University of Dhaka

Case Study: AES Tiete: Expansion Plant in Brazil

Course: Capital Investment Decisions
Course Code: F-601
Section: A, Summer 2021

Submitted to
Prof. Dr. M. Sadiqul Islam
Department of Finance, FBS, University of Dhaka

Submitted by
Md. Aroz Kabir ID: 36013
Abdullah Al Noman ID: 42061
Sazzad Hossain ID: 42064

Department of Finance, 42th Batch

University of Dhaka

Date of Submission: 18 October, 2021

 Letter of Transmittal

18th October, 2021

Prof. Dr. M. Sadiqul Islam
Department of Finance
Faculty of Business Studies,
University of Dhaka

Subject: Submission of case report on AES Tiete: Expansion Plant in Brazil.

Dear Sir,

We would like to take this opportunity to thank you for the guidance and support you have
provided us during the preparation of the report. Without your help, it would be impossible for us
to complete the report. Your generosity and liberality aid us to go further with this report without
any hazardous situation.

We have tried our best to put careful effort for the preparation of this report and hope that our
endeavor will serve the purpose. We have given most relevant information to make the report as
analytical and reliable as possible. The practical knowledge and experience gathered preparing the
report will surely help us in our future professional life.

It would be really grateful if you enlighten us your thoughts and views regarding the report. Thank
you again for your support and guidance.

Yours sincerely,

Md Aroz Kabir ID: 36013

Abdullah Al Noman ID: 42061

Sazzad Hossain ID: 42064

 Acknowledgement

From the start, we would like to express our thanks to the almighty Allah for giving us the
opportunity of doing case report on AES Tiete: Expansion Plant in Brazil, which should be
presented to the Faculty of Business Administration in partial fulfillment of the requirements for
the Course of Capital Investment Decision.

Then, we express our gratitude to our instructor, Prof. Dr. M. Sadiqul Islam who was enough
supportive and the suggestions given by him was really very important in the process of completing
the report. Moreover, our instructor was very helpful and liberal throughout this course.

We would also like to thank the people who helped out providing solution to every problem
through discussion, without making any fault. We appreciate even the minor sacrifice they made
in doing that.

Without their efforts, it would have been impossible for us to finish this report at such a convenient
way. We would also like to thank our surroundings for showing their support and help us in every
possible way throughout the working process.
 Executive Summary

This report has been prepared for the fulfillment of the course of Capital Investment Decisions.
The Purpose of this report is to provide the finance manager of AES an analysis to figure out an
appropriate bid price to decide whether investment of 1.2 billion in the AES Tiete plant would be
successful or not.
In this case analysis, we have tried to determine the feasibility of taking this project by forecasting
expected sales and costs of sales for the next 15 years. We have come up with forecasted cash flow
and calculated its NPV, tried to evaluate the real option value. We also run simulation for NPV, IRR
and MIRR using crystal ball.
 1. Table of Contents
1 Introduction 7

1.1 Objective Of the Study 8

1.2 Methodology 8

1.3 Limitations 8

2 Analysis of Economy, Industry and Company 9

2.1 Brazil’s Economy 9
3 Industry Analysis 12
3.2 Porter’s Five Forces: 13
3.3 Analysis of Company 17
3.3.1 Swot Analysis 18
3.3.2 PESTLE Analysis 20
4 Country Risk Analysis 23
4.1 International Country Risk Guide (ICRG) Method 23
4.1.1 Political Risk of Brazil 24
4.1.2 Economic Risk of Brazil 26
4.1.3 Financial Risk of Brazil 27
4.1.5 29
Additional Risk Premium for Country Risk

5 29
Problem Statement

6 32
Evaluation Of the Alternatives

7 33
Risk Analysis

7.1 34
Monte Carlo Simulation

7.1.1. 35
Net Present Value (NPV)

7.1.2. 37
Internal Rate of Return (IRR)
 7.1.3. 38
Moderate Internal Rate of Return (MIRR)

7.1.4. Decision Table 40

7.1.5 Recommendation Based on Monte Carlo 40
Simulation
7.2 Project Valuation and Sensitive Analysis 41
7.3 7.3 Real Option Consideration 43
8. Recommendations 45
9. References: 46
1. Introduction

AES Corporation is a leading utility company that conducts business across 5 continents
around the world. AES Brasil is the subsidiary company of AES Corporation and it owns 24%
controlling interest in the third-largest private generator in Brazil, which was Tiete. In late
2013, AES is facing a decisional point on an investment on a 500 MW natural gas power plant
project in the state of Sao Paulo. Luiz Costa, as a manager in Investment Analysis Group, needs
to evaluate the project and come up with a bidding price.

Electricity Structure in Brazil

According to the energy expansion report 2012 to 2022, the whole energy structure is built up
by six parts, which are hydroelectric, thermal, small hydro, biomass, wind power and other.
Comparing to the other sectors listed above, there are several advantages that natural gas power
plant has:

1. Capable of generating stable electric steam;

2. Less construction work needed than wind power plants;

3. Less pollution than coal and oil.

In details, hydro power plant accounts up a large amount, which is around 70%, of the total
electronic capacity in Brazil. The production of electronic from the hydro power plant is
heavily relaying on the water reserve, so this feature puts Brazil. Referring to 2014 Statistical
Yearbook of electricity 2013 baseline year, “the hydroelectric generation corresponded to 391
TWh, and showed a shortage of 5.9% over Presentation the value produced in 2012, due to the
enduring drought, and that prolongs until the closing of this edition. This shortage was made
up by an increase in thermoelectric generation, above all, coming from natural gas, that
increased 47.6% in relation to 2012, and totalized 69 TWh, reaching 12% in the Brazilian
electricity matrix participation” (2014 Statistical Yearbook of electricity 2013, 7). Moreover,
Gas-fired power plant requires less construction work and geographical pre-requirements than
the other renewable power plants, such as wind power plants.
 a. Objective of the Study

The main objectives of this case analysis are Perform analysis based on the theory and equations
we have learned from our Capital Investment Decision course, and recommend the top
management of American Energy about the viability of the aforementioned project.

b. Methodology

The main source of data for this analysis is the case itself. We have taken help from the web to
gather economic and other relevant data of that period. The sites are properly given as reference
in the Bibliography section of this report.

