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

In this solution we will discuss about capital budgeting method and below are the summaries point:- AES historically used a project finance framework for domestic projects with minimal price risk, which maximized leverage and provided off-balance sheet treatment. Advantages of this approach include agency cost reduction and access to multilateral financial institutions. Disadvantages include project versus division conflicts, complexity, macroeconomic risk, and political risk. Implementing the suggested methodology would result in different discount rates for AES projects globally, with a significant difference between the US and Pakistan projects, favoring the US project. However, the project finance approach may not be suitable for AES's diversification efforts due to increasing symmetrical risks.

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

are 8.07% (4.5%+3.47%), in which both U.S. project and Pakistan project have a same spread,
3.47%. To adjust we add the sovereign risk into calculation. In Exhibit 7a, the sovereign risk for
the U.S. is 0% but for Pakistan is 9.9%. We thereby get the new evaluation of the cost of capital
and cost of debt, which are constant for U.S. and rise to 17.1% and 17.97% for Pakistan. Finally
we calculate the WACC. The formula is leveraged beta * (cost of capital) + Debt to capital *
(cost of debt) * (1-tax rate). Then we get for the U.S. WACC= 6.48% and for Pakistan WACC=
15.93%. Finally, we should adjust the WACC with its risk score. Because everything is calculated
in U.S. dollar, the U.S. risk score is 0. So the U.S. projects WACC is constant. The Pakistan risk
premium is 1.425. So the change is 1.425 * 500= 705bp = 7.05%. Therefore, we get the final
Pakistan WACC, which is 23.08% (15.93%+7.05%). In conclusion, the difference between the
U.S. and Pakistan projects is 16.60%. Obviously, the U.S. project looks much more favorable.
3. Does this make sense as a way to do capital budgeting? The financial strategy employed by
AES was historically based on project finance. The model worked well in the domestic market
and in the international operations. However, when AES started its diversification of business, it
had to face to increasing symmetrical risks, such as business risk. In addition, project finance did
not include 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. And AES should also pay attention to political risk. Hence we see that the
geographical diversification of business made project financing less recommendable as a
symmetrical risk becomes more manifest.
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? In order to
calculate the value of project for the Lal Pir project in Pakistan, we first need to calculate the
Weighted Average Cost of Capital (WACC) using the new proposed methodology. The first step
is to calculate the value of levered β. The value of the levered β comes out to be 38.52%, which
essentially means that our project is not very highly correlated to the market return. Using this
value of β we now calculate the cost of Equity. We have used the return on U.S. Treasury Bond,
which is 4.5%, as the risk free return. The cost of equity comes out to be 7.2% and similarly,
using the risk free return and the default spread we calculate the cost of debt which comes out
to be 8.07%. It is important to note that the cost of debt and the cost of equity also need to be
adjusted for the sovereign spread. Once we have the adjusted costs of equity and capital, the
WACC comes out to be 15.93%. However, now we need to adjust this WACC for the risks
associated with doing the project in Pakistan. As mentioned in part 2, we get final WACC
23.08%, which lead us to calculate NPV from the year 2004 to 2023. And it is -$234.34 million.

For U.S., first we see the sovereign spread is equal to zero. Secondly, in this case we would need
to calculate the business risk using the information given in Exhibit 7a.This score comes out to
be 0.64 and using this score, our business risk comes out to be 3.23% and adding it to
calculated value of WACC, we get our final WACC of 9.64%. Using this we calculate our NPV for
USA which comes out to be -$35.92 million.
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.? To calculate the adjusted cost of capital, we
should adjust six common types of risks: Operational, Counterparty, Regulatory, Construction,
Commodity, Currency and Legal. In Pakistan, it is possible to meet all these risks except
construction. Additionally, the highest probability is the legal risk. When we calculate the WACC
for Pakistan through traditional formula it comes out to be 15.93%, however in order to
incorporate the risk factor associated with Pakistan we need to adjust it for the Total Risk Score,
which in this case is 1.425. So we need to adjust our WACC 23.08%. As mentioned earlier the
discount rate is adjusted based on the total risk score of the country. This total risk score is
compiled from 6 main types of risks, the probability of which varies from country to country.
While currency, regulatory and legal risks are significantly high in Pakistan, the operational,
counterparty and commodity risks are higher in U.S.. Similarly when come to the adjusted
WACC for Pakistan (23.08%) and WACC for U.S. (6.48%), we can conclude that Pakistan is much
riskier to invest than the U.S..