Globalizing the Cost of Capital

and Capital Budgeting at AES

Dr. Himanshu Joshi
FORE School of Management, New Delhi
ONGC Enterprise Risk Management Program September 2019
Assignment Questions
1. How would you evaluate the capital budgeting method used historically by AES?
What’s good and bad about it?
2. If Venerus implements the suggested methodology, what would be the range of
discount rates that AES would use around the world?
3. Does this make sense as a way to do capital budgeting?
4. What is the value of the Pakistan project using the cost of capital derived from
the new methodology? If this project was located in the U.S., what would its
value be?
5. How does the adjusted cost of capital for the Pakistan project reflect the
probabilities of real events? What does the discount rate adjustment imply about
expectations for the project because it is located in Pakistan and not the U.S?
Learning Objectives.
• Explore the problem faced by the managers who have to evaluate
different types of projects across countries with different political and
economic characteristics.
• Evaluate the approach to capital budgeting used by a global firm.
• Calculate the cost of capital (hurdle rate) for 15 projects around the
World using a new methodology that incorporates 
Country risk and other types of project specific risks that arise in
international investments into each project’s cost of capital.
 Determine how the adjusted cost of capital derived from the new
methodology affects the valuation of a particular project.
Q1.
• What was AES’s original business and how did it change?
Blank PPT for Discussion
AES’s four types of businesses
• Contract Generation – Supplied power under long term contracts
• Competitive Supply – Provided electricity on the spot market or
through short term contracts
• Larger Utilities – Included AES’s regulated power companies in the US,
Brazil, and Venezuela.
• Growth Distribution- Power business in emerging and less developed
markets around the world, including China.
AES Transformation
• AES grew from a domestic firm in a regulated industry to an
international company with businesses ranging from large utilities in
industrialized countries to power supply business in emerging
markets.
 AES in 1980s

• Revenues
Costs
• $ based AES $ based
Fixed by long term
• Long term contracts contracts
AES’s Business Transformation..

Costs
Revenues Largely US $
- Multiple local based
currencies AES as an International  Mainly fixed
- -Determined Business by long term
by both spot contracts
prices and long
term contracts
 Blank PPT for Discussion
• Q. What are the key principles of AES’s Capital budgeting approach?
What are the key principles of AES’s Capital budgeting approach?

Three Basic Principles –

1. All flows were considered equally risky.
2. All non-recourse debt was deemed good.
3. A 12% discount rate was used for all projects.
Q. Did this approach to capital budgeting make sense in the context of
AES’s world in mid -1980s?
Q. How was the AES business in 1980s?
Q. Did this approach to capital budgeting make sense in the context of
AES’s world in mid -1980s?

• Predictable US dollar revenues

• Long term contracts
• Regulated electricity prices
Capital Budgeting ?
• Predictable US dollar costs
Q. What about Capital Budgeting Approach
in 1990s (after AES got transformed)?
Costs
Revenues Largely US $
- Multiple local based
AES as an International
currencies  Mainly fixed
Business
- -Determined by long term
(Contract Generation, Large
by both spot contracts
Utilities, Competitive Supply,
prices and long
and Growth Distribution)
term contracts

Three Basic Principles of Capital Budgeting –

1. All flows were considered equally risky.
2. All non-recourse debt was deemed good.
3. A 12% discount rate was used for all
projects.
Blank PPT for Discussion
What was AES doing prior to its
implementation?
• Discounting dividends at parent level 12%.. When does this make
sense?
• In the early US business, $/Fixed revenues and $/Fixed Costs
• But soon they are applying this to business, where Local/Flexible
revenues and $/Fixed Costs
• This is now a very different set of risks!!
• on the top of that, the 12% was applied atop a pyramid of sorts…
• Thus, AES became a highly levered play on local currencies…
 Review Investment Structure of AES (As
given in Exhibit 6).
• Also Review AES Stock Price History as Given in Exhibit 4.
Holding Company Structure of AES and Its
Capital Budgeting.

US Parent A L+NW

Latin
American
Holding A L+ NW
Company

Operating Operating A L + NW
Company Company
Some Questions.
• How this picture helps explain why AES skyrocketed in the late 1990s
and faltered so severely in the early 2000s?
• How does a 12% rule on equity dividends to AES translate into
required returns on the operating assets?
A. Operating assets are expected to earn 12%? OR
B. Operating assets are expected to earn more than 12%? OR
C. Operating assets are expected to earn less than 12%?
Holding Company Structure of AES and Its Capital
Budgeting (12% return on the dividend stream)

US Parent A L+NW

(12% Ke) WACC = Ke*We + Kd*Wd

Latin
American
Holding A L+ NW
Company

(12% Ke) WACC = Ke*We + Kd*Wd

Operating Operating A L + NW
Company Company
AES Structure and Capital Budgeting
• AES’s requirement of 12% return on its dividend stream translated
into operating subsidiaries effectively using substantially lower hurdle
rates for their operating assets.
• Such a practice encouraged non-recourse debt as a means of creating
12% returns rather than seeking projects that might independently
have produced such returns.
Q. How so many lenders were willing to lend capital to these holding
companies at relatively reduced rates?
AES Becomes a levered play on emerging
markets and local currencies..
• While non-recourse debt was helpful in limiting liability for the
parent, it also allowed AES to become a levered play with lots of
dollar debt supporting a local currency/emerging market revenue
stream.
• This helps explain why AES’s market capitalization boomed with
emerging markets.
Q. Then why did the AES’s market capitalization burst with the turn of
the decade?
Q. Then why did the AES’s market capitalization burst with the turn of the decade?