1.3 Limitations

To help in few of the calculation, we have assumed some data which might be different from the
exact value. Due to time constraint, we have avoided detailed explanation of the theories we have
used in our study and hope our best effort would be appreciated by the readers.
 2. ANALYSIS OF ECONOMY, INDUSTRY AND COMPANY

2.1 BRAZIL’S ECONOMY

Brazil has a developing mixed that is the twelfth largest in the world by nominal gross domestic
product (GDP) and eighth largest by purchasing power parity in 2020. According to International
Monetary Fund (IMF) estimates, Brazil's 2020 nominal GDP was R$7.348 trillion or US$1.363
trillion. Brazil is the 83rd country in the world in GDP per capita, with a value of US$6,450 per
inhabitant The country is rich in natural resources.

The Gross Domestic Product (GDP) in Brazil was worth 1444.73 billion US dollars in 2020,
according to official data from the World Bank. The GDP value of Brazil represents 1.28 percent
of the world economy.

As of late 2010, Brazil's economy was the largest in Latin America and the second largest in the
Americas. From 2000 to 2012, Brazil was one of the fastest-growing major economies in the world,
with an average annual GDP growth rate of over 5%. Its GDP surpassed that of the United
Kingdom in 2012, temporarily making Brazil the world's sixth-largest economy. However, Brazil's
economic growth decelerated in 2013 and the country entered a recession in 2014. The economy
started to recover in 2017, with a 1% growth in the first quarter, followed by a 0.3% growth in
second quarter compared to the same period of the previous year. It officially exited the recession.
Brazil has remained stuck in the "middle income trap" and also faces high unemployment.
 ➔ The above-mentioned graph indicates that GDP in Brazil is not stable over the years, in
2010 GDP was highest, 2012 to 2014 almost stable, 2014 to 2015 downward and finally in
2020 is the lowest due to covid.

Brazil's central bank targets inflation at 3.75% for this year, and 3.5% for 2022. Swap rates
on the contract due on January 2022, which indicate market expectations for the benchmark
rate at year-end, rose 4.5 basis points as investors priced in a key rate increase of over 119
basis points next month.
 ➔ The graph shows that Brazil faces high ups and down in inflation during the period from
1986 to 1996, after 1996 inflation rate in Brazil is overall stable.

Income inequality in Brazil is also a marked feature of the Brazilian economy, an aspect which is
frequently highlighted abroad. According to data from the Brazilian Institute of Geography and
Statistics, extreme poverty had increased by 11 per cent in 2017, while inequalities also increased
again (the Gini index rose from 0.555 to 0.567). The increase of informal work would be the
leading cause, according to economists.

➔ In 2018, the poverty headcount ratio at 3.20 U.S. dollars a day in Brazil amounted to 9.2
percent, which means that the proportion of the Brazilian population was living on less
than 3.20 U.S. dollars per day. The poverty rate has continuously increased since 2014,
when this percentage stood at around seven percent.
 3. INDUSTRY ANALYSIS

3.1 ANALYSIS OF INDUSTRY

Brazilian industry has its earliest origin in workshops dating from the beginning of the 19th
century. Most of the country's industrial establishments appeared in the Brazilian southeast
(mainly in the provinces of Rio de Janeiro, Minas Gerais and, later, São Paulo), and, according to
the Commerce, Agriculture, Factories and Navigation Joint, 77 establishments registered between
1808 and 1840 were classified as “factories” or “manufacturers”. However, most, about 56
establishments, would be considered workshops by today's standards, directed toward the
production of soap and tallow candles, snuff, spinning and weaving, foods, melting of iron and
metals, wool and silk, amongst others. They used both slaves and free laborers.

As our topic is a power company in Brazil, so now we are focusing on the sector:
The electricity sector in Brazil is the largest in South America. Its capacity at the end of 2020 was
175,407 MW. The installed capacity grew from 11,000 MW in 1970 with an average yearly growth
of 5.8% per year. Brazil has the largest capacity for water storage in the world, being highly
dependent on hydroelectricity generation capacity, which meets over 70% of its electricity
demand. The national grid runs at 60 Hz and is powered 80% from renewable sources. This
dependence on hydropower makes Brazil vulnerable to power supply shortages in drought years,
as was demonstrated by the 2001-2002 energy crisis. The National Interconnected System (SIN)
comprises the electricity companies in the South, South-East, Center-West, North-East and part of
the North region. Only 3.4% of the country's electricity production is located outside the SIN, in
small isolated systems located mainly in the Amazonian region.

Structural condition of Electricity in Brazil

According to the energy expansion report 2012 to 2022 in Brazil, the whole energy structure is
built up by six parts, which are hydroelectric, thermal, small hydro, biomass, wind power and
other. Comparing to the other sectors listed above, there are several advantages that natural gas
power plant has:
1. Capable of generating stable electric steam;
2. Less construction work needed than wind power plants;
3. Less pollution than coal and oil.
In details, hydro power plant accounts up a large amount, which is around 70%, of the total
electronic capacity in Brazil. The production of electronic from the hydro power plant is heavily
relaying on the water reserve, so this feature puts Brazil. Referring to 2014 Statistical Yearbook
of electricity 2013 baseline year, “the hydroelectric generation corresponded to 391 TWh, and
showed a shortage of 5.9% over Presentation the value produced in 2012, due to the enduring
drought, and that prolongs until the closing of this edition. This shortage was made up by an
increase in thermoelectric generation, above all, coming from natural gas, that increased 47.6% in
relation to 2012, and totalized 69 TWh, reaching 12% in the Brazilian electricity matrix
participation” (2014 Statistical Yearbook of electricity 2013, 7). Moreover, Gas-fired power plant
requires less construction work and geographical pre-requirements than the other renewable power
plants, such as wind power plants.

