Globalizing the Cost of Capital and Capital Budgeting at “AES” Harvard Case Solution & Analysis

Globalizing the Cost of Capital and Capital Budgeting at “AES” Case Study Solution

Historical Capital Budgeting Method:

AES had constructed a capital budgeting model at its parent company to facilitate its stand in the domestic market. Since AES operated within one country and dealt with same economic conditions throughout, it smartly used same discount rate of 12% in all its projects (i.e. Red Oak). The level of risk in dividend flows was considered equally at every project and therefore considered the same discount rate, which based on equity. All debts were non-recourse and were deemed good by its Venerus- director of the Corporate Analysis and Planning group of AES- and also Venerus decided to apply the same model to its new overseas subsidiaries.

Having the same model for different countries is only effective when each country has same economic conditions, regulations and same market, which is highly unlikely. AES may have successfully avoided the risk attached to market initially, but this could not go forever, and this is exactly what happened. Once the market started facing disruptions, AES’s model became less and less effective. To entertain the market variations, AES must have had a capital budgeting model that reflects market standards and not just take the general assumptions.

The decision of assuming the same risk for all its dividends can only work if all subsidiaries belong to the same region, same market and face same economy, which was good enough for Red Oak. But here AES has expanded its operations to more countries, and therefore AES should have had separate discount rates to treat various risk in different markets.This is probably the reason why AES failed to balance itself against the currency crises in Argentina where 50 percent depreciation in currency against US dollar lead to AES in recording$456 million of loss in 2002.

In addition to same discount rate strategy, another unwise decision was to keep all its subsidies on non recourse-debt. This means that the parent company was not obligedfor any of its subsidiaries debts.

The damage increased when the AES’s subsidiaries in South America defaulted on its debt and needed some help from its parent, which ultimately affected AES through unexpectedly low dividends in the following year.

Although most of the situations related to currency and economic crises were out of AES’s control, it could have minimized its losses (i.e. of $2.3 billion) if it were to use relevant capital budgeting models for each of its markets.

Overall AES performed better than good at its initial stages but could not hover the position for long, in both markets- domestic and overseas.

Relating this to Red Oak (Local Subsidiary), AES can evaluate that Red Oak has high tax rates and is operated under high gearing structure. Red-Oak’s default spread is 4% and has case business-specific risk of 1.18. Initially, the discount rate of 12% seem considerable for Red Oak, as it belongs to the USA, but this may change if the country faces economic crises or reflects a global down fall.

Q-3) Does this make sense as a way to do capital budgeting?

Capital Budgeting for Lal pir:

Table A represents the business-specific risk for the Lal-Pir project computed through a risk score calculation.All seven categories of every project are evaluated by their relativeness to the project. These categories are further scored on a scale of 0 to 3, where 0 represents to minimum exposure, and 3 defines the maximum exposure of the Lal-Pir project about each category.

Operation/Techincal risk:

Operational risk relates to the risk of failing to meet a contractual obligation, by generating enough electricity as required by the contracting party. Lal-Pir accounts for 3.5% operational/technical risk, which is comparatively the lowest of all other risks. Lal-Pir’s debt to equity is 35% which although high but not too high to risk its survival, which means that Lal-Pir does not face major threat to its going concern. Lal-Pir’s nature of being a contract generation must have given it an early view of how much and in what variations does its contractual party need it to produce until the end of the contract period. In other words, Lal-Pir’s operational team must have made early arrangements for the resources it will need to fulfill its side of the bargain, which makes it very likely the lowest risky category on the chart. Even after all the arrangements, Lal-Pir does face an average exposure to the risk and so remains at 3.5% or .035.

Counter party Credit/Performance risk:

Counter party Risk relates to the risk of not being able to recover its debts or receive the services promised by its supplier. Although not as low as operational risk, counter party risk seems to be low for Lal-Pir. This indicates that either Lal-Pir has strong control over its credit policies or its debtors have a strong reputation for paying back their dues.  In either case, Lal-pir is facing a balanced exposure to this risk, which is ultimately contributing 0.075 to its business-specific risk.................

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