Manan | IPM01037

Globalizing the Cost of Capital and Capital Budgeting at AES.

Solution:
To ascertain the project value for Pakistan's Lal Pir project, it is imperative to initially
calculate the Weighted Average Cost of Capital (WACC) utilizing the current proposed
methodology, following the steps outlined in Exhibit 8 of the case.
The first step involves determining the levered value, which stands at 38.52%, indicating a
limited correlation of our project with market returns. Subsequently, we compute the cost of
equity, referring to Exhibit 4A and using the U.S. Treasury bond's risk-free return (4.5%).
This yields a cost of equity of 7.2%, while the cost of debt is 8.07%, determined by factoring
in the risk-free rate and the default spread from Exhibit 7a in the case. It's crucial to consider
that the sovereign spread impacts both the cost of debt and equity (0.0990 for Pakistan). With
the adjusted costs of equity and debt in hand, we calculate the project's WACC using the
formula provided in the case, involving the adjustment of equity and debt ratios with the
respective costs of equity and debt. In this scenario, the WACC computes to 15.95%.
Nevertheless, this WACC needs further adjustment to accommodate the risks associated with
project execution in Pakistan, which is achieved by referencing Table A in the case. With
Pakistan's overall risk score at 1.425, and recognizing the linear relationship between
business-specific risk scores and cost of capital, we make an additional adjustment of
7.125%, resulting in a final WACC of 23.075%. This final WACC serves as the basis for
calculating the Net Present Value (NPV) for the period from 2004 to 2023, amounting to a
negative $234.34 million, as indicated in Exhibit 6.