3.2 Porter’s Five Forces:

Aes Tiete Expansion Plant In Brazil Porter five forces reflects the competitive environment of an
industry. It is a strategic tool that is used to avoid or minimize the risk of losing the competitive
edge that the organization has and to ensure the profitability of the products in the long run. The
company holds its vision closely as it allows them to orientate its innovation in terms of choices
regarding the investment and strategies. Within the industry the businesses profitability is
dependent upon the following forces:
• Competitive rivalry
• Threats of new entrants
• Threats of substitute
• Bargaining power of suppliers
• Bargaining power of customers
 Supplier Threat of
Power new entry

Competitive
Rivalries

Threat of Buyer
substitution Power

• Threat of New Entry:

It is in the favor of the companies that exist in the market to create barriers for the new entrants to
prevent them from entering into the industry. The organizations could be the new companies or
the companies that are planning to diversify itself in the market. The barriers can be both industrial
and legal. Apart from this the size and the reputation of the companies that are already operating
in the market also play an important. Furthermore, the cost related to the entry, access to raw
materials, barriers related to culture and technical standards also play a major role and can affect
the decision of the new entrants in the market.
• Capital requirements:
A strong barrier to entry as new entrants will require strong financial and resource cushioning for
operations to take off and be sustained. It’s quite normal that in power industry a company
needs huge investment.

• The risk to new entrants because of high entry barriers:

The risk of entry in an industry depends upon on the peak of entry barriers and limitations that are
a blessing for players such as American power expansion into Brazil and on the response that new
entrants can count on from existing players.

• Competitive Rivalry
The competition among the firms helps in identifying the lucrativeness of an industry where
companies are competing hard in order to maintain their power within the industry. The Aes Tiete
Expansion Plant In Brazil competition is moreover on basis of diversity, the development within
the sector and the barriers related to entrance in the market. The competitive rivalry is the analysis
of the brands and the product, its strengths and weakness along with the strategies, competitors
and the share in the market.

Nature of fragmentation

O The market is highly fragmented, which makes it more competitive.

O The market is never too concentrated, and as a result, it has players of
varying size of operation – from very small to big players.

• Threat for Substitute Products

The Aes Tiete Expansion Plant In Brazil substitute products are an alternatives that are available
in the market such as oil & gas. Such products prevail due to the technological and innovative
advancement. The substitute products are dangerous as the companies are under constant threat of
being replaced.

High threat of substitute leads to low profitability as it limits the industry profits by placing a price
ceiling due to the fear of being substituted by other product. Apart from this it also affects the
growth potentials of the industry as a whole but reducing the profitability margins.

O There are always different alternatives or substitutes for various products that lead an industry.
 O With the number of power companies already in the industry, new entrants would find it very
difficult to make a strong showing in the market. Substitute has low impact in this industry
because of the many business opportunities that exist.

a) Bargaining Power of Supplier:

Powerful suppliers possess more power to capture significant value for themselves by demanding
high prices while limiting the quality and the quantity of the product or services or by transferring
the cost on the participant of the industry. Many conditions imposed by the suppliers generally
include the increase in price while compromising the quality and quantity.

A bargaining power of a supplier in the market is strong if:

• It is more concentrated than the industry it is selling to.
• It is not heavily relying on the industry for its profits
• If the participants in the industry have to incur high cost for switching suppliers or the firms are
located adjacent to the suppliers manufacturing facilities.
• The product being offered by the suppliers are highly differentiated.
• And when there is no close substitute available for the products being supplied by the suppliers.

Who is the supplier?

Supplier power refers to the power that is held by the suppliers in terms of pricing of the raw
materials and inputs used for the business.

There are less number of substitute inputs available against electricity price so here bargaining
Aes Tiete is moderate and supplierAes Tiete has higher bargaining power.

b) Bargaining power of Buyer:

Powerful buyers could flip the side of the powerful supplies by forcing the prices to move
downwards and by demanding high quality and services by creating a competition between the
participants in the industry on the basis of price and quantity. Aes Tiete Expansion Plant In Brazil
Customer are deemed strong if they contain negotiating leverage specifically if the industry is
sensitive to price, the buyers can pressure suppliers for further price reductions.
 The customer is assumed to have strong buying power in case:
• If the number of buyers is limited or each of the buyer purchases large quantity relative to the size
of the suppliers.
• The products in the industry are standardized or are undifferentiated.
• The cost of switching is comparatively low.
• Powerful buyers have the ability to reduce prices, demand better quality or more service and play
industry participants off against each other.

3.3 Analysis of Company

AES Corporation is a leading utility company that conducts business across 5 continents around
the world. AES Brasil is the subsidiary company of AES Corporation and it owns 24% controlling
interest in the third-largest private generator in Brazil, which was Tiete. In late 2013, AES is facing
a decisional point on an investment on a 500 MW natural gas power plant project in the state of
Sao Paulo. Luiz Costa, as a manager in Investment Analysis Group, needs to evaluate the project
and come up with a bidding price.

AES corporate brought the Tiete’s economic interest in 1999 with a conditional clause. Tiete, as
an electricity generator, is having unitary business portfolio with 12 hydroelectric power plants. In
2013, AES Tiete was experiencing several necessary business or strategy changes, which including
one investment project on a thermal power plant. However, three major issues that AES Tiete was
facing regarding the current situation if AES Tiete in Brazil and thermal power plant project Issues:
1) deprecating Brazilian Real; 2) Unitary business portfolio (only have hydroelectric power plant
under drought period); 3) Obligation to fulfill the conditional clause. The first recommendation is
that AES Tiete should hedge the currency risk by using derivative market or natural hedge. Second
of all, Tiete should pursue this contract under the WACC from the case study, in order to
counterpoise the heavy dependence on hydroelectric generation, especially under difficult weather
period in Brazil, and to avoid breaking the conditional clause of expanding capacity in Sao Paulo
by 15%. Though, the company should hunt for strategies to increase the return on this project, by
increasing and winning the contract with a higher bidding price or reducing costs. Finally, if AES
choose to have a low level of risk tolerance, it may need to reconsider the investment and the
WACC.

