Project #47362 - Cost of Capital and Capital Budgeting at AES

Explanation: I need the remaining question answered in blue (for the AES case study) that have not been answered. The ones that have been answered reviewed to make sure they are correct. At the bottom I need a powerpoint with bullet points on the section I have marked powerpoint. The ppt do not have to be detailed...I need powerpoint bullent points for 2nd case study


Powerpoint AES case study


AES is a global power firm with operations in 30 countries and on five continents. The company operates in four business segments: utilities, contract generation, competitive supply and growth distribution. After going public in 1991, AES grew rapidly with much of its growth coming from its international expansion. The global economic downturn that began in late 2000 had a severe impact on AES. The company was hit by currency devaluations in South America, Lower energy prices, and changes in the regulatory regimes for energy in some countries. AES’s deteriorating performance led to a steep decline in its stock price and the company’s market capitalization fell almost 95% over a two year period.

The financial crisis led AES to create a new planning group, charged with valuing the company’s assets and developing a methodology for calculating the cost of capital for AES’s diverse businesses around the world. In the past, AES had used a 12% cost of capital to evaluate all projects worldwide. 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 specific to a project into the cost of capital for each project. Venerus has to decide if this approach , designed to provide a more accurate financial assessment of the company’s diverse international businesses, would actually improve AES’s financial decision making.


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Cost of Capital and Capital Budgeting at AES

1)    How would you evaluate the capital budgeting method used historically by AES? What’s good and bad about it?

Historically, the AES capital budgeting method primarily used the following assumptions: • All nonrecourse debt was regarded as good

• Dividend cash flow were considered equally risky

• Project was evaluated by the equity discount rate for the dividends from the project

• A 12% discount rate was applied to all projects.

The historical method is quite simplistic in terms of project evaluation as it ignores the volatility in the market and the economy, it is more suited to a domestic market and a constant discount rate across all projects is usually unrealistic as projects usually have varying risks and specific considerations which arise.

Although the reason for AES to use this methodology is due to its business operation of domestic contract generation projects where they believe the price-change risk is minimal, the volatility can still be considerable if the economic outcomes are not as accurate as predicted. This may lead to the nonrecourse debt that is riskier than originally thought, and it will affect the business operations (e.g. lack of cash flow). The assumption of equal risk of dividends is subject to the economy and the longer time it is into the future, the more risk will be involved as the uncertainty and accuracy of dividend prediction is larger. Hence a constant 12% discount rate does not take account of these factors mentioned above. There also there are other risks involved:

• For various projects, different location within the world will trigger different risks

o Regulatory (e.g. tax differences across different states)

o Operational risk (e.g. different projects requiring different cooperation between the divisions, and a ranking to the importance of different division will result in the different operational risk)

o Political (e.g. unstable or corrupt governments usurping project assets)

To summarise the pros and cons of the historical method:


• Easy to compute and use in the project evaluation

• Makes all projects seem comparable to other projects

• Can be a good indicator in a good economy


• Method is detached from reality

• Ignores the fact that economy is not good all the time and prediction can be inaccurate

• Distant dividend risk is hardly evaluated but assumed constant in this method

• A constant discount rate ignores the fact that different projects involve different risk (e.g. operational risk, market risk (e.g. different prices for raw materials at different times), regulatory risk, credit risk (e.g. bank’s willingness to lend the money to company for one project in a bad economy)

• Ignores the priority in deciding which risk is relating to the project and company in the process of determining the discount rate (as it assumes 12% constant rate)

2) Explore the problems faced by the managers who have to calculate different types of projects across countries with different political and economic characteristics.


3) If Venerus implements the suggested methodology, what would be the range of discount rates that AES would use around the world?


Based on the calculation of the various discount rates for all AES projects, the discount rates range from a high of 17.13% to a low of 6.78%.

4) Evaluate the approaches to capital budgeting used by a global firm.

5) Does this make sense as a way to do capital budgeting? Justify your answer.


Technically, given the individual rationale for each risk measure in the new adopted methodology of AES, the procedure proposed makes sense.

Accounting for the default risk spread and sovereign risks makes intuitive sense, as these are obvious risks faced by the company in various countries. Next, given the perceived difficulty of predicting expected project specific cash flows, and the need to somehow account for unsystematic risks which the manager believes cannot always be diversified, an attempt has been made to calculate probability weighted business risk; this is a very effective way to calculate a business risk premium, provided the risks identified are collectively exhaustive, and the weightings are accurate. If there are risk factors omitted, or if some of the risk factors are under-weighted or over-weighted, the premium becomes inaccurate and can sometimes lead to bad decisions by management.

