Essay on Aes - Hbs Case Study

1360 Words Nov 29th, 2010 6 Pages
1. How would you evaluate the capital budgeting method used historically by AES? What's good and bad about it?

Historically, the AES capital budgeting method primarily used the following assumptions: • All nonrecourse debt was regarded as good

• Dividend cash flow were considered equally risky

• Project was evaluated by the equity discount rate for the dividends from the project

• A 12% discount rate was applied to all projects.

The historical method is quite simplistic in terms of project evaluation as it ignores the volatility in the market and the economy, it is more suited to a domestic market and a constant discount rate across all projects is usually unrealistic as projects usually have varying risks
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If there are risk factors omitted, or if some of the risk factors are under-weighted or over-weighted, the premium becomes inaccurate and can sometimes lead to bad decisions by management.

2 additional major points which need to be addressed:

1. Initially, AES assumed non-recourse debt, i.e. the failure of one project should not have ideally affected the parent company and consequently other projects. However, during the downturn, it was clear this did not happen. Individual projects did have an exposure to the parent's health (which depended on dividend flow from various other subsidiaries). AES itself borrowed at the parent level to fund holding companies and subsidiary projects, and the ability to borrow efficiently depended on its consolidated balance sheets which were significantly dependant on the subsidiaries' financial health.

Thus a weighting of risk exposure to other projects needed to be taken into account.

2. The sustainability of maintaining a matrix of risk ranks and probabilities is not clear. While the method makes sense, it needs to been evaluated in terms of whether AES is trying too hard to capture the business risks, or if they are successfully doing so. As mentioned above, sovereign specific risks would account for a majority of the common risk factors accounted for in the business risk. Hence, we need to ask whether AES intends to update the

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