Globalizing the Cost of Capital and Capital Budgeting at Aes

Globalizing the Cost of Capital and Capital Budgeting at AES In June 2003, Rob Venerus, director of the newly created Corporate Analysis & Planning group at The AES Corporation, thumbed through the five-inch stack of financial results from subsidiaries and considered the breadth and scale of AES. In the 12 years since it had gone public, AES had become a leading independent supplier of electricity in the world with more than $33 billion in assets stretched across 30 countries and 5 continents.Venerus now faced the daunting task of creating a methodology for calculating costs of capital for valuation and capital budgeting at AES businesses in diverse locations around the world.

He would need more than his considerable daily dose of caffeine to point himself in the right direction. Much of AES’s expansion had taken place in developing markets where the unmet demand for energy far exceeded that of more developed countries. By 2000, the majority of AES revenues came from overseas operations; approximately one-third came from South America alone.Once a critical element in its recipe for success, the company’s international exposure hurt AES during the global economic downturn that began in late 2000. A confluence of factors including the devaluation of key South American currencies, adverse changes in energy regulatory environments, and declines in energy commodity prices conspired to weaken cash flow at AES subsidiaries and hinder the company’s ability to service subsidiary and parent-level debt.As earnings and cash distributions to the parent started to deteriorate, AES stock collapsed and its market capitalization fell nearly 95% from $28 billion in December 2000 to $1. 6 billion just two years later.

The willingness ofinternational developmentbanks to invest alongside AES in volatile parts of the world helped mitigate the risk of expropriation, and the increased breadth of the global financial markets provided greater access to capital. AES initiated its international expansion in 1991–1992 with the purchase of two plants in Northern Ireland. The following year, AES began what would become a massive expansion into Latin America with the acquisition of the San Nicolas generation facility in Buenos Aires, Argentina.A year later, AES created a separately listed subsidiary, AES China Generating Co. , to advance Chinese development projects. As the pace of deregulation quickened around the world, AES was presented with an abundant supply of capital and a wealth of opportunities for investments in energy-related businesses, some of which were more complex than AES’ portfolio of contract generation projects. In addition to expanding its line of business profile, it continued its geographic expansion and between 1996 and 1998 the company acquired several large utility companies in Brazil, El Salvador, and Argentina.

By this time the company was spending an estimated 80%–85% of its capital investment overseas in places as diverse as Australia, Bangladesh, Canada, Cameroon, The Dominican Republic, Georgia, Hungary, India, Kazakhstan, the Netherlands, Mexico, Pakistan, Panama, Puerto Rico, Ukraine, The United Kingdom, and Venezuela. 2 1 Much of this overview comes from Paula Kepos, ed. , International Directories of Company Histories, Volume 10 (Detroit: St. James Press, 1995), pp. 25–27. 2 Paula Kepos, ed. , International Directories of Company Histories, Volume 53.

S. energy regulations had required AES to sell a fourth such company, Central Indiana Light and Power (CILCORP), when AES purchased IPALCO, a sale that was completed near the end of 2002. Growth distribution Growth Distribution businesses offered AES significant potential growth due to their location in developing markets where the demand for electricity was expected to grow at considerably faster rates than in developed countries.However, these businesses also faced notable risks related to operating difficulties, less stable governments, and regulatory regimes, and differing cultural norms regarding basic principles such as payment conventions and safety regulations. Two new Growth Distribution businesses in Ukraine (Kievoblenergo and Rivoblenergo) and one in Cameroon (SONEL) were acquired as recently as 2001. 3 The description for these lines of businesses comes largely from AES’s annual reports; see AES Corporation, 2001 Annual Report (Arlington: AES Corporation, 2002) and AES Corporation, 2002 Annual Report (Arlington: AES Corporation, 2003). Energy companies typically refer to generation companies not as members of a “portfolio” but members of a “fleet.

” 3 204-109 Globalizing the Cost of Capital and Capital Budgeting at AES Recent Difficulties AES’s placement in foreign markets as well as poor performance at several new U. S. businesses nearly crippled the company during the global economic slowdown that began in 2001. AES’s market value started to fall slowly in 2001 but fell precipitously in 2002. Having traded for more than $70 per share in October 2000, AES stock hovered around $1 per share in the same month of 2002 (see Exhibit 4).Wall Street began to question the company’s ability to weatherthe storm, and one analyst wrote, “It is clear that AES’s current stock price is reflecting the scenario that the company will not survive. ”5 The collapse of the stock price and the subsequent $3.

