Cost of Capital Budgeting at Aes

CASE #2: Globalizing the Cost of Capital and Capital Budgeting at AES

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

The project finance framework historically adopted by AES in its capital budgeting was simple and straightforward. This method of taking all nonrecourse debt as good and discounting dividends from all projects at a 12% rate might have served well for AES initial period when it undertook primarily contract generation projects in the US. When using this same framework for a company in rapid expansion, particularly in emerging markets, we can see that the negative aspects of this method far outweigh the positives. In fact the only positive aspect of this method is its simplicity and its ability of making similar project comparable. When facing though the many risks of international projects such as currency devaluation, regulatory changes, operational difficulties to name a few, an overly simplistic model is not necessarily what is needed. The main flaws that to be underlined are the following: using a 12% discount rates for all projects seems like an oversimplification. It is hard to imagine that all projects could achieve equal capital structures and even harder to assume that most risks could be hedged. Barely the US market has the financial degree of sophistication required for this to be true. It should therefore early on been foreseen that this model could not hold outside the US market. Furthermore considering all dividend payments to be equally risky seems to overlook the reality of the nature of different projects. Each project necessarily encounters its own set of difficulties that impacts in different way the risky ad uncertainty of cash flows. These differences are not only related to being in different markets and different countries but also related to the nature of the project. As described in the case for example contract generation projects allowed limited exposure...