Cases in Finance Assignment

This assignment discusses two case studies on international finance. The first case focuses on the cost of capital and capital budgeting at AES, covering risk factors, capital budgeting techniques, computation of WACC, and systematic and unsystematic risks. The second case explores Netscape's initial public offering, discussing the reasons for higher valuation, advantages and disadvantages of going public, the IPO process, and the impact of increasing the offer price. Both cases provide insights into the concept of international finance.

CASES IN FINANCE ASSIGNMENT

Finance
Executive Summary
International finance has assumed a place of special importance because a company needs to
undergo many concepts in the normal course of business. When it comes to the performance
of the company various parameters is taken into consideration. In this report, two case studies
relating to international finance is being discussed. The first case sheds light on the concept
of cost of capital. The report initiates with the risk factors that are undertaken by AES. It is
then followed by the different mechanism of capital budgeting and the WACC of the
company is computed. Further, systematic and unsystematic risk is being discussed together.
Lastly, it comes to the forefront that AES has foreign expansions and therefore, the hurdle
rate matters a lot. If the wrong rate is computed or mechanism is wrong then it will affect the
financial structure and will generate a wrong result for the business. The second case study is
about Netscape and the planning for IPO to raise more funds. The report initiates with the
reason of why a loss of making the new company is hitting a high valuation scene and the
result is owing to the fundamentals of the company. further, matters relating to the pros and
cons of IPO and the general process of IPO is being described. Lastly, the risk and reward of
increasing the offer price if being discussed in the light of Netscape. Ideally, the report
balances two parts that are the cost of capital and IPO in the domain of international business.
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Contents
Introduction...........................................................................................................................................4
Part A - Case: Globalizing the Cost of Capital and Capital Budgeting at AES......................................4
1. Risk factors that AES had come across in developing markets and factors that influence the
company................................................................................................................................................4
2. Utilization of different capital budgeting techniques......................................................................5
3. Computation of WACC.....................................................................................................................6
4. Systematic and unsystematic risks.....................................................................................................9
5. Consequences of the wrong methodology of computing cost of capital on AES.............................10
Part B - Case: Netscape’s Initial Public Offering................................................................................11
1. Reason for higher valuation of Netscape.....................................................................................11
2. Advantage & disadvantage of going public..................................................................................12
3. Describe the general IPO process giving examples from Netscape’s IPO....................................13
4. Features and characteristics of preferred stocks and common stocks............................................14
5. Increment of the offer price for Netscape from $14 to $28 as suggested by the underwriters.......16
Conclusion...........................................................................................................................................18
References...........................................................................................................................................19
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Introduction
Companies, as well as investment funds, are riding on a huge sum of money and before it is
invested various factors is taken into consideration. The most important consideration is that
each company comprises its own cost of capital. In the report, the case study of AES will be
discussed in light of the cost of capital and capital budgeting. Secondly, IPO is a lucrative
option that provides a huge boost to the company because once listed the company attains
paramount goodwill and comes in the notice of the investors. In the second case, the case
study of Netscape is dealt with. The public issues and the related matter is vividly discussed
in the report. Hence, both the case studies shed light the concept of international finance such
as adverse regulatory changes and currency devaluation.
Part A - Case: Globalizing the Cost of Capital and Capital Budgeting at AES
1. Risk factors that AES had come across in developing markets and factors that
influence the company
Currency Devaluation
It was observed that Argentina was facing a political and economic crisis in the year 2001
because of which degradation of the South American currencies was observed against the US
dollar. Also, it was observed in December that the newly elected government abandoned the
markets fixed the dollar to Argentina-peso exchange rate and further also changed all the
loans taken in the form of US dollar into pesos. It was observed on the very first day of
trading that pesos lost 40% of its value against the US dollar acting as a floating currency. By
the end of the year, it was observed that the trading rate of the peso was 3.32 against the US
dollar. Earlier this rate has been as high as 3.9 pesos (Desai, 2006). The currencies in Brazil
and Venezuela very important for the Australian stock exchange market because they were
depreciating with the rate of 50% approximately against the US dollar in the same period.