2 additional major points which need to be addressed:

1. Initially, AES assumed non-recourse debt, i.e. the failure of one project should not have ideally affected the parent company and consequently other projects. However, during the downturn, it was clear this did not happen. Individual projects did have an exposure to the parent's health (which depended on dividend flow from various other subsidiaries). AES itself borrowed at the parent level to fund holding companies and subsidiary projects, and the ability to borrow efficiently depended on its consolidated balance sheets which were significantly dependant on the subsidiaries' financial health.

Thus a weighting of risk exposure to other projects needed to be taken into account.

2. The sustainability of maintaining a matrix of risk ranks and probabilities is not clear. While the method makes sense, it needs to been evaluated in terms of whether AES is trying too hard to capture the business risks, or if they are successfully doing so. As mentioned above, sovereign specific risks would account for a majority of the common risk factors accounted for in the business risk. Hence, we need to ask whether AES intends to update the risk factor ranking regularly because the probability matrix depends on changing economic and business conditions.

6) Calculate the cost of capital for 15 projects around the world using a methodology that incorporates country risk and other type of risks that arise in international investments into each project’s cost of capital.

7) Determine how the adjusted cost of capital derived from the new methodology affects the value of a particular project.

8) 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?


9) 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.?


The adjusted cost of capital consists of sovereign risk, default risk, business risk and project-specific capital structure.

Regarding the Pakistan project, the rate firstly reflects the specific country risk by adding a sovereign spread to both cost of debt and cost of equity. It is the extra return for doing project in that specific country. Secondly, the adjusted rate adds default spread to the cost of debt. It is the extra required return for the possibility of debt default. Thirdly, the new rate also directly adds undiversifiable project specific risk, also known as business risk, to the cost of capital. This addresses the risk of specific risky events by allocating grades and weights based on the relevance of the risk. The events cover varied areas, and indicate the possibility of adverse movements in areas like currency, regulation, contracts and operations.

B) What does the discount rate adjustment imply about expectations for the project because it is located in Pakistan and not the U.S.?

According to the above calculation, the difference between the US and Pakistan cost of capital is mainly varied in 2 aspects:

1) The sovereign risk premium. Pakistan has a sovereign premium of 9.9%, while the US is zero. The reason is obvious, as in this case, US is considered as the benchmark of sovereign-risk-free countries. It also shows that there is more risk to take out project in Pakistan compared to in US. Examples of sovereign risk events include the war, political issues and default in government bonds.

2) The business specific risk premium. The Pakistan project has a higher score than the US project, which makes its business risk premium higher. When taking a deeper analysis, we can also see that the US project has a high risk in construction, counterparty and commodity, while the Pakistan project has a higher risk in regulatory, currency, contract and legal aspects. This implies an expectation that when compared to the US project, the project in Pakistan may have a higher probability of currency turbulence (deflation), adverse or conservative regulation policy after investment and failure to enforce the local contracts.

10) Assess the broader implications of using sovereign spreads and idiosyncratic risk factors to evaluate international projects



Second case ppt only:


In 1995, the Argentine government announced plans to privatize 51% of PBB, a company that produced ethylene and polyethylene. Dow Chemical managers are considering bidding on the privatization and, in the process, must consider how to incorporate the risks of the acquisition and its long-term potential into a valuation. The acquisition of PBB would make Dow the leading polyethylene producer in Latin America.

PBB is an attractive investment to Dow on several counts. Polyethylene is used mainly in packaging, and the Latin American market for the product is projected to grow substantially as standards of living improve and consumers demand high-quality packaging. Argentina appears to have achieved some economic stability in recent years, with the peso currently pegged to the U.S. dollar and the government committed to a program of economic reforms. The PBB production facilities, however, need to be upgraded to world standards and Dow anticipates that additional investments in capacity will be required to consolidate its market position in polyethylene. The overall project, therefore, includes investments in addition to PBB and this makes the valuation more complex. Given Argentina’s long history of economic turmoil, Dow’s executives have to consider how risks such as currency crisis will affect the project. The Dow executives need to identify the project’s key risks, decide how to incorporate these risks in the valuation, and determine what to bid for PBB.


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Due By (Pacific Time) 11/13/2014 06:00 pm
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