AES Case study report

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 Contents:

Executive Summary…………………………………………………………………………… 3
Introduction………………………………………………………………………………………. 4
Case Analysis
Current Method and Problem Identification………………………………….. 4
The New Method…………………………………………………………………………… 6
Comparison of the two Methods…………………………………………………… 8
Recommendation………………………………………………………………………………. 8
Conclusion…………………………………………………………………………………………. 9
Appendix…………………………………………………………………………………………… 10
Reference………………………………………………………………………………………….. 19

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 Executive Summary:

In the 1990s, AES corporation becomes one of the world's leading

independent suppliers of electricity in the world. During the late 2000s, AES'
stock price suffered a sudden and sharp decline, causing a widespread
financial crisis throughout the company. Several factors such as the
devaluation of essential operating currencies, regulation changes and
declining commodity prices affected AES's project's profitability in foreign
markets. It has been identified that the current calculation methodology for
Cost of Capital (CoC) does not consider variable factors and is therefore
inadequate. AES has now appointed Rob Venerus (supported by a team of
analysts & planners) to resolve this issue by formulating a new methodology
for CoC calculations for all its ventures.

The current approach by AES and the new methodology by Venerus

both have pros and cons when evaluating international projects. Current
capital budgeting processes use a 12% discount on all projects to calculate
the CoC. Therefore, it suits domestic and international projects with similar
risk and capital structures. Nevertheless, the result will be highly volatile if all
projects are evaluated using the same equity discount rate for all returns. As
a result, the current method does not meet the needs of a company with
numerous projects located in different countries with varying risk profiles.

On the other hand, the new proposed methodology for capital

budgeting incorporates country, project-specific risk, and other factors for
each project. It also demonstrates different discount rates to evaluate
different investments. However, the new method has some disadvantages as
it double counts some risks and can lead to over or underestimating project
risks since it treats foreign projects of different types with the same risk
exposure when calculating risk score factors. This may lead to the rejection
of a viable project or the opposite.

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 Therefore, the company should evaluate international projects by
applying Scenario Analysis, which combines the project's expected free cash
flow with a profitability model, making the evaluation more accurate.

Introduction:

The AES Corporation was founded by Roger San and Dennis Bakke in
1981. The company operates in 30 countries and 5 continents. The company
is divided into four segments: Utilities, Contract Generation, Competitive
Supply, and Growth Distribution. Since AES went public in 1991, it has
overgrown, mainly due to its international expansion. However, the
downturn in the global economy began in late 2000, and AES's market
capitalisation started declining dramatically. In addition, the firm was
affected by currency devaluations in South America, a decrease in energy
prices, and shifts in some countries' regulatory rules for energy. Several
factors contributed to their stock price decline, including foreign exchange
market shifts, regulatory policies, and commodity price increases.

All projects evaluated by AES are based on a 12% cost of capital.

However, the financial crisis led AES to adopt a new methodology for
calculating the CoC for AES's diverse business around the world. Rob
Venerus, the director of the new planning group, aims to improve on this
approach by developing a methodology that incorporates country risk and
other risks specified to a project into the CoC for each project, enabling it to
make better financial decisions for the company.

Case Analysis:
Current Method and Problem Identification:
Before entering the global market, AES's current budgeting appeared
to work well, and there was no effect caused by current capital budgeting.
Therefore, it is logical to have a capital structure similar to the competitors
with the same risk profile when the company only operates in the U.S.

When the company expanded their business in the foreign market

and used the same capital budgeting process, it failed to account for the
increased currency and project-specific risks. Moreover, the cash flow (in the

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 form of dividend) obtained from the subsidiaries were significantly lower
than expected.

Evaluating dividend flows at a 12% discount rate is not problematic

when the investment opportunity structure is the same. However, the
situation is somewhat different in emerging economies with relatively
unstable monetary uncertainties. Argentina's local currency depreciation also
affected other South American countries where the company had
subsidiaries. Currency instabilities increase the leverage at subsidiaries and
holding companies, making them unable to service foreign currency debts.
As dividends were translated into USD, currency risk increased. A fluctuating
exchange rate affects the cash flow for financial statements.

