AES CASE STUDY

AES Corporation
Tim Castorena

AES CASE STUDY

Date: April 26, 2011
To: Dr. David Hemley
From: Tim Castorena
Subject: AES Case Study

Introduction
An analysis of AES Company case has been performed, which consists of assessments of the

case, evaluating AES’s standard WACC, evaluating Venerus’s adjusted WACC, and determining

if Venerus should present his adjusted WACC to the board and use the Venerus’s adjusted

WACC.

AES brought Rob Venerus in June 2003 to direct the newly created Corporate Analysis &

Planning. A combination of factors including the devaluation of key South American currencies,

adverse changes in energy regulatory environments, and declines in energy commodity prices

conspired to weaken cash flow at AES subsidiaries and hinder the company’s ability to service

subsidiary and parent-level debt. As earnings and cash distribution to the parent started to

deteriorate, AES stock collapsed and its market capitalization fell nearly 95% from $28 billion in

December 2000 to 1.6 billion just two years later. Venerus reviewed the company’s existing

assets, which required creating a new method of calculating the cost of capital for AES business.

In 2002, AES was organized around four separate lines of business: Contract Generation,

Competitive Supply, Large Utilities, and Growth Distribution.

1
 AES CASE STUDY
AES Corporation
Tim Castorena

Evaluation of Standard WACC

Capital budgeting for AES was simple while using the standard WACC formula because AES

mainly did domestic contract generation projects where the risk of changes to input and output

prices was minimal. All dividend flows were considered equally risky, and a 12% discount rate

was used for all projects. However, the current model had become strained because of the

expansions in Brazil and Argentina where hedging key exposures such as regulatory or currency

risk was not feasible. Venerus did not believe that the World CAPM was sufficient for AES use,

because World CAPM was not ideal for developing countries. Also, Venerus feared that the

World CAPM would yield artificially low costs due to low correlation of developing countries.

Venerus also did not advocate the using Local CAPM, because the beta measured the covariance

of a project’s returns with a portfolio of local equities and certain countries did not have

meaningful equity markets or local benchmarks.

Evaluation of Venerus’s Adjusted WACC

Venerus’s approach to an adjusted WACC for AES consisted of five steps. Step 1 was to

calculate the unlevered equity beta. He derived his calculations from betas of comparable U.S.

companies and then averaged them together. Step 2 Relevered the equity betas at AES’s targeted

capital structure. This was taking the unlevered beta and dividing it by the equity weight of that

specific project. Step 3 calculated cost of equity for each of AES business. Step 3 was basically

his relevered beta implemented into the CAPM. The risk-free rate, 4.5%, was derived from 10-

year U.S. Treasury Bond. Equity risk premium, 7%, was the long-term average difference

2
 AES CASE STUDY
AES Corporation
Tim Castorena

between the S&P 500 and U.S. Treasuries. The table below is an example of the relevered beta

included in the Venerus’s CAPM for Project 1, Andres. Exhibit 1 shows all of the projects and

the beta was relevered and how the CAPM was calculated per project.

Andres CG
Dominican Republic
CAPM
Risk-free rate 4.5%
Equity risk premium 7%
Unlevered beta 0.25
D/E Ratio 35.10%
Relevered beta .25/1-35.10% 0.39
CAPM 7.20%

Step 4 calculated the cost of debt. Venerus used a default spread per project where he observed

the relationship between EBIT coverage ratios for comparable energy companies and their cost

of debt. The default spread for that specific project was then added to the risk-free rate to total up

a cost of debt for that project. Step 5 then added country specific risk to the cost of debt and cost

of equity. The local sovereign spread was added to both cost of debt and cost of equity prior to

inputting them into the WACC. The sovereign spread was the difference between the yield on

local government bonds and the yield on corresponding U.S. Treasury Bonds. Once the WACC

was calculated the business-specific risk score was added to WACC. The business-specific risk

score was calculated by the weight of seven categories of risk for AES and multiplied to a

measure of that risk in that specific project. The measures in the projects were from 0 to 3. The

table below shows an example for Andres’ project. Exhibit 2 shows every project and how each

business-risk score was calculated.

