Aes Cost of Capital

trans guinea pig superior construction and the approach of dandy Agenda 1 2 3 4 5 outside(a) majuscule Structure and the greet of big(p) Analyzing toll of Capital among Countries home run Border Listing of Stocks International addition Pricing Model (IAPM) The fiscal Structure of Subsidiaries Case Analysis AES Corpo proportionalityn 6 International Capital Structure and the bell of Capital Your Logo International Capital Structure and the Cost of Capital Firms be becoming multinational in twain(prenominal) scope AND in great social organisation Fully integ considerd fiscal commercializes = the equal damage of jacket crown both nationalally and abroad o If non, opportunity whitethorn exists to decrease bell of pileus Cost of Capital The minimum aim of surpass an investment must gene rate to bandaging its fiscal backing toll Firms will undertake projects if the return is expected to drop dead the apostrophize of outstanding turn back = Cost of Ca pital comfort same(predicate) Return Cost of Capital squ ars value increases Return Cost of Capital bad investment Weighted Average Cost of Capital (K) When a sign of the zodiac has both debt and candour support, encumbranceed bonny equal of bang-up K = (1-? )K+ ? (1- t)i K = (1-? )KL + ? i(1- t) (1- ? = weight of speak to of smashing that is from equity KL = appeal of equity capital ? = debt-to- occur- marketplace-value ratio (weight of total hail of capital that is from debt) i = before- impose follow of debt capital (borrowing) t = peripheral bodied income tax rate o Interest payments are tax departable K = (1-? )KL + ? i(1- t) (1- ? ) = weight of follow of capital that is from equity KL = apostrophize of equity capital ? = debt-to-total-market-value ratio (weight of total greet of capital that is from debt) i = before-tax bell 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 personify 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 Example K = (1-? )KL + ? (1- t)i o Company is pay 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 capital is 10% Befo re-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 just cost of capital(WACC) Lowest WACC is obtained when the optimal combination of debt and equity are utilize Increases of profitable capital expenditures o Firm value is change magnitude as long as the return on new projects exceeds the debaucheds WACC Internationalizing the firms capital expression helps to decrease the cost of capital Firms Investment Decision and the Cost of Capital A firm that can reduce its cost of capital will be able to increase the profitable capital expenditures that they can invest in This results in increasing treat patroniseer wealth We can do this by beingwideizing our cost of capital Factors that affect the WACC Controllable Uncontrollable 1 Capital structure policy Proportion of debt and equity Interest rates Increases cost of debt, may collaterally increase cost of equity Investment polity Degree of endangerment 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 count on the firms equity cost of capital Usually estimated victimization the Capital Asset Pricing Model (CAPM) Ri = Rf + ? (Rm Rf) Ri Expected return of security I Rf Risk-free interest rate ? measures capriciousness of security i compared to the market portfolio Rm Market portfolio Cost of capital in segmented vs. integrated 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 development the MSCI World index Cost of capital in segmented vs. ntegrated markets go on Same future cash flows are likely to be priced divers(prenominal)ly in different countries in segmented markets, why? o ? is heedful against the domestic market portfolio a this differs from country to country In fully integrated markets, same future cash flows will be priced the same as ? is now measured against the same mankind market portfolio Analyzing Cost of Capital among Countries Your Logo Does the Cost of Capital Differ among countries? ? Researches suggest that although transnationalist financial markets are not segmented anymore, they are still not fully integrated ? The empirical evidence is not clear-cut If the international financial markets = less than fully integrated, then there can be systematic differences To illustrate that capital markets are less than fully integrated, McCauley and baby-walker (1994) provided a direct comparison of the cost of capital among the 4 study countries Germany, 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 for each one country as the weight 3. compute the cost of capital in real terms after adjusting for the inflation rate Effective documentary 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, all oversight decided to finance planned future growth of company by entering international capital markets Danish stemma market was pocket-sized and il fluidness company needed to internationalize Novo management felt they were facing a hig her cost of capital than competitors because of the segmented nature of the Danish stock market Example Novo Industri Went international by Increased transparency by presenting financial and technical statements in Danish and English Cross-listed on the capital of the United Kingdom Stock Exchange, Listed ADRs (so that US investors can invest in US dollars quite a than Danish) The Result Novo Industris stock price increased while power(a) Danish stocks didnt Implications of the example Firms operating in small, segmented domestic capital market can gain access to new capital and dis pose the cost of capital by listing their stocks on large, liquid capital markets like the New York and London Stock Exchanges. Cross moulding 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 lowering cost of capital by increasing investor base o Increase in stock prices due to more demand and trading of the stock Cross-Border Listings of Stocks Firms expect to prefer 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 costs ? improvement in quality and quantity of firm specific information available to investors o Creates a secondary market for the companys shares and facilitates raising new capital in inappropriate markets liquidity of a companys stock o arouse Cross-Border Listings of Stocks Generally, o Enhances the visibility of the company and its products in outside markets shares may be use as the acquisition currency 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 Once companies cross-lists it s shares on foreign exchanges (NYSE, LSE), they are required 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 Dis favors o see disclosure and listing requirements can be costly (U. S. GAAP) in foreign markets o Volatility o alieners may take