicing capacity. At the same time, its foreign subsidiaries also witnessed adverse change in regulatory environment in the host country which was mainly aimed to promote the interest of locally generated assets. Apart from this, decline of commodity prices globally further deteriorated the situation for the company. As a result of these incidents, the share prices of the company came falling from $75 to $1 which is quite a drastic fell.

Statement of the problem

The case titled “Globalizing Cost of Capital and Capital Budgeting” at AES is essentially relates to difficulties faced by a company which has gone global and now faces the complexities of situations which put forward the demand for superior level of financial models to reassess the cost of capital. Initially, the company has transferred the domestic model to all its foreign subsidiaries. Subsequently, authorities realized that presence of diverse risks at varying levels that are often unique to geographic locations cannot be assessed by a standard valuation model and therefore, a new ...