3
 AES CASE STUDY
AES Corporation
Tim Castorena

Andres CG
Dominican Republic
Business-Risk Score
Grade Risk Weight
Construction 3 0.145
Operation/tech 3 0.035
Regulatory 3 0.105
Currency 3 0.215
Counterparty 3 0.07
Contract enforcement/legal 3 0.25
Commodity 3 0.18
Business-specific Risk Score 3.00

The business-specific risk score was adjusted into the WACC by taking the highest score and

measuring it at 1500bp. The 1500bp translates into 15% which was added to the results of

Venerus’s WACC. The table below shows the calculations of the Venerus’s WACC in the

Andres project. Exhibit 3 shows the WACC calculations for all projects in AES.

Andres CG
Dominican Republic
WACC
Cost of Debt 17.00%
After tax cost of debt 12.75%
Debt Weight 35.10%
Equity Weight 64.90%
Equity Cost 16.13%
WACC 14.94%

Cost of debt was calculated by adding the default spread of 3.57% for Andres to the risk-free rate

of 4.5% and then adding the sovereign spread of Andres to the overall cost of debt. The cost of

equity was the CAPM results for Andres plus the sovereign spread.

4
 AES CASE STUDY
AES Corporation
Tim Castorena

Conclusion
Venerus had a decision to make. He wondered whether he should move forward with proposing

this new methodology of adding business-specific risk scores to the WACC to the board.

Venerus was brought onto a newly created Corporate Analysis & Planning department. Board

members are aware that the traditional WACC was not working due to the events that were

occurring internationally.

The proposal by Venerus should be nothing short of a great idea. The adjusted WACC would be

pessimistic for AES, but it should be what they needed. AES was being too optimistic in their

cash flows. AES assumed that the subsidiary companies were going to maintain 12% dividends

to the parent company, and never considered potential disasters they were to face in developing

countries. The new conservative approach in the WACC would keep their cash flows more

realistic.

While exercising Venerus’s WACC the company would also be in movement of recapitalizing

their capital structure to something more optimal or reasonable to maintain. Defaulting on debt

was one of the largest problems the company was facing when the international adverse factors

took place. Venerus should strongly advice AES to adopt his method for at least two years to

determine if it works. Worst case scenario would be that the results were too pessimistic for

AES, but the factors Venerus utilized in his methods could be further adjusted.

The sovereign spread is a good idea to add it in on both forms of capital structure. As stated

before, AES’s prior methods were not considering enough risk. Also the areas at which AES

5
 AES CASE STUDY
AES Corporation
Tim Castorena

operated were not exactly familiar territories in terms of how much risk to apply. Overall

Venerus understands that AES needs to consider enough risk. He adds that in his adjustments

and they could be further adjusted if they were assuming they were taking too much risk.

Options could be to add sovereign spread to only cost of debt or to only cost of equity. Exhibit 4

shows WACCs under those situations. His decision should be to move forward with his

methodology and propose it to the board. AES at this point should be aware that they need to

find out ways to derive feasible risks in their operations.

6
 AES CASE STUDY
AES Corporation
Tim Castorena

Exhibit 1:

Company Andres Caracoles Drax Eletropaulo Gener Haripur Kelvin Lal Pir Los Mina OPGC Ottana Red Oak Rivnoblenergo Telasi Uruguaiana
Tax Rate 25.00% 35.00% 0.00% 34.00% 17.00% 0.00% 25.00% 23.00% 25.00% 7.90% 35.00% 37.50% 30.00% 20.00% 34.00%
D/E Ratio 35.10% 40.80% 29.50% 30.00% 35.20% 33.30% 32.90% 35.10% 28.70% 30.40% 42.50% 39.50% 36.50% 26.10% 32.20%
EBIT Coverage 3.0 3.0 3.0 3.5 2.5 2.5 2.5 3.0 4.0 3.0 2.5 3.0 2.5 4.0 4.0
Default Spread 3.57% 3.57% 3.57% 2.89% 4.34% 4.34% 4.34% 3.57% 1.85% 3.57% 4.34% 3.57% 3.57% 1.85% 1.85%
Sovereign Spread 8.93% 16.25% 0.00% 8.93% 1.73% 5.23% 3.14% 9.90% 8.93% 3.60% 0.14% 0.00% 9.98% 9.98% 8.93%
Line of Business CG CS CS LU CG CG CG CG CG CG CS CG GD GD CG
Beta levered 0.39 0.84 0.71 0.36 0.39 0.37 0.37 0.39 0.35 0.36 0.87 0.41 0.39 0.34 0.37
CAPM 7.20% 10.41% 9.46% 7.00% 7.20% 7.12% 7.11% 7.20% 6.95% 7.01% 10.59% 7.39% 7.26% 6.87% 7.08%