a irresponsible interest in the company and challenge domestic control International Asset Pricing Model IAPM Your Logo IAPM For understanding the achievements of international cross-listings. assuming cross-listed summations 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 take chances- offense Y*=E(r)-rf/(A? 2) AM is a measure of aggregate take chances aversion M is aggregate market value of market portfolio = Ri=Rf+ AMM Cov(Ri,RM) IAPM Asset pricing mechanism under Comp permite integration assets ar e wad internationally according to world systematic risk Complete partitioning assets are trade respected to country systematic risk. Suppose dickens countries Domestic Country and Foreign Country IAPM Complete Segmentation 1 Domestic Country E(R) Foreign Country E(R) Rg = Rf + AFF Cov (Rg , RF) Ri = Rf + add together 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 part 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 directly voluminous in it. Pollution, technology, even financial markets IAPM Nontradable assets of the domestic country Ri=Rf+ AwW Cov*(Ri, RW)+ minimal brain damage Cov(Ri , RD)- Cov*(Ri , RD) Cov* (Ri , RW) Indirect world systematic risk Cov*(Ri,RW) is the indirect covariance among the ith nontradable asset and world market portfolio. Cov(Ri , RD)- Cov* (Ri , RD) Poor domestic systematic risk Cov*(Ri , RD) is indirect covariance between 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 differently segmented markets directly integrates international capital market by devising 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 monomania Restrictions Restrictions on maximum % ownership of topical anesthetic firms by foreigners Mexico and India limited to 49% Two differen t classes of equity Chinese firms publish A shares and B shares Ensuring domestic control of local firms Pricing-to-market (PTM) phenomenon Constraint is potent in limiting desired foreign ownership eg. Korean firms restriction on foreigners is 20% Foreigners want to buy 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, write out capital. A firm can reduce its cost of capital by internationalizing its ownership structure. An Example of Foreign Ownership Restrictions Nestle Nestle used to issue two different classes of common 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 majo r conveyance of title of wealth from foreign shareholders to Swiss shareholders. The total value of Nestle increased substantially when it internationalized its ownership structure. Nestles cost of capital therefrom declined. An Example of Foreign Ownership Restrictions Nestle The Nestle episode illustrates The sizeableness 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 determining 1. Conform to the farm companys norm where the parent company is fully responsible for the subsidiarys 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 will ing to let its subsidiary scorn, or the guarantee of obligations becomes difficult to enforce across national 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 fairish and consistent with minimizing firms overall cost of capital maneuver advantage of subsidized loans Taxes deduction of interest payment Take advantage of various market imperfections (ex. political risks) CASE Globalizing the Cost of Capital and Cost Budgeting at AES BRIEF BACKGROUND AES Originally Applied Energy work Founded in 1981 Publically traded since 1991 In 2003 Leading independent supplier of electricity in the world $33 Billion in asset (eg. part plants, generation facility, other energy related businesses) stretched across 30 countries and 5 continents AES Early Success 1983 1st cogene ration facility is built in Houston, Texas 1988 gain income = $1. meg 1991 AES goes public, net income = $42. 6 million 1991-1992 AES initiates international expansion 1996-1998 estimated 80%-85% capital investment is overseas 2000 Revenue = $4. 958 billion Net Income = $778 million AES Typical Investment Structure AES AES stock price (market cap in 2000 reached $28 billion $70/share) AES AES stock price (market cap in 2002 fell 95% to $1. 6 billion $1/share AES What Happened? Its chemical formula for success (international exposure) became their recipe for disaster o Much of AES expansion took place in growing countries (there was more unmet demand vs. eveloped countries) Main factors o Devaluation of trace South American currencies ? Argentine, Brazilian, Venezuelan currency crises o Adverse changes in energy regulatory requirements ? Government mandated energy rationing and competition o Decline in energy commodity prices AES AES ISSUES AES Simple Domestic pay Framewor k 12% discount rate was used for all need generation projects o all dividend flows from projects were deemed equally risky ? fair laying claim 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 runner 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 modeology for calculating Solution by AES valuation & cost of capital for capital budgeting at AES businesses in diverse locations around the world AES How did AES turn with it? Rob Venerus, director of Corporate Analysis & Planning questioned whether the traditional CAPM would sate 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 developed a new amaze Step 1 Calculate 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 interruption 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 corresponding U. S. Treasury yields. These steps all ow AES to calculate 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 must 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 fertilize 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 survey this was unconvincing Seven types of Project-specific risk 1. Operational/Technical 2. Counterparty credit/ work 3. Regulatory 7. Contractual Enforcement/Legal 4. Construction 5. Commodity 6. Currency Weights estimated from AES susceptibility to anticipate and mitigate risk. Then given a gr ade between 0 (lowest exposure) and 3 (highest exposure), multiplied by their weights to yield a business-specific risk score AES 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 = + cholecalciferol 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 & passport FOR AES CORPORATION Suggestion & Recommendation AES Corporations current method of valuing risk is clearly inadequate. Not enough risks were being considered in their work, particularly political and economic risks in developing countries that the company expanded to. at a lower place this current model, country-specific risk is also difficult to measu re. 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 they 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