AES Case Analysis
AES - Case Analysis & Write up
How would you evaluate the capital budgeting method used historically by AES? What is good and bad about it?
Previously, the economics of a given project were evaluated at an equity discount rate for the dividends from any project and as it was mostly financed through local debt, which was non-recourse to the parent company, AES use to evaluate the dividend cash flows at a standard 12%. It is a simple approach with portions of sound reasoning. One could argue that all of these are being judged on a level playing field with a standardized discount rate, not to mention it saves time and effort. However, this methodology obviously fails to consider the factors of currency risk as seen in Argentina & Venezuela, regulatory risk, commodity risk and other risks involving the assumption that they will be able to receive the dividends fully denominated in US Dollars without any loss in value.
Does this make sense as a way to do capital budgeting?
The following reasons make Venerus’ model superior to the traditional model of capital budgeting used by AES.
1. Venerus has used 3 main parts to measuring his cost of capital in the new methodology. Broadly they are, the overall risk (systematic), the country specific risk and the project /(cash-flow) specific risk. This new way of making capital budgeting decisions is not only more comprehensive but also more flexible. For example, if an additional rating or factor has to be added to the business-specific risk score, it can be done with ease. In this case, I have assumed the weights for the different categories for risk (counterparty credit, currency, regulatory etc.) are the same across countries. It is essential to understand that depending on the economy that AES operates in, these would have to be altered before calculating the risk adjustment.
2. This method also pushes the cost of capital in several countries much above the previously used 12%. From a case and logical perspective,
How would you evaluate the capital budgeting method used historically by AES? What is good and bad about it?
Previously, the economics of a given project were evaluated at an equity discount rate for the dividends from any project and as it was mostly financed through local debt, which was non-recourse to the parent company, AES use to evaluate the dividend cash flows at a standard 12%. It is a simple approach with portions of sound reasoning. One could argue that all of these are being judged on a level playing field with a standardized discount rate, not to mention it saves time and effort. However, this methodology obviously fails to consider the factors of currency risk as seen in Argentina & Venezuela, regulatory risk, commodity risk and other risks involving the assumption that they will be able to receive the dividends fully denominated in US Dollars without any loss in value.
Does this make sense as a way to do capital budgeting?
The following reasons make Venerus’ model superior to the traditional model of capital budgeting used by AES.
1. Venerus has used 3 main parts to measuring his cost of capital in the new methodology. Broadly they are, the overall risk (systematic), the country specific risk and the project /(cash-flow) specific risk. This new way of making capital budgeting decisions is not only more comprehensive but also more flexible. For example, if an additional rating or factor has to be added to the business-specific risk score, it can be done with ease. In this case, I have assumed the weights for the different categories for risk (counterparty credit, currency, regulatory etc.) are the same across countries. It is essential to understand that depending on the economy that AES operates in, these would have to be altered before calculating the risk adjustment.
2. This method also pushes the cost of capital in several countries much above the previously used 12%. From a case and logical perspective,