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

“When AES undertook primarily domestic contract generation projects where the risk of changes to input and output prices was minimal, a project finance framework was employed.”

Usually, project finance framework is used when the project has predictable cash flows, which can easily represent operating targets through explicit contract. When cash flows are certainty, the company can have higher level of leverage and it is easier to separate project assets from the parent company.

Advantages and Disadvantages: 1) Advantages a. Maximize Leverage b. Off-Balance Sheet Treatment c. Agency Cost d. Multilateral*…show more content…*

project and Pakistan project are 8.07% (4.5%+3.47%), in which both U.S. project and Pakistan project have a same spread, 3.47%.

To adjust we add the sovereign risk into calculation. In Exhibit 7a, the sovereign risk for the U.S. is 0% but for Pakistan is 9.9%. We thereby get the new evaluation of the cost of capital and cost of debt, which are constant for U.S. and rise to 17.1% and 17.97% for Pakistan.

Finally we calculate the WACC. The formula is leveraged beta * (cost of capital) + Debt to capital * (cost of debt) * (1-tax rate). Then we get for the U.S. WACC= 6.48% and for Pakistan WACC= 15.93%.

Finally, we should adjust the WACC with its risk score. Because everything is calculated in U.S. dollar, the U.S. risk score is 0. So the U.S. projects WACC is constant. The Pakistan risk premium is 1.425. So the change is 1.425 * 500= 705bp = 7.05%. Therefore, we get the final Pakistan WACC, which is 23.08% (15.93%+7.05%).

In conclusion, the difference between the U.S. and Pakistan projects is 16.60%. Obviously, the U.S. project looks much more favorable.

3. Does this make sense as a way to do capital budgeting?

The financial strategy employed by AES was historically based on project finance. The model worked well in the domestic market and in the international operations. However, when AES started its diversification of business, it had to face to increasing symmetrical risks, such as business risk. In addition, project finance did not include the risk of

“When AES undertook primarily domestic contract generation projects where the risk of changes to input and output prices was minimal, a project finance framework was employed.”

Usually, project finance framework is used when the project has predictable cash flows, which can easily represent operating targets through explicit contract. When cash flows are certainty, the company can have higher level of leverage and it is easier to separate project assets from the parent company.

Advantages and Disadvantages: 1) Advantages a. Maximize Leverage b. Off-Balance Sheet Treatment c. Agency Cost d. Multilateral

project and Pakistan project are 8.07% (4.5%+3.47%), in which both U.S. project and Pakistan project have a same spread, 3.47%.

To adjust we add the sovereign risk into calculation. In Exhibit 7a, the sovereign risk for the U.S. is 0% but for Pakistan is 9.9%. We thereby get the new evaluation of the cost of capital and cost of debt, which are constant for U.S. and rise to 17.1% and 17.97% for Pakistan.

Finally we calculate the WACC. The formula is leveraged beta * (cost of capital) + Debt to capital * (cost of debt) * (1-tax rate). Then we get for the U.S. WACC= 6.48% and for Pakistan WACC= 15.93%.

Finally, we should adjust the WACC with its risk score. Because everything is calculated in U.S. dollar, the U.S. risk score is 0. So the U.S. projects WACC is constant. The Pakistan risk premium is 1.425. So the change is 1.425 * 500= 705bp = 7.05%. Therefore, we get the final Pakistan WACC, which is 23.08% (15.93%+7.05%).

In conclusion, the difference between the U.S. and Pakistan projects is 16.60%. Obviously, the U.S. project looks much more favorable.

3. Does this make sense as a way to do capital budgeting?

The financial strategy employed by AES was historically based on project finance. The model worked well in the domestic market and in the international operations. However, when AES started its diversification of business, it had to face to increasing symmetrical risks, such as business risk. In addition, project finance did not include the risk of

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