Aes Cost of Capital

International great(p) coordinate and the make up of majuscule Agenda 1 2 3 4 5 International Capital social system and the personify of Capital Analyzing salute of Capital among Countries mystify Border Listing of mo moolahary funds International asset price baby-sit (IAPM) The Financial Structure of Subsidiaries Case Analysis AES peck 6 International Capital Structure and the Cost of Capital Your Logo International Capital Structure and the Cost of Capital Firms atomic number 18 becoming multinational in both scope AND in big(p) structure Fully corpo assess financial grocerys = the equal woo of keen both domesticatedatedatedally and abroad o If non, opportunity may exists to decrease appeal of detonator Cost of Capital The minimum deem of return an investment moldiness gene lay out to cover its financial support greet Firms will undertake projects if the return is expected to exceed the live of detonating device Return = Cost of Capital cheer unchanged Return Cost of Capital watertights value increases Return Cost of Capital bad investment Weighted Average Cost of Capital (K) When a tighten has both debt and uprightness funding, weighted average represent of expectant K = (1-? )K+ ? (1- t)i K = (1-? )KL + ? i(1- t) (1- ? = weight of greet of jacket that is from whoremasterdour KL = cost of beauteousness roof ? = debt-to- sum of money- commercialize-value ratio (weight of add up cost of capital of the United States that is from debt) i = before-tax income cost of debt capital (borrowing) t = marginal corpo assess income tax rate o Interest payments argon tax allowable K = (1-? )KL + ? i(1- t) (1- ? ) = weight of cost of capital that is from rectitude KL = cost of equity capital ? = debt-to- extreme-market-value ratio (weight of total cost of capital that is from debt) i = before-tax cost of debt capital (borrowing) t = marginal corporal income tax rate o Interest payments argon tax deduc tible K = (1-? )KL + ? i(1- t) (1- ? ) = weight of cost of capital that is from equity KL = cost of equity capital ? = debt-to-total-market-value ratio (weight of total cost of capital that is from debt) i = before-tax cost of debt capital (borrowing) t = marginal corporate income tax rate o Interest payments are tax deductible K = (1-? )KL + ? i(1- t) (1- ? ) = weight of cost of capital that is from equity KL = cost of equity capital ? = debt-to-total-market-value ratio (weight of total cost of capital that is from debt) i = before-tax cost of debt capital (borrowing) t = marginal corporate income tax rate o Interest payments are tax deductible K = (1-? )KL + ? i(1- t) (1- ? ) = weight of cost of capital that is from equity KL = cost of equity capital ? = debt-to-total-market-value ratio (weight of total cost of capital that is from debt) i = before-tax cost of debt capital (borrowing) t = marginal corporate income tax rate o Interest payments are tax deductible ex emplar K = (1-? )KL + ? (1- t)i o Company is financing 30% of capital by debt (? ) ? So theyre financing 70% (1-0. 30) by equity (1-? ) Cost of equity capital is 10% Before-tax cost of borrowing is 6% Marginal corporate tax rate is 15% K = (0. 0)0. 10 + 0. 30(1-0. 15)0. 06 Example K = (1-? )KL + ? (1- t)i o Company is financing 30% of capital by debt (? ) ? So theyre financing 70% (1-0. 30) by equity (1-? ) Cost of equity capital is 10% Before-tax cost of borrowing is 6% Marginal corporate tax rate is 15% K = (0. 70)0. 10 + 0. 30(1-0. 15)0. 06 Example K = (1-? )KL + ? (1- t)i o Company is financing 30% of capital by debt (? ) ? So theyre financing 70% (1-0. 30) by equity (1-? ) Cost of equity capital is 10% Before-tax cost of borrowing is 6% Marginal corporate tax rate is 15% K = (0. 70)0. 10 + 0. 30(1-0. 15)0. 06 Example K = (1-? )KL + ? (1- t)i o Company is financing 30% of capital by debt (? ) ? So theyre financing 70% (1-0. 30) by equity (1-? ) Cost of equity capita l is 10% Before-tax cost of borrowing is 6% Marginal corporate tax rate is 15% K = (0. 70)0. 10 + 0. 30(1-0. 15)0. 06 Example K = (1-? )KL + ? (1- t)i o Company is financing 30% of capital by debt (? ) ? So theyre financing 70% (1-0. 30) by equity (1-? ) Cost of equity capital is 10% Before-tax cost of borrowing is 6% Marginal corporate tax rate is 15% K = (0. 70)0. 10 + 0. 30(1-0. 15)0. 06 Example K = (1-? )KL + ? (1- t)i o Company s financing 30% of capital by debt (? ) ? So theyre financing 70% (1-0. 30) by equity (1-? ) Cost of equity capital is 10% Before-tax cost of borrowing is 6% Marginal corporate tax rate is 15% K = (0. 70)0. 10 + 0. 30(1-0. 15)0. 06 K = 8. 