Globalization of cost of capital and capital budgeting Harvard Case Solution & Analysis

Globalization of cost of capital and capital budgeting Case Solution

Introduction of AES Corporation

                After AES Corporation will come into existence, it will become the largest electricity supplier in the world having operations in 33 different countries and AES has more than $33 billion assets worldwide. Consistently, AES is deciding regarding the low cost and better utility electrical power supply to the consumers, which would provide improve the name of the company. After capturing the US market, AES seeks the opportunity from developing countries. AES enters in different markets through acquisitions, partnerships, capital projects, power generation projects and making subsidiaries in different countries. AES Corporation is divided into four lines of business: contract generation, competitive supply, utilities and growth distribution.

Contract generation division requires long term contracts of power supply, which include mega projects such as 2560MV project in Brazil. Contract generation division provides 29% of the total revenue to the company as well as it takes a lot of shares in the overall overheads of the company. Long term contracts provide prospective decision making for AES and better avoidance of risk of volatility of electricity prices.

Competitive supply uses the strategy of targeting the small businesses and merchandisers by giving short term contracts of power supply. This division provides 21% of the total revenue of the company, however it is also facing numerous risks like fluctuation in interest rate, coal prices, fuel prices, natural gas prices and other raw material prices. Changes in electric market regulations, Competition and weather conditions also threaten the business revenue of competitive supply.

Case environmentand problems facing by AES

The major revenue of AES Corporation is derived from developing countries where the demand of electricity is higher than the developed country. Subsidiaries of AES Corporation are facing different local challenges, which affect the parent company such as changes in energy regulations, declining in energy commodity prices and devaluation of currencies. These issues will lead the company towards loss in market capitalization about 95% which indicates that currently it stands at $1.9 billion, which shows that investors’ confidence on AES is heavily declining.

During the financial crisis faced byAES Corporation, it evaluated the new strategy for valuing the assets in different companies by new and appropriate cost of capital; this is a major issue for AES tolocally find appropriate cost of capital. Adverse foreign exchange fluctuation would lead to huge losses for AES Corporation as it has portfolio of projects in different countries.

Loss of $456 million from foreign exchange fluctuation has raised a question question on the company’s ability to run as a going concern.The loss of $756 million is due to the adverse changes in regulation of Brazilian regulatory authorities. Changes in regulation of the UK would also give high competition and lower prices. Almost 30% decline in prices will threaten the margins of electricity utilities, in fact due to these changes, the company suffers from losses.

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

AES corporation uses traditional method of capital budgeting, which includes similarities in different projects operates in different continents of the world. By using 12% discount rate for all projects to discount the dividend flows to the parent company, capital budgeting can be done by AES corporation. This method has its own limitations like different countries are having different problems such as political, social, legal, environmental, technological issues. Applying the 12% discount rate on all projects in different countries is not appropriate because in developing countries, there are numerous fluctuations in economic indicators as compared to developed countries.

The discount rate computes present value from future flows; if the incorrect discount rates have been taken, then the present value computed is also not correct. It also indicates that the project will generate the expected return however, due to high cost of local capital it will provide negative present value which would decrease the company’s value overall. Although the dividend flows taken into calculation of NPV of the project is very much relevant as it indicates that cash flows after deducting all relevant expenses, are only relevant to the parent.................

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