MULTINATIONAL CAPITAL

BUDGETING
Globalizing the Cost of Capital and Capital Budgeting at
AES, Harvard Case 5-206-080

TABLE OF CONTENT
Description of the case
The Venerus methodology
Our mitigations

DESCRIPTION OF THE CASE

Company overview
New countries, new businesses, new risks

OVERVIEW OF THE COMPANY

US-based global power company: electricity
generation and distribution
1985: Texas
2000: 30 countries and 5 continents
4 separate lines of business

NEW COUNTRIES, NEW BUSINESSES,

NEW RISKS
Originally, similar investments => 1 unique
discount rate
Overseas development implied businesses with:
New risks
New financial structure
But still same discount rate
Overvaluing and undervaluing projects
Great losses for AES

A NEW METHODOLOGY
Description
Lal Pir Project
Considerations on the methodology

DESCRIPTION
Step

Required Information

1. Calculate unlevered equity beta

Betas at comparable U.S.

Companies

2. Relever equity betas at target

capital structure

Target capitalization ratios

Risk-free rate
3. Calculate cost of equity for each
AES business

Equity risk premium

Relevered equity beta

Risk-free rate
4. Calculate the cost of debt

Default spread

5. Add country specific risk to the cost

Local sovereign spread
of debt and cost of equity

Approach
Unlever and average equity betas for
comparables in each AES line of
business

Estimated by project using cash flows

to calculate desired EBIT coverage

10-Year U.S. Treasury Note

Long-term avg. Difference between
S&P 500 and U.S. Treasuries
Levered = Unlevered / (E/V)

10-Year U.S. Treasury Note

Relationship between EBIT coverage
ratios for comparable companies and
their costs of debt

The difference between local

government dollar-denominated bond
yields and the corresponding U.S.
Treasure Note

BETA ESTIMATION

Select Financial Information

Un-levered Equity Betas by Line of
Business
Contract Generation

0,25

Large Utility

0,25

Growth Distribution

0,25

Competitive Supply

0,50

BETA ESTIMATION
Step

Required Information

1. Calculate unlevered equity beta

Betas at comparable U.S.

Companies

Approach
Unlever and average equity betas for
comparables in each AES line of
business

Select Financial Information

Un-levered Equity Betas by Line of
Business

Contract Generation
Large Utility
Growth Distribution
Competitive Supply

0,25
0,25
0,25
0,50

COST OF EQUITY
Step

Required Information

Approach

2. Relever equity betas

at target capital
structure

Target capitalization
ratios

Estimated by project
using cash flows to
calculate desired EBIT
coverage

Levered
Unlevered
D/V

35,10%

E/V

64,90%

Tax Rate

23,00%

Levered

Step

Required Information

3. Calculate cost of
equity for each AES
business

0,39

Cost of Equity
(Ke)

Approach

10-Year U.S. Treasury

Note
Long-term avg.
Equity risk premium Difference between S&P
500 and U.S. Treasuries
Levered =
Relevered equity beta
Unlevered / (E/V)
Risk-free rate

0,25

Rf

4,50%

MRP

7,00%

Levered
Ke

0,39
7,20%

COST OF DEBT
Step

Required Information

Approach

Risk-free rate

10-Year U.S. Treasury Note

Default spread

Relationship between EBIT

coverage ratios for
comparable companies and
their costs of debt

4. Calculate the cost of debt

Cost of Debt
(Kd)
Rf

4,50%

Default
Spread

3,57%

Kd

8,07%

COUNTRY RISK PREMIUM

Step

Required Information

5. Add country specific risk to the cost

of debt and cost of equity

Local sovereign spread

Adjusted Cost of Debt

(Kd)

Adjusted Cost of Equity

(Ke)
Rf
Levered

4,50%
0,39

MRP

7,00%

Ke

7,20%

Country Risk

9,90%

Adjusted Ke

Approach
The difference between local
government dollar-denominated bond
yields and the corresponding U.S.
Treasury Note

17,10%

Rf

4,50%

Default Spread

3,57%

Kd

8,07%

Country Risk

9,90%

Adjusted Kd

17,97%

BUSINESS RISK
Categories of Risk

Weight

Grade for Lal Pir

Risk Scores (grade x

weight)

Operational / Technical

3,50%

0,035

Counterparty Credit /
Performance

7,00%

0,070

Regulatory

10,50%

0,210

Construction

14,50%

0,000

Commodity

18,00%

0,180

Currency

21,50%

0,430

25,00%

0,500

1,425

Contractual
Enforcement / Legal
Sum of individual
scores = business
specific risk score

Adjustment to
WACC: 712,5 bp.

