AES Case
Sunday, March 15, 2009
COST OF CAPITAL AT AES
Evaluating the Historical Capital Budgeting Method
Currently AES employs Project Finance Framework. Project finance tends to be used in projects with tangible assets with predictable cash flows in which construction and operating targets can be easily established through explicit contract.
The key to AES projects financing lies with the precise forecasting of cash flows. In effect, the possibility of estimating cash flows with an acceptable level of uncertainty allows for allocation of risks among various interested parties. The ensuing certainty in cash flows allows for high level of leverage and enables project assets to be separated from the parent company.
Let us now take a closer look at the pros and cons of the Capital Budgeting System currently in place.
Principal Advantages
Non-Recourse
The separation of the parent company is structured through the creation of a Special Purpose Vehicle (SPV). This SPV is the formal borrower under all loan documents so that in event of default or bankruptcy AES is not directly responsible before financial creditors. Instead, their legal claims are against the SPV assets.
Maximize Leverage
Currently AES seeks to finance the cost of development and construction of the project on highly leveraged basis. High leveraged in non-recourse project financing permits AES to put less in capital to put at risk permits AES to finance the project without diluting its equity investment in the project.
Off-Balance Sheet Treatment
AES may not be required to report any of the project debt on its balance sheet because such debt is non-recourse. Off balance sheet treatment can have the added practical benefit of helping the AES comply with covenants and restriction relating to borrowing funds contained in loan agreements to which AES is also a party.
Agency Cost
The agency costs of free cash flow are reduced. Management incentives are to project performance. Most
COST OF CAPITAL AT AES
Evaluating the Historical Capital Budgeting Method
Currently AES employs Project Finance Framework. Project finance tends to be used in projects with tangible assets with predictable cash flows in which construction and operating targets can be easily established through explicit contract.
The key to AES projects financing lies with the precise forecasting of cash flows. In effect, the possibility of estimating cash flows with an acceptable level of uncertainty allows for allocation of risks among various interested parties. The ensuing certainty in cash flows allows for high level of leverage and enables project assets to be separated from the parent company.
Let us now take a closer look at the pros and cons of the Capital Budgeting System currently in place.
Principal Advantages
Non-Recourse
The separation of the parent company is structured through the creation of a Special Purpose Vehicle (SPV). This SPV is the formal borrower under all loan documents so that in event of default or bankruptcy AES is not directly responsible before financial creditors. Instead, their legal claims are against the SPV assets.
Maximize Leverage
Currently AES seeks to finance the cost of development and construction of the project on highly leveraged basis. High leveraged in non-recourse project financing permits AES to put less in capital to put at risk permits AES to finance the project without diluting its equity investment in the project.
Off-Balance Sheet Treatment
AES may not be required to report any of the project debt on its balance sheet because such debt is non-recourse. Off balance sheet treatment can have the added practical benefit of helping the AES comply with covenants and restriction relating to borrowing funds contained in loan agreements to which AES is also a party.
Agency Cost
The agency costs of free cash flow are reduced. Management incentives are to project performance. Most