The majority of Brazil’s generation capacity was hydroelectric, and energy deficiencies were exacerbated in 2001 and 2002 by below-average rainfall. In response, the Brazilian regulatory authorities began rationing energy consumption in June 2001. 8 In addition to the loss of sales volume, the decline of the Brazilian real against the dollar triggered a regulatory 5 Ali Agha and Ed Yuen, Banc of America Securities, “AES Corporation, Analysis of Sales and Earnings,” October 25, 2002, available from The Investext Group, http://www. nvestext. com, accessed July 15, 2003. 6 “Argentina’s Peso I Expected to Face Pressure This Week,” The Wall Street Journal, January 14, 2002, available from Factiva, http://www. factiva.

com, accessed July 7, 2003. 7 AES Corporation, 2002 Annual Report (Arlington: AES Corporation, 2003), p. 38. 8 Ibid. , p. 20. 4 Globalizing the Cost of Capital and Capital Budgeting at AES 204-109 conflict concerning the applicable exchange rate for the real-to-dollar energy-cost pass-through provisions in AES’s contract.

Eletropaulo. The $2. 3 billion in asset impairment charges included the $706 million after tax impairment charge at 11 “AES Stock Shoots Up as Refinancing Keeps Bankruptcy at Bay,” The Washington Post, December 17, 2002, available from Factiva, http://www. factiva. om, accessed July 17, 2003. 12 AES Corporation, 2002 Annual Report, p. 36.

5 204-109 Globalizing the Cost of Capital and Capital Budgeting at AES dividend flows were considered equally risky, and a 12% discount rate was used for all projects. In a world of domestic contract-generation projects where most risks could be hedged and businesses had similar capital structures, Venerus felt that this model worked fairly well. Beginning in the early 1990s, with AES’s international expansions, this model of capital budgeting was exported to projects overseas.Early on, the model worked well (as it had with the initial expansion in Northern Ireland), because this project had many of the characteristics of domestic opportunities. Venerus explained that the model became increasingly strained with the expansions in Brazil and Argentina because hedging key exposures such as regulatory or currency risk was not feasible. In addition, the financial structure of a going-concern business like a utility is notably different than that of a limited-lifep asset like a generating facility. Nonetheless, in the absence of anacademicor other alternative, the basic methodology remained intact.

Similarly, Venerus did not advocate the use of a “Local CAPM” where beta measured the covariance of a project’s returns with a portfolio of local equities. Countries such as Tanzania or Georgia, where AES had projects, did not have any meaningful equity markets or local benchmarks. Still, he knew he had to find a way to capture the country-specific risks in foreign markets.At a high level, Venerus developed an approach with two parts. First, he calculated a cost of debt and cost of equity for each of the 15 projects using U. S. market data.

Second, he added the difference between the yield on local government bonds and the yield on corresponding U. S. Treasury bonds to both the cost of debt and the cost of equity. Venerus believed that this difference or “sovereign spread” approximated the incremental borrowing costs (and market risk) in the local country. Exhibit 8 summarizes Venerus’s approach.Calculating the Cost of Equity and the Cost of Debt To estimate an equity beta for each project, Venerus first had the Corporate Analysis & Planning group take unlevered equity betas from comparable U. S.

13 Also referred to as the “country spread model” or the “Goldman Model. ” See Jorge O. Mariscal and Rafaelina M. Lee, Goldman Sachs, “The Valuation ofMexicanStocks: An Extension of the Capital Asset Pricing Model,” 1993. 8 Globalizing the Cost of Capital and Capital Budgeting at AES 204-109 In order to compensate for this “undiversifiable project-specific risk,” the Corporate Analysis & Planning group created a risk scoring system designed to supplement the initial cost of capital. First, seven categories of project-level risk were identified.Each category was ranked and weighted according to AES’s ability to anticipate and mitigate certain risks.

For example, because AES was unable to hedge changes in currencies in certain markets, “currency risk” received a high weight and rank. In contrast, AES felt it could control for most technical or plant-related problems and, as such, “operational risks” received a relatively low weight. See Exhibit 11 for the seven risks and examples for each. Second, projects were graded on their level of exposure to the seven categories of project risk.For each category, a project was assigned a grade between 0 (lowest exposure) and 3 (highest exposure). Next, the grades were multiplied by the respective weights and the seven categories added together to yield a single business-specific risk score. For example, Table A shows how the Lal Pir project, a contract generation business in Pakistan, might be assigned grades that translated into a businessspecific risk score of 1.

