Write-up #4 AES Tiete Expansion Plant in Brazil PDF

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FNCE 208: International Corporate Finance - Professor Karen Lewis...

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Write-up #4: AES Tiete: Expansion Plant in Brazil Part A: (4pts) DCF Sensitivity Analysis: Based upon this analysis alone, should AES bid at this price? What is the minimum price AES could bid given your NPV calculation for each scenario? - Based upon the analysis alone, AES should bid at this price of BRL50/MWh because it yields a positive NPV for all three cases: $53.62 million (base), $80.00 million (upside) and $41.48 million (downside). - The minimum price AES could bid given our NPV calculation for each scenario is: BRL44.6981/MWh (Base), BRL42.3689/MWh (Upside), BRL45.7938/MWh (Downside). We found this by finding the minimum base price using Excel’s SOLVER that yields a positive NPV. Part B: (4 pts) Effects of Projected Exchange Rates: Now analyze the DCF of the project under two alternative scenarios using only the base case assumptions for inflation and/or exchange rate from Part A. - The NPV for Scenario 1 (purchasing power parity) is $21.10 million - The NPV for Scenario 2 (interest parity) is $51.62 million Part C: (4pts) APV: Now calculate the APV of the project in the tab “APV Valuation Draft” under the base scenario alone, valuing the dollar cash flows at the dollar cost of capital and the BRL cash flows at the BRL cost of capital assuming that AES bids at the price of BRL50/MWh. - The APV under the base case is $48.03 million Part D: Assessment Given your analysis, please provide an overall assessment of the project. 1. (3 pts) Compare and contrast the valuation approaches you analyzed in Parts A through C under the base case scenario. Which one do you think is better? Do you have recommendations for a better approach? Essentially, we used the Discounted Cash Flow method in Part A/B and used the Adjusted Present Value method in Part C to find AES’s project valuation. In the discounted cash flow method, we first converted the free cash flows from BRL to USD for each year, then discounted using a singular US cost of capital (9.27%). In the adjusted present value method, we separated free cash flows based on currency and discounted each cash flow with its respective currency discount rates (9.27% for US FCF and 11.57% for BRL FCF). After that, we only used one currency exchange rate from 2013 (time 0) to convert the BRL NPV to USD.

When comparing the valuation approaches in Parts A through C, we believe that the APV approach used in Part C is better. Unlike the DCF method, APV eliminates the risk of exchange rate fluctuations and applies the correct discount rate for each cash flow based on currency. The economic landscape of an emerging market like Brazil is hard to predict, and accurately forecasting exchange rates 30 years into the future is nearly impossible. Moreover, as AES is evaluating an international project, the company should more accurately factor in the fundamental economic differences between the interest rates and inflation rates in the US and Brazil. In the APV approach, we found the Brazilian NPV and the US NPV separately using their own discount rates to account for economic differences. Hence, we think that the APV approach is more accurate in projecting the value of AES’s project compared to DCF. Between Part A, Part B scenario 1 and scenario 2, which all rely on the DCF method, we think that the differences in the final NPV value is driven by the underlying exchange rate assumptions and how aggressive/conservative they are. Specifically, part A, part B scenario 1 and part B scenario 2’s exchange rate projections are derived from the case’s exchange rate assumptions, PPP assumptions and CIP assumptions respectively. Alternatively, we recommend valuing Tiete’s project using the Comparable Multiple Method approach. Although the projected free cash flows for Tiete are growing at a steady rate in the DCF approach, given Brazil’s deceleration of economic growth in 2013 and recession in 2014, we believe that applying a multiple calculated from a set of similar companies (same industry, same expected growth, similar risk characteristics) is a useful check for the DCF approach. 2. (2 pts) Are there additional risks not included in the scenarios and, if so, what are they? How do you recommend they address them? As our understanding of the project increases, we can use the APV and add on other side effects such as the indirect/direct cost of financial distress, the agency costs, geopolitical risk, and the direct cost of issuing equity or debt. Essentially, the APV method allows for us to discount each cash flow stream by a rate that is more clearly justified by its riskiness. Additionally, although WACC was given to us by AES’ global investment team, it is worth knowing the exact cost of equity approach used to calculate this discount rate. Perhaps using different equity approaches with multiple benchmarks can properly

account for the geopolitical risk and yield a more accurate NPV. For example, the company could consider applying a sovereign spread to the company’s discount factor. Another risk not considered is the monopolistic power the supplier of natural gas, Petrobras, has in Brazil. While natural gas costs were accounted for in our cash flows at international market price, Petrobras has the ability to raise their prices due to their prominent position in the natural gas market, thus increasing the AES’s operational costs. In order to address this issue, AES should negotiate better terms with Petrobras to ensure that they are locked in a contract where they gain greater benefits to compensate for the risk of being taken advantage of by Petrobras’ monopolistic power. 3. (2 pts) Given the risks and returns in the project, do you recommend that AES Tiete bid on the project? Use your analysis to provide management with a recommended bid price and explain why you chose that price. AES Tiete should bid on this project. Although there are additional risks that aren’t considered, both valuation methods yield a positive NPV in the base, downside, and upside cases. Regarding the recommended bid price, we used the APV valuation method to calculate this. We discussed how the APV method yields a more accurate valuation in Part D - Question I, and the APV valuation offers a more conservative valuation that ensures that AES doesn’t overspend with its bid price. We calculated our recommended bid price by taking the expected average return of the NPV in the base, upside, and downside scenarios. Assuming that the base case has a 60% probability of occurring, the pessimistic case has a 20% probability of occurring, and the optimistic case has a 20% probability of occuring, our recommended bid price under the APV valuation method is BRL44.8312/MWh. This was calculated by taking the expected return of each scenario and their corresponding minimum bid prices to ensure that AES paid the least amount possible. The minimum bid price for the base case per the APV method is BRL45.21595174/MWh; for the upside case, BRL42.36644638/MWh; and for the downside case, BRL46.14175994/MWh. If we were given better estimates regarding the future economic conditions faced by AES, we could better specify a minimum bid price for this project....