Augsburg University of Applied Sciences - Faculty of Business

International Business and Finance

International Corporate Finance

Case Study Write-Up

AES Tietê: Expansion Plant in Brazil

Author:
Carlos Achón Velásquez (Student ID:2149839)
Oleksandr Gonza (Student ID:2150769)
Oksana Polikarchyk (Student ID:2168487)
Sunny Antony Dsouza (Student ID:2152747)
Valeria Andrea Sanchez Davila (Student ID:2149826)

Lecturer:
Prof. Dr. Bulent Aybar

Augsburg, 04.06.2023
1 Introduction
The case study is based on the AES Tietê: Expansion Plant in the context of Brazil as a leading
global energy producer. The country’s energy market is heavily regulated and supported by
the government, through the auctioning tool that rewards production efficiency in the form of
long-term contracts. The 2001 drought in Brazil led to a number of difficulties in the energy
production sector, which in turn prompted the government to take incentive measures to expand
the power generation segment through auctions.

AES Brasil is a diversified energy company focused on electricity generation and distribution.
AES Tietê is one of its production companies which is also one of the largest private electricity
producers in Brazil. To expand its generating capacity in the state of São Paulo, AES decided
to develop plans to build a natural gas-fired thermal power plant. The strategy was that
thermal power would compensate for the dependence on hydroelectric power plants for electricity
generation. Winning the state auction provides an opportunity to implement a 25-year long-term
production sharing contract and invest in the thermal project. The total capital expenditure
on the project is estimated to be BRL 1.2 billion. One of the conditions was the signing of an
agreement with Petrobras, the state-owned energy company that has a monopoly on Brazilian
natural gas. The project includes fixed and variable operating costs, which also include the cost
of natural gas. In addition, the plant will incur annual regulatory costs of BRL 20 million.

In 2010, the companies reached an agreement, and a year later the state environmental agency
issued Tietê an environmental licence to continue construction of the GSA plant. This created
all the conditions for Tietê to participate in the auction, but the final step was to assess the
thermoelectric capacity to compete in the market.

2 Case Analysis
2.1 Assumptions
To begin the evaluation of the project, first it was crucial to map out all of the information
that was given across the case. Therefore, a series of assumptions had to be made clear before
continuing with the evaluation of the project.

• Revenue Scenarios: In the case, the valuation had to be analyzed with three scenarios: the
base, pessimistic and the optimistic. For the base scenario there had to be a mark-up of
15%, for the pessimistic scenario of 5% and for the optimistic scenario it was of 20%.

• Bid Price (50 BRL): For our bid price, we took into consideration two scenarios. The first
one is based on the fact that the bid price is constant and already adjusted with inflation,
therefore, during all of the life of the project, the price will be of 50 BRL. However, the
second scenario is based on the fact that the bidding price could change with inflation

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 during the 25 years and could be affected in the three scenarios already mentioned before.

• Dispatch Capacity: In the case it was mentioned that the overall capacity of the thermo-
electric plant was of 500 MW, however, we had to take into account how much would be of
the final product. Discounting maintenance stops, and internal consumption the capacity
of the plant would lower to a 90% and discounting all of the variables that could affect the
plant during the year, the dispatch would be of 50% final. However, in our evaluation we
used the 100% of the capacity of the plant and conducted a sensitivity analysis with all of
the dispatch scenarios possible.

• Exchange Rates & CPI: In the case, it was established to use the fluctuations of the
exchange rates and CPI rates depending on the three scenarios. Moreover, it was possible
to calculate the effects on the exchange rates when doing the analysis in USD plus adding
the effects of inflation in the variables needed.

2.2 Evaluation
Taking into account the assumptions made by the analyst in the case and our own assessment, we
initiate the process of evaluating the case in two scenarios. The first scenario assumes a constant
Bid price over time, while the second scenario adjusts the Bid price for inflation throughout the
duration. To provide a more comprehensive analysis and aid in decision-making, we conducted
a sensitivity analysis within these two evaluation cases. This analysis aims to enhance our
understanding by establishing the Net Present Value (NPV) evaluation and Internal Rate of
Return (IRR) evaluation.