• Currency Devaluations (Emerging Markets)

• Adverse Regulatory Changes
• Commodity Price Decline
What is the problem??
• Designing a methodology where businesses operating in different
settings can be valued simultaneously.
• How to develop a rigorous methodology of evaluating these risks?
The Proposed New Methodology
Q. What is the new methodology supposed to accomplish?
 What does the new methodology do? (1) Ke
• Apply WACC to the operating company flows!
• WACC = [We x Ke + Wd x Kd]
• Where do I get cost of equity for Pakistan from?
• First, let’s get the cost of equity as if project was in U.S…
• KeUS = Rf + βe (Rm – Rf) using βe = βAssets/E/V
• Then, let’s add on the risk of operating in Pakistan using a “sovereign
spread”…..
• KePakistan = KeUS + SS = KeUS + (RfPakistan – RfUS)
• {βL = βU x (1 + (1-T) x D/E}
Un-levered (Asset) Beta for AES Businesses

Exhibit 7b AES Selected Financial Data

Select Financial Information  

10 Year US Treasury Bond 4.50%

US Risk Premium 7.00%

Un-levered Equity Betas by Line of Business

Contract Generation 0.25

Large Utility 0.25

Growth Distribution 0.25

Competitive Supply 0.50

What does the new methodology do? (2) Kd
• WACC = [We x Ke + Wd x Kd]
Exhibit 9b EBIT Coverage Ratios and Default Spreads

• Kd = Rf + Default Spread
Credit EBIT Coverage
US Rating Ratio Default Spread
Aaa 21.1x 0.20%
Aa1 15.1x 0.30%

• KdPakistan = KdUS + SS = KdUS + (RfPakistan – RfUS) Aa2

Aa3
A1
10.9x
8.1x
6.3x
0.40%
0.60%
0.70%
A2 5.2x 0.90%
A3 4.6x 1.20%
Baa1 4.2x 1.50%
Baa2 3.9x 1.90%
Baa3 3.6x 2.30%
Ba1 3.2x 2.90%
Ba2 2.6x 3.60%
Ba3 1.9x 4.30%
B1 1.0x 5.20%
B2 0.8x 6.20%
B3 0.6x 7.40%
Caa1 0.4x 8.60%
Caa2 0.1x 10.00%
Caa3 0.1x 11.40%
AES Projects, Default and Sovereign Spreads
Business / Project Country Line of Business Tax Rate Debt to Cap. EBIT Coverage Default Spread Sovereign Spread
Andres Dominican Republic CG 0.25 0.351 3.0x 0.0357 0.0893
Caracoles Argentina CS 0.35 0.408 3.0x 0.0357 0.1625
Drax United Kingdom CS 0 0.295 3.0x 0.0357 0
Eletropaulo Brazil LU 0.34 0.3 3.5x 0.0289 0.0893
Gener Chile CG 0.17 0.352 2.5x 0.0434 0.0173
Haripur Bangladesh CG 0 0.333 2.5x 0.0434 0.0523
Kelvin South Africa CG 0.25 0.329 2.5x 0.0434 0.0314
Lal Pir Pakistan CG 0.23 0.351 3.0x 0.0357 0.099
Los Mina Dominican Republic CG 0.25 0.287 4.0x 0.0185 0.0893
OPGC India CG 0.079 0.304 3.0x 0.0357 0.036
Ottana Italy CS 0.35 0.425 2.5x 0.0434 0.0014
Red Oak USA CG 0.375 0.395 3.0x 0.0357 0
Rivnoblenergo Ukraine GD 0.3 0.365 2.5x 0.0357 0.0998
Telasi Georgia GD 0.2 0.261 4.0x 0.0185 0.0998
Uruguaiana Brazil CG 0.34 0.322 4.0x 0.0185 0.0893
What does the new methodology do? (3)
putting it together..
• WACC = = D/V*Kd + E/V*Ke + Idiosyncratic Risk Measure
• Where do Idiosyncratic risk measures Comes from??
• Subjective assessment according to risk criteria (operations, currency
etc.)
• Scaled between 0 and 3
• Mapped to 0 to 1500 bps additional risk premia..
Calculation of Idiosyncratic Risk Scores for
AES Projects
Risk CategoryWeight Andes Caracoles Drax Haripur Lal pir Red Oak
Operational 3.50% 3 2 2 0 1 2
Counterparty 7.00% 3 0 2 1 1 3
Regulatory 10.50% 3 2 2 1 2 0
Construction 14.50% 3 3 0 0 0 0
Commodity 18.00% 3 1 3 2 1 2
Currency 21.50% 3 2 0 1 2 0
Legal 25.00% 3 2 2 0 2 0

Risk Score 3 1.825 1.46 0.75 1.425 0.64

Risk Adder 5% 15.00% 9.13% 7.30% 3.75% 7.13% 3.20%
Does this Methodology Make Sense?
• Where did 1500 bps comes from? 0-3 comes from?
• Should Idiosyncratic risk be in there?
• How do you know what these add-on’s are doing?
• Are we double counting? Triple counting?
• Should we do this is cash flows or discount rate?
• Why can’t we trust them to do it in cash flows?
• But what happens if they know its in discount rates?
• How does these add-on’s translate into changed probabilities of
specific events?