SOUTHERN

METHODIST
UNIVERSITY
HW4. Globalizing the Cost of Capital at AES
Decision Point:

Rob Venerus, the head of Corporate Analysis & Planning Group,

has to develop a methodology for calculating the cost of capital
for AESs diverse businesses around the world.

Setting:

U.S. multinational with businesses in 30 countries and on five

continents, 2003.

Analytic Exercise:

Calculation of the cost of capital for projects in 15 countries.

Each projects WACC is initially derived from the CAPM then
adjusted for country and project-specific risks according to the
methodology presented in the case.

Key Learning Points

AES faces a problem common to every company that invests

beyond its home borders: how to asses the risks of projects in
different countries and how to incorporate these risks in its
financial analyses of these projects. The case allows students to:
o Explore the problems managers confront when they have
to evaluate different types of projects across countries
with different political an economic characteristics
o Use the CAPM in an international context
o Consider how a projects value is affected when it is
valued using an adjusted cost of capital and if such
revised values are credible.

Case Questions:

PLEASE READ AES FAQs BEFORE COMPLETING

How would you evaluate the capital budgeting method used
historically by AES? What is good and bad about it?
If Venerus implements the suggested methodology, what would
be the range of discount rates that AES would use around the
world?
Does this make sense as a way to do capital budgeting?
What is the value of the Pakistan project using the cost of capital
derived from the new method? If this project was located in the
U.S., what would its value be?
How does the adjusted cost of capital for the Pakistan project
reflect the probabilities of real events? What does the discount
rate adjustment imply about expectations for the project because
if its located in Pakistan and not the U.S.?

SOUTHERN
METHODIST
UNIVERSITY
AES FAQ
Is there any limit to the number of pages for the write up?
No reasonable limit, turn in what you feel is necessary to answer the questions
completely.
Do we need to calculate all the WACCs for each project?
Yes, you should build a spread sheet to show you the range of discount rates implied by
the new method
To get the value of the project, can we just take the FCFs as given, or do I need to adjust
them for anything (like taxes or initial investment).
You can use the FCFs as given. Note these are the unlevered cash flows. When you use
the cost of capital that includes a mix of debt and equity, to be consistent with it, the
numerator has to be unlevered cash flows (i.e., cash flow that is available for distribution
to both debt and equity holders).
Is that a typo on Table A, shouldnt the risk score for operational/technical be .035 and
the total 1.425?
Yes, Ill take either answer as correct, that is, using 1.41 or 1.425.
Do I need to recalculate default premiums or can I take them as given in Table 7a?
You can just use the Table 7a default premiums.
On Question 2 of the case, when we are trying to calculate the cost of capital for the
Pakistan project, we are supposed to find comparable betas of other companies doing a
similar line of business, which we would subsequently unlever to find a project specific
beta. Do you know where I can find their betas?
See unlevered betas, which are synonymous to asset betas in Exhibit 7b.
In exhibit 12, the cash flows with TV (terminal value) and without it are exactly the
same. How can that be?
It is presumably because it is a project with a finite life, i.e., 20 years with the explicit
forecasting period of 20 years so there is nothing left in terminal value. In company
valuations (as opposed to project valuations), the cash flows with or with TV differ
simply because companies are treated as going concerns.
Should I try to recompute FCF when I do my valuation?
No, take the FCFs as given and discount by the WACC you compute from the new
method. This case is designed to get you to discuss the specific COC method by using the
projected FCFs as given, rather than spending a lot of time doing a perfect valuation.
Also note while leverage changes thru time, you can assume one WAAC for the life of
the project with the given cash flows.

SOUTHERN
METHODIST
UNIVERSITY

How much detail should I go into when analyzing changes in the cash flows?
Heres a suggestion: Just take the FCF as given, then play around with scenarios like (1)
full expropriation in X number of years or (2) 50% expropriation starting in year Y (3)
etc. The Dow case had a more detail that allowed more specifics, this time the above
should allow you to get the jist of what is going on.
What is the debt to capital in exhibit 7a?
That is the debt to value ratio.