Globalizing the Cost of Capital and

Capital Budgeting at AES

GROUP D
Alessandro
Maysoon
Andrew
Diogo
Claire
Luca

AES Corporation
Electrical power generation and distribution company
Founded in 1981 in the US
Company goes public in 1991
International expansion started in 1991-1992
Organized around four lines of business:
Contract generation
Competitive supply
Large utilities
Growth distribution

Operating in 17 countries across four continents

GEOGRAPHIC PRESENCE & LOB

REVENUES
Lines of Business (% of AES
Revenues)

Historical Capital Budgeting Method

The Capital Budgeting method used by AES followed a simple set of
assumptions:
All nonrecourse debt was deemed good
A project was evaluated by the equity discount rate for the dividends
from the project
All dividend flows were considered equally risky
Applied to all projects was a discount rate of 12%
AES undertook mainly domestic contract generation projects
International expansion of AES Problems started

Problem Description
PROS

CONS

Easy to compute and use in project appraisals

Method is detached from reality

Makes all projects seem comparable to one

another

Subsidiaries will have different costs of capital

Dividend risk is assumed constant in this method
Ignores business specific risk (e.g. operational risk,
market risk, regulatory risk, credit risk)
Ignores the country risk (e.g. political, FX)

If Venerus implements the suggested methodology,

what would be the range of discount rates that AES
would use around the world?

SUGGESTED METHODOLOGY
1. Adjust beta:
2. Calculate cost of equity (Ke)
3. Calculate cost of debt (Kd)
4. Add Sovereign Spread (SS) to both Ke & Kd
5. Compute WACC
6. Add Business-specific risk (BSR) adjustment

BUSINESS-SPECIFIC (UNDIVERSIFIABLE)
RISK
1. Operational/Technical
2. Counterparty Credit/Performance

Risk
Score

Added Risk
(% equivalent)

5%

4. Construction

10%

5. Commodity

15%

3. Regulatory

6. Currency
7. Contractual Enforcement/Legal

Does this make sense as a way to do capital budgeting?

PROS

CONS

Need to assess various risk dimensions for

different projects in locations with varying risk
profiles

BSR methodology double-counts FX and

regulatory risk

Uniform 12% discount rate was

unsustainable
Most foreign projects NPV would be
systematically overvalued or undervalued
otherwise

Sovereign Spread (SS) already captures these

sources of country specific risk. All projects run
the risk of being slightly undervalued
Assumes risk dimensions can be reliably
quantified

What is the value of the Pakistan Project using the

cost of capital derived from the new methodology? If
this project were located in the US, what would its
value be?

PAKISTANPROJECT(usingrevisedWACC)
NPV(SS)
NPV(SS&BSR)

413.41
290.08

ProjectYear
UnleveredCF
DiscountedCF(SS)
DiscountedCF(SS&BSR)

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023
63.2 63.6
64 64.4 64.8 65.2 65.7 66.1 66.5 66.9 67.3
67.7
68.2 68.6
69 69.4 69.8 70.3 70.7 71.1
55.04 48.24 42.27 37.04 32.46 28.44 24.96 21.87 19.16 16.79 14.71 12.88 11.30 9.90
8.67 7.60 6.65 5.84 5.11 4.48
51.82 42.76 35.29 29.12 24.02 19.82 16.38 13.51 11.15 9.19 7.58
6.26
5.17 4.26
3.52 2.90 2.39 1.97 1.63 1.34

USAPROJECT(usingrevisedWACC)
NPV(SS)
NPV(SS&BSR)

804.36
623.12

ProjectYear
UnleveredCF
DiscountedCF(SS)
DiscountedCF(SS&BSR)

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023
63.2 63.6
64 64.4 64.8 65.2 65.7 66.1 66.5 66.9 67.3
67.7
68.2 68.6
69 69.4 69.8 70.3 70.7 71.1
60.00 57.32 54.75 52.30 49.96 47.72 45.65 43.60 41.64 39.77 37.98 36.26 34.68 33.12 31.62 30.19 28.83 27.56 26.31 25.12
58.23 53.99 50.05 46.40 43.02 39.88 37.02 34.32 31.81 29.48 27.32 25.32 23.50 21.78 20.18 18.70 17.33 16.08 14.90 13.81

USAPROJECT(usinghistorical WACC)
Historical WACC
NPV

0.12
490.55

ProjectYear
UnleveredCF
DiscountedCF

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023
63.2 63.6
64 64.4 64.8 65.2 65.7 66.1 66.5 66.9 67.3
67.7
68.2 68.6
69 69.4 69.8 70.3 70.7 71.1
56.43 50.70 45.55 40.93 36.77 33.03 29.72 26.70 23.98 21.54 19.35 17.38 15.63 14.04 12.61 11.32 10.17 9.14 8.21 7.37

How does the adjusted cost of capital (WACC) for the Pakistan Project
reflect the probabilities of real events? What does the discount rate
adjustment imply about expectations for the Project because it is located in
Pakistan and not in the US?

CONCLUSIONS
Revised methodology suggests major differences between the risk profiles of
these countries
Pakistan more likely to suffer from regulatory, construction and FX and legal risk
while not in the US
Country specific risk would include real events like currency fluctuations,
contractual and legal issues, and counterparty credit issues.
Project NPV halved if the project is done in Pakistan rather than the US