ADJUSTED COST OF CAPITAL

Adjusted Cost of Debt
(Kd)

Adjusted Cost of Equity

(Ke)
Rf

4,50%

Levered

0,39

MRP

7,00%

Ke

7,20%

Country Risk

9,90%

Adjusted Ke

17,10%

Rf

4,50%

Default Spread

3,57%

Kd

8,07%

Country Risk

9,90%

Adjusted Kd

17,97%

Adjusted Cost of Capital

(WACC)
Adj. Ke
E/V
Adj. Kd
D/V
WACC

Business Risk
Adjustment to WACC

Adj. WACC

17,10%
64,90%
17,97%
35,10%
15,95%

1,425
7,125%

23,08%

LAL PIR PROJECT

Discounted CF (Old Ke)

End of 2003
Growth

Discounted CF (New WACC)

End of 2003
0,0%

Cost of Equity

12,00%

Terminal Value

0,0

Explicit Horizon

179,6

Equity Value

179,6

Growth

0,0%

Cost of Capital

23,08%

Terminal Value

0,0

Explicit Horizon

276,6

Enterprise Value

Market Value of Debt

Excess
Cash
Equity
Value

276,6

430,7
0,0

-154,0

MITIGATIONS
New methodology results
Ke y i n t e rro g a t i o n s
Suggested alternatives

THE NEW METHODOLOGY RESULTS

Business /
Project

Country

Line of
Business

Sovereign
Spread

Cost of
Equity (Ke)

Cost of Debt
(Kd)

Business
Risk

Cost of
Capital
(WACC)

Red Oak

USA

CG

0,00%

7,39%

8,07%

3,20%

9,66%

Ottana

Italy

CS

0,14%

10,73%

8,98%

2,13%

10,77%

Gener

Chile

CG

1,73%

8,93%

10,57%

3,75%

12,63%

Kelvin

South Africa

CG

3,14%

10,25%

11,98%

5,35%

15,18%

Drax

United
Kingdom

CS

0,00%

9,46%

8,07%

7,30%

16,35%

Haripur

Bangladesh

CG

5,23%

12,35%

14,07%

3,95%

16,88%

OPGC

India

CG

3,60%

10,61%

11,67%

7,45%

18,11%

Rivnoblenergo

Ukraine

GD

9,98%

17,24%

18,05%

3,03%

18,58%

Lal Pir

Pakistan

CG

9,90%

17,10%

17,97%

7,13%

23,08%

Uruguaiana

Brazil

CG

8,93%

16,01%

15,28%

11,05%

25,15%

Eletropaulo

Brazil

LU

8,93%

15,93%

16,32%

10,88%

25,26%

Los Mina

Dominican
Republic

CG

8,93%

15,88%

15,28%

12,83%

27,44%

Telasi

Georgia

GD

9,98%

16,85%

16,33%

12,65%

28,51%

Andres

Dominican
Republic

CG

8,93%

16,13%

17,00%

15,00%

29,94%

Caracoles

Argentina

CS

16,25%

26,66%

24,32%

9,13%

31,36%

KEY INTERROGATIONS
Beta based only on US comparables
Business risk discrepancies:
The UK plant has a higher business risk than Lar Pir in
Pakistan, than Haripur in Bangladesh
Project-specific spread is linear

Cost of equity is often lower than cost of debt

Suggest alternatives:
Sovereign risk premium
Beta
Business-risk

SUGGESTED ALTERNATIVES
THE SOVEREIGN RISK PREMIUM (1/2)
Methodology:
Sovereign premium based on
ratings
Measure of the default risk of
country

Issues:
certain lag in comparison to
markets when it comes to
responding to changes in the
default risk
Rating agencies focus more on
default risk : understatement of
the equity risk premiums

SUGGESTED ALTERNATIVES
THE SOVEREIGN RISK PREMIUM (2/2)

Numerical country risk scores vs. rating agencies

Country Risk Model (the Economist)
6 categories of risk:
1.
2.
3.
4.
5.
6.

Sovereign Risk
Currency Risk
Banking Sector Risk
Political Risk
Economic Structure Risk
Overall Country Risk

SUGGESTED ALTERNATIVES
THE BETA ESTIMATION (1/2)
Separate developed and strong emerging
economies
Find local comparables

Other emerging countries

Find US comparables with exposure on emerging
economies
3-steps approach McKinsey Valuation Methodology
1.
2.
3.

Identify the broader industry in the emerging country

Analyse historical discrepencies
Add mark-up to the equity beta of the US-comparables
accordingly

SUGGESTED ALTERNATIVES
THE BUSINESS-SPECIFIC RISK

Double counting risks?

Regulatory, currency and commodity might already be
included in the sovereign spread
Represent 50% of the business-specific risk

Weights allocation?
Subjective
Should they be the same for each project?

The adjustment to the WACC should be

exponential

CONCLUSION
No consensus to have the best risk estimation
Accuracy and relevance improvement suggested