Evaluate AES's Capital Budgeting Method: Advantages, Disadvantages, and Adjusted Cost of Capital

Aes Case Solution
1. How would you evaluate the capital budgeting method used historically by AES? What’s good
and bad about it? “When AES undertook primarily domestic contract generation projects where
the risk of changes to input and output prices was minimal, a project finance framework was
employed.” Usually, project finance framework is used when the project has predictable cash
flows, which can easily represent operating targets through explicit contract. When cash flows
are certainty, the company can have higher level of leverage and it is easier to separate project
assets from the parent company.
Advantages and Disadvantages:
1) Advantages
a. Maximize Leverage
b. Off-Balance Sheet Treatment
c. Agency Cost
d. Multilateral Financial Institutions
2) Disadvantages
a. Projects V/S Division
b. Complexity
c. Macroeconomic Risk
d. Political Risk:
2. If Venerus implements the suggested methodology, what would be the range of discount
rates that AES would use around the world? If Venerus and AES implement the suggested
methodology, the projects would change while WACC changes. To find WACC we must first
calculate the leveraged bets for each the US Red Oak and Lal Plr Pakistan projects, using the
equation unleveled beta/(1-D/V). It is easy to find debt to capital ratios, which are 39.5% for U.S
and 35.1% for Pakistan, and the unleveled beta, which are both 0.25, in Exhibit 7a and 7b. Then
we can obtain a leveraged beta for the U.S., 0.41, and for Pakistan, 0.3852. Second we should
find the risk free and risk premium rates. Because all debts are finance in U.S. dollar, we use the
risk free rate, which is equal to U.S. T-bill, and risk premium rate, which is equal to U.S. risk
premium, to calculate the cost of capital for all countries. Using equation cost of capital = Risk
Free Rate + levered beta * Risk Premium, we can get the cost of capital for U.S. project, 7.27%,
and for Pakistan project, 7.2%. After that we should find the cost of debt. Using the formula risk
free rate + default spread, we can get the cost of debt for both U.S. project and Pakistan project