The Fuqua School of Business 2/27/02

Teaching Notes And Case Solution

El Faro Project:Building A Liquefied Natural Gas Power Plant In Honduras

Introduction

The decision to consider in this case is whether or not a fictitious company, United Energy, should invest in an energy project in Central America. The US$ 640 million project, El Faro, would build a liquefied natural gas (LNG) power plant and represents the largest foreign investment in the history of Honduras. It would create a relatively clean supply of electricity for Central America, a region that is in desperate need for new electricity sources to fuel economic growth. Given its mission to promote private sector development in emerging markets, the project is being supported by the World Bank’s International Finance Corporation (IFC) as well as Export Credit Agencies. Unlike the IFC, though, United Energy does not have to consider the impact of its investment in deciding whether to make a commitment. Carlos and Stan (the case protagonists) must decide whether or not to invest in the El Faro project.

Learning Objectives of Case and Discussion

This case provides students with the opportunity to value a project in an emerging market, and offers various avenues of exploration. Relevant topics for class discussion include:

1. Justification for project finance (as opposed to internal financing of the project).2. Difference in objectives and valuation methods of multilateral development lenders (in this

case, the IFC) and commercial investors (in this case, United Energy).3. Risk evaluation, including country and project-specific risks, as well as factors to mitigate

these risks.4. Cost of capital calculation for valuing a project in an emerging market region that

encompasses multiple countries.5. Real option valuation.6. Sensitivity analysis of key variables, including Monte Carlo simulation of unpredictable

commodity price inputs.7. Distinction between numerator (or idiosyncratic) risks, which are addressed in the modeling

of cash flows, and denominator (or systemic) risks, which are addressed in the determination of the discount rate.

Duke MBA candidates Stan Brunson, Rachel Fefer, Andrew Frankel, and Carlos Sanchez prepared this case under the supervision of Professor Campbell R Harvey, Emerging Markets Corporate Finance, as the basis for discussion rather than to illustrate either effective or ineffective handling of an administrative issue. Certain assumptions were made by the authors.

1

El Faro Project

Project Finance

The instructor should begin the case discussion by reviewing the difference between project finance and corporate finance. The class can then explore the reasons why the former is being pursued in this case. Reasons include: non-recourse characteristic of project financing, lower level of project risk compared to overall company or country risk, involvement of outside players (private and multilateral investors), etc.

2

El Faro Project

Multilateral Development Lenders

The World Bank’s IFC plays an important role in the El Faro project. The instructor should have the class explain the goals of the IFC and its value to the project. Discussion should highlight:

1. The value that the IFC places on financial and economic development in evaluating investments in emerging markets.

2. World Bank emphasis on environmental and social factors.3. The required rate of return by the IFC in contrast to that by commercial investors.4. IFC’s role as a risk reducer (regarding expropriation risk) and the historically low default

rate on IFC loans.5. The IFC’s ability to bring in outside investors to participate in project loans through its

loan syndication program, which benefit from the IFC’s AAA rating.

Project Valuation

Financial Projections

Students should create their own balance sheet and income statements using the information provided in the case. Attached, please find a suggested balance sheet and income statement for the project (see Exhibit 1).

Students are encouraged to use the abnormal earnings model to value this project due to difficulty discerning actual cash flows and local treatment of interest deductibility on debt. Given that the project does not have an existing value, the abnormal earnings model implies that all value is captured in future growth from the project.

At this point, the instructor should review the methodology for accounting for risk when valuing a project. The methodology suggests that one should include idiosyncratic (or project specific) risks in the cash flow calculations and include elements of systematic risk in the cost of capital calculations. Thus, the numerator for the value calculation includes the projected cash flow, including all operating uncertainties, which is divided by the cost of capital denominator, which reflects the emerging market country’s risk.

Risks

The project includes various risk factors that must be taken into consideration. Specifically, these risks can be broken into the following categories: operating risks (pre and post completion), sovereign risks (political, economic, and financial), and financial risks (financial structure). (See Exhibit 2 for a listing of the risks suggested by this case.) After discussing each of the risk categories, the instructor should lead students in a determination of the cost of capital that reflects the appropriate risks.