Still, questions lingered in his mind. He reviewed the project cash flows for the AES Lal Pir contract generation plant in Pakistan presented in Exhibit 12 as a way of gauging the effect of his new methodology. In doing so, he considered the differences in value created by each of the adjustments to the discount rate. Was his discount rate an actual representation of the risk associated with the project? Did it yield the correct value? More generally, did the sovereign spreads accurately capture the market risk specific to a given country?Had he used the appropriate risk categories and suitable weights to reflect AES’s appetite for risk? It was time for him to decide. Should he move forward with the addition of the business-specific risk score or should he simply use the traditional sovereign spread model? The board’s reaction was impossible to predict. What if the results were inconsistent with observable trading multiples? Would they accuse him of creating an over-complicated method, or would they applaud the new technique as a pragmatic way to calculate the cost of capital in an international context? 0 Globalizing the Cost of Capital and Capital Budgeting at AES 204-109 Exhibit 1 AES Consolidated Income Statement 2002 $4,317 4,315 8,632 (3,627) (3,086) (6,713) (112) (2,031) 312 219 (87) (1,600) (612) (456) (203) (2,651) (27) (34) (2,590) (573) (3,163) (346) $(3,509) 2001 $3,255 4,390 7,645 (2,416) (3,052) (5,468) (120) (131) (1,575) 189 116 (65) 18 (30) 176 755 206 103 446 (173) 273 $273 2000 $2,661 3,545 6,206 (2,093) (2,210) (4,303) (82) (79) (1,262) 201 51 (52) 143 (4) 475 1,294 368 120 806 (11) 795 $795Amounts in millions except per share figures Revenues Regulated Non-regulated Total revenues Cost of sales Regulated Non-regulated Total cost of sales SG&A expenses Severance and transaction costs Interest expense Interest income Other income Other expense (Loss) gain on sale of investments and asset impairment expense Goodwill impairment expense Foreign currency transaction loss Equity in pre-tax (loss) earnings of affiliates (Loss) income before income taxes and minority interest Income tax (benefit) expense Minority interest (income expense) (Loss) income from continuing operations Loss from operations of dicontinued businesses (net of income tax benefit of $90, $10 and $5, respectively) (Loss) income before cumulative effect of accounting change Cumulative effect of change in accounting principle (net of income tax benefit of $72) Net (loss) income BASIC (LOSS) EARNINGS PER SHARE (Loss) income from continuing operations Discontinued operations Cumulative effect of accounting change Basic (loss) earnings per share Source: $(4. 81) $(1.

05) $(0. 65) $(6. 51) $0. 84 $(0. 32) $$0. 52 $1. 67 $(0.

0 0. 5 Jan-01 May-01 Brazilian Real (left) Source: Bloomberg LP. 1,600 1,400 1,200 1,000 800 600 400 200 Sep-01 Jan-02 May-02 Sep-02 Venezuelan Bolivar (right)Argentine Peso (left) 15 204-109 -16- Exhibit 6 Typical Structure of an AES Investment AES Parent Corporation Assets Liabilities US Bank Debt Equity subsidiary Equity holding co. Corporate Debt Local AES Holding Company Assets Liabilities $-denominated debt Equity subsidiary (non-recourse to parent) AES Subsidiary A Assets Liabilities Fossil fuel power plant $-denominated debt (non-recourse to parent) AES Subsidiary B Assets Liabilities Hyrdo power plant $-denominated debt (non-recourse to parent) Source: Company documents and casewriter analysis. 204-109 -17- Exhibit 7a Risk Scores AES Project Data Line of Project Description Spread 3. 57% 8. 3% 3 3 Spread 300 MW gas fired combined cycle plant currently under construction 30 km east of Santo Domingo 123 MW hydroelectric power plant located on the San Juan river in western Argentina Largest coal-fired power station in western Europe.

It can produce enough electricity – about 4000 MW- to meet the needs of approximately four million people Distribution company that serves a population of 14 million in Sao Paulo 277 MW fossil fuel plant located in Tocopilla, 1500 km north of Santiago 360 MW gas turbine facility located 25 kilometers southeast of Dhaka, capital of Bangladesh 600 MW coal fired power plant 337 MW coal fired power plant 210 MW Oil-fired facility supplying the capital city of Santo Domingo Joint Venture with the Government of Orissa. Two 210 MW P. C. oal-fired units Oil fired 140 MW cogeneration facility – under contracts of up to 10 years, electricity, steam, compressed air, dematerialized water and nitrogen to three chemical facilities adjacent to the plant 832 MW natural gas-fired plant Distribution Company serving 380,000 customers Distribution Company serving Tbilisi, the capital of Georgia. 600 MW gas-fired combined cycle power plant 7. 9% 25. 0% 23% 35.

