Brazil: Leading the Brics?

International Financing Projects Analysis

                                                         ------AES Case

                                Group Number: 9

 Group Member: Jinqiong Chen

                   Jiayi Mai

                   Luyi Han

                Yue He

                    Zeping Li

   Class: IFM Wed 11:00-13:00 pm

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

The capital budgeting method used historically by AES was fairly straightforward and appropriate for domestic contract-generation projects where most risks could be hedged and businesses had similar capital structure. However, this method was increasingly strained since AES engaged in projects overseas with AES’s international expansions.

The advantages of this method include:

1. Worked well in domestic projects.
2. Using the subsidiary structure and evaluated dividend flows at the same 12% discount rate were beneficial to make similar projects seemingly comparable.

The disadvantages of this method include:

1. It was not feasible to hedge key exposures such as regulatory or currency risk.
2. It was not suitable for projects that contained different financial structures.
3. It had difficulty for applying to overseas settings because the ever-increasing complexity in the financing of international operations.
4. Using the subsidiary structure and evaluated at the same 12% led to the results that leverage at the subsidiary and holding company level effectively increased, as well as the subsidiaries struggled to service 5 foreign currency debt.
5. It had no ideas to account for changes in required returns due to leverage, and to incorporate some understanding of projects’ risk profile.

2. What is the new method Venerus is suggesting?

In order to calculate a cost of capital for each of the many diverse AES businesses, Venerus considered 15 representative projects. Besides, the new method used two steps to capture the country-specific risks in foreign markets.

1. Calculate a cost of debt and cost of equity for each of the 15 projects using U.S. market data.
2. Add the difference between the yield on local government bonds and on corresponding U.S. Treasury bonds to both the cost of debt and the cost of equity.

And in order to compensate for “undiversifiable project-specific risk”, the new method created a risk scoring system designed to supplement the initial cost of capital.

The process for the method is detailed below.

      1. The calculation of cost of equity

1. Take unlevered equity betas from comparable U.S. companies for each of the 15 projects.
2. Average the betas to yield one unlevered beta for each of the four lines of business.
3. Relever the equity betas at indicative capital structures for each of the 15 projects using formula 1.

[pic 1]

1. Calculate the cost of equity for each project using formula 2.

[pic 2]

      2. The calculation of cost of debt

1. Estimate “default spread” based on the observed relationship between EBIT coverage ratios for comparable energy companies (given its volatility of cash flows and leverage) and their cost of debt.
2. Calculate the cost of debt by estimate the return of debt demanded by investors given the cash flow risks of a given project using formula 3.

     3. Add the Sovereign Spread

     In order to account for country-specific market risk, this method added the “sovereign spread” (the difference between local government bond yields and the corresponding U.S. Treasury yields) to both the cost of equity and cost of debt.

    4. The calculation of WACC

The new method used those values calculated above and formula 4 to derive a WACC for each project.

   5. WACC adjustments for unsystematic risk

Use the business-specific risk scores to calculate an adjustment to the initial cost of capital.

3. If Venerus implements the suggested methodology, what would be the range of discount rates that AES would use around the world? Show discount rate calculations for all projects.

Through the exhibit 8, we get the way to calculate WACC. We collect data of tax rate, debt to capital, equity to capital, unlevered beta, default spread and sovereign spread of each project from exhibits. Using the equations mentioned before, we get relevered beta, cost of equity and cost of debt separately. As Venerus mentioned in his suggested methodology, we add sovereign spread to cost of equity and cost of debt correspondingly as adjusted statistics, then getting the WACC without business-specific risk using WACC formula. As new methodology suggested, the WACC with business-specific risk considered adjusted unsystematic risk. The following two tables show the range of WACC without business-specific risk from 6.46% to 22.23%, and the range of WACC with business-specific risk from 9.66% to 31.36%. The average WACC without business-specific risk is 12.94% while the average WACC with business-specific risk is 20.59%, having a nearly 8% average difference of unsystematic risk.

[pic 3][pic 4]

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

Venerus created a new way to calculate WACC as above, based on the traditional way. This way has advantages compared with the traditional one.

First, as cost of equity, using new relevered beta removes the influence of debt. For market, debt is an important consideration for investors to decide the risk of a company. And it can influence the return of the company on the stock market. According to CAPM, return is decided by β, the systematic risk of a stock. Unlevered β only considers the part of risk equity creates, and abandoned repeating to calculate the debt risk.