Harvard Case - Aboitiz Power Corporation: Cost of Capital During the Pandemic
"Aboitiz Power Corporation: Cost of Capital During the Pandemic" Harvard business case study is written by Maria Theresa Manalac, Mica Ella Cu, Regine Aida Catapia, John Balce, Lawrence Sumera. It deals with the challenges in the field of Finance. The case study is 15 page(s) long and it was first published on : Jan 28, 2024
At Fern Fort University, we recommend that Aboitiz Power Corporation (APC) adopt a multifaceted approach to managing its cost of capital during the pandemic, balancing financial stability with strategic growth opportunities. This involves a combination of financial analysis, risk management, and capital structure optimization to navigate the volatile economic environment and emerge stronger.
2. Background
Aboitiz Power Corporation (APC) is a leading power generation company in the Philippines, operating in a diverse range of energy sources. The COVID-19 pandemic had a significant impact on the company's operations, leading to decreased demand for electricity, increased financial risk, and uncertainty about future economic recovery. The case study focuses on APC's need to determine its cost of capital, a crucial factor in evaluating investment opportunities and making strategic decisions.
The main protagonists of the case study are:
- APC Management: Responsible for navigating the company through the pandemic and making crucial decisions regarding capital structure, investment, and growth strategy.
- Investors: Concerned about the company's financial health and the potential impact of the pandemic on their returns.
- Analysts: Evaluating APC's performance and providing insights into its cost of capital and future prospects.
3. Analysis of the Case Study
The case study can be analyzed using a framework that combines financial analysis with strategic considerations:
Financial Analysis:
- Cost of Capital Calculation: The case study highlights the importance of accurately determining the cost of capital, which is the minimum return required by investors to justify investing in the company. This involves analyzing the cost of debt, cost of equity, and the company's capital structure.
- Financial Statements Analysis: A thorough analysis of APC's financial statements, including the balance sheet, income statement, and cash flow statement, is crucial to understand its financial health, profitability, and liquidity. This helps identify potential risks and opportunities.
- Ratio Analysis: Calculating key financial ratios, such as profitability ratios, liquidity ratios, and asset management ratios, provides insights into the company's performance and efficiency.
- Financial Modeling: Developing financial models to forecast future cash flows, profitability, and debt repayment capacity is essential for assessing the impact of different investment decisions and scenarios.
Strategic Considerations:
- Risk Assessment: The pandemic has introduced new risks to APC's business, including decreased demand, supply chain disruptions, and regulatory changes. Assessing these risks and developing mitigation strategies is crucial.
- Growth Strategy: APC needs to balance its commitment to sustainable growth with the need for financial stability. This requires a well-defined growth strategy that considers the evolving energy landscape and potential investment opportunities.
- Capital Structure Optimization: The company needs to carefully manage its capital structure, balancing debt and equity financing to minimize the cost of capital and maintain financial flexibility.
- Environmental Sustainability: APC's commitment to environmental sustainability is a key differentiator and a source of long-term value creation. This requires careful consideration of the environmental impact of its investments and operations.
4. Recommendations
To address the challenges posed by the pandemic, APC should implement the following recommendations:
- Refine Cost of Capital Calculation: Conduct a comprehensive review of the cost of capital calculation, considering the current economic environment, market conditions, and the company's specific risk profile. This involves:
- Updating Beta: Adjusting the beta coefficient to reflect the increased risk associated with the pandemic and the company's specific industry.
- Reassessing Risk Premium: Considering the current risk-free rate and the market risk premium, taking into account the volatility and uncertainty in the global financial markets.
- Analyzing Debt Costs: Evaluating the cost of debt, considering the company's credit rating, interest rates, and the availability of financing.
- Implement a Robust Risk Management Framework: Develop a comprehensive risk management framework to identify, assess, and mitigate potential risks associated with the pandemic and other external factors. This includes:
- Scenario Planning: Developing multiple scenarios to assess the potential impact of different economic conditions and market trends on the company's financial performance.
- Hedging Strategies: Employing hedging strategies to mitigate risks related to currency fluctuations, commodity prices, and interest rates.
- Contingency Planning: Developing contingency plans to address potential disruptions to operations, supply chains, and customer demand.
