GLOBALIZING THE COST OF CAPITAL & CAPITAL BUDGETING AT AES Case Solution And Analysis, HBR Case Study Solution & Analysis of Harvard Case Studies

GLOBALIZING THE COST OF CAPITAL & CAPITAL BUDGETING AT AES Case Solution

Question 1

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

Currently, the Project Finance Framework is employed by AES. This methodology is used for those projects which have tangible assets with predictable cash flows in which the operating targets and the cash flows could be easily established through the explicit contracts. The key to the financing of the AES projects lies with the precise forecasting of the cash flows. However, the possibility of estimating the cash flows of the projects with an acceptable level of uncertainty has created the need for the allocation of the risks among the various interested parties. The project assets are also separated from the parent company due to the ensuing certainty in the cash flows which allows for the higher level of leverage. The pros and cons of the traditional capital budgeting used by AES are evaluated below:

Advantages

Maximize Leverage

Currently, the management of the company seeks to finance the construction and development costs of the projects on a highly leveraged basis. Therefore, the high leverage in the non recourse project financing permits the company to contribute less capital and thus, the company does not dilute its equity for investing in the project.

Non Recourse

The Special Purpose Vehicle is created for structuring the separation of the parent company. This special purpose vehicle is then the formal party which is the borrower and then in the case of default on the loans, the company itself is not liable to the creditors. The legal claims of the creditors stand against SPV assets.

Off-Balance sheet treatment

As all the debt raised by the company for financing the construction and development costs is non recourse therefore, AES is not required to report any of the debt on the balance sheet. Off balance sheet treatment of the debt gives the benefit to the company for complying with all the restrictions and covenants related to the borrowing of the funds which are contained in the loan agreements to which AES is also one of the party.

Agency Costs

The agency costs associated with the free cash flows are also reduced. The incentives of the management are dependent on the basis of the performance of the project. Apart from this, there is also facilitation of the monitoring by the investors.

Multilateral Financial Institutions

There are four constituents which have a contractual agreement with the SPV for any of the typical projects and banks are also one of them. These banks also include the multilateral financial institutions like CAF and IFC etc. The presence of such institutions indicates a positive sign by the commercial banks and it also lowers the cost of borrowing.

Drawbacks

Projects Vs Divisions

Along with the geographical expansion, AES is also diversifying into new businesses through forward and backward integration. Therefore, the current financial framework model of the company or capital budgeting does not have the capability to incorporate more variables which are being influenced by a number of different factors due to the increase in the breadth and depth of the company.

Complexity

There are a number of parties in project financing, therefore it becomes complex to arrange all the parties and can also prove to be costly. Secondly, a higher management time is also required to make all these arrangements.

Macroeconomic Risk

The exchange rate risk is not taken into account by the current capital budgeting methodology used by AES. The risk of currency fluctuations is much higher in the developing countries due to their unstable fiscal and monetary policies. This case also shows that the exchange rate risks have significantly impacted on the AES business because the management had not anticipated this risk. Therefore, keeping a proper check on the currency movements requires the management of AES to timely adjust the expenditure, revenue items as well as the liabilities and assets in the different currencies....................

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