7
 AES CASE STUDY
AES Corporation
Tim Castorena

Unlevered Beta
CG 0.25
LU 0.25
GD 0.25
CS 0.5

Exhibit 2:

Andres Caracoles Drax Eletropaulo Gener Haripur Kelvin Lal Pir Los Mina OPGC Ottana Red Oak Rivnoblenergo Telasi Uruguaiana
Construction 3 3 0 0 0 2 1 0 0 0 0 0 0 0 0
Operation/tech 3 2 2 1 0 0 0 1 3 1 0 2 0 2 0
Regulatory 3 2 2 3 1 0 1 2 3 3 0 0 1 3 3
Currency 3 2 0 3 1 0 2 2 3 2 1 0 2 3 3
Counterparty 3 0 2 1 1 1 2 1 3 3 3 3 1 3 2
Contract enforcement/legal 3 2 2 3 0 1 1 2 3 2 0 0 0 3 3
Commodity 3 1 3 2 2 1 0 1 3 0 0 2 0 3 2
Business-specific Risk Score 3.00 1.83 1.46 2.18 0.75 0.79 1.07 1.43 2.57 1.49 0.43 0.64 0.61 2.53 2.21
bp adjustment 1500 912.5 730 1087.5 375 395 535 712.5 1282.5 745 212.5 320 302.5 1265 1105
bp adjustment as a % 15.00% 9.13% 7.30% 10.88% 3.75% 3.95% 5.35% 7.13% 12.83% 7.45% 2.13% 3.20% 3.03% 12.65% 11.05%

8
 AES CASE STUDY
AES Corporation
Tim Castorena

Risk Weight
0.145
0.035
0.105
0.215
0.07
0.25
0.18

9
 AES CASE STUDY
AES Corporation
Tim Castorena

Exhibit 3:

Venerus Adjusted WACC Andres Caracoles Drax Eletropaulo Gener Haripur Kelvin Lal Pir Los Mina OPGC Ottana Red Oak Rivnoblenergo Telasi Uruguaiana
Cost of Debt 17.00% 24.32% 8.07% 16.32% 10.57% 14.07% 11.98% 17.97% 15.28% 11.67% 8.98% 8.07% 18.05% 16.33% 15.28%
After tax cost of debt 12.75% 15.81% 8.07% 10.77% 8.77% 14.07% 8.99% 13.84% 11.46% 10.75% 5.84% 5.04% 12.64% 13.06% 10.08%
Debt Weight 35.10% 40.80% 29.50% 30.00% 35.20% 33.30% 32.90% 35.10% 28.70% 30.40% 42.50% 39.50% 36.50% 26.10% 32.20%
Equity Weight 64.90% 59.20% 70.50% 70.00% 64.80% 66.70% 67.10% 64.90% 71.30% 69.60% 57.50% 60.50% 63.50% 73.90% 67.80%
Equity Cost 16.13% 26.66% 9.46% 15.93% 8.93% 12.35% 10.25% 17.10% 15.88% 10.61% 10.73% 7.39% 17.24% 16.85% 16.01%
WACC 14.94% 22.23% 9.05% 14.38% 8.88% 12.93% 9.83% 15.95% 14.61% 10.66% 8.65% 6.46% 15.56% 15.86% 14.10%
WACC + Business Risk 29.94% 31.36% 16.35% 25.26% 12.63% 16.88% 15.18% 23.08% 27.44% 18.11% 10.77% 9.66% 18.58% 28.51% 25.15%

10
 AES CASE STUDY
AES Corporation
Tim Castorena

Exhibit 4:

