However, this methodology obviously fails to consider the factors of currency risk as seen in Argentina & Venezuela, regulatory risk, commodity risk and other risks involving the assumption that they will be able to receive the dividends fully denominated in US Dollars without any loss in value. Does this make sense as a way to do capital budgeting? The following reasons make Veneers’ model superior to the traditional model of capital budgeting used by AES. 1. Veneers has used 3 main parts to assuring his cost of capital in the new methodology.
Broadly they are, the overall risk (systematic), the country specific risk and the project ‘(cash-flow) specific risk. This new way of making capital budgeting decisions is not only more comprehensive but also more flexible. For example, if an additional rating or factor has to be added to the business-specific risk score, it can be done with ease. In this case, I have assumed the weights for the different categories for risk (counterparts credit, currency, regulatory etc. ) are the same across countries.
It is essential to understand that depending on the economy that AES operates in, these would have to be altered before calculating the risk adjustment. 2. This method also pushes the cost of capital in several countries much above the previously used 12%. From a case and logical perspective, several of the countries where the new model has yielded high discount rates are known to have intensified level of currency or regulatory risks. 3. In several of these countries the lack or minimal regulation of efficient markets causes the correlation between the local indices and American markets to be low, causing beta to be abnormally low.
However, because Veneers’ model uses several additional factors to calculate the discount rate, it minimizes the effect of this anomaly. Nevertheless, there are a few limitations that the model is yet to accommodate. 1. Despite the risks being considered, the probability of enforcement of laws differs between each legal system and country. There is no measure to incorporate that into this. 2. Even if the cash flow is generated from the project as expected, the expropriate rate and the risk associated with it should be deed to accurately value projects. 3.
Several variables used in the model are stationary and are not forward looking. This makes the forecasting technique equally unpredictable. 4. It doesn’t have the provision to analyze real-events that might occur in the future like war or ego-political tensions. 5. The currently used sovereign spread reflects only a debt-risk spread and assumes the same can be used for equity. Also, the sovereign risk cannot be measured in economies without a public debt market. If Veneers implements the suggested methodology, what would be the range f discount rates that AES would use around the world?
If the new methodology is implemented the projects would be discounted using a large range of discount rates as low as 10% to as high as over 30%, a total range of over 20 percentage points or 2000 BSP. This obviously suggests that the variables used to measure various risk premiums across countries are different and tailored. Below is the spreadsheet with the various adjusted WAC calculated for different projects across 1 5 countries. What is the value of the Pakistan project using the cost of capital derived from he new method?
If this project was located in the LLC. S. , what would its value be? If the Ala PRI project would be in USA: To come up with an appropriate discount rate for the valuation I have added the project specific risks that Ala PRI has to the country WAC associated with LISA. This valuation has been performed only according to DC as we are unaware of the interest payments that would be due if the project was location in America. How does the adjusted cost of capital for the Pakistan project reflect the probabilities Of real events?
The adjusted cost Of capital as calculated by Veneers’ method reflects portions of current risk that are involved in investing in a project located in Pakistan. However, forward looking estimates of real- events such as future regulatory conditions regarding the amount of repatriation or the economic standing of a party that will be elected to power in the following years are unknown. These factors while greatly affects the risks and cash-flow probabilities for AES have not been reflected in the adjusted discount rate.