Also, a loss in the foreign currency transactions worth 456 million dollars was observed in
the year 2002. Many subsidiaries in South America were observed to default their debt
obligations and also were forced to restructure so that they are not anymore connected to the
parent corporation. It was observed that the parent company suffered from shortfalls in cash
flow and also received dividend which was less than the actual budget. The degradation in the
value of the foreign currencies made the foreign businesses to pay the debt obligations in US
dollars (Desai, 2006).
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Adverse regulatory changes
In the late 1990s, it was observed at various regulatory agencies of Brazil fail to produce a
market structure that may attract the industries to generate new assets. Major of Brazil's
hydroelectric power plants were being inefficient because of the below average rainfall
received by it in the year 2001 and 2002. The authorities also tried to control the energy
consumption that was being done by the population in June 2001. The decrease in the sales
volume and the decline of the Brazilian currency value figured a conflict that was present
between the exchange rate of the dollar in relation and other international currencies (Desai,
2006). The Government of Brazil was also forced to purchase the dollars which were yet to
be reimbursed because of the deflated exchange rate observed in that particular period.
Impairment charges on one of the most important Brazilian businesses were observed in the
fourth quarter of 2002.
Commodity prices decline
In the year 2001, a change in the regulatory concerns of UK was observed which was
impacted by AES in relation to the increasing competition and low prices that were being
generated in the markets. The unusual weather of the UK also so led it to bring wholesale
electricity prices down approximately 30% (Desai, 2006). This precious also affected the
country in the long-term purchase agreements and several changes were made in the
commodity market because of the financial pressure that was being observed on the
organization. Organizations were not able to sell electricity of their marginal cost were shut
down or taken off the line. The irregular currency and regulatory changes made the company
to charge significant impairment charges because of which the profitability of the firm was
demolished. Total after-tax charge of 465 million dollars was paid by the company in the year
2002 for development and construction projects that were being conducted by it (Desai,
2006).
2. Utilization of different capital budgeting techniques
There is a different type of technique that was being used by the organizations to determine
the investment funds that were being capitalized for expenditure projects. The proper time
value of money concept should be considered while analyzing the attractiveness of the capital
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investment so as to determine the uncertainty of the cash flows and the performance that are
present in the particular project (Bailey, Kumar & Nag, 2011).
Capital budgeting is a very important step by step process that is needed to be conducted in
every investment project. This helps to determine whether the investment is good for the
company’s growth initiatives or not (Merchant, 2012). The return that will be generated by
conducting the operation of the project can be very profitable for the organization and hence
proper capital budgeting should be conducted for analyzing it (Da, Guo, & Jagannathan,
2012). Moreover, the capital budgeting at AES was simple and straight forward. It needs to
be noted when the company undertook domestic contracts where the risk of changes to input
and output was negligible then the project finance mechanism was deployed. Initially, the
model worked well because of the capital structure of similar nature however, as the
expansion occurred, the model became strained and there was urgency for different capital
budgeting techniques.
Earlier in the model, it was observed that the project had different domestic opportunities that
were changed with expansions in Brazil and Argentina. Also, the risk of changing currency
values was not feasible in nature. Also, the financial structure of the organization will be
harmed if the going concern concept will not be taken into consideration carefully.
Internal rate of return
The internal rate of return can be defined as the rate in which the net present value of the
investment is considered to be zero. Also, the total discounted cash inflow is equal to the
discounted cash outflow because of which this process also requires proper ascertainment of
the time value of money (Needles & Powers, 2013). The organization tries to achieve the rate
of interest in which it can balance the cash inflows and outflows so as to make the project
profitable for the organization (Adra & Barbopoulos, 2018). Hence, the computation of the
internal rate of return is compulsory for the organization.
3. Computation of WACC
Venerus calculated the Cost of Equity as per CAPM Method as under:
Cost of Equity = Risk-Free Rate of Return + Beta * (Market Rate of Return - Risk-Free Rate of
Return).