3.3.1 Swot analysis

Strength

Strength is a characteristic that adds value to something by making it more special, unique and
advantageous when compared.

The Company has a broad track record with the operation of renewable power generation assets
and owns an asset portfolio with a total installed capacity of 4.4 GW, consisting of 2,658.4 MW
originated from hydroelectric energy sources, 1,435.9 MW originated from wind energy sources
and 294.1 MW originated from solar energy sources. In addition, the Company continues to
develop part of its wind and solar assets pipeline, which projects remain subject to ongoing
negotiations and may add up to 1.5 GW of installed capacity.

So, these experiences and reputation are the strengths of the company over the period since 28
january, 1981 (founded in Arlington, Virginia, USA).
Weakness of Aes Tiete Expansion Plant In Brazil

Aes Tiete Expansion Plant In Brazil Weakness refer to the situation in which the existing
capabilities and the resources the company holds are weaker or not sufficient compared to others
organizations in the market. In other words it means the aspects in which the organization is less
efficient and needs to improve in order to align with the market trends.
In some cases, Infrastructural, geographical difficulties, social and political turmoil are the weak
points of the company.

Opportunities of Aes Tiete Expansion Plant In Brazil Opportunities

It is the convenient time or situation that is present in the environment and will help the
organization in achieving its goals. It is a factor that contribute positively towards the growth of
the organization. It is a condition existing in the external environment that allow the organization
to take an advantage of the organizational strengths, and help in overcoming the weaknesses and
to neutralize the threats present in the environment.

In this respect, huge demand of electricity for enhancement of various sectors such as
manufacturing and service industries will act as driving force of the company.

Threats of Aes Tiete Expansion Plant In Brazil

Threats are the factors that prevent the organization from the actualization of an activity. It is an
unfavorable situation that exist in the environment making it difficult for the organization to
achieve its defined goals. All the environmental factors are consider as a threat to an organization
that could affect the efficiency and effectiveness of the organization.

For example –draught in 2001 and flood in 2005 in brazil baffles many expansion project in the
southern part of the country. Another threat is social unrest and political turmoil.
However, there are certain limitation attached with it.

The SWOT analysis is only a one stage of the business planning process and do not provide the
organization with an in-depth analysis or research that could lead to a firm decision. Apart from
this it only cover the issues that are definite and doesn’t priorities them. In addition to this it does
not provide any solution or alternatives decisions. As a framework, SWOT does process a value
but it doesn’t provide the organization with any specific direction on how the key aspects can be
identified.

It significantly relies on the capabilities of the manager that how effectively it can prioritize and
determine the most important element. Another limitation associated with Aes Tiete Expansion
Plant In Brazil SWOT analysis is that it provide equal weight to each factor regardless of their
impact or relevancy.

3.3.2 PESTLE Analysis regarding Brazil

PESTLE analysis is one the significant and widely used tool or framework mostly by organizations
with the intent of considering the market environment before commencing the process of
marketing. In fact, the analysis of the environment needs to feed all planning aspects as well as it
should be continuous. The internal environment of an organization includes internal customers or
staff, wages, office technology and finance etc. whereas the micro environment includes the
external customers of an organization, distributors or agents, competitors and suppliers.
Additionally, the macro environment includes legal and political factors, sociocultural forces,
economic forces and technological factors.
The factors or forces are discussed below;
Political forces:

These are the Aes Tiete Expansion Plant In Brazil forces that tends to be altered by the influence
of government on the infrastructure of country. The political factors may involves environment
regulations, employment laws, tariffs, tax policy, trade restrictions, political stability and reforms.
It is noteworthy, that the charities needs to be included where a government are not willing services
and goods to be provided.

As there is high political risk in brazil, so there is a challenge to meet up the mentioned components
smoothly.

Economic factors:
The Aes Tiete Expansion Plant In Brazil will have to face economic factors or forces involves
interest rates, inflation, and growth of economy, cost of living, working hours, wage rate and
exchange rates.
Economic factors are moderate at risk in Brazil, so they will overcome it with fewer difficulties.

Social factors:
The culture or social influence on certain businesses varies from country to country. It is significant
to consider these factors. The social factors include safety and health consciousness, various
demographics, population growth rates and cultural aspects.
As there is social unrest to some extent in Brazil, they need better clarification of demand and
supply of the product of the particular region.

Technological factors:
Technology is one of the most important way of being competitive in the highly competitive
market arena. Not only this, it drives globalization, the factors include environmental and
ecological aspects, and available services as well as products. An organization should innovate
and be compatible with the technologies.
In relation to the issue, Aes tiete belongs to long experience in technology.

Legal factors:

It also includes impending and current legislation that tends to impact on the industry in areas
including competition, employment, safety and health. An organization should consider the
influence of the national and international laws where the organization would originate the
business operations.

Environmental factors:

The factors involve awareness of the seasonal or climate change or terrain variation. The analysis
of the environment including internal and external elements is vital for organization since it
impacts on the performance of an organization.

The limitations are discussed below;

This analysis does not consider pandemic, natural calamities etc. Sudden situation can mismatch
the target and purpose that is avoided in pestel analysis.
4. Country Risk Analysis
Country risk is critical to consider when investing in less-developed nations. To the degree that
factors such as political instability can affect the investments in a given country, these risks are
elevated because of the great turmoil that can be created in financial markets. Such country risk
can reduce the expected return on investment (ROI) of securities being issued within such
countries, or by companies doing business is such countries.
Country risk refers to the uncertainty associated with investing in a particular country, and more
specifically the degree to which that uncertainty lead to losses for investors. This uncertainty can
come from any number of factors including political, economic, and sovereign default risk.

