AREC 550 homework 7
Globalizing the Cost of Capital Budgeting at AES
Chia yun ,Tsai(Debbie)
The reason why Rob Venerus used the cost of capital concept to improve upon what AES had used in the past for a discount rate is because the old model always used the same discount rate for the model. However, with electricity generating businesses around the world, the old model started to cause some problems. In the past, AES used the same cost of capital for all of its capital budgeting, but the company's international expansion has raised questions about this approach and whether a single cost of capital adequately accounts for the different risks AES faces in its diverse businesses and diverse environments. Furthermore, they did take the unique risks in different area into account. When subsidiaries local currency real exchange rate depreciated, leverage at the subsidiary and holding company level effectively increased, and the subsidiaries struggled to service their foreign currency debt, the old model broke down. The sovereign spread is the difference between local government dollar denominated bond yields and the corresponding US Treasury note. The reason why it is important is because sovereign spread can take country specific market risk into account. That gave the model ability to explain different market risk in different areas. As we can see in the Exhibit 10, US given the rank AAA will have 0% of spreads found to both the cost of equity and the cost of debt. China given the rank BBB will have 2% of spreads found to both the cost of equity and the cost of debt. However, Argentina given the rank D will have about 16% of spreads found to both the cost of equity and the cost of debt. The risk scoring model which is designed by Venerus can 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...
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