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For Kelvin, which is in Contract Generation
(CG) Business,
Beta is 0.25
as per exhibit
7b
Risk free rate is 4.5%
as per exhibit
7b & 8
Market Return assumed to
be U.S Risk Premium = 7%
as per exhibit
7b
Cost of Equity= 4.50% + 0.25 (7.00% -
4.50%) = 5.125%
Venerus calculated the Cost of Debt as under:
Cost of Debt= Risk free rate of return +
Default Spread
Risk free rate is 4.5%
as per exhibit
7b & 8
Default Spread is 4.34%
as per exhibit
7a
Cost of Debt= 4.5% + 4.34%= 8.84%
4. For Calculation of Weighted Average Cost of Capital,
Venerus added the Sovereign spreads as given in Exhibit 10 to cost of equity and cost of debt
Sovereign spread as per Exhibit 7a and Exhibit 10 is 3.14%
For Weighted Average Cost of Capital = Total Cost of Equity= (Cost of Equity + Sovereign
Spread) = 5.125%+3.14%= 8.27%
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Total Cost of Debt= (Cost of Debt + Sovereign Spread)*(1-tax rate) = (8.84%+3.14%)*(1-0.23)= 8.86%
Proportion Cost of Weighted
(%) Capital Cost
Equity Share Capital 67% 8.27 5.55
Debt 33% 8.86 2.91
Total 1.00 8.46
For finding out the unsystematic risk score-
For Kelvin
Categories of Risk Weight Grade Risk Score
(Exhibit 11) (for Kelvin)
Weight*
grade
Construction 14.50% 1 0.145
Operational/ Technical 3.50% 0 0
Regulatory 10.50% 1 0.105
Currency 21.50% 2 0.43
Counterparty 7.00% 2 0.14
Contract/ Legal 25.00% 1 0.25
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Commodity 18.00% 0 0
Risk Score 1.07
As per Venerus, the business specific risk score of 1 would yield an adjustment of 500bp.
So total risk factor is 500bp* 1.07% = 5.35%
Hence the total WACC for Kelvin = 8.46% + 5.35%= 13.81%
4. Systematic and unsystematic risks
It is very important for organizations to determine the systematic risk because of the
volatility present in the market or industry. The systematic risk will not only affect a
particular product or stock but will affect the industry at whole. Also, this kind of ways is
unpredictable in nature because of which it is impossible to avoid them. Correct
allocation of assets and proper diversification can help the organization to ignore such
risks (Davies & Crawford, 2012). There are various kind of investment was also involved
with the systematic risk and hence it is important for the investors to provide more
emphasis on the cybersecurity stocks so as to diversify the range of investments that are
being made by them in the healthcare and infrastructure industries. The systematic risks
are also prone to interested changes, installation, reception and other major changes in the
domain which can affect the entire market.
The systematic risk that is present in the business is that of currency and regulatory
difficulties. It needs to be noted that the company cannot mitigate this risk as is inherent
in the business environment. Hence, changes in the commodity market is left to the
scenario in the market and hence, inherent in the business.
Regulation is another systematic risk because the regulations differ from one country to
another. For example the market structure in Brazil failed to help in construction of new
projects. In this scenario, the demand leaped ahead of the supply and this is not in the
hand of the company because it happened due to the market forces and no mechanism to
stop this.
Unsystematic risk
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This kind of risk is very unique in nature because of which it can affect the business of
the organization and also the investment portfolio. In order to remove such risks,
diversification should be present in the portfolio that has been accepted by the
organization.
This kind of risks can also be described as uncertainties that are present in the investment
strategies of the organization. This kind of unsystematic risk includes various types of
competitors in the market place because of which the organizational profits are affected at
large and regulatory changes can be observed in the management structure of the
organization (Parrino,Kidwell & Bates, 2012). Some of the systematic risks can be
anticipated but not all of them.
The operational or the technical area is another important aspect that comes under the
ambit of unsystematic risk. It is well observed that any deficiency in the area of operation
or technical can lead to major issues and halting the progress however, it can be mitigated
through proper managerial tools and effective planning.
5. Consequences of the wrong methodology of computing cost of capital on AES
The cost of capital should be computed with the accurate methodology because if the
inaccurate method is followed then it will project a market condition that does not exist.
