Hope you had a beautiful week. It is Friday again and the weekend is just there. Let´s stress the financial context of the Entrepreneurial Contextual Analysis. Once we have analyzed the latter twelve contexts, the last one to do is the financial one. Why? Because if we do it first, we will be biased by the “money” aspects of it. And, it is crucial to keep our analysis out of the “money” to be the most objective.

The financial context is the one in which we can use numbers to “value” our projects at our best. This context provides as many alternatives as scenarios we can build for each project. Since we are at a preliminary stage, and the Entrepreneurial Contextual Analysis is designed as the first step in our road-map, the financial context means to understand the process and calculate our project (or projects) cost of capital.  As simple as that. As complex as it is.

How to measure the appropriate cost of capital for each of the Salvadoran “wish-list projects” to negotiate with China? Remember we are doing this analysis from El Salvador best interests.

As mentioned previously, the nature of the financial context is really simple in concept, but complicated in the implementation. We presume that our country El Salvador is considering a proposed list of investment projects to show off to China. Before going to knock the door to the Chinese, we assume the Government of El Salvador  gathered a team of members from its different divisions or ministries:

• Agriculture & Livestock
• Economy
• Education and Learning
• Environment & Natural Resources
• Finance
• Foreign Relations
• Judicial-law System
• Sports
• Labor & Social Welfare
• Public Security & Justice
• Public Works
• Tourism
• Attorney General

And we assume that every ministry from the Cabinet has a wish-list of projects. Each division knows its own project priorities for El Salvador. Moreover, I presume, all of them did their homework and had a capital budgeting for every one of their new or on-going projects.

We also presuppose each of the ministries bureaus know if those projects add value to the growth of El Salvador or not (with a consistent and qualified financial analysis). And all these projects have measured a specific cost of capital. So, when the president decides to join the dots with China, he calls his cabinet, and altogether, are prepared to build a dossier of projects with its respective financial budgets and costs of capital. We also suppose each Salvadoran ministry has a blow-by-blow capital budgeting analysis and ESG (environmental-social-governance) impact for each proposal, and the expected after-tax cash flows associated with each of them and their projects lives. The latter paragraph makes me wonder: Do we really have quality capital budgeting for our wished projects? Is the Government of El Salvador ready and able to manage a quantified portfolio of reviewed and approved “wish-list” public projects to negotiate with the Chinese Government? or with any other nation? In addition, we suppose the Government of El Salvador has already defined or determined whether the projects create economic and social value, and all these projects have been publicly debated and approved by the majority of the population.  We guess our Government is only managing a portfolio of projects which create economic growth. Under the financial context, we have to ask ourselves: What methods and techniques are being used for measuring the appropriate value? In relation to these financial techniques, is El Salvador Government and the Chinese government on the same page? Are both governments using the same approach to calculate the “financial value”?. For those who aren´t familiar with financing aspects, there are several techniques, from the point of view of financial evaluation, used to measure economic value creation. And, we have to ask if the financial techniques used by our government have a common ground or are well accepted by the Chinese authorities.

Let´s move a step back: Before applying any quantitative technique for financial evaluations, we need to answer the following question: Are these projects aligned with the El Salvador financial strategic goals? or are these projects aligned with China strategic vision?  If there is no strategic alignment of the Salvadoran “wish-list” projects with China “agenda” for investments, maybe we are not doing our previous homework well. And to be fair, we have to see all these future negotiations from our own perspective, not only as a “taker” of other nation´s priorities. Is China able to accept the “wish-list” projects that the Salvadoran team is bringing to the table?

Is the Government of El Salvador ready with all the capital budgeting, financial scenarios, and discounted cash flow techniques utilized for each of the “wish-list” projects? Let´s say the Government of China utilizes Discounted Free Cash Flow Techniques for project evaluation. That means, that each proposal from El Salvador requires forecasts for future cash-flows, choose the appropriate discount rate and find the present value of the forecasted cash flows. Each project has to be evaluated in terms of Net Present Value (NPV) or derived NPV methodologies such as free-cashflows to equity, EVA, multiples, or similar. What could happen if the government of China doesn´t want to negotiate in terms of Discounted Cost of Capital Techniques but in terms of real options?

Even though the financial context is analyzed with preliminary numbers, those estimated amounts (budgets) have to be well estimated and calculated, because the primary goal of this context is to help to increase the value of El Salvador, by choosing the appropriate discount rate for each project. The cost of capital depends on the riskiness of each project. And therefore, it is expected to have a different cost of capital for each of the Salvadoran State projects. Variables such as long-term vs short-term durations, flotation costs, interest rates, fixed limits on capital expenditures, subsidies, highly regulatory industries projects, leasing, concessions, hedging costs, tied aid factors, etc. It is important to hedge the effects of international capital markets in the estimated costs of capital for each of the projects.

The financial context is the most quantitative one. Some of the Salvadoran “wish-list” projects will be riskier than others. And all these risks must be accounted for. On my next post, we will write some comments about the CAPM or Capital Asset Pricing Model rationale to estimate the cost of capital for foreign projects, and I will try to explain using the most simple vocabulary e. g. using a figure, why the “cost of capital” is so determinant when analyzing this context. Let me finish today´s publication by sharing pearls of financial wisdom:  “the cost of capital for each of the potential Salvadoran projects with China depends on the risk of each project”. This is the basic foundation concept for the financial context.

To be continued… Stay tuned.

Source References utilized for this article: 

http://knowledge.wharton.upenn.edu/article/almost-everyone-underestimates-true-economic-power-china/

Disclaimer: All the presentation slides shown on this blog are prepared by Eleonora Escalante MBA-MEng. Nevertheless, all the pictures or videos shown on this blog are not mine.  I do not own any of the lovely photos or images posted unless otherwise stated.

Published by eleonoraescalantestrategy

Corporate Strategy Artist, San Salvador, El Salvador View all posts by eleonoraescalantestrategy