- Optimize Capital Structure: Review and adjust the company's capital structure to balance financial stability with growth opportunities. This may involve:
- Debt Management: Managing debt levels to ensure the company's ability to service its debt obligations while maintaining financial flexibility.
- Equity Financing: Considering equity financing options to fund strategic investments and maintain a healthy capital structure.
- Capital Budgeting: Prioritizing investment projects based on their potential for profitability, risk, and alignment with the company's long-term growth strategy.
- Enhance Financial Transparency: Increase transparency in financial reporting to build investor confidence and attract capital. This includes:
- Regular Communication: Providing regular updates to investors and analysts on the company's financial performance, risk assessment, and strategic plans.
- Detailed Disclosures: Providing detailed disclosures on key financial metrics, including the cost of capital, risk factors, and debt management strategies.
5. Basis of Recommendations
These recommendations are based on the following considerations:
- Core Competencies and Consistency with Mission: The recommendations align with APC's core competencies in power generation, its commitment to environmental sustainability, and its mission to provide reliable and affordable energy to the Philippines.
- External Customers and Internal Clients: The recommendations address the needs of external stakeholders, including investors, regulators, and customers, while also supporting the company's internal stakeholders, including employees and management.
- Competitors: The recommendations help APC maintain its competitive advantage in the Philippine energy market by ensuring financial stability, attracting capital, and pursuing growth opportunities.
- Attractiveness ' Quantitative Measures: The recommendations are expected to improve the company's financial performance, as measured by metrics such as return on equity, return on assets, and profitability ratios.
- Assumptions: The recommendations are based on the assumption that the Philippine economy will recover from the pandemic and that the energy demand will increase in the coming years.
6. Conclusion
By implementing these recommendations, APC can navigate the challenges posed by the pandemic, maintain its financial stability, and position itself for future growth. The company's ability to manage its cost of capital effectively will be crucial to its long-term success.
7. Discussion
Other alternatives not selected include:
- Reducing Investments: APC could reduce its investment activity to conserve cash and reduce financial risk. However, this could limit the company's growth potential and make it less competitive in the long run.
- Merging with a Larger Company: APC could merge with a larger power generation company to gain access to greater resources and financial stability. However, this could lead to job losses and a loss of control for APC's management.
Risks and Key Assumptions:
- Economic Recovery: The recommendations are based on the assumption that the Philippine economy will recover from the pandemic. A prolonged economic downturn could significantly impact APC's financial performance and growth prospects.
- Energy Demand: The recommendations assume an increase in energy demand in the coming years. A decline in energy demand could lead to lower profitability and reduced investment opportunities.
- Regulatory Changes: The recommendations assume that the regulatory environment for the energy sector will remain stable. Changes in government policy or regulations could significantly impact APC's operations and profitability.
8. Next Steps
To implement these recommendations, APC should take the following steps:
- Establish a Task Force: Create a dedicated task force to oversee the implementation of the recommendations, including representatives from finance, risk management, and strategy departments.
- Develop Action Plans: Develop detailed action plans for each recommendation, outlining specific activities, timelines, and responsible individuals.
- Regular Monitoring and Evaluation: Monitor the progress of the implementation process and evaluate the effectiveness of the recommendations on a regular basis.
By taking these steps, APC can effectively manage its cost of capital, navigate the challenges of the pandemic, and position itself for long-term success.
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Case Description
In January 2021, an equity analyst in the Student Managed Investment Fund of the Asian Institute of Management was trying to estimate the weighted average cost of capital (WACC) of Aboitiz Power Corporation (AP) based on the capital asset pricing model. The WACC estimate would be part of her discounted cash flow valuation, which would then help her determine whether or not the fund should invest in Aboitiz Power Corporation. AP was a leading power generation and distribution company in the Philippines with ₱81.1 billion in revenues over the nine-month period ended September 2020. The Philippines was in the middle of a lockdown related to the COVID-19 pandemic, and while the stock market was showing signs of recovery, the analyst was worried that record low interest rates might exert unwarranted downward pressure on her WACC estimate and artificially raise her discounted cash flow valuation of AP. The company's WACC had decreased from 2019 to 2020, reflecting a lower risk-free rate, lower borrowing rate, lower stock price, and resulting weight of equity. The analyst needed to explore potential adjustments to normalize the WACC away from pandemic conditions in order to confirm her recommendation regarding investing in AP stock.
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