Assignment questions

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Assignment questions Week 1 (AES case).
For the first class, please prepare your answers to the following two questions on this case 1. Calculate the cost of capital for the 15 projects around the world (shown in Exhibit 7a) using a methodology that incorporates country risk and other types of risk that arise in international investments into each project’s cost of capital.

?levered = ?unlevered/(E/C) = ?unlevered/(1-(D/C))
both ?unlevered and D/C can be obtained from exhibit 7a.

Next: U.S. T-bill+ leveraged beta (U.S. risk premium)
4.5% + ?levered * 7% = cost of capital1

Add sovereign spread:
Cost of capital1 + sovereign spread = cost of capital final

2. What is the value of the Pakistan project using the cost of capital derived from the new methodology? If this project was located in the U.S., what would its value be? Discuss the reasons for the difference in the valuations.

First:
Calculate value of levered beta:

Debt to capital = liabilities/capital =
D/C = D/(D+E)
D(D+E) = DC
D+E = C
E = C-D
E/C = 1-D/C

?levered = ?unlevered/(E/C) = ?unlevered/(1-(D/C))

Pakistan: D/C is given in exhibit 7a as 0.351 and ?unlevered = 0.25 (exhibit 7b) so ?levered = 0.25/(1-0.351) = 0.3852

US: D/C = 0.395 and ?unlevered = 0.25 ?levered = 0.25/(1-0.395) = 0.4132

Second step is to calculate cost of equity:
U.S. risk free and risk premium rates, because all debt is financed in USD. U.S. T-bill+ leveraged beta (U.S. risk premium)
Pakistan: 4.5%+0.3852(7%) = 0.07196 = 7.2%
US: 4.5%+0.4132(7%) = 7.4%

Third cost of debt:
Cost of Debt = risk free + default spread
Both US and Pakistan have 3.57% default spread
Cost of debt = 4.5% + 3.57% = 8.07%

Fourth add country specific risk:
Since only Pakistan faces sovereign spread:
Soevereign spread = 9.9%
Pakistan: So the cost of equity = 7.2 + 9.9 = 17.1%
Pakistan: Cost of debt = 8.07+9.9 = 17.97%

WACC:
Pakistan:
WACC = E/V*cost of capital + D/V*cost of debt*(1-tax rate)...
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