4.1 International country Risk Guide (ICRG) Method

The ICRG system presents a comprehensive risk structure for the country with ratings for its
overall, or composite, risk, for its political, financial, and economic risk and for the risk
components that make up these broad risk categories. This approach enables the user to track the
effect of a single risk component, or group of components, on the overall risk of a country.

In our case capital Budgeting case analyze we have followed ICRG method. The assessment of
the risk for Brazil is based on the International Country Risk Guide (ICRG) model for
forecasting financial, political, and economic risk of the country.

O The International Country Risk guide rating compromises 22 variables in three

subcategories of risk: Political, Financial, and Economic, A separate index is created for
each of the subcategories. The political risk index is based on 100 points, Financial Risk
on 50 points, and Economic Risk is on 50 points.

O The total points from the three indices are divided by two to produce the weights for
inclusion in the composite country risk score. The composite scores, ranging from zero to
100,are then broken into categories from very low risk (80 to 100) to very High Risk
(zero to 49.9 points).
 O For our case, we have estimated the country risk by considering two among the three risk
categories along with their major components. Our estimation of the country risk
parameters as per ICRG is as following:

4.1.1 Political Risk of Brazil

This currently places the country in a high political risk classification. These are issues, such as
the ones that we discuss below, that are assessed by the market when investing or closing deals.
Here we aim to consolidate today’s main variables, looking at Brazil and the market as a whole.
The study is useful for presidents, CEOs, Board members and company leaders intending to make
informed decisions. It is also useful for political leaders, as it provides better visibility of the issues
that are most critical to the business community, so that public policies capable of improving our
risky environment are prioritized.

Tensions between government branches are a symptom of transformation. In a broad analysis, the
country's political powers are now fragmented and shifting, seeking their new positions in the
political scene. New, emerging political forces in Brazil are neither defined, nor belong in the
traditional political spectrum (there is currently a non-partisan President and a renovated Congress
with actors with no political history), leading to a scenario of constant adjustment in searching for
a fresh balance.

In general, current relations are under a tense stability that tends to remain until the end of 2021
and could heat up again with the presidential race. The Executive Branch’s rapprochement with
the Centrão bloc can take its toll over the next two years, with increasingly higher costs of political
articulations, possibly hindering the Federal Government’s stability.

Political risk is the risk an investment’s returns could suffer as a result of political changes or
instability in a country. Instability affecting investment returns could stem from a change in
government legislative bodies other foreign policymakers or military control.
 Political Risk Rating of Brazil
Points
Sequence Components Max Point
Obtatin
1 Government Stability 9 12
A. Government Unity 3 4
B. Legislative Strength 3 4
C. Popular Support 3 4

Socio Economic
2 6 12
Conditions
A. Unempoyment 2 4
B. Consumer Confidence 2 4
C. Poverty 2 4

3 Investment Profile 6 12
A. Contract Viability 2 4
B. Profit repatrition 2 4
C. Payment Delays 2 4

4 Internal Conflict 8 12
A. Civil War 4 4
B. Political Violance 2 4
C. Civil Disorder 2 4

5 External Conflict 8 12
A. War 3 4
B. Cross Border Conflict 3 4
C. Foreign Pressure 2 4
 6 Corruption 2 6

7 Military in Politics 2 6

8 Religious Tension 4 6

9 Ethnic Tension 2 6

10 Law and Order 2 6

11 Democratic Accountability 3 6

12 Bureaucracy Quality 2 4

Total 54 100

In our estimation, Brazil’s political risk rating is 55, which is considering a high risk in political
context. Moreover, it is important that poor political risk rating can be compensated for by better
financial risk rating.

4.1.2 Economic Risk of Brazil

Economic risk can be described as the likelihood that an investment will be affected by
macroeconomic conditions such as government regulation, exchange rates, or political stability,
most commonly one in a foreign country. In other words, while financing a project, the risk that
the output of the project will not produce adequate revenues for covering operating costs and
repaying the debt obligations. This risk refers to a country’s ability to pau back its debts. A country
with stable finances and a stronger economy should provide more reliable investments than a
country with weaker finances or an unsound economy.
 Economic Risk Rating of Brazil
The Economic Risk Rating Maximum Point Point obtain
A. GDP Per Head 5 4
B. Real Gdp Growth 10 9
C. Annual Inflation Rate 10 9
D. Budget Balance as a % of GDP 10 2
E. Current Account Balance as a % of GDP 15 11
Total 50 35

An economic risk rating of less than 0-24.99 points is an indicative factor for very high risk,
25.29.33 indicates high risk, 30-34.99 consider moderately risky, 35-39.99 implies low risk, and
40-50 implies very low risk.

We can find from our estimation, Brazil’s economic risk is 40, which implies very low risk
situation in economic context.

4.1.3 Financial Risk of Brazil

Financial Risk assesses a country’s ability to pay its official, commercial and trade debt
obligations. Our estimation of the total financial risk for Brazil’s in 2020 is shown:

Financial Risk Rating of Brazil

Point
Sequence Component Max Point
obtain
A Foreign Debt as a % of GDP 10 8
B Foreign Debt services as a % o Exports goods and services 10 3.5
C Current Account as a % of exports gods and services 15 12
D Net international Liquidity as Months cover 5 5
E Exchange Rate Stability 10 8
Total 50 36.5
A financial risk rating of 0 to 24.99 is an indicative factor for very high risk, whereas 25 to 29.99
indicates high risk, 30 to 34.99 indicates moderately risky, 35 to 39.99 shows low risks, and 40 to
50 consider very low risk.

In our risk rating, Brazil’s financial risk rating is 36.5, which implies a low risk in financial context.

The composite Risk Rating

Composite Political, Economic, and Financial Risk rating,

CPER(Brazil) = .5 (PR + ER + FR) Where,

=.5 (55+35+36.5) PR= Political Risk= 55

= 63.25ER= Economic Risk= 35

FR= Financial Risk= 36.5

4.1.5 Additional Risk Premium for Country Risk

We have considered ICRG method rating for Brazil’s Country risk. We calculate that Brazil’s
country risk is moderate. Because our calculation risk rating for Brazil is 63.25.

