Q3.

How will you evaluate the capital budgeting method used by AES
historically? What will be its merits and demerits?
Historically, the project finance framework is used regardless of geographic
location. The method was based on 4 rules as under:
1. All recourse debt was considered good
2. The economics of a given project were evaluated at an equity discount
rate for the dividends from the project
3. All dividend flows were considered equally risky
4. A discount rate of 12% was used across all projects
This method when implemented in international markets other than the US,
started giving unrealistic NPV
There was a significant currency risk for both parent AES and its subsidiaries in
the debt structure as the debt was denominated in USD while revenues were
earned in foreign currency
Advantages:
1. Maximize Leverage: Currently the project is financed on highly
leveraged basis. Thus, the company does not dilute its equity for
investing in the project.
2. Non-Recourse: The SPV is created for the project and as a result in case
of default on the loans which are non-recourse, the parent company itself
is not liable for the same.
Disadvantages:
1. Complex and Costly Arrangement: It becomes complex to arrange all the
number of parties in project financing and can also prove to be costly.
2. Macroeconomic Risk: This method doesn’t take into consideration
macroeconomic factors like exchange risk and thus therefore is not an
appropriate method for international markets