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COST OF CAPITAL AT AES

Evaluating the Historical Capital Budgeting Method Currently AES employs Project Finance Framework. Project finance tends to be used in projects with tangible assets with predictable cash flows in which construction and operating targets can be easily established through explicit contract. The key to AES projects financing lies with the precise forecasting of cash flows. In effect, the possibility of estimating cash flows with an acceptable level of uncertainty allows for allocation of risks among various interested parties. The ensuing certainty in cash flows allows for high level of leverage and enables project assets to be separated from the parent company. Let us now take a closer look at the pros and cons of the Capital Budgeting System currently in place.

Principal Advantages
Non-Recourse

The separation of the parent company is structured through the creation of a Special Purpose Vehicle (SPV). This SPV is the formal borrower under all loan documents so that in event of default or bankruptcy AES is not directly responsible before financial creditors. Instead, their legal claims are against the SPV assets.
Maximize Leverage

Currently AES seeks to finance the cost of development and construction of the project on highly leveraged basis. High leveraged in non-recourse project financing permits AES to put less in capital to put at risk permits AES to finance the project without diluting its equity investment in the project.
Off-Balance Sheet Treatment

AES may not be required to report any of the project debt on its balance sheet because such debt is non-recourse. Off balance sheet treatment can have the added practical benefit of helping the AES comply with covenants and restriction relating to borrowing funds contained in loan agreements to which AES is also a party.
Agency Cost

The agency costs of free cash flow are reduced. Management incentives are to project performance. Most importantly close monitoring by investors is facilitated. Multilateral Financial Institutions One of the four constituents that have contractual arrangement with the SPV in a typical project are the banks (an integral part group of financiers that include share holders, insurers, equipment manufacturers, export credit agencies and funds).Among these banks there are multilateral financial institutions (like IFC, CAF and etc). Presence of these institutions as financiers helps in raising capital from these institutes at lower cost and secondly it is also read as a positive sign by commercial banks.

Drawbacks
Projects V/S Division

The company is not only expanding its geographical boundaries, but it is also diversifying its business through backward and forward integration. The current financial model does not provide the AES with the big picture, which now constitutes more number of variables that are being influenced by multiple factors due to the increase in depth and breadth of the organization.

Hence we see that the geographical diversification of business causes asymmetrical risk to increase causing bimodal behavior in the result. Other factor that current model was not able to include was the risk of devaluation of currency in developing economies which resulted in significant losses due to the inability of the company to survive its international debt obligations. The model worked well for the domestic market as well as for the international operations. provided the opportunities undertook by AES were either in the sector of building and running a power plant or simply buying an existing facility and upgrading it and then operating. This constitutes a problem for emerging countries where these risks tends to be at the forefront. The underlying assumption over here was that the symmetrical and asymmetrical risks faced by the project were more or less same irrespective of its geographical location (Refer to Exhibit 3). This will be of significant importance when it comes to investing in developing countries where frequent changes in government policies occur. Political Risk: This is another important factor which the current financial management system does not take into account. Project financing becomes less recommendable as a symmetrical risk becomes more manifest. As we have seen that fluctuation in exchange rate has greatly hurt the AES business and they were unable to mitigate this risk as they haven·t anticipated it. This risk will be of higher magnitude in the developing countries because of their unstable monetary and fiscal policies[2]. Expansion in developing economies also exposed the business to political risk where the policies change erratically with changes in government. This approach solely took into account those factors that minimized AES exposure to the project and achieved the most beneficial regulatory treatment thus ensuring availability of financial resources to complete the project. Does this system make sense? The financial strategy employed by AES was historically based on project finance. However when AES started diversifying the breadth of its operations by incorporating other offshoots of energy related business and transforming from a cogeneration to a more utility organization with majority of expansion occurring in developing economies. They can be quite complex and can be expensive to arrange. Macroeconomic Risk The current methodology employed by AES for capital budgeting does not take into account the exchange rate risk. This risk becomes important when the exchange rate fluctuation affects balance sheet items unequally. This diversification of business increased the symmetrical risks like business risk. and those of assets and liabilities in different currencies. Thus keeping check on the foreign exchange rate requires timely adjustment of both the items of revenue and expenditure. Secondly it demands greater amount of management time.Complexity Financing of projects requires involvement of a number of parties. a classic example of which we see in Brazil where AES experience shortfall in demand /sales volume due to Energy Conservation Policy of Brazilian government and this had a chain effect on debt servicing capacity of the SPV as well the stock price of the parent company. Lal Pir Project Valuation .