Composite Risk Type Additional Risk Brazil’s Composite

Country Risk Premium Risk Rating

Rating

80.0 to 100 Points Very Low 1%

70.0 to 79.5 Points Low 2%

60.0 to 69.5 Points Moderate 3%

63.25

50.0 to 59.5 Points High 4%

00.0 to 49.5 Points Very High 5%

5. Problem Statement

5.1 What would be the capital structure?

Answer: Equity capital structure will be used according to the funding of the AES Tiete. For this
project AES Tiete finances its investment almost exclusively with equity.
 5.2 What steps should be taken in case of project delay?

Answer: If there is a project delay for any unwanted situation like environmental, political and
pandemic approvals and other permitting, the companies will have to spend more 10 million USD
in the project. So, reduce the risk of project delay the work will be monitored properly and
if any barrier arises that should be controlled or managed properly.

5.3 How will the project reduce hold up problems?

Answer: The major problems, could be faced by AES Tiete in Brazil, are the risk of market and
the delay in completion due to some environmental issues.
Market risk will be reduced from pre sales capacity contracts from high rated companies covering
most of the cost. environmental approval and other permitting issue will be reduced by
understanding the authority that they are eco-friendly company and they used the new machineries
which is less dilute the environment.

5.4 Which is the best approach to calculate cost of equity for the emerging market? And
why?

Answer: Many models are developed for calculating discount rate for emerging market but
among them four model are used widely accepted. Those are proposed by Lessard, Godfrey and
Espinosa, Goldman and Sachs, and the last one is Salmon Smith Barney. Among them the salmon
Smith Barney approach is the better because of this model proposes accounting for the risk of
investing in a specific industry, for the risk of investing in a specific country, and for some
characteristic of both the project and the company considering the investment.

5.5 Whether the company’s current profitability and earnings capability would be able
to sustain the investment period?
Answer: We can see from the AES Tiete’s income statement that in 2007 and 2008 net income
and cash flow are positive. If the expansion project take then net income will decrease but cash
flow will increase.
The company needs to address some other following questions to evaluate this project and we
would try to answer these questions with rationale so that the management, evaluating this
project, can take their investment decisions about this project effectively.

O Which risk will affect this project?

O How much risk you add to your risk-free rate to invest in this project?
O Will there be any managerial real option associated with this project?
O What will be the call value of real option?
O What is the true Net Present Value?
6. Evaluation of the Alternatives
The cost of the AES Tiete thermal electricity plant is USD 360 million and AES have to provide
30% of the fund. So among the remaining 70% the cost is diverse in the following three ways:
Using of government investment fund, common stock and preferred stock:

Government Loan Preferred Stock Common Stock

(30%) (10%) (20%)
Required Amount 10,80,00,000.00 3,60,00,000.00 7,20,00,000.00
Weight 0.5 0.166666667 0.333333333
Cost 0.118 0.2 0.16
Corporate tax 0.34
WACC 0.125606667
Country Risk 0.02
Adjusted WACC 0.145606667
NPV 373,332,324.37
IRR 29%
MIRR 18%

Using Bank Debt and Common Stock:

Bank Debt (40%) Common Stock (30%)
Required Amount 14,40,00,000.00 10,80,00,000.00
Weight 0.571428571 0.428571429
Cost 0.14 0.16
Corporate tax 0.34
WACC 0.121371429
Country Risk 0.02
Adjusted WACC 0.141371429
NPV 393,871,118
IRR 29%
IRR 18%
Using preferred and common stock:
Preferred stock (20%) Common Stock (50%)
Required Amount 7,20,00,000.00 18,00,00,000.00
Weight 0.285714286 0.714285714
Cost 0.2 0.16
Corporate tax
WACC 0.171428571
Country Risk 0.02
Adjusted WACC 0.191428571
NPV 201,139,812
IRR 29%
MIRR 18%

7. Risk Analysis
Risk analysis is the process of identifying and analyzing potential issues that could negatively
impact key business initiatives or projects. This project is done in order to help organizations avoid
or mitigate those risk.
AES uses risk analysis to-
Anticipate and reduce the effect of harmful results from adverse events.
Evaluate whether the potential risks of this project are balanced by its benefits to aid in the
decision process when evaluating whether to move forward with the project.
Evaluate whether there are more benefits to a project than risks before initiation.
Plan responses for technology or equipment failure or loss from adverse events, both
natural and human caused.

7.1. Monte Carlo Simulation

We analyze the expansion project of AES Tiete considering three different valuation, a base case,
an optimistic scenario and a pessimistic scenario. If the project is taken AES needs to invest 1.2
billion (1200 in million). All the operations and maintenance costs are included as variable costs
and all the PMSO (personnel, materials, services and others) costs and regulatory costs are
included as fixed costs. AES has a revenue growth rate of 10% per year. For this project, AES will
use the straight line method for depreciation and there will be a salvage value of 5% at the end of
the project. Working capital requirement is one-twelfth of the net income of each year. The
corporate tax rate for this project is 34% and the revenue tax rate in 9.25%. For the calculation we
assume the following:
(We converted each value in the USD)

Operational assumption:
Installed Capacity 500 MWh
Numbers of Hour per year 8760 hours
Capacity Factor 0.9 %
Dispatch/year 0.5 %
Total Energy/ year 1971000 MWh/year

Pricing assumption:
BIDDING PRICE 50 (ADJUSTED FOR INFLATION)
ADD: REQUIRED CAPACITY Bidding price*Install capacity*N0. Of hours
ADD: REVENUE PASS THROUGH (GAS Gas costs+ Markup+ (1- revenue tax-
COST) COFFINS)
ADD: REVENUE-PASS THROUGH Variable costs + Markup + ( 1- revenue tax-
(VARIABLE O & M) COFFINS)
LESS: REVENUE TAX 9.25% PIS/COFFINS rate applied to all gross
revenue steams
LESS: REVENUE TAX
In this project, the revenue growth will increase by 10% per year. And the working capital requires
for each year is One-Twelfth of the Net Income of each year. Here we have used straight line
method for depreciation.

