Finance Assignment: Cost of Capital and IPO Analysis (AES & Netscape)

This assignment analyzes two case studies in international finance: AES and Netscape. The AES case examines risk factors in developing markets (currency devaluation, regulatory changes, and commodity price declines), capital budgeting techniques, WACC calculation (including sovereign and unsystematic risk adjustments), and the consequences of inaccurate cost of capital methodologies. The Netscape case explores the rationale behind its high valuation during its IPO, the advantages and disadvantages of going public, the IPO process, the features of preferred and common stocks, and the implications of increasing the offer price. The assignment provides calculations and explanations based on the case data and addresses key concepts in international finance, risk management, and valuation.

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.
2

Finance
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
3

Finance
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).
4

Finance
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
5

Finance
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).
6

Finance
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%
7

Finance
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
8

Finance
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
9

Finance
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
10

Finance
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.
11

Finance
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.
12