Aboitiz Power Corporation: Cost of Capital During the Pandemic Custom Case Solution & Analysis

Evidence Brief: Aboitiz Power Corporation

Financial Metrics

• Risk-Free Rate: The 10-year Philippine Bloomberg Valuation (BVAL) Service reference rate stood at 2.76 percent as of July 2020, down significantly from 5.03 percent in December 2019.
• Market Risk Premium: Estimated range between 6.0 percent and 9.14 percent based on historical Philippine market performance and Damodaran country risk adjustments.
• Beta: Aboitiz Power historical 5-year beta is 0.94. Peer group average beta for First Gen and Manila Electric is 0.85.
• Capital Structure: Total debt to total capital ratio is 68 percent. Total equity to total capital ratio is 32 percent.
• Cost of Debt: Pre-tax cost of debt is approximately 5.5 percent based on recent bond issuances and bank loans.
• Tax Rate: Corporate income tax rate is 30 percent.

Operational Facts

• Generation Portfolio: A mix of thermal (coal and oil) and renewable (hydro, geothermal, and solar) assets.
• Market Position: One of the largest power producers in the Philippines with a significant share of the national grid capacity.
• Regulatory Environment: Operations are subject to the Electric Power Industry Reform Act (EPIRA) and oversight by the Energy Regulatory Commission (ERC).
• Pandemic Impact: Decline in commercial and industrial power demand offset by increased residential consumption; overall volatility in collections and cash flow.

Stakeholder Positions

• Liza Luv Montelibano (CFO): Seeks an accurate Weighted Average Cost of Capital (WACC) to guide capital allocation and project valuation during a period of extreme market distortion.
• Board of Directors: Concerned with maintaining dividend stability while funding the long-term transition toward more renewable energy.
• Investors: Expecting a risk-adjusted return that accounts for the heightened uncertainty in emerging markets during a global health crisis.

Information Gaps

• Specific terminal growth rate assumptions used in internal project models.
• Detailed breakdown of fixed versus floating rate debt obligations.
• Explicit Energy Regulatory Commission (ERC) guidance on allowed rates of return for the upcoming regulatory period.

Strategic Analysis

Core Strategic Question

• Should Aboitiz Power lower its investment hurdle rate to reflect the current low-interest-rate environment, or should it maintain a higher threshold to account for pandemic-related risk and potential future inflation?

Structural Analysis

The Capital Asset Pricing Model (CAPM) currently produces a deceptively low cost of equity due to the 2.76 percent risk-free rate. This rate is influenced by central bank liquidity measures rather than long-term economic fundamentals. Applying a standard CAPM approach yields a WACC significantly lower than historical averages, which may lead to over-investment in projects that are not viable when interest rates normalize. The gearing level of 68 percent makes the WACC highly sensitive to the cost of debt, providing a tax shield but increasing financial risk during periods of demand contraction.

Strategic Options

Option 1: Spot Market WACC Calculation. Use the current 2.76 percent risk-free rate and current market premiums. This reflects the immediate cost of capital but risks using a temporary trough in interest rates for 20-year project valuations.

Option 2: Normalized Hurdle Rate. Use a 5-year average risk-free rate (approximately 4.5 percent) and a stabilized market risk premium of 7.5 percent. This provides a more consistent benchmark for long-term infrastructure assets and prevents cyclical over-investment.

Option 3: Segmented WACC. Apply different rates for renewable projects (lower risk, stable cash flows) and thermal projects (higher regulatory and environmental risk). This aligns capital allocation with the strategic shift toward green energy.

Preliminary Recommendation

Adopt Option 2 (Normalized Hurdle Rate) for core valuation while utilizing Option 3 (Segmented WACC) as a secondary lens. The current low-interest-rate environment is a policy-driven anomaly. Basing 25-year energy investments on a 2.76 percent risk-free rate would lead to poor capital discipline. A normalized WACC ensures that only projects with structural viability move forward.

Implementation Roadmap

Critical Path

• Phase 1 (Days 1-15): Finance team to finalize the normalization parameters for the risk-free rate and the equity risk premium.
• Phase 2 (Days 16-45): Re-evaluate the current pipeline of generation projects using the normalized 8.5 percent WACC.
• Phase 3 (Days 46-90): Present updated capital allocation priorities to the Investment Committee and Board of Directors.

Key Constraints

• Gearing Covenants: High debt levels limit the ability to take on new projects if valuations fluctuate significantly.
• Regulatory Lag: The Energy Regulatory Commission may use different WACC assumptions for tariff setting, creating a gap between internal costs and allowed returns.

Risk-Adjusted Implementation Strategy

The implementation will utilize a sensitivity-based approach. All project valuations must include a stress test where the cost of debt increases by 200 basis points. This ensures that projects approved during the pandemic remain solvent if the Philippine Peso weakens or if global interest rates rise sharply. We will prioritize projects with shorter payback periods to maximize liquidity during the next 24 months of economic recovery.

Executive Review and BLUF

BLUF

Aboitiz Power should set a normalized WACC of 8.5 percent for all new capital allocations. The current market risk-free rate of 2.76 percent is an artificial floor created by central bank intervention and does not reflect the long-term sovereign risk of the Philippines. Maintaining a disciplined hurdle rate prevents the acquisition of low-yield assets that will become liabilities when the interest rate cycle turns. Capital must be prioritized for renewable transitions where long-term regulatory support mitigates the higher cost of equity.

Dangerous Assumption

The most consequential unchallenged premise is that the Philippine Peso will remain stable against the US Dollar. A significant portion of power generation equipment and fuel costs is dollar-denominated. If the currency devalues, the real cost of capital for Aboitiz Power will spike regardless of local BVAL rates, rendering current WACC calculations obsolete.

Unaddressed Risks

Unconsidered Alternative

The analysis failed to consider an aggressive debt refinancing strategy. Instead of just adjusting the WACC for new projects, Aboitiz Power could lock in the current low rates by issuing long-term, fixed-rate retail bonds to replace more expensive legacy bank debt. This would structurally lower the actual WACC and improve the internal rate of return on the existing portfolio without changing the investment hurdle rate.

Verdict: APPROVED FOR LEADERSHIP REVIEW