SuryaTejaAESCaseSubmission

EvaluatingtheHistoricalCapitalBudgetingMethod

CurrentlyAESemploysProjectFinanceFramework.Projectfinancetendstobeusedinprojects
withtangibleassetswithpredictablecashflowsinwhichconstructionandoperatingtargetscan
beeasilyestablishedthroughexplicitcontract.
ThekeytoAESprojectsfinancinglieswiththepreciseforecastingofcashflows.Ineffect,the
possibilityofestimatingcashflowswithanacceptablelevelofuncertaintyallowsforallocationof
risksamongvariousinterestedparties.Theensuingcertaintyincashflowsallowsforhighlevel
ofleverageandenablesprojectassetstobeseparatedfromtheparentcompany.
LetusnowtakeacloserlookattheprosandconsoftheCapitalBudgetingSystemcurrentlyin
place.

PrincipalAdvantages
NonRecourse

TheseparationoftheparentcompanyisstructuredthroughthecreationofaSpecialPurpose
Vehicle(SPV).ThisSPVistheformalborrowerunderallloandocumentssothatineventof
defaultorbankruptcyAESisnotdirectlyresponsiblebeforefinancialcreditors.Instead,their
legalclaimsareagainsttheSPVassets.

MaximizeLeverage
CurrentlyAESseekstofinancethecostofdevelopmentandconstructionoftheprojecton
highlyleveragedbasis.HighleveragedinnonrecourseprojectfinancingpermitsAEStoput
lessincapitaltoputatriskpermitsAEStofinancetheprojectwithoutdilutingitsequity
investmentintheproject.

OffBalanceSheetTreatment
AESmaynotberequiredtoreportanyoftheprojectdebtonitsbalancesheetbecausesuch
debtisnonrecourse.Offbalancesheettreatmentcanhavetheaddedpracticalbenefitof
helpingtheAEScomplywithcovenantsandrestrictionrelatingtoborrowingfundscontainedin
loanagreementstowhichAESisalsoaparty.

AgencyCost
Theagencycostsoffreecashflowarereduced.Managementincentivesaretoproject
performance.Mostimportantlyclosemonitoringbyinvestorsisfacilitated.
MultilateralFinancialInstitutions
OneofthefourconstituentsthathavecontractualarrangementwiththeSPVinatypicalproject
arethebanks(anintegralpartgroupoffinanciersthatincludeshareholders,insurers,
equipmentmanufacturers,exportcreditagenciesandfunds).Amongthesebanksthereare

multilateralfinancialinstitutions(likeIFC,CAFandetc).Presenceoftheseinstitutionsas
financiershelpsinraisingcapitalfromtheseinstitutesatlowercostandsecondlyitisalsoread
asapositivesignbycommercialbanks.

Drawbacks

ProjectsV/SDivision
Thecompanyisnotonlyexpandingitsgeographicalboundaries,butitisalsodiversifyingits
businessthroughbackwardandforwardintegration.Thecurrentfinancialmodeldoesnot
providetheAESwiththebigpicture,whichnowconstitutesmorenumberofvariablesthatare
beinginfluencedbymultiplefactorsduetotheincreaseindepthandbreadthofthe
organization.

Complexity
Financingofprojectsrequiresinvolvementofanumberofparties.Theycanbequitecomplex
andcanbeexpensivetoarrange.Secondlyitdemandsgreateramountofmanagementtime.

MacroeconomicRisk
ThecurrentmethodologyemployedbyAESforcapitalbudgetingdoesnottakeintoaccountthe
exchangeraterisk.Thisriskwillbeofhighermagnitudeinthedevelopingcountriesbecauseof
theirunstablemonetaryandfiscalpolicies.Aswehaveseenthatfluctuationinexchangerate
hasgreatlyhurttheAESbusinessandtheywereunabletomitigatethisriskastheyhavent
anticipatedit.Thisriskbecomesimportantwhentheexchangeratefluctuationaffectsbalance
sheetitemsunequally.Thuskeepingcheckontheforeignexchangeraterequirestimely
adjustmentofboththeitemsofrevenueandexpenditure,andthoseofassetsandliabilitiesin
differentcurrencies.

