Evaluation of Historical Capital Budgeting Method Used by AES: Pros and Cons
Added on 2023-06-15
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How would you evaluate the capital budgeting method used historically by AES? What is
good and bad about it?
Capital budgeting at AES was used for all projects being examined, regardless of location. This
method entailed four rules which were: all recourse debt was deemed good, the economics of a
given project were evaluated at an equity discount rate for the dividends from the project, all
dividend flows were considered equally risky, and a 12% discount rate was used for all projects.
This method worked flawlessly when implemented in the U.S., but when it began being applied
to international projects, it gave the company unrealistic NPV’s. While some concern existed,
having no alternative, they continued to use the original method. By failing to take into account
increased WACC, currency risk, political risk, and sovereign risk, the company developed
projects that soon began to fail. This in turn, destroyed its stock price and market capitalization,
costing them millions in shareholders equity.
Principal Advantages
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
good and bad about it?
Capital budgeting at AES was used for all projects being examined, regardless of location. This
method entailed four rules which were: all recourse debt was deemed good, the economics of a
given project were evaluated at an equity discount rate for the dividends from the project, all
dividend flows were considered equally risky, and a 12% discount rate was used for all projects.
This method worked flawlessly when implemented in the U.S., but when it began being applied
to international projects, it gave the company unrealistic NPV’s. While some concern existed,
having no alternative, they continued to use the original method. By failing to take into account
increased WACC, currency risk, political risk, and sovereign risk, the company developed
projects that soon began to fail. This in turn, destroyed its stock price and market capitalization,
costing them millions in shareholders equity.
Principal Advantages
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.
Complexity
Financing of projects requires involvement of a number of parties. They can be quite complex
and can be expensive to arrange. Secondly it demands greater amount of management time.
Macroeconomic Risk
The current methodology employed by AES for capital budgeting does not take into account the
exchange rate risk. This risk will be of higher magnitude in the developing countries because of
their unstable monetary and fiscal policies. 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 becomes important when the exchange rate fluctuation affects balance
sheet items unequally. Thus keeping check on the foreign exchange rate requires timely
adjustment of both the items of revenue and expenditure, and those of assets and liabilities in
different currencies.
Political Risk:
This is another important factor which the current financial management system does not take
into account. This will be of significant importance when it comes to investing in developing
countries where frequent changes in government policies occur.
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
drastically due to a change in WACC. To find WACC we must first calculate the leveraged
betas for each the US Red Oak and Lal Plr Pakistan projects, the equation unleveled beta/1-(debt
to capital) will be used. The unleveled beta can be found in exhibit 7b, and is .25 for both
projects. The debt to capital ratios can be found in exhibit 7a, for the U.S. it is 39.5%, and for
Pakistan it is 35.1%. By plugging the numbers into the equation a leveraged beta can be found
for the U.S. it is .41, and for Pakistan it is .3852.
The next step would be to find the cost of capital which is ultimately different for each country,
but uses the U.S. risk free and risk premium rates, because all debt is financed in USD. The cost
of capital is equal to U.S. T-bill+ leveraged beta (U.S. risk premium). For the U.S. project it is
4.5%+.41(7%) which is equal to 7.37%. For the Pakistan project it is 4.5%+.3852(7%) which is
equal to 7.2%.
Now the cost of debt must be found, by using the formula U.S. t-bill+ default spread. Both the
U.S. and Pakistan projects have equal spreads of 3.47%, therefore both yield the same cost of
debt. Plugging in the numbers you have, 4.5%+3.47% which is equal to 8.07%. This clearly
does not make sense given the vast differences in the markets structure of each country, the
political risk involved.
being influenced by multiple factors due to the increase in depth and breadth of the organization.
Complexity
Financing of projects requires involvement of a number of parties. They can be quite complex
and can be expensive to arrange. Secondly it demands greater amount of management time.
Macroeconomic Risk
The current methodology employed by AES for capital budgeting does not take into account the
exchange rate risk. This risk will be of higher magnitude in the developing countries because of
their unstable monetary and fiscal policies. 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 becomes important when the exchange rate fluctuation affects balance
sheet items unequally. Thus keeping check on the foreign exchange rate requires timely
adjustment of both the items of revenue and expenditure, and those of assets and liabilities in
different currencies.
Political Risk:
This is another important factor which the current financial management system does not take
into account. This will be of significant importance when it comes to investing in developing
countries where frequent changes in government policies occur.
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
drastically due to a change in WACC. To find WACC we must first calculate the leveraged
betas for each the US Red Oak and Lal Plr Pakistan projects, the equation unleveled beta/1-(debt
to capital) will be used. The unleveled beta can be found in exhibit 7b, and is .25 for both
projects. The debt to capital ratios can be found in exhibit 7a, for the U.S. it is 39.5%, and for
Pakistan it is 35.1%. By plugging the numbers into the equation a leveraged beta can be found
for the U.S. it is .41, and for Pakistan it is .3852.
The next step would be to find the cost of capital which is ultimately different for each country,
but uses the U.S. risk free and risk premium rates, because all debt is financed in USD. The cost
of capital is equal to U.S. T-bill+ leveraged beta (U.S. risk premium). For the U.S. project it is
4.5%+.41(7%) which is equal to 7.37%. For the Pakistan project it is 4.5%+.3852(7%) which is
equal to 7.2%.
Now the cost of debt must be found, by using the formula U.S. t-bill+ default spread. Both the
U.S. and Pakistan projects have equal spreads of 3.47%, therefore both yield the same cost of
debt. Plugging in the numbers you have, 4.5%+3.47% which is equal to 8.07%. This clearly
does not make sense given the vast differences in the markets structure of each country, the
political risk involved.
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