The Capital Expenditure Percentage for each year is:

Year Capital Expenditure
2015 30%
2016 30%
2017 20%
2018 20%

For evaluation purpose we will consider the base case scenario since macro phenomenon future is
uncertain. We have taken all above factors under consideration and then we calculated the NPV,
IRR & MIRR of the project. The values are given below:

Base Optimistic Pessimistic

NPV $40741912 $7331076 -$105849053

IRR 8.53% 7.92% 4.52%

MIRR 9% 8.77% 7.46%

We did the Monte Carlo simulation on the basis of pessimistic scenario to estimate the worst
possible situation. We have run 1,000 trials in Monte Carlo Simulation. The assumption are given
below:

7.1.1. Net Present Value (NPV)

The simulation shows that the mean NPV is negative $105.85million. It is a clear indication of the
loss of the project. The risk of the project is low as Coefficient of Variation is less than 0.5. So the
simulation shows that the low riskiness of the project.
 Forecast: NPV
Statistic Forecast values
Trials 1,000
Base Case ($105.85)
Mean ($104.40)
Median ($105.75)
Mode '---
Standard
Deviation $19.51
Variance $380.72
Skewness 0.3441
Kurtosis 3.17
Coeff. of Variation -0.1869
Minimum ($158.00)
Maximum ($30.95)
Mean Std. Error $0.62

Sensitivity Analysis
The NPV is negatively 99.8% sensitive to the cost of capital. . If cost of capital decreases the NPV
will also go up. Next the NPV is negatively 0.2% sensitive to net revenue. The NPV is also 1%
negatively sensitive to total fixed cost and 0% sensitive to the variable cost.

7.1.2. Internal Rate of Return (IRR)

After running 1000 simulations we find out the IRR as 5%. The Coefficient of Variation of IRR is
0.1022 that indicates a low risk for the project.

Forecast: IRR
Statistic Forecast values
Trials 1,000
Base Case 5%
Mean 5%
Median 5%
Mode 5%
Standard Deviation 0%
Variance 0%
Skewness '---
Kurtosis '---
Coeff. of Variation 0.1022
Minimum 5%
Maximum 5%
Mean Std. Error 0%
Sensitivity Analysis
The IRR is positively 99.4% sensitive to the total fixed cost. If the fixed costs goes up the IRR will
also go up. The IRR is negatively 0.4% sensitive to the cost of capital. If the cost of capital goes
up the IRR will go down. The IRR is 0% sensitive to the total Variable cost.

7.1.3. Moderate Internal Rate of Return (MIRR)

After running 1000 simulations we find out the MIRR here is 7%. The Coefficient of Variation
of MIRR is 0.0833 that indicates a low risk for the project.

Forecast: MIRR
Forecast
Statistic values

Trials 1,000

Base Case 7%

Mean 7%
 Median 7%

Mode '---

Standard Deviation 1%

Variance 0%

Skewness 0.0398

Kurtosis 3.28

Coeff. of Variation 0.0833

Minimum 6%

Maximum 10%

Mean Std. Error 0%

Sensitivity Analysis
The MIRR is mostly sensitive to cost of capital. MIRR is positively 99.7% sensitive to the cost of
capital. It indicates if cost of capital increases then the MIRR will go up. The MIRR is positively
0.3% sensitive to the variable cost. If variable cost goes up the IRR will go down. The MIRR is
0% sensitive to net revenue and total fixed cost.
7.1.4. Decision Table
Cash Flow Simulation
Component Result Decision CV Decision
NPV Negative Rejected Less than 0.5 Less risky
MIRR Lower than the discount rate Rejected Less than 0.5 Less risky
IRR Lower than the discount rate Rejected Less than 0.5 Less risky

7.1.5. Recommendation Based on Monte Carlo Simulation

So, considering all the assumption under the pessimistic scenario AES should not take the project,
because all the assumption is showing that AES Tiete has a negative NPV and even though the
coefficient of variances of NPV, IRR and MIRR is less than 0.5 the project will be a loss project.
But in base case and optimistic scenarios NPV are positive and IRR, MIRR are higher than the
discount rate.
7.2 Project Valuation and Sensitive Analysis
For the project valuation, three scenarios (base, optimistic, and pessimistic) would be tested
and the scenario are corresponding to 3 variables, including currency rate1 (BRL/USD), inflation
rate2 (Brazil’s CPI), and Markup rate3 as shown in Table 2 and Table 3. By changing the scenarios,
those data would fact natural gas in BRL4, Bidding Price5 (adjusted for inflation), Variable cost6
(adjusted for inflation), Capacity Revenue, Pass Through Revenue (Gas Costs), Pass Through
Revenue (Variable O&M), Gas Cost, Operation and Maintenance (O&M) Expense, and fixed cost.

Table 2. Annual Gas Price, Biding Price, and Variable Cost Scenario Analysis :

1
Extract BRL/USD (2013-2043) from Exhibit 7. Macro Forecast in AES Tiete: Expansion Plant in Brazil.
2
Extract inflation rate (2014-2043) data from Exhibit 7 in AES Tiete: Expansion Plant in Brazil
3
Extract markup rate for different scenario from Exhibit 6. Revenue Calculation on AES Tiete: Expansion
Plant in Brazil.
4
Natural gas in BRL = Henry Hub-$/MMBtu (from Exhibit 7 in AES Tiete: Expansion Plant in Brazil) *
currency rate in BRL /USD in the same year.
5
Bidding price (adjusted for inflation) = Bidding price from last year * (1+current inflation rate)
6
Variable cost (adjusted for inflation) = Variable cost * (1+current inflation rate)
 Table 3. Markup Forecast for Different Scenarios