53% Minimizing weighted average cost of capital(WACC) worst WACC is obtained when the optimal combination of debt and equity are used Increases of profitable capital expenditures o Firm value is increased as long as the return on new projects exceeds the unassailables WACC Internationalizing the tautens capital structure helps to decrease the cost of capital Firms Investment conclusion and the Cost of Capital A firm that gage reduce its cost of capital will be able to increase the profitable capital expenditures that they can invest in This results in increasing shareholder wealth We can do this by arena-wideizing our cost of capital Factors that affect the WACC Controllable Uncontrollable 1 Capital structure policy Proportion of debt and equity Interest infinite Increases cost of debt, may in learnly increase cost of equity Investment Policy Degree of risk associated with new projects Tax rates Increase in corporate tax rate decreases cost of debt decreases WACC Economic conditions Ie. Financial crisis of 2007/2008 Calculating the firms equity cost of capital Usually estimated using the Capital Asset set Model (CAPM) Ri = Rf + ? (Rm Rf) Ri Expected return of security I Rf take chances-free interest rate ? measures irritability of security i compared to the m arket portfolio Rm Market portfolio Cost of capital in segmented vs. incorporated markets Ri = Rf + ? (Rm Rf) In segmented markets, Rm is usually proxied by the S for the United States In integrated markets, Rm can be proxied using the MSCI World index Cost of capital in segmented vs. ntegrated markets continued Same future tense cash flows are likely to be priced differently in different countries in segmented markets, wherefore? o ? is measured against the domestic market portfolio a this differs from hoidenish to country In fully integrated markets, same future cash flows will be priced the same as ? is now measured against the same world market portfolio Analyzing Cost of Capital among Countries Your Logo Does the Cost of Capital Differ among countries? ? Researches suggest that although international financial markets are non segmented anymore, they are still not fully integrated ? The verifiable evidence is not clear-cut If the international financial markets = le ss than fully integrated, then there can be regular differences To illustrate that capital markets are less than fully integrated, McCauley and Zimmer (1994) provided a direct comparison of the cost of capital among the 4 major countries Ger more, Japan, UK and US Method 1. estimate the cost of debt and equity capital 2. compute the cost of funds (weighted average cost of capital) using capital structure in each country as the weight 3. compute the cost of capital in real terms after adjusting for the inflation rate Effective real After-Tax Cost of Debt Cost of Equity Debt -to-Equity Value Ratios Real After-Tax Cost of Funds Example Novo Industri Produces industrial enzymes and health care products 1970s, management decided to finance aforethought(ip) future growth of beau monde by entering international capital markets Danish stock market was small and illiquid company needed to internationalize Novo management felt they were facing a higher cost of capital than competit ors because of the segmented nature of the Danish stock market Example Novo Industri Went international by increase transparency by presenting financial and technical statements in Danish and English Cross-listed on the London Stock Exchange, Listed ADRs (so that US investors can invest in US dollars rather than Danish) The Result Novo Industris stock price increased while other Danish stocks didnt Implications of the example Firms operating in small, segmented domestic capital market can gain approach to new capital and begin the cost of capital by listing their stocks on large, liquid capital markets like the New York and London Stock Exchanges. Cross border listing of stocks Your Logo Cross-Border Listings of Stocks Firms can potentially benefit from crossborder listings Why? o Gain access to additional sources of capital while set downing cost of capital by increasing investor base o Increase in stock prices due to more demand and trading of the stock Cross-Border Listi ngs of Stocks Firms seem to privilege to list in neighbouring markets Why? o Similarities in markets o A home bias Cross-Border Listings of Stocks Generally, o Potentially expand investor base, which leads to a higher stock price and lower cost of capital lower transaction cost ? improvement in quality and quantity of firm specific information addressable to investors o Creates a secondary market for the companys shares and facilitates raising new capital in contrary markets liquidity of a companys stock o Enhance Cross-Border Listings of Stocks Generally, o Enhances the visibility of the company and its products in foreign markets shares may be used as the acquisition capital for taking over foreign companies o Cross-listed o May improve the companys corporate governance and transparency Cross-Border Listings of Stocks May improve the companys corporate governance and transparency one time companies cross-lists its shares on foreign exchanges (NYSE, LSE), they are require d to follow strong disclosure and listing requirements On average, foreign companies listed on U. S. exchanges are valued 17% higher Cross-Border Listings of Stocks Disvantages o Meeting disclosure and listing requirements can be costly (U. S. GAAP) in overseas markets o Volatility o unusualers may take a controlling interest in the company and challenge domestic control International Asset Pricing Model IAPM Your Logo IAPM For understanding the effects of international cross-listings. assuming cross-listed assets are internationally tradable assets and internationally nontradable assets. IAPM CAPM Ri=Rf+(RM-Rf)Bi Bi = Cov(Ri , RM)/Var(RM) = Ri=Rf+(RM-Rf)/Var(RM)Cov(Ri,RM) AMM risk-aversion Y*=E(r)-rf/(A? 2) AM is a measure of aggregate risk aversion M is aggregate market value of market portfolio = Ri=Rf+ AMM Cov(Ri,RM) IAPM Asset pricing mechanism under end integration assets are trade internationally according to world systematic risk Complete naval division assets a re trade respected to country systematic risk. Suppose two countries Domestic Country and overseas Country IAPM Complete Segmentation 1 Domestic Country E(R) Foreign Country E(R) Rg = Rf + AFF Cov (Rg , RF) Ri = Rf + ply Cov (Ri , RD) Complete Integration Both Domestic and Foreign Ri = Rf + AwW Cov (Ri , RW) In realty, assets are priced as partially integrated world financial markets IAPM Partially Integrated World Financial Markets Internationally tradable assets are priced as if world financial markets were completely integrated Non-tradable assets will be priced by world systematic risk (pricing spillover effect) and a country-specific systematic risk. o o Spillover effect externalities of economic activity or processes those who are not instantaneously involved in it. Pollution, technology, even financial markets IAPM Nontradable assets of the domestic country Ri=Rf+ AwW Cov*(Ri,RW)+ ADD Cov(Ri , RD)- Cov*(Ri , RD) Cov* (Ri , RW) Indirect world systematic risk Cov*(Ri,RW ) is the indirect covariance amidst the ith nontradable asset and world market portfolio. Cov(Ri , RD)- Cov* (Ri , RD) light domestic systematic risk Cov*(Ri , RD) is indirect covariance mingled with the future returns on the ith non-tradable asset and domestic countrys market portfolio that is induced by tradable assets. IAPM implications 1. International listing (trading) of assets in otherwise segmented markets directly integrates international capital market by making these asset tradable. 2. Firms with non-tradable assets get free ride from firms with tradable assets in sense that former indirectly benefit from international integration in terms of a lower cost of capital and higher asset prices. Effect of Foreign Equity self-command Restrictions Restrictions on utmost % self-possession of local firms by foreigners Mexico and India restrain to 49% Two different classes of equity Chinese firms core A shares and B shares Ensuring domestic control of local firms Pricin g-to-market (PTM) phenomenon Constraint is effective in limiting desire foreign ownership eg. Korean firms restriction on foreigners is 20% Foreigners want to corrupt 30% Foreign and domestic investors may face different market share prices Asset Pricing under Foreign Ownership Restrictions A firms cost of capital depends on which investors, domestic or foreign, supply capital. A firm can reduce its cost of capital by internationalizing its ownership structure. An Example of Foreign Ownership Restrictions draw near Nestle used to issue two different classes of honey oil stock Bearer shares foreigners Registered shares Swiss citizens The bearer stock was more expensive. Nestle An Example of Foreign Ownership Restrictions Nestle On November 17, 1988, Nestle lifted restrictions imposed on foreigners, allowing them to hold registered shares as well as bearer shares. A major transfer of wealth from foreign shareholders to Swiss shareholders. The total value of Nestle incre ased substantially when it internationalized its ownership structure. Nestles cost of capital therefore declined. An Example of Foreign Ownership Restrictions Nestle The Nestle episode illustrates The importance of considering market imperfections The peril of political risk The benefits to the firm of internationalizing its ownership structure The Financial Structure of Subsidiaries Your Logo The Financial Structure of Subsidiaries Three different approaches to determine 1. Conform to the parent companys norm where the parent company is fully responsible for the supplemental companys financial obligations not necessarily consistent with minimizing the parents overall cost of capital The Financial Structure of Subsidiaries Three different approaches to determining 2. Conform to the local norm of the country where the subsidiary operates When the parent company is willing to let its subsidiary default, or the guarantee of obligations becomes difficult to enforce crosswise n ational borders Not the optimal one approach (immature nature of local financial markets) The Financial Structure of Subsidiaries Three different approaches to determining 3. Vary judiciously to capitalize on opportunities to reduce financing costs and risks Most reasonable and consistent with minimizing firms overall cost of capital Take advantage of subsidized loans Taxes deduction of interest payment Take advantage of various market imperfections (ex. political risks) character reference Globalizing the Cost of Capital and Cost Budgeting at AES BRIEF BACKGROUND AES Originally Applied Energy run Founded in 1981 Publically traded since 1991 In 2003 Leading independent supplier of electricity in the world $33 Billion in asset (eg. Power plants, generation facility, other energy related businesses) stretched across 30 countries and 5 continents AES Early Success 1983 1st cogeneration facility is built in Houston, Texas 1988 Net income = $1. million 1991 AES goes publi c, net income = $42. 