Case Analysis

Case Analysis

The main innovation in WACC calculation is in calculating the cost of beat from comparable US company’s betas and in adjusting the WACC for Idiosyncratic risk

Cost of equity capital and debt capital using the US benchmark

The steps involved include first calculating the cost of beta (by getting betas at comparable companies in US and un-levering and averaging equity betas for the comparable in each AES business lines) (Harvard Business School, 2006). Then Re-levering the equity beta at the target capital structure estimated using the project cash flow that is desired EBIT coverage. Thirdly, calculating the cost of equity to each AES business using the risk free rate (US treasury), equity premium (S&P 500), and re-levered beta. The cost default spread was added to the risk free rate to get the cost of debt.

Unlevered beta for contract generation = 0.25 (after averaging).

Levered equity beta (Bl = Bul/U/V) = 0.25/ (1-0.315/1)

= 0.36

Cost of equity = 3.57% + 0.6*7%

=7.7%

Default spread = 3.57%

Cost of debt = 3.57 + 3.57

= 7.14%

Sovereign spread

This was obtained by getting the difference between the yields of government bonds and corresponding US Treasury yields. Sovereign spread for the Lal Pir (Contract Generation) project in Pakistan is 9.9%

Idiosyncratic Risk Measures

A risk scoring system was designed to compensate for idiosyncratic risks. First seven categories of risks in the project were identified, and each category was ranked and weighted according to the AES’s ability.  Secondly, the projects were graded based on their level of exposure to the identified risk categories. Then the business specific risks were used to get the adjustment to the initial cost of capital. After giving the score, the WACC of Lal Pir (Contract Generation) project in Pakistan IS 23%.

References

Harvard Business School (2006). Globalizing the cost of capital and cost capital budgeting at AES. October 23 2006