Cost of capital helps in defining the hurdle rate of the company. It is the minimum rate of
return needed by the company to attain the value (Bernard, 2011). Hence, if inaccurate
methodology exists then a wrong projection will be observed that will ultimately reflect a
wrong momentum. This will distract the company from reaching its goal. Further, the
wrong mechanism will bring the issue of financing in terms of international operations. It
is important for the company to know the exact hurdle rate otherwise the financing
planning is severely disturbed (Bloomberg, 2018). In this scenario, it is observed that the
company AES has foreign expansions and therefore, the hurdle rate matters a lot. If the
wrong rate is computed or mechanism is wrong then it will affect the financial structure
and will generate a wrong result for the business.
Cost of capital is an important aspect because it is a variable that is crucial and helps in
ascertaining the capital structure. Further, it is even the discount rate when it comes to the
free cash flow in the model of DCF analysis. Therefore, any wrong computation will
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project a wrong capital structure. Capital structure is essential for various purposes and
plays an important role in the company’s functioning. Hence, when the capital structure is
wrongly computed, it will lead to wrong calculations and chances of wrong decision are
likely to happen.
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Part B - Case: Netscape’s Initial Public Offering
1. Reason for higher valuation of Netscape
The business of Netscape is new and operated for only two years. It certainly comprises of some
value, however the company is incurring net losses. It is a loss making and an unprofitable company
at the current point of time. But, looking at the fundamentals we can judge the reason of its
valuation. The initial factor is the multiple of sales. Going by the sales forecast we can arrive at the
figure:
Sales forecast
Sales
695871 1994
16625391 1995
32554911 1996
Going by the trend of Netscape, it can be expected that the sale of the company will move to
a rapid height owing to the movement in the industry. It is one of the reasons why the
company is overvalued because of the potential to make strong business and to grow in the
future (Petty et. al, 2012). Sales are one of the prime factors because a business can grow
when the sales are effective. On the application of the forecast formula, it comes to the
forefront that the business will provide strong sales and hence, is one of the reasons for
overvaluation (Hirshleifer, Hsu & Li, 2013). The gross profit is further an indication that the
company will attain a better prospect in the time to come. The operating expenses are high
however, it denotes that the company is operating to cement its place in the market and hence
can be taken in a positive manner (Bodie, Kane & Marcus, 2014).
Another key factor that influences the high valuation is the presence of a higher level of
assets as compared to liabilities. This means that the company has a higher dependency on
equity as compared to debts. This factor provides a chance that the company in the future will
be able to procure loans (Porter & Norton, 2014).
Therefore, the higher valuation is justified by the strong fundamentals of the company.
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2. Advantage & disadvantage of going public
Advantage
There are multiple advantages of going public via an IPO. The best part of going public via
IPO is that it allows the company to raise immediate capital by catering to a large number of
investors. The capital raised by the organization can be later used in the expansion of its
business by means of employing the same in enhancing the infrastructure, the research, and
development, the launching of new products, etc. Organizations that are new or less popular
can technically enhance their business opportunities by means of issuing shares. Being listed
on a reputed stock exchange is a matter of prestige and it also why certain organizations opt
for going public via an IPO (Brigham & Daves, 2012). Organizations are also able to cater
and retain employees through IPOs by means of offering schemes such as stock options.
Here, Netscape can get an additional advantage by listing on the stock exchange and raising
money through the IPO route.
IPOs also facilitate public awareness. Most organizations opt for IPOs so as to enhance
public awareness for its products. This makes the products of the organizations look more
desirable therefore, engage new customers. This ultimately allows an organization to enhance
its market share. IPOs are of great utility to several venture capitalists as they are able to
make a significant amount of money on such well doing entities who they once assisted
during their initial stage (Carmichael & Graham, 2012).
Disadvantages of IPOs
The main disadvantage of going public via an IPO is that it is time-consuming and an
expensive affair. Going public via an IPO route takes a minimum of 6 to 9 months and
sometimes it takes even longer as well. The management of the group pays more attention to
the procedure of IPO all this time which may ultimately impact the other areas of the same.
Going public via an IPO route is undoubtedly a costly affair as there are various costs
associated with the same such as filing fees, underwriting fees and so on. Also, even after the
organization goes public, there are numerous costs involved pertaining to various disclosures
and additional reporting (Choi & Meek, 2011). Hence, this needs to be taken into
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consideration by Netscape that the expenses will be high because there are much compliance
that need to be adhered to.
