Multinational capital budgeting

Globalizing the Cost of Capital and Capital Budgeting at AES, Harvard Case 5-206-080Multinational capital budgeting

Table of contentDescription of the case

The Venerus methodology

Our mitigations

Description of the caseCompany overviewNew countries, new businesses, new risks

Overview of the companyUS-based global power company: electricity generation and distribution

1985: Texas

2000: 30 countries and 5 continents

4 separate lines of business

New countries, new businesses, new risksOriginally, similar investments => 1 unique discount rate

Overseas development implied businesses with:New risksNew financial structureBut still same discount rate

Overvaluing and undervaluing projects Great losses for AES

A new methodologyDescriptionLal Pir ProjectConsiderations on the methodology

descriptionStepRequired InformationApproach1. Calculate unlevered equity betaBetas at comparable U.S. CompaniesUnlever and average equity betas for comparables in each AES line of business2. Relever equity betas at target capital structureTarget capitalization ratiosEstimated by project using cash flows to calculate desired EBIT coverage3. Calculate cost of equity for each AES businessRisk-free rate10-Year U.S. Treasury NoteEquity risk premiumLong-term avg. Difference between S&P 500 and U.S. TreasuriesRelevered equity betaLevered = Unlevered / (E/V)4. Calculate the cost of debtRisk-free rate10-Year U.S. Treasury NoteDefault spreadRelationship between EBIT coverage ratios for comparable companies and their costs of debt5. Add country specific risk to the cost of debt and cost of equityLocal sovereign spreadThe difference between local government dollar-denominated bond yields and the corresponding U.S. Treasure Notebeta estimationSelect Financial InformationUn-levered Equity Betas by Line of Business Contract Generation0,25 Large Utility0,25 Growth Distribution0,25 Competitive Supply0,50beta estimationSelect Financial InformationUn-levered Equity Betas by Line of Business Contract Generation0,25 Large Utility0,25 Growth Distribution0,25 Competitive Supply0,50StepRequired InformationApproach1. Calculate unlevered equity betaBetas at comparable U.S. CompaniesUnlever and average equity betas for comparables in each AES line of businessCOST OF EQUITY LeveredUnlevered 0,25D/V35,10%E/V64,90%Tax Rate23,00% Levered0,39Cost of Equity (Ke)Rf4,50%MRP7,00% Levered0,39Ke7,20%StepRequired InformationApproach2. Relever equity betas at target capital structureTarget capitalization ratiosEstimated by project using cash flows to calculate desired EBIT coverageStepRequired InformationApproach3. Calculate cost of equity for each AES businessRisk-free rate10-Year U.S. Treasury NoteEquity risk premiumLong-term avg. Difference between S&P 500 and U.S. TreasuriesRelevered equity betaLevered = Unlevered / (E/V)COST OF DEBTStepRequired InformationApproach4. Calculate the cost of debtRisk-free rate10-Year U.S. Treasury NoteDefault spreadRelationship between EBIT coverage ratios for comparable companies and their costs of debtCost of Debt (Kd)Rf4,50%Default Spread3,57%Kd8,07%Country risk premiumStepRequired InformationApproach5. Add country specific risk to the cost of debt and cost of equityLocal sovereign spreadThe difference between local government dollar-denominated bond yields and the corresponding U.S. Treasury NoteAdjusted Cost of Equity (Ke)Rf4,50% Levered0,39MRP7,00%Ke7,20%Country Risk9,90%Adjusted Ke17,10%Adjusted Cost of Debt (Kd)Rf4,50%Default Spread3,57%Kd8,07%Country Risk9,90%Adjusted Kd17,97%Business riskCategories of RiskWeightGrade for Lal PirRisk Scores (grade x weight)Operational / Technical3,50%10,035Counterparty Credit / Performance7,00%10,070Regulatory10,50%20,210Construction14,50%00,000Commodity18,00%10,180Currency21,50%20,430Contractual Enforcement / Legal25,00%20,500Sum of individual scores = business specific risk score1,425Adjustment to WACC: 712,5 bp.Adjusted Cost of capitalAdjusted Cost of Equity (Ke)Rf4,50% Levered0,39MRP7,00%Ke7,20%Country Risk9,90%Adjusted Ke17,10%Adjusted Cost of Debt (Kd)Rf4,50%Default Spread3,57%Kd8,07%Country Risk9,90%Adjusted Kd17,97%Adjusted Cost of Capital (WACC)Adj. Ke17,10%E/V64,90%Adj. Kd17,97%D/V35,10%WACC15,95%Business Risk1,425Adjustment to WACC7,125%Adj. WACC23,08%Lal pir projectDiscounted CF (Old Ke)End of 2003Growth0,0%Cost of Equity12,00%Terminal Value0,0Explicit Horizon179,6Equity Value179,6Discounted CF (New WACC)End of 2003Growth0,0%Cost of Capital23,08%Terminal Value0,0Explicit Horizon276,6Enterprise Value276,6Market Value of Debt430,7Excess Cash0,0Equity Value-154,015MitigationsNew methodology resultsKey interrogationsSuggested alternatives

