23 Jun 2010

Sample Essay: Globalizing the Cost of Capital and Capital Budgeting at AES

Before setting up business either international or local, there are some factors to put into consideration. Even if your business is doing well and expanding at a high rate one must put into consideration the risks that ascertain that particular business. In the case of the AES, the founders did not put much consideration into their expanding business to the overseas accounts. Their main undoing was the assumption of the risks involved as same as in the U.S as it were in the foreign countries. The AEs had its majority revenues linked to overseas operations with approximately one-third coming from South America alone. Since the company depended on these operations almost wholly, any changes involved as per this could have affected them greatly. And that’s why the company’s international exposure hurt AEs during the global economic downturn that began in late 2000.

In addition, they did not take into consideration that as a global company with operations in countries that are hugely different from the U.S they needed a more sophisticated way to think about risk and the cost of capital around the world. besides,, with AES’s international expansions, the model of capital budgeting was not supposed to be exported to projects overseas, since the same model became increasingly strained with the expansions in brazil and Argentina because hedging key exposures such as regulatory or currency risk was not feasible. In addition, the financial structure of a going-concern business like a utility was notably different than that of a limited-lifespan asset like a generating facility.

factors such as the devaluation of key south American currencies, especially during 2001, when a  political and economic crisis in Argentina brought about a significant devaluation of most south American currencies against the U.S. dollar, conspired to weaken cash flow at AEs subsidiaries and hinder the company’s ability to service subsidiary and parent-level debt. This was much evident in December, the same year, when the newly elected government abandoned the country’s fixed dollar-to-argentine-peso exchange rate (1:1) and converted us. dollar-denominated loans into pesos. This resulted to the peso losing 40% of its value against the U.S dollar. In addition, the currencies in Brazil and Venezuela followed suit, with the Brazilian real and the Venezuelan Bolivar each depreciating approximately 50% against the us. dollar during the same period. As a result, AEs recorded foreign currency transaction losses of $456 million in 2002, creating an influx of financial problems to the company. the subsequent impact of the apparent devaluation was increased when foreign businesses were paid in local currency but had obligations to repay debt denominated in U.S. Dollars.

besides this, the adverse changes in energy regulatory environments especially in brazil, when it had failed to produce a market structure sufficiently attractive to encourage domestic construction of new generation assets, the demand exceeded supply, causing shortages. this created the loss of sales volume when it started a power rationing program due to short rainfalls; the majority of brazil’s generation capacity is hydroelectric, triggering a regulatory conflict concerning the applicable exchange rate for the real-to-dollar energy-cost pass-through provisions in AES’s contract thus resulting to AEs taking a pretax impairment charge of approximately $756 million on the Eletropaulo, one of its major Brazilian businesses.

In addition to AEs woes, was the decline in energy commodity prices. As the earnings and cash distributions to the parent started to deteriorate, AEs stock collapsed and its market capitalization fell nearly 95% from $28 billion in December 2000 to $1.6 billion just two years later. The change in the regulatory regime in the U.K. also adversely impacted AEs by increasing competition and reducing prices in its generation markets. That, along with an unusually warm winter in the U.K., brought wholesale electricity prices down approximately 30%. These pressures caused several counterparties to default on their long-term purchase agreements. This counterpart risk, coupled with changes in the commodity markets, enhanced the financial pressure on AEs facilities, and those that could not sell electricity above their marginal costs were taken off-line or shut down.

To crown it all, overdependence of the company on foreign worlds especially on Competitive supply, Accounting for 21% of AES revenues, was to risky. This was because this depended heavily on changes in the price of electricity, natural gas, coal, oil and other raw materials, weather conditions, competition, changes in market regulations, interest rate and foreign exchange fluctuations, and availability and price of emissions credits. Any chances to this involved price volatility which indented several businesses including the Drax plant in the U.K., the largest plant in AES’s competitive supply fleet. Financially speaking, the company should have reduced its overdependence or did its risk assessment to that effect.

At first the employment of a 12% discount rate was used for all projects. In a world of domestic contract-generation projects where most risks could be hedged and businesses had similar capital structures, that’s why it worked well initially since, capital budgeting at AES was fairly straightforward. When AES undertook primarily domestic contract generation projects where the risk of changes to input and output prices was now increased the situation changed. But the company still held on the economics of a given project was 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 was particularly risky since there were other factors that were different in other projects than others. The model became increasingly strained with the expansions in Brazil and Argentina because hedging key exposures such as regulatory or currency risk was not feasible. In addition, the financial structure of a going-concern business like a utility is notably different than that of a limited-lifespan asset like a generating facility. Nonetheless, in the absence of an academic or other alternative, the basic methodology remained intact. Besides, the ever-increasing complexity in the financing of international operations also contributed to this. From the exhibit 6, this was evident in that, subsidiary A and B were financed with debt that was nonrecourse to the parent. The subsidiaries’ creditors had claims on the hard assets at the power plants but not on any other AES affiliate or subsidiary. The local holding company, which often represented multiple subsidiaries, also borrowed to finance construction or acquisitions and received equity in the various subsidiaries it held. In addition, the holding company had debt that was nonrecourse to the parent, secured by dividends from the operating company. Finally, AES borrowed once again at the parent level in order to contribute equity dollars into holding companies and subsidiary projects. At the end of 2002, AES had $5.8 billion in parent company (recourse) debt and $14.2 billion in nonrecourse debt. Using this subsidiary structure, the parent company received cash flows in the form of dividends from each subsidiary (some of which were holding companies) and, because the structure of every investment opportunity was essentially the same, all dividend flows were evaluated at the same 12%discount rate. This had the benefit of making similar projects seemingly comparable. However, when subsidiaries’ local currency real exchange rates depreciated, leverage at the subsidiary and holding company level effectively increased, and the subsidiaries struggled to service their foreign currency debt. Imagine a real devaluation of 50%. That cuts EBITDA in dollar terms by 50% and coverage ratios deteriorate by more than 50%. The local holding company cannot service its borrowing, and dividends to the parent are slashed. Ultimately the consolidated leverage was well over 80% without any hedging of foreign exchange for any meaningful duration; this is where the model broke down. A calculation of a firm’s cost of capital in which each category of capital is proportionately weighted. All capital sources – common stock, preferred stock, bonds and any other long-term debt – are included in a WACC calculation. All else help equal, the WACC of a firm increases as the beta and rate of return on equity increases, as an increase in WACC notes a decrease in valuation and a higher risk. Venerus’s solution to the problem had to be consistent, transparent, and accessible. He knew his solution would have to account for changes in required returns due to leverage, incorporate some understanding of a project’s risk profile, potentially include country risks, and still provide values that were consistent with market behavior, including trading multiples. Broadly speaking, a company’s assets are financed by either debt or equity. WACC is the average of the costs of these sources of financing, each of which is weighted by its respective use in the given situation. By taking a weighted average, we can see how much interest the company has to pay for every dollar it finances.

A firm’s WACC is the overall required return on the firm as a whole and, as such, it is often used internally by company directors to determine the economic feasibility of expansionary opportunities and mergers. It is the appropriate discount rate to use for cash flows with risk that is similar to that of the overall firm. To overhaul the capital budgeting process and evaluate each investment as a distinct opportunity with unique risks


According to the new approach,

WACC = E V r e + DV rd (1-τ)

Re = cost of equity
Rd = cost of debt
E = market value of the firm’s equity
D = market value of the firm’s debt
V = E + D
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate

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