The class should discuss currency risk. While the prices of inputs and outputs will be in U.S. dollars, the project’s cost and revenue stream (or cash waterfall) will be managed in the region. Thus, several contingencies must be considered, such as fund transferability out of individual countries, as well as possible local currency devaluations against the U.S. dollar. The halo effect resulting from IFC and ECA involvement minimizes the possibility that any one country will

3

El Faro Project

block financial payments in U.S. dollars. Thus, one may adjust downward, but not eliminate, the project cost of capital number since it is somewhat shielded from currency risk.

The greatest operational risks are pre-completion construction risk (timely completion of the project) and post-completion price risk of the LNG input. Pre-completion risks are mitigated by AES’ vast international experience in constructing power plants. However, AES’ experience does not serve as protection against fluctuations of the price of LNG. Varying the output price for electricity according to the LNG input price acts as a natural hedging, limiting exposure to this operational risk and allowing one to adjust downward the cost of capital.

Financial risk is minimized due to IFC involvement, given its AAA credit rating and extensive political and financial influence. The risk exists, though, that AES may abandon the project altogether, causing others to pull out of the project as well.

Expropriation concerns are minimal due to IFC involvement and the fact that the assets are in Honduras, which does not have a history of expropriating private assets. However, there is still the risk of creeping expropriation, which could come from Honduran government changes to the status of the free trade zone. This latter risk is mitigated by the fact that Honduras is relying on future involvement by the international community to build the aforementioned regional electricity grid, and for investment into future unrelated projects.

Cost of Capital

The instructor should walk through the process of determining the appropriate discount rate for this project. The class should review the importance of using a blended cost of capital rate, to reflect exposure to multiple countries, instead of the single rate for Honduras. (See Exhibit 3 for the calculation of the cost of capital.)

1. An average LNG power plant project in the United States for the sponsor would have a cost of capital of approximately 14.3%. This is determined using the World CAPM formula and AES’ specific beta (given by Standard & Poor’s). The same rate, however, cannot be used in an emerging market because the risk is significantly different.

2. The cost of capital appropriate for the El Faro project is approximated by taking the cost of capital for the average Central American project and, then, adjusting it accordingly. Using the International Cost of Capital Risk Calculator (ICCRC), and plugging in 5.63% for the risk-free rate – the 25-year U.S. treasury -- and 5% for the risk premium, the cost of capital for the average project in each country is determined using the appropriate individual country credit ratings. The rates are then be weighted according to each country’s electricity consumption from the El Faro project to determine a blended rate.

3. The blended rate is adjusted downward for factors specific to the El Faro project (discussed above and in Exhibit 2).

The cost of capital is approximated as follows:

Average Cost of Capital (blended rate) 29.91%Currency risk -5.75%Operational risk -1.50%Financial risk -3.00%Project Cost of Capital 19.66%

4

El Faro Project

Real Options

Real options must also be taken into consideration. At this stage, AES is raising only enough money for the steam turbine, one LNG turbine, the storage facility, and the terminal. The possibility that the second LNG turbine is either not constructed or is delayed (the same is true of the third LNG turbine) should be modeled into the case. Also, there will be the option to temporarily reduce output if demand for natural gas-generated electricity decreases (due to a rise in LNG prices) or if tax levels rise too steeply. (These last options were not modeled in the solution presented here.) The instructor may walk through a real options valuation for these or other options that students bring up in class. (See Exhibit 4 for the decision tree illustrating several real options.)

Project Valuation Calculation

By bringing together the information above, students should be able to determine the value of the project and conclude whether or not the expected return is sufficient given the hurdle rate.

The base case scenario provides a projected Net Present Value of $14,084,611. (See Exhibit 5 for the valuation worksheet.)

The results of the Monte Carlo simulation indicate that the mean value of the project is significantly higher than the base case scenario. The Monte Carlo mean valuation is $45,713,964. This number reflects the fact that the price charged per kWh will be allowed to fluctuate – although it is not a perfect hedge – with the price of LNG at NYMEX spot. (See Exhibit 6 for the Crystal Ball Monte Carlo simulation results.)