Exhibit 6 shows that subsidiaries A and B are financed by non-

recourse debt. AES holding company had a non-recourse debt to the parent
secured by dividends from operating companies. AES's parent company
borrowed debt to contribute equity dollars to the holding companies and the
subsidiary projects. Therefore, the parent company received dividends (cash
flows) from each subsidiary and discounted those dividends at the same rate
(12%). With the current capital budgeting method, subsidiaries' and holding
companies' leverage drastically decreased if their local currencies
depreciated. Due to this, the local holding company had difficulty servicing its
foreign currency debt and could not pay dividends to its parent company.

The current method also ignores political risks in its capital structure.
Due to the company's entry into many developing markets, it is seeking to
grow from the increasing demand within these markets. Furthermore,
government policies and regulations are more likely to change frequently in
developing countries.

Furthermore, two projects in the same country might have different

risks. Therefore, even with two identical plants in Brazil, the cash flow
variation for a given year may vary, affecting the company's value. Due to
this budgeting system, net income in 2002 was negative $3,509 million
(Exhibit 1).
The New Method:

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 Rob Venerus developed a new methodology to calculate the accurate
CoC of projects worldwide to account for these uncounted risks in the
current capital budgeting structure. The new method adjusts every project's
Weighted Average Cost of Capital (WACC) according to seven risk categories
and it can compare different project with each other or with different
countries for selecting the most appropriate investment.

The current CoC model uses equal risk and the same discount rate for
all projects. However, as markets, governments, and policies changed, it
became apparent that the current model was ineffective for all divisions and
locations. Thus, the proposed CoC model considers country-specific, project-
specific, and business-specific factors.

For example, the Present Value (PV) for the Lal Pir project, a contract
generation business in Pakistan, will have a different WACC if the new
methodology is accepted. The calculation of the WACC steps is shown in
Exhibit 8. Table 1 shows that the leveraged beta is 0.39 based on target
capitalization ratios, indicating a low correlation between the project and the
market.
Lal Pir Levered Beta

Unlevered Equity Beta 0.25 (Exhibit 7b)

Debt Ratio 35.1% (Exhibit 7a)
Equity Ratio (1-35.1%) = 64.9%
Relevered Beta (0.25/64.9%) = 0.39 (Table 1)

In the second step, calculate the equity cost based on the 10-year
Treasury note rate of 4.5% and the U.S. Risk Premium of 7% provided in
exhibit 7b.
4.5%+0.385*7%= 0.072 (Table 1)

Then using the same risk-free rate and Default spread of 3.57%
(exhibit 7a), the cost of debt can be calculated as

4.5%+3.5%= 0.0807 (Table 1)

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 As shown in exhibit 8, add the local sovereign spread to the cost
calculated above to account for country-specific risks. Taking Lal Pir as an
example, its sovereign spread is 9.90%.

Adjusted cost of equity: 0.072+0.099= 0.171 (Table 1)

Adjusted Cost of debt: 0.0807+0.099=0.1797 (Table 1)

WACC for the project is calculated by multiplying equity and debt

ratios by adjusted costs. Lal Pir's debt-to-capital ratio is 35.1%, so its equity
ratio is 100% - 35.1% = 64.9%. WACC is calculated as follows:

(0.171*0.649) + (0.1797*0.351) + (1-0.23) = 0.1595= 15.95% (Table 1)

Lastly, the final step is to calculate risk adjusted WACC. Risk

adjustment is calculated from seven risk scores (Construction, Operations,
Regulatory, Currency, Contract and Community) multiplied by the particular
weight. Then every change in 1 score will lead to the WACC adjustment of
0.5 ppt. However, WACC has not yet been adjusted for the country risk score
of Pakistan, which is 1.425, as shown in Table A. Since the relationship
between specific risk score and cost of capital is linear, the WACC needs to
be adjusted by 1.425*5= 7.12%. The new WACC as follows:

15.95%+7.125%= 23.08% (Table 1)

