Aes - Hbs Case Study
1. How would you evaluate the capital budgeting method used historically by AES? What's good and bad about it?
Historically, the AES capital budgeting method primarily used the following assumptions: • All nonrecourse debt was regarded as good
• Dividend cash flow were considered equally risky
• Project was evaluated by the equity discount rate for the dividends from the project
• A 12% discount rate was applied to all projects.
The historical method is quite simplistic in terms of project evaluation as it ignores the volatility in the market and the economy, it is more suited to a domestic market and a constant discount rate across all projects is usually unrealistic as projects usually have varying risks and specific considerations which arise.
Although the reason for AES to use this methodology is due to its business operation of domestic contract generation projects where they believe the price-change risk is minimal, the volatility can still be considerable if the economic outcomes are not as accurate as predicted. This may lead to the nonrecourse debt that is riskier than originally thought, and it will affect the business operations (e.g. lack of cash flow). The assumption of equal risk of dividends is subject to the economy and the longer time it is into the future, the more risk will be involved as the uncertainty and accuracy of dividend prediction is larger. Hence a constant 12% discount rate does not take account of these factors mentioned above. There also there are other risks involved:
• For various projects, different location within the world will trigger different risks
o Regulatory (e.g. tax differences across different states)
o Operational risk (e.g. different projects requiring different cooperation between the divisions, and a ranking to the importance of different division will result in the different operational risk)
o Political (e.g. unstable or corrupt
Historically, the AES capital budgeting method primarily used the following assumptions: • All nonrecourse debt was regarded as good
• Dividend cash flow were considered equally risky
• Project was evaluated by the equity discount rate for the dividends from the project
• A 12% discount rate was applied to all projects.
The historical method is quite simplistic in terms of project evaluation as it ignores the volatility in the market and the economy, it is more suited to a domestic market and a constant discount rate across all projects is usually unrealistic as projects usually have varying risks and specific considerations which arise.
Although the reason for AES to use this methodology is due to its business operation of domestic contract generation projects where they believe the price-change risk is minimal, the volatility can still be considerable if the economic outcomes are not as accurate as predicted. This may lead to the nonrecourse debt that is riskier than originally thought, and it will affect the business operations (e.g. lack of cash flow). The assumption of equal risk of dividends is subject to the economy and the longer time it is into the future, the more risk will be involved as the uncertainty and accuracy of dividend prediction is larger. Hence a constant 12% discount rate does not take account of these factors mentioned above. There also there are other risks involved:
• For various projects, different location within the world will trigger different risks
o Regulatory (e.g. tax differences across different states)
o Operational risk (e.g. different projects requiring different cooperation between the divisions, and a ranking to the importance of different division will result in the different operational risk)
o Political (e.g. unstable or corrupt