Sensitivity Analysis

A sensitivity analysis is conducted to determine the impact of specific variables. One extremely sensitive variable, the price of LNG at NYMEX spot, is already modeled in a Monte Carlo simulation. Another variable considered -- in a simple lookup table -- is the terminal growth rate assumption. It should be noted that the project valuation is not very sensitive to a change in the terminal growth rate. (See Exhibit 7 for sensitivity analysis results.)

5

El Faro Project

Recommendation

The instructor should lead a discussion of the recommendation that students would make if they were in Carlos and Stan’s place. Students may recommend either investing, not investing, or investing under certain conditions in the project. This conclusion should be supported by a project valuation.

Updated Project Status

The current status of the El Faro project is unclear. In February 2002, AES announced that it is over-invested in Latin America and will divest most of its interests in the region, including two under performing plants in Brazil. The company will sell at least US$ 1 billion worth of assets in order to prevent it from running out of cash. Approximately US$ 16 billion of AES’ US$ 22 billion in debt is non-recourse debt from project financing, such as that proposed for the El Faro project. Standard & Poor’s has announced that it will most likely downgrade AES’ debt. It is uncertain who, if anyone, will take over sponsorship of the El Faro project.

6

El Faro Project

Exhibit 1: Balance Sheet

Note: Financial projections were made through year 2026.

7

Balance Sheet2002 2003 2004 2005 2006

ASSETSCurrent Assets Cash and cash equivalents 4.0% of operating revenues - - 4,741,438 4,741,438 8,301,852 Short-term investments 18,500,000 18,500,000 18,500,000 18,500,000 18,500,000 Accounts receivable 30 DSO - - 9,877,995 9,877,995 17,295,525 Inventories (FIFO) 80.0% of LNG storage capacity - - 2,649,611 2,649,611 2,649,611 Other 2.0% of operating revenues - - 2,370,719 2,370,719 4,150,926 Total current assets 18,500,000 18,500,000 38,139,763 38,139,763 50,897,914 PP&E - - 357,500,000 357,500,000 484,000,000 Less: accumulated depreciation - - 11,916,667 23,833,333 39,966,667 Construction work in progress 178,750,000 178,750,000 - 126,500,000 - PP&E, net 178,750,000 178,750,000 345,583,333 460,166,667 444,033,333 Other noncurrent assetsTotal Assets 197,250,000 197,250,000 383,723,096 498,306,429 494,931,248

LIABILITIES AND OWNERS' EQUITYCurrent liabilities Current portion of long-term debt (38,056,578) (38,056,578) (38,056,578) (51,772,125) (51,772,125) Accounts payable 30 days credit - - 496,802 276,001 276,001 Accrued wages 30 days - - 197,560 197,560 345,911 Other accrued expenses 30 days - - 395,120 395,120 691,821 Other Total current liabilities (76,113,155) (76,113,155) (75,023,674) (102,675,569) (102,230,517) ContingencyNet debt 235,800,471 219,161,592 201,082,941 266,412,339 239,041,058 Common stock 124,878,049 124,878,049 124,878,049 160,873,984 160,873,984 Retained earnings (77,130,655) (154,261,311) (150,515,890) (161,300,670) (146,258,862) Total Liabilities and Owners' Equity 197,250,000 197,250,000 383,723,096 498,306,429 494,931,248

Retained earnings(t-1) - (77,130,655) (154,261,311) (150,515,890) (161,300,670) Net income(t) (77,130,655) (77,130,655) 12,484,736 (10,784,780) 50,139,360 Dividends(t) - - 8,739,315 - 35,097,552 Retained earnings(t) (77,130,655) (154,261,311) (150,515,890) (161,300,670) (146,258,862)