PoliticalRisk:

Thisisanotherimportantfactorwhichthecurrentfinancialmanagementsystemdoesnottake
intoaccount.Thiswillbeofsignificantimportancewhenitcomestoinvestingindeveloping
countrieswherefrequentchangesingovernmentpoliciesoccur.


Doesthissystemmakesense?

ThefinancialstrategyemployedbyAESwashistoricallybasedonprojectfinance.This
approachsolelytookintoaccountthosefactorsthatminimizedAESexposuretotheprojectand
achievedthemostbeneficialregulatorytreatmentthusensuringavailabilityoffinancial
resourcestocompletetheproject.Themodelworkedwellforthedomesticmarketaswellasfor
theinternationaloperations,providedtheopportunitiesundertookbyAESwereeitherinthe
sectorofbuildingandrunningapowerplantorsimplybuyinganexistingfacilityandupgradingit
andthenoperating.Theunderlyingassumptionoverherewasthatthesymmetricaland
asymmetricalrisksfacedbytheprojectweremoreorlesssameirrespectiveofitsgeographical
location(RefertoExhibit3).HoweverwhenAESstarteddiversifyingthebreadthofits
operationsbyincorporatingotheroffshootsofenergyrelatedbusinessandtransformingfroma
cogenerationtoamoreutilityorganizationwithmajorityofexpansionoccurringindeveloping
economies.Thisdiversificationofbusinessincreasedthesymmetricalriskslikebusinessrisk,a
classicexampleofwhichweseeinBrazilwhereAESexperienceshortfallindemand/sales
volumeduetoEnergyConservationPolicyofBraziliangovernmentandthishadachaineffect
ondebtservicingcapacityoftheSPVaswellthestockpriceoftheparentcompany.Other
factorthatcurrentmodelwasnotabletoincludewastheriskofdevaluationofcurrencyin
developingeconomieswhichresultedinsignificantlossesduetotheinabilityofthecompanyto
surviveitsinternationaldebtobligations.Expansionindevelopingeconomiesalsoexposedthe
businesstopoliticalriskwherethepolicieschangeerraticallywithchangesingovernment.
Henceweseethatthegeographicaldiversificationofbusinesscausesasymmetricalriskto
increasecausingbimodalbehaviorintheresult.Projectfinancingbecomesless
recommendableasasymmetricalriskbecomesmoremanifest.Thisconstitutesaproblemfor
emergingcountrieswheretheseriskstendstobeattheforefront.


LalPirProjectValuation

Scenario1:Pakistan

InordertocalculatethevalueofprojectfortheLalPirprojectinPakistan,wefirstneedto
calculatetheWeightedAverageCostofCapital(WACC)usingthenewproposedmethodology.
Forthiswehavefollowedtheapproachgiveninexhibit8ofthecase.Thefirststepisto
calculatethevalueofleveredusingtheformulaandinformationgiveninthecase.Thevalue
oftheleveredcomesouttobe0.3852or38.52%,whichessentiallymeansthatourprojectis
notveryhighlycorrelatedtothemarketreturn.Usingthisvalueofwenowcalculatethecostof
Equity(referExhibit4A).WehaveusedthereturnonU.S.TreasuryBond(i.e.4.5%)astherisk
freereturnincalculatingthecostofequity.Thecostofequitycomesouttobe0.072and
similarly,usingtheriskfreereturnandthedefaultspread(giveninexhibit7aofcase)we
calculatethecostofdebtwhichcomesouttobe0.0807.Itisimportanttonotethatthecostof
debtandthecostofequityalsoneedtobeadjustedforthesovereignspread(0.0990for
Pakistan).Oncewehavetheadjustedcostsofequityandcapitalwecannowcalculatethe
WACCfortheprojectusingtheformulagivenincasewhereweessentiallymultiplyequityand
debtratiowiththeadjustedcostsofequityanddebtrespectively.TheWACCinthisscenario
comesouttobe0.1595or15.95%.However,nowweneedtoadjustthisWACCfortherisks
associatedwithdoingtheprojectinPakistanandwedothisbyusingTableAgiveninthecase.
WeknowthatthetotalRiskScoreforPakistanis1.425andsincethereisalinearrelationship
betweenbusinessspecificriskscoresandcostofcapitalweneedtoadjustourWACCby
7.125%thusmakingourfinalWACC23.075%,usingwhichwecalculateourNPV(referto
Exhibit6)fromtheyear2004to2023,anditcomesouttobenegative$234.34million.

