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 governments usurping project assets)
To summarise the pros and cons of the historical method:
• Easy to compute and use in the project evaluation
• Makes all projects seem comparable to other projects
• Can be a good indicator in a good economy
• Method is detached from reality
• Ignores the fact that economy is not good all the time and prediction can be inaccurate
• Distant dividend risk is hardly evaluated but assumed constant in this method
• A constant discount rate ignores the fact that different projects involve different risk (e.g. operational risk, market risk (e.g. different prices for raw materials at different times), regulatory risk, credit risk (e.g. bank’s willingness to lend the money to company for one project in a bad economy)
• Ignores the priority in deciding which risk is relating to the project and company in the process of determining the discount rate (as it assumes 12% constant rate)
2. If Venerus implements the suggested methodology, what would be the range of discount rates that AES would use around the world?
Based on the calculation of the various discount rates for all AES projects, the discount rates range from a high of 17.13% to a low of 6.78%. The full version of this calculation table can be seen in the Appendix at the end of the document.
3. Does this make sense as a way to do capital budgeting?
Technically, given the individual rationale for each risk measure in the new adopted methodology of AES, the procedure proposed makes sense.
Firstly, accounting for the default risk spread and sovereign risks makes intuitive sense, as these are obvious risks faced by the company in various countries. Next, given the perceived difficulty of predicting expected project specific cash flows, and the need to somehow account for unsystematic risks which the manager believes cannot always be diversified, an attempt has been made to calculate...