El Faro Project

Exhibit 1: Income Statement

8

Income Statement2002 2003 2004 2005 2006

Operating revenues Contract Honduras - - 35,560,782 35,560,782 62,263,890 El Salvador - - 44,450,978 44,450,978 77,829,863 Guatemala - - 17,780,391 17,780,391 31,131,945 Nicaragua - - 11,853,594 11,853,594 20,754,630 Costa Rica - - 8,890,196 8,890,196 15,565,973 Spot Honduras - - - - - El Salvador - - - - - Guatemala - - - - - Nicaragua - - - - - Costa Rica - - - - - Total operating revenue - - 118,535,940 118,535,940 207,546,300 Operating expenses LNG - - 3,312,014 3,312,014 3,312,014 Labor 2.0% of operating revenue - - 2,370,719 2,370,719 4,150,926 SG&A 4.0% of operating revenue - - 4,741,438 4,741,438 8,301,852 Other costs 2.0% of operating revenue - - 2,370,719 2,370,719 4,150,926 Depreciation - - 11,916,667 11,916,667 16,133,333 Total operating expenses - - 24,758,970 24,758,970 36,132,070 Operating income (loss) - - 93,776,970 93,776,970 171,414,230 Debt principal repayment 15,321,480 16,638,879 18,078,651 25,174,667 27,371,281 Debt interest 22,735,098 21,417,699 19,977,927 26,597,458 24,400,844 Interest income 5.5% of short-term investments 1,017,500 1,017,500 1,017,500 1,017,500 1,017,500 Total expenses 77,130,655 77,130,655 77,130,655 104,561,750 104,561,750 Income (loss) before taxes (77,130,655) (77,130,655) 16,646,314 (10,784,780) 66,852,480 Sales tax - - - - - Income tax - - 4,161,579 - 16,713,120 Net income (loss) (77,130,655) (77,130,655) 12,484,736 (10,784,780) 50,139,360

El Faro Project

Exhibit 2: Risks And Options

9

Risk CategoryRegiona, Honduras and

El Faro Power Plant Specific Mitigating FactorsOperating Risks - PreCompletion:Resource Availability of Natural Gas Plentiful supply in Trinidad & Tobago and

worldwide; liquification allows for easy shipping from different parts of the world

Completion Completion of terminal and storage facilities by AES

Well established U.S. corporation with plenty of experience in foreign investment and such construction

Cost overruns Delays in labor construction, environmental setbacks (flooding, etc.)

AES international experience

Market risk Technological upgrade of competitive electricity providers

Operating Risks - PostCompletion:Supply/input: prices (stability, break-even, projection, current), quantities (demand)

Natural gas prices are set at spot prices. Natural gas is an extremely volatile commodity, price spikes are common place.

Hedge contracts for output sale prices help mitigate this risk

Labor - Issues with poverty, socioeconomic strife may lead to strikes if wages are not fair

None

Force majeure Natural Disaster (hurricanes, mudslides) None

Operating cost changes Variable Input Costs (natural gas) have high volatility

Some hedging in tariff structure

Competitive energy sources Existence of other sources of energy if natural gas prices increase dramatically

None

El Faro Project

Exhibit 2: Risks And Options

10

Risk CategoryRegiona, Honduras and

El Faro Power Plant Specific Mitigating FactorsSovereign - Political:Corruption Corruption is common in emerging

market countriesIFC involvement

Political leadership stabilityConflict (external/civil war) All countries are currently under stable

democracies committed to open market reforms

Sovereign - Macroeconomic:Exchange rate changes Concerns that currency is overvalued,

due to fiscal and external imbalancesInput and output prices in USD

Currency convertibility/transferability (liquidity)

Power supplied to different countries, exposing project to multiple currency risks including hold up of payment

Currency volatility between countries not a problem as all trade is in USD

Inflation Since all cash inflows are in US dollar denominated, there is a risk of severe devaluation of neighboring countries currency to the US dollar

Contract price renegotiation possible if dire economic circumstances necesitate

Foreign trade N/A

Sovereign - Financial:Taxes/custom duties Free Trade Zone, but government may

eliminate tax exemptions (creeping expropriation)

Government will not want to jeopardize planned IDB involvement in construction of regional electricity grid

