AES is a leading independent supplier of electricity in the world with more than $33 billion in assets. Rob Venerus, the director of Corporate Analysis and Planning group was faced with a task of calculating the capital cost of the business. Many financial information and results were collected from subsidiaries in June 2003. The manager was obligated to develop a methodology to use the data to determine the costs of capital significantly in valuation and for capital budgeting. The group was created to solve the financial crisis, current and future strategic challenges.
The global economic instability had adverse effects such as devaluation of currencies, changes in energy regulatory environments and the reduction in commodity prices. This led to decline in their revenues and, therefore, they could not service subsidiary and parent-level debt. The enterprise collapsed and its market share reduced because of shortage in earnings and cash distributions to the parent. The Corporate Analysis and Planning group created a new method for evaluating the capital cost for AES businesses. The process established was to be unique because the corporation was dealing with various countries and considered finance textbooks insignificant.
Veneers proposed two new methods that were to be used in the capital budgeting process and in calculating the capital cost. AES employed a project finance framework, in which all nonrecourse debt were good and investments assessed at an equity discount rate for the dividends earned. Returns were considered equally risky, and a discounted rate of 12% was used for all the projects. The method worked fairly well in a world where risks could be hedged and enterprises having similar capital structures. The international expansions of the company, however, strained the technique because of hedging exposures. The efficient solution had to be transparent, consistent, and accessible. It should account for the required alterations to ensure leverage, and should integrate aspects of a project’s risk profile.
Venerus evaluated the capital cost for each of the AES business in order to change the capital budgeting approach and to examine each capital input as a different project with exclusive risks. He derived a weighted average capital cost for each project by using the formula:
WACC= E/V*re+ D/v*rd (1-t)
The calculation of WACC involved the measurement of the cost of debt, the target capital structure, tax rates and cost of equity. The latter was estimated from an equity beta that did not measure the covariance of a project’s return to the world market portfolio. He developed an approach with two parts that included calculating cost of debt and equity for projects using the market data. He then added the difference between the yields on local and treasury government bonds to both costs of capital.
Calculating cost of equity and debt
Equity beta for a levered project= beta of unlevered/ E/V
Cost of Equity= rf +B (rm -rf), the traditional CAPM equation.
The calculation of cost of debt involved estimation of return on debt demanded by investors.
Cost of debt=rf + Default Spread
The default spread determination was based upon the relationship between EBIT coverage Ratios and cost of debt of other energy companies. The sovereign spread was added then added to cost of equity and cost of debt to generate WACC for each product. This was significant since it could provide a capital cost, which reflected the systematic risks in the local market. To solve the undiversifiable project-specific risk, the group created a risk scoring system to supplement the initial capital cost. This involved identification of seven categories of project –level risk. Each category was assigned a grade between zero and three, which were multiplied by their weights and then added together. This yielded a single business-specific risk score that was used to calculate an adjustment to the initial capital cost. A linear relationship was identified between business-specific scores and adjustments to the capital cost.
Alternative method used in calculating the capital cost is the use of the Dividend discount approach. The dividend payout for the company is 11.9%, the retention ratio, therefore, is 88.1% (Grose 2007, p.28).
The cost of equity is estimated by finding the product of the retention ratio and the expected return on equity.
The expected return on equity is 12%
The cost of equity =12%*88.1%= 10.57%
The cost of debt can be calculated by the formula:
Vd is the value of debt, t is the corporate tax.
The value of debt= 32.68billion
Value of equity= 7.73 billion
WACC= value of debt/total market value*cost of debt+ value of equity/ total market value *cost of equity
Total equity and debt 32.68+7.73=40.41
Grose, P. 2007. Power to people the inside story of AES and the globalization of electricity. Washington: Island Press
Chang, C. M. 2010. Service systems management and engineering: creating strategic differentiation and operational excellence. Hoboken, N.J.: John Wiley & Sons.