Question

What are the possible consequences of accepting inaccurate methodology of computing cost of capital on AES? AES case study

Answer 1

Consequence of accepting inaccurate methodology of computing cost of capital on AES are:

Non recourse​

The​​​​​​ separation of the parent companies structure through the creation of a special purpose vehicle. this SPV is the formal borrower under all loan documents so that in event of default or bankruptcy AES is not directly responsible for financial creditors instead their legal claim are against the SPV assets.

Maximum leverage

Currently AES seeks to finance the cost of development and construction of the project on highly leveraged basis. High leveraged in non recourse project financing permits AES to put less in capital to put at risk permits AES to finance the project without diluting its equity investment in the project.

Off Balance sheet treatment

AES may not be required to report any of the project on its balance sheet because such debt is non recourse. Off balance sheet treatment can have the added practical benefit of helping the years complete with covenants and restriction relating to borrowing fund contained in a loan agreement to which AES is also a party.

Agency cost

The agency cost of free cash flow are reduced. Management incentive are to project perform. Most importantly close monitoring by investors is facilitated multilateral financial institution one of the four constituent that have contractual agreement with the spv in the typical project are called banks. Among these banks there are multilateral multilateral institution like IFC,CAF and etc.Presence of these institutions as financiers help in raising capital from these institutes at lower cost and secondly it is also read as a positive sign by commercial banks.

Case study:-

How would you evaluate the capital budgeting method used historically by AES what's good and bad about it?

Currently, the project finance framework is employed by AES. This methodology is used for those project which have tangible assets with predictable cash flow in which the operating targets and the cash flow could be easily established through the explicit contracts. The key of financing of a AES project lies with the precious forecasting of cash flow however the possibility of estimating the cash flow of the project with an acceptable level of uncertainty has created the need for the allocation of the risk among the various interested parties. The project assets are also separated from the parent company due to the ensuring certainty in the cash flows which allows for the higher level of leverage.