Loan default Defaults due to natural disaster, have happened in the past

IMF and World Bank relief available

Expropriation (direct, cash diversion, creeping)

IFC involvement and risk of international isolation/retaliation as deterrents

Delayed payment/repudiation Severe currency devaluation of neighboring countries to the US dollar could delay payment

None

El Faro Project

Exhibit 2: Risks And Options

11

Risk CategoryRegiona, Honduras and

El Faro Power Plant Specific Mitigating FactorsFinancial (Structure):Default (debt service coverage ratio) If AES abandons the project others

lenders will pull out as wellCredit rating AES, with favorable debt rating, pulls out

of projectIFC involvement lends its AAA rating

IRR sufficient (versus re) Hurdle rate adequately reflects all the risks of the project

Hurdle rate as blended rate reflecting all countries involved

Debt issues IFC involvement and halo effect will bring in outside lenders through syndicated B loans

IFC involvement Largest investment ever in Honduras, high need for power

Other factors for IFC involvement positive, reflect IFC mission: build infrastructure, spur investment, provide jobs. Partial aim of overall project is to unify and develop this region.

Options:Expansion Plans to expand transmission to

Guatemala and MexicoTemporary Reduction in Output Reduction in output from the project is

viable due to the fact that the electric grid can handle increases/decreases without costThe cost of start-up of an existing plant is minimal. Cost of restarting turbines is minimal.

El Faro Project

Exhibit 3: Cost Of Capital Calculation

12

El Faro Project

Exhibit 4: Decision Tree of Real Options

The decision tree implies that the optimal outcome would be for all three LNG turbines to be built on time.Exhibit 5: Project Valuation, IRR and Revenue/Net Income

13

El Faro Project

Note: Financial projections were made through year 2026.

14

Income Statement2002 2003 2004 2005 2006

Net income (loss) (77,130,655) (77,130,655) 12,484,736 (10,784,780) 50,139,360

Dividends 0.70 dividend payout ratio - - 8,739,315 - 35,097,552

IRR, Year 10 18.6%IRR, Year 15 25.3%IRR, Year 20 26.7%IRR, Year 25 27.1%

IFC, Financial IRRPre-interest, after income tax - - 89,615,391 93,776,970 154,701,110 Project costs (estimated) 376,000,000 - - 126,500,000 - Financial Rate of Return Cash Flows (376,000,000) - 89,615,391 (32,723,030) 154,701,110 IRR 24.60%

El Faro Project

-$100,000,000

-$50,000,000

$0

$50,000,000

$100,000,000

$150,000,000

$200,000,000

$250,000,000

$300,000,000

$350,000,000

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

2019

2020

2021

2022

2023

2024

2025

2026

Year

Total operating revenue Net income (loss)

El Faro Project

Exhibit 5: Project Valuation, Abnormal Earnings Model

15

Equity Valuation2002 2003 2004 2005 2006

Abnormal Earnings ModelNet income (77,130,655) (77,130,655) 12,484,736 (10,784,780) 50,139,360 r(e)B(t-1) - 9,385,944 (5,776,015) (5,039,759) (83,876) Abnormal earnings to El Faro equity owners (77,130,655) (86,516,599) 18,260,750 (5,745,022) 50,223,236 PV(AE) (64,459,524) (60,425,408) 10,658,568 (2,802,412) 20,474,112 Total PV(AE) 14,640,868 Terminal value (49,405,346) PV(Terminal value) (556,257) B(t-1) -

Total equity value 14,084,611

Required return on equity, r(e) 19.66%

El Faro Project

Exhibit 6: Monte Carlo Results

The solution presented is based on the following Monte Carlo simulation inputs:

5,000 trials. A 10-50-90 distribution used to vary the print of LNG on NYMDEX spot, with input

prices of US$ 1.65, 3.50, and 7.50.

A data lookup table was used to tie the price of LNG-generated electricity to that of the commodity input.) The total project valuation was determined according to the abnormal earnings model.

Exhibit 7: Sensitivity Analysis

16