/ Legal 3 3 3 3 2 2 2 2 2 2 3 3 1 3 1 1 1 1 1 1 2 2 1 2 2 1 2 3 3 3 3 3 2 3 2 1 3 3 1 2 1 3 3 3 3 3 3 2 3 Andres Dominican Republic CG Caracoles Argentina CS 2 DraxUnited Kingdom CS – 2 Eletropaulo Brazil LU 8. 93% – 1 Gener Chile CG 1. 73% – – Haripur Bangladesh CG 4. 34% 5. 23% 2 – Kelvin South Africa CG 2. 5x 3. 0x 4.

0x 4. 34% 3. 57% 1. 85% 3. 14% 9. 90% 8. 93% 1 – 1 3 Lal Pir Pakistan CG Los Mina Dominican Republic CG OPGC India CG 30.

93% – 2 2 – Rivnoblenergo Ukraine GD Telasi Georgia GD Uruguaiana Brazil CG Source: Company document. Project descriptions taken from http://www. aes. om/businesses/default. asp. Commodity 3 1 3 2 2 1 1 3 2 3 2 Business / Project Country Business 204-109 Globalizing the Cost of Capital and Capital Budgeting at AES Exhibit 7b AES Selected Financial Data Select Financial Information 10-Year U. S.

Treasury Bond U. S. Risk Premium Unlevered Equity Betas by Line of Business Contract Generation Large Utility Growth Distribution Competitive Supply 4. 5% 7. 00% 0. 25 0. 25 0.

0% 8. 0% 15. 0x 6. 0% 10. 0x 4. 0% 5. 0x 2.

0% Baa1 Baa2 Baa3 Caa1 Caa2 Caa3 Ba1 Ba2 Ba3 B1 B2 Aa1 Aa2 Aa3 A1 A2 Aaa A3 B3 – EBIT Coverage Ratio Source: Company documents. Default Spread 19 204-109 Globalizing the Cost of Capital and Capital Budgeting at AES Exhibit 9b EBIT Coverage Ratios and Default SpreadsCredit Rating Aaa Aa1 Aa2 Aa3 A1 A2 A3 Baa1 Baa2 Baa3 Ba1 Ba2 Ba3 B1 B2 B3 Caa1 Caa2 Caa3 EBIT Coverage Ratio 21. 1x 15. 1x 10. 9x 8. 1x 6. 3x 5.

2% 7. 4% 8. 6% 10. 0% 11. 4% Source: Company documents. 20 Globalizing the Cost of Capital and Capital Budgeting at AES 204-109 Exhibit 10 Credit Ratings and Sovereign Spreads Used by AES US (AAA) Australia (AAA) Bahamas (n/a) Canada (AAA) UK (AAA) Italy (AAA) Spain (AAA) Netherlands (AAA) Hungary (A-) Chile (A-) Qatar (A-)Czech Republic (A-) Mexico (BBB) China (BBB) Oman (BBB) South Africa (BBB-) India (BB) Bangladesh (n/a) Sri Lanka (n/a) El Salvador (BB+) Kazakhstan (BB) Panama (BB) Brazil (BB) Dominican Republic (BB-) Bolivia (B) Georgia (n/a) Pakistan (B) Ukraine (B) Venezuela (CCC+) Argentina (D) Cameroon (n/a) Nigeria (n/a) Tanzania (n/a) Uganda (n/a) 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% Source: Company document; Standard and Poor’s and Lehman Brothers. 21 204-109 Globalizing the Cost of Capital and Capital Budgeting at AES Exhibit 11 Project Specific Risk Categories and Weightings Risk Category Operational Example An AES plant may fail to operate at capacity or fail to produce sufficient electricity to meet contractual obligations.

AES has offtake agreements that—like futures and other derivative instruments—require credit; the counterparty may either fail to post additional collateral as required or fail to pay. Contract settlement processes in a foreign country may change after AES has made investments in a generation facility. Regulatory agencies may choose not to adjust rates for a utility after inflation goes up or other market dynamics change. Construction of a specific plant is complete but the plant may not perform they way it is supposed to (the heat rate is too high, the output too low, the availability too low, etc. ). Prices of coal, oil, or other fuels may spike.