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    ________________________________________________________________________________________________________________ Professor Mihir Desai and Research Associate Doug Schillinger prepared this case. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management. Copyright 2004 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any meanselectronic, mechanical, photocopying, recording, or otherwisewithout the permission of Harvard Business School.

    M I H I R D E S A I

    Globalizing the Cost of Capital and Capital Budgeting at AES

    In June 2003, Rob Venerus, director of the newly created Corporate Analysis & Planning group at The AES Corporation, thumbed through the five-inch stack of financial results from subsidiaries and considered the breadth and scale of AES. In the 12 years since it had gone public, AES had become a leading independent supplier of electricity in the world with more than $33 billion in assets stretched across 30 countries and 5 continents. Venerus now faced the daunting task of creating a methodology for calculating costs of capital for valuation and capital budgeting at AES businesses in diverse locations around the world. He would need more than his considerable daily dose of caffeine to point himself in the right direction.

    Much of AESs expansion had taken place in developing markets where the unmet demand for energy far exceeded that of more developed countries. By 2000, the majority of AES revenues came from overseas operations; approximately one-third came from South America alone. Once a critical element in its recipe for success, the companys international exposure hurt AES during the global economic downturn that began in late 2000. A confluence 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 companys ability to service subsidiary and parent-level debt. As earnings and cash distributions 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.

    As one part of its response to the financial crisis, AES leadership created the Corporate Analysis & Planning group in order to address current and future strategic and financial challenges. To begin the process, the CEO and board of directors asked Venerus, as director of the new group, to revalue the companys existing assets, which required creating a new method of calculating the cost of capital for AES businesses. Central to the questions facing Venerus was the international scope of AES, as he explained: As a global company with operations in countries that are hugely different from the U.S., we need a more sophisticated way to think about risk and our cost of capital around the world. And, frankly, the finance textbooks arent that helpful on this subject.

    The mandate from the board of AES to create a new methodology presented an interesting but overwhelming challenge. As he prepared his materials for the board, Venerus wondered if his new approach would balance the complexities of the unique business situations around the world with

  • 204-109 Globalizing the Cost of Capital and Capital Budgeting at AES


    the need for a simple, straightforward process that could be implemented accurately and consistently throughout the organization.

    AES Corporation1

    Roger Sant (MBA 60, HBS) and Dennis Bakke (MBA 70, HBS) founded AES Corporation (originally Applied Energy Services) in 1981 shortly after the adoption of federal legislation that became known as the Public Utility Regulatory Policy Act (PURPA). The legislation was part of the United States governments reaction to growing concern over American dependence on foreign oil. The act sought to diminish this dependence by requiring that electric utilities source some of their new power needs through qualified cogenerators and small independent power producers, provided that the power generated by independents cost less than if the utility were to produce the power itself. Sant and Bakke recognized that in shielding small independent power producers from costly state and federal regulation, PURPA actually created a market for a new private sector power market. In practice, the act almost ensured that independent power producers could undercut a utilitys cost of production.

    The company initially struggled to raise financing but after the construction of its first cogeneration facility in Houston, Texas, in 1983 and the subsequent development of a profitable cogeneration facility in Pittsburgh, Pennsylvania, in 1985, AES experienced rapid growth. By the time the company went public in 1991, revenues had grown to $330 million and net income had soared to $42.6 million from $1.6 million just three years earlier.

    In the early 1990s, AES began to shift its focus overseas where there were more abundant opportunities for the company to apply its nonrecourse, project finance model to the development of contracted generating facilities. In addition, foreign governments often provided incentives to attract foreign direct investment in infrastructure projects like power plants. The willingness of international development banks to invest alongside AES in volatile parts of the world helped mitigate the risk of expropriation, and the increased breadth of the global financial markets provided greater access to capital.

    AES initiated its international expansion in 19911992 with the purchase of two plants in Northern Ireland. The following year, AES began what would become a massive expansion into Latin America with the acquisition of the San Nicolas generation facility in Buenos Aires, Argentina. A year later, AES created a separately listed subsidiary, AES China Generating Co., to advance Chinese development projects. As the pace of deregulation quickened around the world, AES was presented with an abundant supply of capital and a wealth of opportunities for investments in energy-related businesses, some of which were more complex than AES portfolio of contract generation projects. In addition to expanding its line of business profile, it continued its geographic expansion and between 1996 and 1998 the company acquired several large utility companies in Brazil, El Salvador, and Argentina. By this time the company was spending an estimated 80%85% of its capital investment overseas in places as diverse as Australia, Bangladesh, Canada, Cameroon, The Dominican Republic, Georgia, Hungary, India, Kazakhstan, the Netherlands, Mexico, Pakistan, Panama, Puerto Rico, Ukraine, The United Kingdom, and Venezuela.2

    1 Much of this overview comes from Paula Kepos, ed., International Directories of Company Histories, Volume 10 (Detroit: St. James Press, 1995), pp. 2527.

    2 Paula Kepos, ed., International Directories of Company Histories, Volume 53. (Detroit: St. James Press, 1995), p. 17.

  • Globalizing the Cost of Capital and Capital Budgeting at AES 204-109


    AES in 2002

    By 2002, AES was one of the largest independent power producers in the world. (See Exhibits 1, 2, and 3 for AES consolidated financial statements.) The company was organized around four separate lines of business: Contract Generation, Competitive Supply, Large Utilities, and Growth Distribution.3

    Contract generation In 2002, AESs Contract Generation business accounted for approximately 29% of AES revenues and consisted of generation facilities, which sold electricity under long-term (five years or longer) contracts. The term of the contracts allowed AES to limit its exposure to volatility in electricity prices. The resulting stable production requirements enabled AES to accurately predict supply needs and enter into similarly long-term agreements for coal, natural gas, and fuel oil, thereby limiting its exposure to fuel price volatility. Facilities varied considerably in size, with plants as small as the 26 MW Xiangci-Cili hydro plant in China to the enormous 10-plant 2,650 MW Tiete hydro complex in Brazil.

    Competitive supply Accounting for 21% of AES revenues, the Competitive Supply line of business sold electricity directly to wholesale and retail customers in competitive markets using shorter-term contracts or daily spot prices. Competitive Supply businesses, sometimes called merchant plants, were highly susceptible to changes in the price of electricity, natural gas, coal, oil and other raw materials. AESs margin in U.S. dollars was influenced by a host of factors including weather conditions, competition, changes in market regulations, interest rate and foreign exchange fluctuations, and availability and price of emissions credits. Such price volatility had recently damaged several Competitive Supply businesses including the Drax plant in the U.K., the largest plant in AESs Competitive Supply fleet.4

    Large utilities By the end of 2002, the Large Utility business included only three major utilities, each in a different country: Indiana Power and Light Company in the U.S. (IPALCO), Eletropaulo Metropolitana Electricidade de Sao Paulo S.A. in Brazil (Eletropaulo), and C.A. La Electricidad de Caracas i


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