From the new WACC, we calculate the PV of the project with different
scenarios (Table 2)
SCENARIO 1: Current Practice 12% Discount rate $490.64
   
SCENARIO 2: New Methodology WACC without country risk 15.95% Lal Pir Project $388.36
   
SCENARIO 3: New Methodology WACC without country risk 6.46% Red Oak Project $732.44
   
SCENARIO 4: New Methodology WACC with country risk 23.08% Lal Pir Project $276.63
   
SCENARIO 5: New Methodology WACC with country risk 9.66% Red Oak Project $574.34

Comparison of the two models:

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 The value of the Lal Pir project has been calculated using unlevered
cash flow with TV from 2004 to 2023, representing both debt and equity
investors' cash flows. As shown in Table 1, the work has been conducted
using both methodologies (current 12% and new methodology).

PV calculated using the current methodology is $490.64, whereas PV

calculated using the new methodology is $276.56. In addition, Table 2 shows
the U.S. has a lower discount rate when considering all risk factors as per the
new methodology, and the company may be able to obtain a higher
valuation when accepting local projects (for example, U.S. PV with country
risk is $574.34 when compared to $490.64 with the current discount rate).

The new method is comprehensive and flexible in making capital

budgeting. There are three main parts for measuring CoC in the new method:
overall risk (systematic), country/regional risk, and project risk. Additionally,
the new methodology can consider other factors when calculating the risk
score. As a result, risks can be comprehensively identified if the correct
weight is assigned. Table 2 shows how the new methodology can change
AES's PV if one of the risk factors is ignored in a specific project. For example,
Lal Pir's PV is higher when compared without country-specific risk than when
considering all risk-adjusted factors. However, using 12% WACC for all
projects tends to accept risky projects and does not reflect additional risks in
other countries due to the high PV for each project (Table 2).

Recommendation:

The new method benefits AES in choosing a suitable investment in

foreign markets. AES targets emerging markets with higher energy demand
growth potential. Venerus' method does not consider a 12% fixed discount
rate and more thoroughly analyses CoC for each project. According to the
new methodology, each project is examined individually based on sovereign
and default risk spreads, generally the most critical risks to calculate CoC.
However, there were a few shortcomings in the model that can be
rectified using the following recommendations:

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  Considering the provided information, the sovereign spread
methodology double-counts some project-specific risks (as
reflected in the sovereign spread), resulting in higher discount
rates than necessary. There is a possibility that the country-
specific market risk has already considered the project-specific
risks (Regulation, Currency, and Contract Enforcement/Legal).
These three project-specific risks comprise over half the
project-specific risk value weighting. To mitigate this, the
recommendation is to use sovereign spread to estimate the
cost of equity.

 To improve the model's validity, it is essential to include a

scenario analysis that reflects the additional risks associated
with foreign countries. Adjusting the project's future cash
flows and the probability of these risks will improve the
model's validity. (Table 3- Sensitivity Analysis)

Conclusion:

AES’ foreign operations face a wide variety of risks such as legal &
regulatory barriers, stability of the local government and volatility of
currency exchanges. Current methodology of considering a 12% discounted
rate is not justified considering the wide range variable factors.
The proposed method to calculate WACC is for more robust. By
implementing the new methodology, the company would be able to enhance
its capital structure, making it optimal and reasonable to maintain.
Incorporating the recommendations for the proposed methodology
will further improve the accuracy of the rate calculation.

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 Exhibit 1

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 Exhibit 2

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 Exhibit 3

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 Exhibit 4

Exhibit 5

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 Exhibit 6:

Exhibit 7a

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 Exhibit 7b

Exhibit 8

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 Exhibit 9a

Exhibit 9b

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 Exhibit 10

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 Exhibit 11

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 Exhibit 12

Reference:

Desai, M & Schillinger, D 2003 (rev. 2006), ‘Globalizing the cost

of capital and capital budgeting at AES’, Harvard Business
Review, pp. 1–23.

Table 1- Provided in the supplementary excel work

Table 2- Provided in the supplementary excel work
Table 3- Sensitivity Analysis- Provided in the supplementary excel work

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