Globalizing the cost of capital and Capital Budgeting at AES Harvard Case Solution & Analysis

Globalizing the cost of capital and Capital Budgeting at AES Case Study Solution

Discount Rate

Discount rate in terms of project investment is the rate at which future cash flows are discounted to come up with the future value of the investment. Furthermore, the discount rate is used to discount the future cash inflows of the project that are projected, after discounting the cash inflows, we could get the value of the project in the future. Therefore, the question arises as to why cash flows are discounted. Investors believe that the dollar earned today would not be worth more than the dollar earned in future, which means dollar’s value decreases in term of inflation. Thus, in order to get the at least the fair value of the investment for the future, the project’s cash flows are discounted.

Constant Discount Rate

The discount rate compensates the inflation, as well as the risk associated the project, which can be systematic, and unsystematic. Moreover, the discount rate also bears the expected return that an investor expects from an investment. However, the discount rate cannot be constant.

Constant discount rate could be explained such as the investment in United States and the investment in Pakistan, or any other country where the project is based, would have the same inflation, risk, and return as well. Whereas, the United States (US) is a developed country, even more economically developed country, in contrast to Pakistan, which is a developing country, and less developed economically,  therefore the inflation in the US cannot be the same as in other country. Similarly, the investment in less economically developed country is more risky than the investment in the US. On the other hand, the discount rate actually represents the expected return that an investor expects from investment, so the discount rate consists of two main factors inflation, and risk.

Determination of Discount Rate

Discount rate varies given the inflation in country, whereas, other factors determine the discount rate, which is calculated by the national bank of the given country, such as in the US the national bank is the Fed. However, in terms of risk, many factors are taken into account to compensate the risk and assume the discount rate; for example, a country, which is unstable economically, and politically, may reach to the point of civil war taking place, or the government may be overthrown by military coup by imposing Marshal Law.

Therefore, the country has more risk than the US, or any other country, therefore, if the investor is ready to invest in such a country, then he will require more return to compensate the risk associated with investment.

Furthermore, all countries have different characteristics in terms of the risk and return, depending upon the country, and the risk associated with the investment.

Globalizing the cost of capital and Capital Budgeting at AES Harvard Case Solution & Analysis

 

 

Assumptions of Valuation

While calculating the cost of equity, it was assumed that the investment made in Pakistan was in dollars, whereas risk-free rate was taken as 10 years U.S Treasury Bond along with the U.S risk premium and un levered beta to calculate the cost equity, because it was an opportunity cost for the investors to invest in U.S but instead it invested in Pakistan. Furthermore while calculating the WACC, it was adjusted to get fair cost of capital for the investment in Pakistan.......................

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