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Easy to compute and use in project appraisals Method is detached from reality
Makes all projects seem comparable to one Subsidiaries will have different costs of capital
another
Dividend risk is assumed constant in this method
5. Compute WACC
5. Commodity 3 15%
6. Currency
7. Contractual Enforcement/Legal
Does this make sense as a way to do capital budgeting?
PROS CONS
Need to assess various risk dimensions for BSR methodology double-counts FX and
different projects in locations with varying risk regulatory risk
profiles
Sovereign Spread (SS) already captures these
Uniform 12% discount rate was sources of country specific risk. All projects run
unsustainable the risk of being slightly undervalued
Most foreign projects NPV would be Assumes risk dimensions can be reliably
systematically overvalued or undervalued quantified
otherwise
What is the value of the Pakistan Project using the
cost of capital derived from the new methodology? If
this project were located in the US, what would its
value be?
PAKISTANPROJECT(usingrevisedWACC)
NPV(SS) 413.41 ProjectYear 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023
NPV(SS&BSR) 290.08 UnleveredCF 63.2 63.6 64 64.4 64.8 65.2 65.7 66.1 66.5 66.9 67.3 67.7 68.2 68.6 69 69.4 69.8 70.3 70.7 71.1
DiscountedCF(SS) 55.04 48.24 42.27 37.04 32.46 28.44 24.96 21.87 19.16 16.79 14.71 12.88 11.30 9.90 8.67 7.60 6.65 5.84 5.11 4.48
DiscountedCF(SS&BSR) 51.82 42.76 35.29 29.12 24.02 19.82 16.38 13.51 11.15 9.19 7.58 6.26 5.17 4.26 3.52 2.90 2.39 1.97 1.63 1.34
USAPROJECT(usingrevisedWACC)
NPV(SS) 804.36 ProjectYear 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023
NPV(SS&BSR) 623.12 UnleveredCF 63.2 63.6 64 64.4 64.8 65.2 65.7 66.1 66.5 66.9 67.3 67.7 68.2 68.6 69 69.4 69.8 70.3 70.7 71.1
DiscountedCF(SS) 60.00 57.32 54.75 52.30 49.96 47.72 45.65 43.60 41.64 39.77 37.98 36.26 34.68 33.12 31.62 30.19 28.83 27.56 26.31 25.12
DiscountedCF(SS&BSR) 58.23 53.99 50.05 46.40 43.02 39.88 37.02 34.32 31.81 29.48 27.32 25.32 23.50 21.78 20.18 18.70 17.33 16.08 14.90 13.81
USAPROJECT(usinghistorical WACC)
Historical WACC 0.12 ProjectYear 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023
NPV 490.55 UnleveredCF 63.2 63.6 64 64.4 64.8 65.2 65.7 66.1 66.5 66.9 67.3 67.7 68.2 68.6 69 69.4 69.8 70.3 70.7 71.1
DiscountedCF 56.43 50.70 45.55 40.93 36.77 33.03 29.72 26.70 23.98 21.54 19.35 17.38 15.63 14.04 12.61 11.32 10.17 9.14 8.21 7.37
How does the adjusted cost of capital (WACC) for the Pakistan Project
reflect the probabilities of real events? What does the discount rate
adjustment imply about expectations for the Project because it is located in
Pakistan and not in the US?
CONCLUSIONS
Pakistan more likely to suffer from regulatory, construction and FX and legal risk
while not in the US
Country specific risk would include real events like currency fluctuations,
contractual and legal issues, and counterparty credit issues.
Project NPV halved if the project is done in Pakistan rather than the US