Scenario2:USA
ForUSAsimilarcalculationsaremadetocalculatetheWACC(Exhibit4B).Howeverthereare
twothingsthataredifferent.Firstweseethesovereignspreadisequaltozero.Secondly,inthis
casewewouldneedtocalculatethebusinessriskusingtheinformationgiveninexhibit7aof
thecase(refertoExhibit5).Thisscorecomesouttobe0.64andusingthisscore,ourbusiness
riskcomesouttobe3.23%andaddingittoourcalculatedvalueofWACC,wegetourfinal
WACCof9.64%.UsingthiswecalculateourNPVforUSAwhichcomesouttobenegative$
35.92million(refertoExhibit7).


AdjustedCostofCapitalandProbabilitiesofRealEventsinPakistan

IncalculatingtheadjustedcostofcapitalforPakistantheWACCisadjustedforsixcommon
typesofrisks:Operational,Counterparty,Regulatory,Construction,Commodity,Currencyand
Legal.WecanclearlyseefromtableAgiveninthecasethatbesidesconstructionthereisa
probabilityofalltheserisksactuallyeffectingtheprojectinPakistan.Inthese,thehighest
probabilityisthatofcurrencyriskandthelegalrisk.Theadjustedcostthatwehavecalculated
isadjustedbythetotalriskscoreforPakistan.Thereisalinearrelationshipbetweenthetotal
riskscoreandadjustmenttothecostofcapital,i.e.ascoreof1leadstoanadjustmentof500
basispointsintheWACC.WhenwecalculatetheWACCforPakistanthroughtraditional
formulaitcomesouttobe15.95%,howeverinordertoincorporatetheriskfactorassociated
withPakistanweneedtoadjustitfortheTotalRiskScore,whichinthiscaseis1.425.Sowe
simplymultiplythisby500andwefindoutthatweneedtoadjustourWACC23.075%.Since
this23.075%isadjustedusingthetotalriskscorewecansafelyassumethatitincorporatesfor
theprobabilityoftheafromentionedsixtypesofrisksinWACCwithrespecttoPakistan.

DiscountRateAdjustment:USAv/sPakistan
Asmentionedearlierthediscountrateisadjustedbasedonthetotalriskscoreofthecountry.
Thistotalriskscoreiscompiledfrom6maintypesofrisks,theprobabilityofwhichvariesfrom
countrytocountry.IfwesimplycomparetheriskscoresforUSAandPakistan,wecanseethat
thereisamajordifferencebetweentheriskprofilesofboththecountries.Forinstance,while
currency,regulatoryandlegalrisksaresignificantlyhighinPakistan,theydonotexistinthe
USAatall.Alsoweseethatoperational,counterpartyandcommodityrisksarehigherinUSA
ascomparedtoPakistan.SimilarlywhentherespectiveWACCsofthetwocountriesare
adjustedfortheirriskweseethattheadjustedWACCforPakistan(23.075%)ismuchhigheras
opposedtothatofUSA(9.64%),whichessentiallyimpliesthatPakistanisinherentlyariskier
countrytoinvestinasopposedtotheUSAandanyinvestmentsmadeinthisregionwouldhave
tocrossahigherhurdleratethaniftheyweremadeintheUSregion.