Aes Case Study

AES CASE STUDY

INTRODUCTION Rob Venerus has been appointed the director of newly created Corporate Planning and Analysis group at AES Corp. He came in after the market Cap of AES Corp. fell by 95% from a peak of $28 Billion in December 2000 to $1.6Billion in just 2 years. This tremendous erosion of wealth for AES investors came during the aftermath of the peso crisis in Argentina and other emerging markets in Latin America, where AES expected one-third of its cash flows to come from. The peso and other Latin American currencies got devalued and the AES subsidiaries didn’t generate sufficient cash flow to pay off dollar denominated debts. In the end of 2002 AES had a recourse parent company debt of $5.8 billion. It was a pivotal moment for AES Corp, as many stock analysts were certain about the company shutting down. Rob Veneras had to come up with a new plan to revalue the emerging market projects, and help in restructuring and stabilizing the company. ISSUES RELATED TO THE CASE The previous method of expecting all dividends to be equally risky and discounting them by 12% using the World CAPM model for all projects had serious repercussions. Due to the complexities of projects (such as growth distribution, large utilities, competitive supply, and contract generation) in developing markets of Latin America and Asia this old method of discounting failed to account for important risk factors such as, regulatory and currency risks. The projects AES had in emerging markets were nonrecourse, and AES relied on them to generate sufficient Cash flows so that it could be awarded with the dividends which were eventually discount. But after peso crisis the all cash flows coming from a big contributor such as Latin America virtually stopped. For instance, in Brazil AES subsidiaries had to purchase energy in current devalued exchange rates and were forced to accept government payments of reals in exchange rates which existed before the peso crisis. SOLVING THE PROBLEMS OF THE CASE Veneres had to tackle the problem of accounting for the currency and regulatory risks in all emerging market projects and change the WACC calculation each of the 15 projects of AES Corp. In the formulae below “Cost on Equity is Re” and “Cost on Debt is Rd”.

Veneras made following changes to the Re and Rd parameters of the WACC calculation

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For calculating the Cost of Debt(Rd) he used Cost of Debt = rf (Risk free rate in US) + Default spread The EBIT coverage ratio would aid in calculating default spread, was the idea behind calculating Rd. Example required EBIT coverage ratio is 3.0x then Default spread was taken to be 300 bps. For calculating Cost of Equity(Re) he used

and applied Beta

levered

to CAPM=

After finding the levered Beta the CAPM formulae helps to find the Cost of Equity The changes made to the formulae for the WACC above only incorporated systemic risk and was lacking a crucial ingredient, this was the addition of unsystematic risk for each project in each country. To Account for unsystematic risk AES first, divided projects into seven business-specific risk. Secondly, each business-specific was graded 0 to 3. Thirdly, the weight of each business specific risk is calculated for all 15 projects. Lastly, for each project the business-specific grade is multiplied with the weight of their respective business-specific risk and is summed up to give a business risk score. Example, Business risk score for project in India Construction Operation/tech Regulatory Currency Counterparty Contract enf. / Legal Commodity

Grade( G)

Risk Weight( W)

0 1 3 2 3

0.145 0.035 0.105 0.215 0.07

2 0

0.25 0.18

The Business Risk Score for India Business Risk (1.49) is halved and then multiplied by Score (Sum of 1000bps. This helps to give a to account G*W) 1.49 for the unsystematic risk and the business score of 7.45% for India above is added to the WACC and called the Adjusted WACC. After finding the adjusted WACC for each project the NPV of all future cash flows is found out by using Adjusted WACC as a discount rate. CONCLUSION

Rob Veneres’s proposed model can intuitively integrate risk specific to each country and each project. His model helps to reflect a more transparent risk and proves to be more realistic than the WACC used previously(flat discount rate of 12%). These changes should be serious considered by the AES Corp. board and implemented immediately after it is accepted.