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Case 3: Globalizing the Cost of Capital and Capital Budgeting at AES

Question 1
Explain and comment on the capital budgeting method used historically by AES. Is there a need for change? Explain.

Question 2
If Venerus implements the suggested methodology, what will be the adjusted discount rate for the Red Oak project (USA) and the Lal Plr project (Pakistan)?

Question 3
Calculate the effect that a revision of its cost of capital will have on the Lal Plr project’s NPV. Comment on the results.

Case 3: Globalizing the Cost of Capital and Capital Budgeting at AES

Q.1

At the AES corporation capital budgeting was historically a very simple method, that was used for all projects being examined, regardless of geographical location. This method entailed 4 rules which were: all recourse debt was deemed good, the economics of a given project were evaluated at an equity discount rate for the dividends from the project, all dividend flows were considered equally risky, and a 12% discount rate was used for all projects.

This method worked flawlessly when implemented in the U.S., but when it began being applied to international projects, it was giving the company unrealistic NPV values. While some concern existed, having no alternative, they continued to use the original method. By failing to take into account increased WACC, currency risk, political risk, and sovereign risk, the company had developed projects that began failing in the early 2000’s. The mistake by the company destroyed its stock price and market capitalization, losing millions of stockholders equity in the process.

The debt structure caused significant currency risk for both the parent AES and its subsidiaries. As shown in exhibit 6, debt was denominated in USD for the subsidiaries, while they were bringing in revenues in foreign currencies. The parent companies also lost cash flows when depreciation occurred since the money made by subsidiaries was worth substantially...
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