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 didnt 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
 - 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 Risk
score for project Grade( Weight(
in India G) W)
Construction 0 0.145
Operation/tech 1 0.035
Regulatory 3 0.105
Currency 2 0.215
Counterparty 3 0.07
Contract enf. /
Legal 2 0.25
Commodity 0 0.18
The Business Risk Score for India
(1.49) is halved and Business Risk then multiplied by
Score (Sum of
1000bps. This helps G*W) 1.49
to give a to account
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 Veneress 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.