An entity is answerable to its shareholders once the same goes public. The shareholders can
vote to overrule the decisions of the top-level executives or to discard directors and managers
of the company if they have significant ownership held in the same (Power, 2017).
Organizations are prone to make inefficient and inappropriate business decisions and may
also prefer short-term profits over long term growth on account of the pressure faced by them
so as to perform better for their existing and potential investors (Hirshleifer, Hsu & Li, 2013).
3. Describe the general IPO process giving examples from Netscape’s IPO.
The organization that is going public has to associate itself with an investment bank or such
banks that handle IPO. An entity can choose to sell shares by itself but in the real world, such
concepts are purely fictional. Investment banks might either operate alone or in a group of
two or more on one IPO where one will lead and the remaining shall follow. Investment
banks generally operate in a group of investors or banks so as to share the risks and funds
associated with the IPO. Then after the next step is underwriting where the investment banks
submit bids to entities that are going public concerning the amount of money that these
entities will receive out of this IPO and what share the banks will hold in the same. Morgan
Stanley or Goldman Sachs are such investment banks that discusses various details with the
company which is going public in the underwriting agreement such as the type of securities
that the company will issue, how much money they can expect to be raised out of an IPO and
all other necessary aspects (Ross et.a l, 2014). Once the underwriting agreement is made
between the investment bank and the company that is going public via an IPO route, the files
a registration statement with the SEC. The registration statement has all the information
pertaining to the offering and entity’s details such as its management background, any legal
cases, financials, where the capital raised shall be employed, the owner of the stock before
the firm goes public via an IPO route.
It is the duty of the SEC to make a detailed investigation of the entity so as to affirm the
fairness of the information received and to assess whether there are proper disclosures
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pertaining to the financial aspects of the company. Upon gaining trust in the company
pertaining to its necessary disclosures and the fairness of the information that is provided to
SEC, the latter will discuss a relevant date for the IPO with the company (Titan, 2105). Once
SEC approves the entity to go public via an IPO, the underwriter must prepare a prospectus
of the same. The prospectus must carry all the financial information of the entity that is going
public via an IPO route. The IPO is funded by a bank or a group of banks. The shares of the
entity are eventually bought by the bank or a group of banks before the same goes public or
prior to the shares of the same are enlisted on a stock exchange. The difference between the
price what the banks had paid for and the price at which the shares are purchased by the
investors is the profits that are earned by the banks or underwriters (Vaitilingam, 2104).
A huge competition prevails between the investment banks pertaining to handling an IPO on
account of various reasons such as the entity that is going public and the profits the
underwriters have pre-evaluated and etc. Morgan Stanley and H&Q issued a circular as at 17
July, 1995 stating that it might offer 3.5 million Netscape shares that were to be priced at $12
to $14 per share (Kester, 1997). The price of Netscape’s shares was determined on the basis
of the company’s future prospects, stock price-related data, financial and operating
information, and various other aspects. The company indulged into a road show prior to the
offering where the management of the same and investment banks assembled altogether so as
to stimulate interest in a large number of investors. Clark and Barksdale to join for a 2-week
road show along with the Morgan Stanley and H&Q (Kester, 1997). The roadshow was
conducted in 20 cities and a conversation was initiated with around 2000 potential investors.
The roadshow was also useful for the underwriters in ascertaining the final offering price of
Netscape’s shares. The underwriters called few of the investors after the roadshow was over
so as to evaluate their perspective pertaining to price and quantity of shares and the response
received by them was positive enough to indicate towards a significant and profound demand.
4. Features and characteristics of preferred stocks and common stocks
Preferred stock is a blend of both common stock and bonds and this is why the same is also
termed as a hybrid security. Preferred stock has qualities of both common stock and bond.
Just like common stock, the holder of preferred stock is not liable to receive a dividend unless
the same is earned and declared by the organization while preferred stock bears a fixed
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percentage dividend which is very similar to any bond. In the earlier times, equity holders
were only bothered about earning dividends while now the things are little twisted. The
equity holders are now less bothered about earning dividends and emphasize more on their
liquidity (Delcey, 2015). This is because of the fact that owing to liquidation preference
investors can earn a significant return on their investment. Nowadays, earning dividends is
just a bonus and it is not considered as a significant source of return on investment (Leo,
2011).