6 million 1991-1992 AES initiates international expansion 1996-1998 estimated 80%-85% capital investment is overseas 2000 Revenue = $4. 958 million Net Income = $778 million AES Typical Investment Structure AES AES stock price (market cap in 2000 reached $28 million $70/share) AES AES stock price (market cap in 2002 fell 95% to $1. 6 billion $1/share AES What Happened? Its recipe for success (international exposure) became their recipe for disaster o Much of AES expansion took place in developing countries (there was more unmet demand vs. eveloped countries) Main factors o Devaluation of key South American currencies ? Argentine, Brazilian, Venezuelan currency crises o Adverse changes in energy regulatory requirements ? Government mandated energy rationing and contest o Decline in energy commodity prices AES AES ISSUES AES Simple Domestic Finance Framework 12% discount rate was used for all contract generation projects o all dividend flows from projects were deemed equally uncivilized ? fair assumption because businesses had similar capital structures o most risks could be hedged in the domestic market AES Same Model was Exported Overseas Worked well initially, when they first expanded to Northern Ireland o had many of the same characteristics as domestic projects Model became increasingly strained in Brazil and Argentina o Hedging key exposures was not feasible (currency, regulatory.. ) AES SO AES needed of a methodology for calculating origin by AES valuation & cost of capital for capital budgeting at AES businesses in diverse locations around the world AES How did AES deal with it? Rob Venerus, director of Corporate Analysis & Planning questioned whether the traditional CAPM would suffice He did not advocate the use of a world CAPM o AES owned businesses in poorly integrated capital markets Countries such as Tanzania and Georgia did not have any meaningful capital markets He did not advocate the use a local CAPM either o AES How did AES deal with it? So Rob Venerus real a new model Step 1 prefigure the cost of equity using U. S. market data for each of AES projects o Average the unlevered equity betas from comparable U. S. companies o Relever the beta to reflect the capital structure of each of AES projects o Cost of equity = Rf + ? (Rm Rf) AES How did AES deal with it? Step 2 Calculate the cost of debt by adding the U. S. risk free rate and a default spread o Cost of Debt = Rf + Default Spread o The default spread is based on the relationship between EBIT ratios for comparable companies and their cost of debt. AES AES How did AES deal with it? Step 3 Add the sovereign spread to both the cost of equity and the cost of debt o this accounts for country-specific market risk, which is the difference between local government bond yields and alike(p) U. S. Treasury yields. These steps allow AES to face a WACC that reflects the systematic risk associated with each project in its local market. AES AES How did AES deal with it? BUT Most of these local markets are developing markets where access to capital was limited and information less than perfect project-specific risk could not be diversified away Project-specific risk essential be accounted for AES How did AES deal with it? Example of project-specific risk There are 2 hydro plants in Brazil that are identical in every aspect, except for the rivers that feed them. River 1 produces cash flows that vary +/50%, River 2 by +/- 10%. If they are financed by 100% equity, CAPM says they are worth the same. Rob Venerus thought this was flimsy Seven types of Project-specific risk 1. Operational/Technical 2. Counterparty credit/performance 3. Regulatory 7. Contractual Enforcement/Legal 4. pull 5. Commodity 6. Currency Weights estimated from AES ability to anticipate and mitigate risk. Then given a grade between 0 (lowest exposure) and 3 (highest exposure), multiplied by their weights to yield a business-specific risk score AE S Example Risk Score Calculation for Lal Pir Project (Pakistan) Business-specific risk score Used to calculate an adjustment to the initial cost of capital o 0 = no adjustment to WACC o 1 = +500 basis points (5%) o 2 = +1000 basis points (10%) o 3 = +1500 basis points (15%) Overall (exhibit 8 from case) 1. calculate cost of equity and cost of debt using U. S. market data 2. add sovereign spread to each 3. calculate WACC 4. Add a business-specific risk adjustment to WACC SUGGESTION & RECOMMENDATION FOR AES CORPORATION Suggestion & Recommendation AES Corporations current method of valuing risk is clearly inadequate. Not enough risks were being considered in their model, in particular political and economic risks in developing countries that the company expanded to. Under this current model, country-specific risk is overly difficult to measure. This new model to value cost and risk should be implemented by AES. It gives the company a more realistic projection of the risks that th ey may face with projects that they take on internationally. Risks such as political, economic, country-specific and business-specific risks are now considered, where in the previous model they were neglected. THE END THANK YOU Your Logo