Words: 1647
1. On one half a page review what does our traditional finance framework and the CAPM model, for example, have to say about risk? What is it? How is it approached? The traditional finance framework uses discounted expected future cash flow to determine the NPV of the project. The amount of the opportunity cost is based on a relation between the risk and return of some sort of investment. People are rational and adverse to risk and need incentive to accept risk. The incentive in finance comes in the form of higher expected returns after buying a risky asset.
In other words, the more risky the investment, the more return investors want from that investment. Using the same example as above, assume the first investment opportunity is a government bond that will pay interest of 5% per year and the principle and interest payments are guaranteed by the government. Alternatively, the second investment opportunity is a bond issued by small company and that bond also pays annual interest of 5%. Virtually all investors would buy the government bond the first is less risky while paying the same interest rate as the riskier second bond.
Furthermore, in order to attract capital from investors, the small firm issuing the second bond must pay an interest rate higher than 5% that the government bond pays otherwise no investor is likely to buy that bond. If the firm offering to pay an interest rate more than than 5%, it gives investors an incentive to buy a riskier bond. The CAPM is a model for pricing an individual security or a portfolio. For individual securities, we made use of the security market line (SML) and its relation to expected return and systematic risk (beta) to show how the market must price individual securities in relation to their security risk class.
The SML enables us to calculate the reward-to-risk ratio for any security in relation to that of the overall market. Therefore, when the expected rate of return for any security is deflated by its beta coefficient, the reward-to-risk ratio for any individual security in the market is equal to the market reward-to-risk ratio, thus: E(Ri) = Rf + beta * [E(Rm) Rf] The risk of a portfolio comprises systematic risk, also known as un-diversifiable risk, and unsystematic risk which is also known as idiosyncratic risk or diversifiable risk.
Systematic risk refers to the risk common to all securities – i. e. market risk. Unsystematic risk is the risk associated with individual assets. Unsystematic risk can be diversified away to smaller levels by including a greater number of assets in the portfolio (specific risks “average out”). The same is not possible for systematic risk within one market. Depending on the market, a portfolio of approximately 30-40 securities will render the portfolio sufficiently diversified to limit exposure to systematic risk only.
In developing markets a larger number is required, due to the higher asset volatilities. A rational investor should not take on any diversifiable risk, as only non-diversifiable risks are rewarded within the scope of this model. Therefore, the required return on an asset, that is, the return that compensates for risk taken, must be linked to its riskiness in a portfolio context – i. e. its contribution to overall portfolio riskiness – as opposed to its “stand alone riskiness. ” In the CAPM context, portfolio risk is represented by higher variance i. . less predictability. In other words the beta of the portfolio is the defining factor in rewarding the systematic exposure taken by an investor. 2. Take half a page to say what you think of the historic capital budgeting model at AES (page 5 of case)? What complications did international operations introduce? At AES, capital budgeting was historically a straightforward method and was used for all projects being examined, regardless of geographical location. This method entailed 4 rules which were: 1)all recourse debt was deemed good, )the economics of a given project were evaluated at an equity discount rate for the dividends from the project 3)all dividend flows were considered equally risky, and 4)12% discount rate was used for all projects. AES has implemented the method in U. S. and has worked great due to hedging and similar capital structures but when AES started applying to international projects, the method was giving the company unrealistic NPV values. The method failed to take into account key exposures like currency risk, political risks, sovereign risks as well as nature of the business (utility vs generating facility), the model became increasingly strained.
Furthermore, the ever increasing complexity in the financing of international operations was another key component why the model was not easily transported to overseas setting. Having no other alternative, the model led to destruction of the company stock price and market capitalization, losing millions of stockholders equity in the process. The debt structure caused significant currency risk for both the parent AES and its subsidiaries. Debt was denominated in USD for the subsidiaries, while they were bringing in revenues in foreign currencies.
The parent companies also lost cash flows when depreciation occurred since the money made by subsidiaries was worth substantially less, after devaluations of foreign currencies. One such example is the Argentinean peso, when it lost 40% of its value on its first day of trading as a float. With such enormous oversights by management, and dramatic realizations of differing risk levels across markets, it’s quite apparent AES must make a change to its capital budgeting structure, if it is to survive. 3. Most importantly, take a page to evaluate the changes that Rob Venerus proposes.
Is his high-level approach (pages 7 & 8 of case) reasonable? What do you make of the risk score adjustment (page 9 of case)? You may refer to the posted note. Venerus aims to improve on the existing AES approach by developing a methodology that incorporates country risk and other risks specific to a project into the cost of capital for each project. Venerus proposes methodology for determining a project’s weighted average cost of capital (WACC) that is based on a domestic CAPM and then provides adjustments for country and project-specific risks. Using the financial data, Venerus envision to derive weighted average cost of capital (WACC) for each project => WACC = (E/V)* re + (D/V) * rd * (1-t) ? To calculate each WACC, Venerus has to calculate the leverage betas for each project, the equation unleveraged beta/( 1-debt to capital) ? To find the cost of capital which is ultimately different for each country, but uses the U. S. risk free and risk premium rates, because all debt is financed in USD. The cost of capital is equal to U. S. T-bill+ leveraged beta (U. S. risk premium). The cost of debt must be found, by using the formula U. S. = t-bill+ default spread. If default spread is same, cost of debt will be same in both countries. This clearly does not make sense given the vast differences in the markets structure of each country, the political risk involved. ?The final step is to again further adjust the WACC according to its risk score. To adjust for these factors the sovereign risk must be taken into account. To reevaluate the cost of capital and cost of debt the sovereign risk is added to them.
The approach looks reasonable because Venerus is taking into account all the possible risks, including “undiversifiable project specific risk”, as evident from the risk score calculation, associated with each project according to its local market. By taking into many more factors than previous models allowed it is clear that the WACC in various countries differ from the 12% standard used historically. The U. S. project (6. 5%) looks much more favorable, while the Argentina project (22. %) is unlikely to be accepted with such a high weighted average cost of capital attached to it. CAPM based sovereign spread approach was not reasonable in developing markets where access to the capital was limited and information was less than perfect. Company specific risks could not be easily diversified. He believed that appropriate discount rate for AES businesses should account for some level of project specific risk and this “undiverifiable project specific risk” is compensated by risk scoring system to supplement the initial cost of capital. Seven project level risk categories were identified and were ranked and weighted according to AES’s ability to anticipate and mitigate risks ???Each project were graded on their level of exposure to these categories of project risk (0- low exposure, 3- high exposure) The risk score accounts for the undiversifiable project specific risks which are used to calculate an adjustment to the initial cost of capital. Risk Score adjusts the widely varying discount rates 4. Is Mr. Venerus just trying to reduce future economic losses or is he trying, in an effective manner, to improve economics?
AES has implemented the method in U. S. and has worked great due to hedging and similar capital structures but when AES started applying to international projects, the method was giving the company unrealistic NPV values. The method failed to take into account key exposures like currency risk, political risks, sovereign risks as well as nature of the business (utility vs generating facility), the model became increasingly strained. Furthermore, the ever increasing complexity in the financing of international operations was another key component why the model was not easily transported to overseas setting.
Having no other alternative, the model led to destruction of the company stock price and market capitalization, losing millions of stockholders equity in the process. Venerus was trying to address current and future strategic and financial challenges and came up with the new model. His model was meant to calculate discount rate and create new method of calculating the cost of capital for each AES business taking into account all risks (systematic and un-diversifiable) so as to maintain constant projected cash flow and earnings.