According to the case study, the company has 2 revenue streams. The first one being the
Capacity revenue is defined by the following equation:

CapacityRevenue = BidP rice ∗ T otalEnergyP roduce

And the second revenue stream being the pass-through fuel and variable cost revenue witch will
be billed to the government which will be incorporated into the next equation:

X
P ass − throughRevenue = ( V ariableCost ∗ M arkup)/(1 − RevenueT ax − COF IN S)

Considering that 100% of the energy dispatch is taken into account for the analysis, we make the
assumption that the plant produces 3.9 million MWh per year. Assuming a constant bid price
throughout the 25-year contract, the continuous revenue would amount to 197,100,000 BRL.
However, if we adjust the bidding price with inflation, the revenue will increase annually based
on the inflation forecast.

The calculation of the second revenue source, which involves government sales, follows a similar

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 Figure 1: Net Profit, BRL - Bid Price Adjusted to Inflation

pattern. In both scenarios, this revenue stream increases in line with inflation and includes a
markup. Unlike the bidding price, the government sales revenue is unaffected by whether the
bid price remains constant or not. Its variation is solely dependent on the inflation forecasted for
the entire 25-year period. To conduct a sensitivity analysis for this revenue source, we consider
a markup price as defined in Table 1.

Base Scenario Optimistic Scenario Pessimistic Scenario

Markup 15% 20% 5%

Table 1: Markup Scenarios

The depreciation values will be calculated over a 25-year period using a linear model. Within
the Profit and Loss (PnL) statement, a corporate tax rate of 34% is incorporated. And each of
the revenue streams is subject to a revenue tax of 9.75%.

The net profit in BRL according to each of the scenarios (Figure 1) shows an upward trend,
while the optimistic scenario trends downwards after 2028 giving the base scenario a better net
profit in BRL and the pesimistic scenario taking over the optimistic one by 2041. We can assest
the value in USD value thanks to the forecasted depreciation of the BRL agaisnt USD. Where
we can get a better understanding on the net profit in USD terms (Figure 2).

Considering the USD net profit converted thanks to the forecasted FX exchange rate and a
depreciation of the value of the money in Brazil you can observed a positive profitability within
the project.

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 Figure 2: Net Profit, USD - Bid Price Adjusted to Inflation

On the other hand, while keeping the bid price constant at 50 BRL the net profit lowers in
comparison to the bid price adjusted for inflation, but still continues to keep an upward trend
when it comes to the optimistic and base scenario. Figure 3 shows the net profit in BRL keeping
the constant bid of 50 BRL, while Figure 4 converts the same net profit into USD value. In
USD terms there is a growth rate between -12.72% in the pessimistic scenario and 16.10% on
the optimistic side for starting from 2019 till 2043 the end of the contract.

Figure 3: Net Profit, BRL - Bid Price Constant

Nonetheless the net profit is not a way to asess the value of the project, thus an NPV and IRR

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 Figure 4: Net Profit, USD - Bid Price Constant

analysis has been made to get the value of project and the viability.

2.2.1 NPV and IRR

When considering all the cash flows of the project and calculating the Net Present Value (NPV)
based on 1/12 of working capital allocations, a Weighted Average Cost of Capital (WACC) of
9.27% for USD, the project demonstrates a positive NPV and Internal Rate of Return (IRR) that
is greater than WACC at 100% dispatch for only inflated bidding price scenario established as
50 BRL. However, it’s important to note that this assessment assumes the project will operate
at full capacity throughout the year without accounting for maintenance or external factors
that could potentially disrupt energy production. The analysis was conducted based on this
assumption.