The new methodology resultsBusiness / ProjectCountryLine of BusinessSovereign SpreadCost of Equity (Ke)Cost of Debt (Kd)Business RiskCost of Capital (WACC)Red OakUSACG0,00%7,39%8,07%3,20%9,66%OttanaItalyCS0,14%10,73%8,98%2,13%10,77%GenerChileCG1,73%8,93%10,57%3,75%12,63%KelvinSouth AfricaCG3,14%10,25%11,98%5,35%15,18%DraxUnited KingdomCS0,00%9,46%8,07%7,30%16,35%HaripurBangladeshCG5,23%12,35%14,07%3,95%16,88%OPGCIndiaCG3,60%10,61%11,67%7,45%18,11%RivnoblenergoUkraineGD9,98%17,24%18,05%3,03%18,58%Lal PirPakistanCG9,90%17,10%17,97%7,13%23,08%UruguaianaBrazilCG8,93%16,01%15,28%11,05%25,15%EletropauloBrazilLU8,93%15,93%16,32%10,88%25,26%Los MinaDominican RepublicCG8,93%15,88%15,28%12,83%27,44%TelasiGeorgiaGD9,98%16,85%16,33%12,65%28,51%AndresDominican RepublicCG8,93%16,13%17,00%15,00%29,94%CaracolesArgentinaCS16,25%26,66%24,32%9,13%31,36%Key interrogationsBeta based only on US comparablesBusiness risk discrepancies:The UK plant has a higher business risk than Lar Pir in Pakistan, than Haripur in Bangladesh Project-specific spread is linearCost of equity is often lower than cost of debt

Suggest alternatives:Sovereign risk premiumBetaBusiness-risk Suggested alternativesthe Sovereign risk premium (1/2)Methodology: Sovereign premium based on ratingsMeasure of the default risk of country

Issues:certain lag in comparison to markets when it comes to responding to changes in the default risk Rating agencies focus more on default risk : understatement of the equity risk premiums

Suggested alternativesthe Sovereign risk premium (2/2)Numerical country risk scores vs. rating agenciesCountry Risk Model (the Economist)6 categories of risk:Sovereign RiskCurrency RiskBanking Sector RiskPolitical RiskEconomic Structure RiskOverall Country RiskSuggested alternativesthe beta estimation (1/2)Separate developed and strong emerging economiesFind local comparables

Other emerging countriesFind US comparables with exposure on emerging economies3-steps approach McKinsey Valuation Methodology Identify the broader industry in the emerging countryAnalyse historical discrepencies Add mark-up to the equity beta of the US-comparables accordingly

Suggested alternativesThe business-specific risk

Double counting risks? Regulatory, currency and commodity might already be included in the sovereign spreadRepresent 50% of the business-specific risk

Weights allocation?SubjectiveShould they be the same for each project?

The adjustment to the WACC should be exponentialConclusionNo consensus to have the best risk estimation

Accuracy and relevance improvement suggested