072 and similarly. we first need to calculate the Weighted Average Cost of Capital (WACC) using the new proposed methodology. Counterparty.075%. The WACC in this scenario comes out to be 0.1595 or 15. For this we have followed the approach given in exhibit 8 of the case. However there are two things that are different. Using this we calculate our NPV for USA which comes out to be negative $ 35.5%) as the risk free return in calculating the cost of equity.0990 for Pakistan). We have used the return on U.Scenario 1: Pakistan In order to calculate the value of project for the Lal Pir project in Pakistan. Secondly.52%. i. the highest probability is that of currency risk and the legal risk. regulatory and .425 and since there is a linear relationship between business specific risk scores and cost of capital[5] we need to adjust our WACC by 7. If we simply compare the risk scores for USA and Pakistan[6]. Construction. while currency. using the risk free return and the default spread (given in exhibit 7a of case) we calculate the cost of debt which comes out to be 0. now we need to adjust this WACC for the risks associated with doing the project in Pakistan and we do this by using Table A given in the case. 4. Regulatory. The adjusted cost that we have calculated is adjusted by the total risk score for Pakistan.92 million (refer to Exhibit 7).95%.e.S.425. The first step is to calculate the value of levered using the formula and information given in the case[3]. Adjusted Cost of Capital and Probabilities of Real Events in Pakistan In calculating the adjusted cost of capital for Pakistan the WACC is adjusted for six common types of risks: Operational. however in order to incorporate the risk factor associated with Pakistan we need to adjust it for the Total Risk Score. Scenario 2: USA For USA similar calculations are made to calculate the WACC (Exhibit 4B). in this case we would need to calculate the business risk using the information given in exhibit 7a of the case (refer to Exhibit 5). It is important to note that the cost of debt and the cost of equity also need to be adjusted for the sovereign spread (0. a score of 1 leads to an adjustment of 500 basis points in the WACC.e. Commodity. There is a linear relationship between the total risk score and adjustment to the cost of capital.34 million. The cost of equity comes out to be 0.64%.075%. First we see the sovereign spread is equal to zero. However. the probability of which varies from country to country.95%. Currency and Legal. When we calculate the WACC for Pakistan through traditional formula it comes out to be 15. our business risk comes out to be 3.23% and adding it to our calculated value of WACC.0807. and it comes out to be negative $234.3852 or 38. we can see that there is a major difference between the risk profiles of both the countries. We can clearly see from table A given in the case that besides construction there is a probability of all these risks actually effecting the project in Pakistan. This total risk score is compiled from 6 main types of risks.075% is adjusted using the total risk score we can safely assume that it incorporates for the probability of the afro-mentioned six types of risks in WACC with respect to Pakistan. using which we calculate our NPV (refer to Exhibit 6) from the year 2004 to 2023. In these. which essentially means that our project is not very highly correlated to the market return. Treasury Bond (i.64 and using this score. we get our final WACC of 9. Once we have the adjusted costs of equity and capital we can now calculate the WACC for the project using the formula given in case where we essentially multiply equity and debt ratio with the adjusted costs of equity and debt respectively[4]. We know that the total Risk Score for Pakistan is 1. Using this value of we now calculate the cost of Equity (refer Exhibit 4A). This score comes out to be 0. Discount Rate Adjustment: USA v/s Pakistan As mentioned earlier the discount rate is adjusted based on the total risk score of the country. For instance. Since this 23. which in this case is 1.125% thus making our final WACC 23. The value of the levered comes out to be 0. So we simply multiply this by 500 and we find out that we need to adjust our WACC 23.

. they do not exist in the USA at all. which essentially implies that Pakistan is inherently a riskier country to invest in as opposed to the USA and any investments made in this region would have to cross a higher hurdle rate than if they were made in the US region.075%) is much higher as opposed to that of USA (9.64%). Similarly when the respective WACCs of the two countries are adjusted for their risk we see that the adjusted WACC for Pakistan (23.legal risks are significantly high in Pakistan. Also we see that operational. counterparty and commodity risks are higher in USA as compared to Pakistan.