Nevertheless, according to the case study, it has been established that the project will continue
running, even in the event of a sudden change in dispatch, at a minimum capacity of 50
We have developed multiple scenarios considering different dispatch factors, and each scenario
has its own optimal points. These optimal points represent the bid price at which the project
would yield a positive return on investment during the evaluation period.

Considering the requirement to achieve a positive NPV and IRR by evaluating the project
at 100% dispatch, and without factoring in the potential impact of maintenance and external
factors resulting in a low dispatch of 50%, AES should reconsider accepting the project with a
bid of 50 BRL/MWh. It would be prudent to explore alternative options and carefully assess
the viability of the project under different circumstances.

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 Figure 5: NPV and IRR - Bid Price Constant

Figure 6: NPV and IRR - Bid Price Inflated

In order to be sure that the investment firm provided analyst with the appropriate WACC as the
discount factor for the future cash flows of the project, we decided to conduct our own analysis.
According to this, we choose the peers for the beta valuation, took all data as of the end of 2013
and choose the target debt-to-equity ratio based on the AES’s financial statement. By using
the CAPM model and the default spread for the AES Tiete credit rank, we evaluated the cost
of capital that equals 13.35% and cost of debt - 4.89%. As a result, we received almost the
identical WACC for the discounting cash flows in USD - 9.56%.

2.3 Limitations
One of the most challenging limitations in the evaluation was to not raise the Bid price over 50
BRL. As it was established in the case, the bid price could not be increased more than 50 BRL
or else the company would not be considered within the auction, this included the exposure the
price had on the inflation rate. Therefore, to raise the project’s revenue, as it was not possible
to raise the bid price in order to stay competitive in the auction, one of the things AES could
do is to cut some of the project’s expenses. The fixed costs of the company were high; these
costs including personnel and material costs, which could easily be decreased by hiring more
local based workers instead of ones from US, and also finding low cost materials that could be
used for the project.

Another limitation was the foreign exchange exposure risk of the company. Since AES is a US
based company working in Brazil, the company is automatically exposed to fluctuations of the
BRL against the USD (BRL/USD). In the case, the BRL is depreciating against the US dollar
during the life period of the plant, therefore it should be useful to implement hedging to protect
AES from foreign exposure risk caused by the fluctuations of the exchange rates. In this case,
AES could turn to the derivative market to use future and forward contracts or also turn to use
more of BR’s local materials and personnel which would lead to the company to not be exposed
to the risk if they were using US’s materials and personnel which would need the use of US
dollars.

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3 Summary
The project’s competitiveness is crucial for long-term success and for enhancing AES Tietê’s
position in Brazil’s energy market. A comprehensive case analysis was conducted, considering
revenue scenarios, bid prices, dispatch capacity, and exchange rates. These assessments provided
a framework for evaluating the project’s financial viability and conducting sensitivity analyses
to account for profitability factors.

Sensitivity analyses, including NPV and IRR assessments, revealed positive trends in net profits
over time. NPV and IRR analyses further confirmed the project’s viability, assuming a 100%
dispatch rate and a bidding price of 50 BRL. However, maintenance and external factors affecting
dispatch capacity were considered

Evaluation of various dispatch capacity scenarios identified optimal bid prices for positive returns
on investment. These findings contribute to informed decision-making regarding the project’s
financial feasibility and provide valuable insights. However, due to the imposed limitations and
a bid price constraint of 50 BRL, the project does not yield positive NPV and falls below the
WACC level of IRR. Consequently, rejecting the project is recommended. By analysing industry
peers and utilizing the relevant WACC inputs from that year, we bolstered our confidence in
the decision to reject the project while confirming the validity of the WACC.

In summary, AES Tietê’s investment in the natural gas-fired thermoelectric plant reflects their
proactive approach to regulatory changes and energy diversification. Although the project
faces limitations in achieving positive financial metrics, exploring alternative strategies can help
mitigate risks and improve its overall financial performance.