The Cost of Capital at AES

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Before setting up business either international or local, there are some factors to put into consideration. Even if your business is doing well and expanding at a high rate one must put into consideration the risks that ascertain that particular business. In the case of the AES, the founders did not put much consideration into their expanding business to the overseas accounts. Their main undoing was the assumption of the risks involved as same as in the U.S as it were in the foreign countries. The AEs had its majority revenues linked to overseas operations with approximately one-third coming from South America alone. Since the company depended on these operations almost wholly, any changes involved as per this could have affected them greatly. And that’s why the company’s international exposure hurt AEs during the global economic downturn that began in late 2000.

In addition, they did not take into consideration that as a global company with operations in countries that are hugely different from the U.S they needed a more sophisticated way to think about risk and the cost of capital around the world. besides,, with AES’s international expansions, the model of capital budgeting was not supposed to be exported to projects overseas, since the same 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 was notably different than that of a limited-lifespan asset like a generating facility.

factors such as the devaluation of key south American currencies, especially during 2001, when a political and economic crisis in Argentina brought about a significant devaluation of most south American currencies against the U.S. dollar, conspired to weaken cash flow at AEs subsidiaries and hinder the company’s ability to service subsidiary and parent-level debt. This was much evident in December, the same year, when the newly elected government abandoned the country’s fixed dollar-to-argentine-peso exchange rate (1:1) and converted us. dollar-denominated loans into pesos. This resulted to the peso losing 40% of its value against the U.S dollar. In addition, the currencies in Brazil and Venezuela followed suit, with the Brazilian real and the Venezuelan Bolivar each depreciating approximately 50% against the us. dollar during the same period. As a result, AEs recorded foreign currency transaction losses of $456 million in 2002, creating an influx of financial problems to the company. the subsequent impact of the apparent devaluation was increased when foreign businesses were paid in local currency but had obligations to repay debt denominated in U.S. Dollars.

besides this, the adverse changes in energy regulatory environments especially in brazil, when it had failed to produce a market structure sufficiently attractive to encourage domestic construction of new generation assets, the demand exceeded supply, causing shortages. this created the loss of sales volume when it started a power rationing program due to short rainfalls; the majority of brazil’s generation capacity is hydroelectric, triggering a regulatory conflict concerning the applicable exchange rate for the real-to-dollar energy-cost pass-through provisions in AES’s contract thus resulting to AEs taking a pretax impairment charge of approximately $756 million on the Eletropaulo, one of its major Brazilian businesses.

In addition to AEs woes, was the decline in energy commodity prices. As the 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 change in the regulatory regime in the U.K. also adversely impacted AEs by increasing competition and reducing prices in its generation markets. That, along with an unusually warm winter...
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