Preferred shareholders are prioritized over the common shareholders in the distribution of the
leftover assets of the company if the same goes into liquidation. There are classifications
made with respect to preferred stock on the balance sheet of a company. It is completely on
an organization so as to choose one or multiple class of preferred stock. The company must
rank it every class of preferred stock giving equal priority and must also rank the same in
sequence in priority of claim.
Preferred stock is used by the Netscape management instead of convertible preferred stock
owing to various reasons. For Netscape, preferred stocks can be used by the management to
procure the necessary investment so that the firm can expand and be recognized as a brand.
Hence, it best suits Netscape because it is blooming and needs to settle in the market. For
companies that are already well established, preferred stock shall be used so as to enhance the
capital of the same. Preferred stock can be classified as they are totally different from debt
instruments. Preferred shareholders are entitled to a payment of a fixed and guaranteed
dividend. Preferred shareholders are often prioritized over the common shareholders (Kester,
1997). Common shareholders may or may not receive dividends. Also, it may happen that the
organization might enhance the dividends to be paid on common stock while the dividends to
be paid for preferred stockholders may not be enhanced by the same. The presence of
preferred common stock ensures that the benefit accrues over a period of time and receives a
fixed and guaranteed dividend (Kaniel, Liu, Saar & Titman, 2012). High salaries will be
constant while the presence of convertible preferred stock will ensure that the return are
provided to the holder of the instrument. It is more lucrative owning to the process of fixed
and guaranteed dividend.
Further, the holder of preferred stock can convert their preferred stock into common stock
and in this way take part in the company’s enhanced earnings (Mallaby, 2010).
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5. Increment of the offer price for Netscape from $14 to $28 as suggested by the
underwriters
The underwriters suggested the increment in price from $14 to $28 due to the surprising
oversubscription for the shares of the Netscape. The main reward of this increment of the
offer prices is:
• The higher offer price will lead to more inflow of money from the investors. When the
investors will bid at the offer price it will help the company is raising more funds. The
accumulation of funds will provide a strong response and will help the company in doing
major developmental things (Melville, 2013)
• When the shares are subscribed at a higher offer price, it will ensure that the company will
have more chances of a strong listing on the stock exchange. This can be linked to the fact
that offers price denotes the strength of the company. When the price is suddenly changing it
will create a strong response in the minds of the customer.
• There are many rivals in the industry and hence, going by the general condition it can be
commented that having a competitive offer price will provide the company a competitive
edge and hence will help in moving ahead in competition though it is highly risky in nature.
The risks that are involved in the increment of the offer price are as follows:
• The higher offer price will help the underwriters to earn more with the help of the
underwriting process. Hence, in this process, the entire benefit will pass on to the
underwriters. Thereby, it is imperative for the company to ascertain the price ceiling as the
higher price might discourage the investors to invest in IPO (Laux, 2014).
• The price dilemma exists in the case of Netscape and it is viewed that the company is yet
to make a profit. Since inception it is unable to make a profit and hence, going by this
scenario, it can be stated that the increment in the offer price is a risky venture because when
the investors and other market players will evaluate the financial performance then the
increment will not be justified. This will discourage the investors to invest in IPO (Konal &
Seker, 2014).
• Since inception, the company is projecting net loss per share and hence, is a dangerous
move to increase the price ceiling of the offer price of IPO.
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Conclusion
From the overall discussion, it can be commented that the financial policy of a firm is of
paramount importance as it provides solidity to the functioning of the company. In the above
case studies, two different aspects were studies one being the cost of capital while another
being the case of IPO. Both provide a strong analysis in the respective topic. The cost of
capital is an important aspect for the business because it is the hurdle rate and needs to be
known so that the company can ascertain the policy. The cost of capital and capital
budgeting of AES is an apt example dealing with the area. On the other hand, Netscape Initial
offering is an apt example of an organization where the valuation touched a commendable
peak owing to its fundamentals. The overall case study gives a sound remark that the
fundamentals of the company are an important aspect that enables the company to get a good
response.
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