WACC w/o Sovereign Spread Andres Caracoles Drax Eletropaulo Gener Haripur Kelvin Lal Pir Los Mina OPGC Ottana Red Oak Rivnoblenergo Telasi Uruguaiana
Interest on Debt 8.07% 8.07% 8.07% 7.39% 8.84% 8.84% 8.84% 8.07% 6.35% 8.07% 8.84% 8.07% 8.07% 6.35% 6.35%
After tax cost of debt 6.05% 5.25% 8.07% 4.88% 7.34% 8.84% 6.63% 6.21% 4.76% 7.43% 5.75% 5.04% 5.65% 5.08% 4.19%
Debt Weight 35.10% 40.80% 29.50% 30.00% 35.20% 33.30% 32.90% 35.10% 28.70% 30.40% 42.50% 39.50% 36.50% 26.10% 32.20%
Equity Weight 64.90% 59.20% 70.50% 70.00% 64.80% 66.70% 67.10% 64.90% 71.30% 69.60% 57.50% 60.50% 63.50% 73.90% 67.80%
Equity Cost 7.20% 10.41% 9.46% 7.00% 7.20% 7.12% 7.11% 7.20% 6.95% 7.01% 10.59% 7.39% 7.26% 6.87% 7.08%
WACC 6.79% 8.30% 9.05% 6.36% 7.25% 7.70% 6.95% 6.85% 6.33% 7.14% 8.53% 6.46% 6.67% 6.40% 6.15%
WACC + Business Risk 21.79% 17.43% 16.35% 17.24% 11.00% 11.65% 12.30% 13.98% 19.15% 14.59% 10.65% 9.66% 9.69% 19.05% 17.20%

WACC Debt SS Andres Caracoles Drax Eletropaulo Gener Haripur Kelvin Lal Pir Los Mina OPGC Ottana Red Oak Rivnoblenergo Telasi Uruguaiana
Interest on Debt 17.00% 24.32% 8.07% 16.32% 10.57% 14.07% 11.98% 17.97% 15.28% 11.67% 8.98% 8.07% 18.05% 16.33% 15.28%
After tax cost of debt 12.75% 15.81% 8.07% 10.77% 8.77% 14.07% 8.99% 13.84% 11.46% 10.75% 5.84% 5.04% 12.64% 13.06% 10.08%
Debt Weight 35.10% 40.80% 29.50% 30.00% 35.20% 33.30% 32.90% 35.10% 28.70% 30.40% 42.50% 39.50% 36.50% 26.10% 32.20%
Equity Weight 64.90% 59.20% 70.50% 70.00% 64.80% 66.70% 67.10% 64.90% 71.30% 69.60% 57.50% 60.50% 63.50% 73.90% 67.80%
Equity Cost 7.20% 10.41% 9.46% 7.00% 7.20% 7.12% 7.11% 7.20% 6.95% 7.01% 10.59% 7.39% 7.26% 6.87% 7.08%
WACC 9.15% 12.61% 9.05% 8.13% 7.75% 9.44% 7.73% 9.53% 8.25% 8.15% 8.57% 6.46% 9.22% 8.49% 8.05%
WACC + Business Risk 24.15% 21.74% 16.35% 19.01% 11.50% 13.39% 13.08% 16.65% 21.07% 15.60% 10.69% 9.66% 12.24% 21.14% 19.10%

Weighted SS WACC Andres Caracoles Drax Eletropaulo Gener Haripur Kelvin Lal Pir Los Mina OPGC Ottana Red Oak Rivnoblenergo Telasi Uruguaiana
Interest on Debt 11.20% 14.70% 8.07% 10.07% 9.45% 10.58% 9.87% 11.54% 8.91% 9.16% 8.90% 8.07% 11.71% 8.95% 9.23%
After tax cost of debt 8.40% 9.56% 8.07% 6.65% 7.84% 10.58% 7.40% 8.89% 6.68% 8.44% 5.78% 5.04% 8.20% 7.16% 6.09%
Debt Weight 35.10% 40.80% 29.50% 30.00% 35.20% 33.30% 32.90% 35.10% 28.70% 30.40% 42.50% 39.50% 36.50% 26.10% 32.20%
Equity Weight 64.90% 59.20% 70.50% 70.00% 64.80% 66.70% 67.10% 64.90% 71.30% 69.60% 57.50% 60.50% 63.50% 73.90% 67.80%
Equity Cost 4.67% 6.16% 6.67% 4.90% 4.67% 4.75% 4.77% 4.67% 4.96% 4.88% 6.09% 4.47% 4.61% 5.08% 4.80%
WACC 5.98% 7.55% 7.08% 5.42% 5.78% 6.69% 5.64% 6.15% 5.45% 5.96% 5.96% 4.70% 5.92% 5.62% 5.22%
WACC + Business Risk 20.98% 16.67% 14.38% 16.30% 9.53% 10.64% 10.99% 13.28% 18.28% 13.41% 8.08% 7.90% 8.94% 18.27% 16.27%

11
AES CASE STUDY
AES Corporation
Tim Castorena

12