Base Case Optimistic Scenario Pessimistic Scenario

Markup 15% 20% 5%

According to the AES Tiete case study, the two main kinds of revenue sources are capacity revenue and
pass-through fuel and variable revenue. Among the calculation for the revenue, the bidding price (start with
the AES proposed bidding price), natural gas price, and variable cost are all adjusted by the annual Brazilian
inflation rate. Besides, the gas price and variable cost are subject to a Brazilian revenue tax and a VAT tax,
which is COFINS. According to PwC7’s worldwide tax summaries, the CONFINS and PIS tax would be
different depends on the company’s accounting system. With tax deduction system, the CONFINS is 7.6%,
PIS is 1.65%, and revenue tax should be 9.25%; Otherwise, without tax deduction system, the CONFINS
is 3%, PIS is 0.65%, and revenue tax 3.65%. In the case study, the author stated that the revenue tax is
9.25%, so an adaptation of an accounting model with the probability of deduction is assumed among the
calculation for this section. Furthermore, five different expenses, including natural-gas cost, operation &
maintenance (O&M) cost, fixed cost, regulatory cost, and depreciation & amortization, have been
considered in this forecast model, where gas cost, O&M cost, and fixed cost are adjusted by the inflation
rate. Besides, a straight-line depreciation method has been applied for the depreciation cost for the 25 years
lifetime of the power plant. A 9.25% revenue tax and a 34% corporate tax are also been considered in this
section. As the result, the net income grows at a steady peace from 2019 to 2043 that is shown on Figure
1, which should be a normal case for the utility industry.

7
Source: PriceWaterHouse.(2018). Worldwide Tax Summaries-Brazil(Corporate – Other taxes).Retrive from
http://taxsummaries.pwc.com/ID/Brazil-Corporate-Other-taxes
 Fig 1: Net Income (Loss) in BRL for the Natural Power Plante
BRL 500,000,000
BRL 450,000,000
BRL 400,000,000
BRL 350,000,000
BRL 300,000,000
BRL 250,000,000
BRL 200,000,000
BRL 150,000,000
BRL 100,000,000
BRL 50,000,000
BRL -
2016P

2019P

2022P

2025P

2028P

2031P
2013A
2014P
2015P

2017P
2018P

2020P
2021P

2023P
2024P

2026P
2027P

2029P
2030P

2032P
2033P
2034P
2035P
2036P
2037P
2038P
2039P
2040P
2041P
2042P
2043P
Figure 1. Net Income (Loss) in BRL for the Natural Power Plante

7.3 Real Option Consideration

Options gives the right to invest in a project, but not the obligation. Their value is thus driven by the
possibility of achieving a large upside gain in combined effect with the fact that companies can usually
abandon their project before their investment in them costs too much, thus eliminating the real benefit. The
value of an option must therefore increase as the uncertainty surrounding the underlying asset increases,
whether that asset is financial or real.
The valuation of the real option is done by using the Black-Schole model. The all-over real option
calculations are given here with all the assumptions.

It is expected that the benefits can be realized for 25 years. We had to value this real option and this value
would be added to the NPV of the project. If the value of the real option is negative then the managers will
not exercise the option. The amount of cost is $359,613,655.34. Net cash flow each year is estimated as
follows-
 Probability
CF Each Year X= Exercise Price 359,613,655.34
(P)
0.1 157,232,003.00 S= Current market
0.25 209,642,670.70
Price 2,180,273,790.75
0.35 235,848,004.52
0.2 314,464,006.00 t= time 5
0.1 504,310,914.36 Rf= Risk Free rate 0.05
VR= variance 4.451259351
SD= Standard deviation 2.109800785

d1 2.793827767

d2 -1.923830206

N(d1) 0.997395589

N(d2) 0.027187935
C [Value of Real
Option] 2,166,980,810.96

Traditional NPV 40,741,912.00

True NPV 2,207,722,722.96

Here the call option value is 2,166,980,810.96.

Since the real option price is positive, so it will increase the firm’s value. Hence, the option
should be taken. Also, the True NPV $2,207,722,722.96. Therefore, we should take the
project. That project will be profitable for the company.
8. RECOMMENDATIONS

Overall, AES should bid for this power plant by using the WACC in the case studies. Doing business in an
emerging market is complicated for foreign companies. The emerging market may have higher industry
growth rate than the market in the developed country; however, there are more risks that the company needs
to face. The emerging market has comparatively unstable currency rate and unsteady political regulation.

• After analyzing the project, NPV value is positive so, we would suggest the top management to accept
the project.
• As NPV is the most accurate among the capital budgeting methods, so we will take the risk analysis of
estimated NPV which conveys that the project is less risky
• Our Real option value is positive which add value to our true NPV. This indicates a lucrative opportunity
to invest.
• Moreover, the real option value is positive, so it will increase the firm’s value and therefore ASE Tiete
should consider the opportunity.
REFERENCES:
Energy Planning Energy (EPE). (2014). 2014 Statistical Yearbook of Electricity. Retrieve from
http://www.epe.gov.br/sites-en/publicacoes-dados-
abertos/publicacoes/PublicacoesArquivos/publicacao-160/topico-
168/Anu%C3%A1rio%20Estat%C3%ADstico%20de%20Energia%20El%C3%A9trica%202014.pdf

MME. (2015). Energy Expansion in Brazil - 2024 Investment Opportunities. retrieve from
http://www.mme.gov.br/documents/10584/3580500/04+-+BRAZIL+-
+2024+Energy+Expansion+Investment+Opportunities+%28PDF%29/2f67b6f3-350e-44c4-aa97-
839508921960;jsessionid=B160548AF67888B9C6D6156270D2BC5B.srv154

Watts, J. (2015). Brazil’s worst drought in history prompts protests and blackouts. Published by The
Guardian.Retrive from https://www.theguardian.com/world/2015/jan/23/brazil-worst-drought-
history

NYU Stern Business College. Working Capital in Valuation. Retrive from

http://pages.stern.nyu.edu/~adamodar/New_Home_Page/valquestions/noncashwc.htm