INTRODUCTION TO COST OF CAPITAL IN A UTILITY-REGULATION CONTEXT

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1 NOTES TO ACCOMPANY DR. CANNON S PRESENTATION AT CAMPUT S 2016 ENERGY REGULATION COURSE INTRODUCTION TO COST OF CAPITAL IN A UTILITY-REGULATION CONTEXT Dr. Bill Cannon Distinguished Faculty Fellow of Finance Smith School of Business Queen s University Queen s University June 21, 2016

2 THE COST OF CAPITAL (k) CONCEPT A utility will be able to secure new capital and replace maturing securities only if investors believe that they will be adequately compensated - private investors are under no obligation to provide capital - government-owned utilities must compete with other government spending priorities k is the required minimum rate of return necessary to attract capital to an investment - rate of return includes income (interest or dividends) plus capital gain or loss, all divided by the initial investment outlay, to make it a % figure Investors required reward must compensate for: (a) their postponing consumption, and (b) the risks their capital funds are exposed to

3 Providing the compensation demanded by investors is a necessary cost of doing business for the utility, i.e., the cost of servicing its capital providers is part of a utility s overall cost of service. k is also the minimum rate of return a utility must promise to achieve on its debt and equity in order to preserve their respective market values where achieving k will protect the wealth of utility investors and retain their allegiance OPERATIONAL DEFINITION OF k k is the truly anticipated rate of return prevailing in the capital mkts on alternative investments of equivalent risk and attractiveness to the utility s securities - 4 concepts: k is a forward-looking concept even tho after-the-fact returns may not equal those required ahead of time k is an opportunity cost concept - utility must compete for capital from investors who have the opportunity to invest their funds in a wide range of other investments k is adjudicated in the capital markets k is a function of the risk of the utility - investors are risk averse and demand higher rewards the riskier the utility

4 In the light of the operational definition WHAT FACTORS PLAY A ROLE IN DETERMINING k FOR ALL FIRMS & UTILITIES? General level of inflation in economy - k must exceed expected inflation rate or investors will purchase real assets instead of investing in a utility s securities General level of interest rates - k must exceed the yields available on default-free gov t bonds, or investors will shun risky utility securities in favour of gov t debt Income tax rates - outside of tax-sheltered accounts, investors recognize that they will have to pay taxes on their investment earnings; therefore, they adjust their before-tax k requirements accordingly to achieve their required after-tax returns Perceptions of overall corporate-sector and financial-sector riskiness relative to investments in government bonds - the difference between the average corporate k and gov t bond yields will widen as perceptions of corporate-sector riskiness rise - perceptions of corporate-sector riskiness are influenced by: - pace of national economic growth - exchange rate changes - shifts in monetary and fiscal policies - shifts in legislative and regulatory environment - uncertainty over access to financing - international tensions, etc

5 WHAT FACTORS DETERMINE RELATIVE k s ACROSS FIRMS AND UTILITIES? Relative business riskiness - overwhelmingly the most important factor - relative business riskiness is a function of: - nature of the business and its products, and degree of diversification of these - long-run reliability of product or service demand - presence or absence of competitive threats - geographic location of production and sales - cyclical sales volatility - use of operating leverage i.e., use of fixed-cost methods of production and distribution - level of company s gross margins and profitability - bankruptcy riskiness inherent in firm s investments - size of the firm or utility - quality of utility s management and work force Secondary factors generally isolated and small effects - liquidity of company s shares penalty for thin trading - company or industry-specific tax circumstances - social-consciousness concerns e.g., tobacco co s

6 THE OVERALL OR WEIGHTED-AVERAGE COST OF CAPITAL (WACC) k reflects required return on the utility s assets as a whole Assets are financed with a mix of debt and equity Therefore, asset earnings, prospectively, must satisfy the return requirements of both the utility s bondholders and shareholders (The utility s capital structure partitions its asset risk between bondholders and shareholders.) Provides conceptual foundation for the WACC approach to estimating a utility s k REGULATED UTILITY AFTER-TAX WACC FORMULA AND INPUTS where: WACC (D/K) k d (1 - τ I ) + (P/K) k P + (E/K) k e D/K = utility s deemed debt (D) financing proportion, as a percentage of its total capitalization (K), expressed in book-value terms; P/K = utility s deemed preferred share (P) financing proportion, in bookvalue terms; E/K = utility s deemed common equity (E) financing proportion, in bookvalue terms, where E is composed of both accumulated retained earnings and proceeds of old and new equity issues; τ I = utility s average expected income tax rate, expressed as a percent;

7 k d = utility s embedded, before-tax cost of debt financing (factoring in the forecasted rates on new debt financings during the test period), expressed as a percentage; k P = utility s embedded, after-tax cost of preferred share financing (factoring in the forecasted rates on new pref financings during the test period), expressed as a percentage; and k e = utility s forward-looking, after-tax effective cost of equity capital, expressed as a percentage. - k e reflects the degree to which the uncertainty and volatility of equity returns have been leveraged up by the utility s use of debt and preferred share financing - i.e., k e embodies both business and financial risk effects, or, more precisely, k e reflects the firm s business riskiness as magnified by its use of fin l leverage Board-deemed capital structure ratios are usually approximately equal to optimal ratios Deemed debt and equity ratios are set for at least a year at a time and are often sticky hearing to hearing even as optimal ratios are constantly changing with changing market conditions - Reason: boards often prefer to adjust allowed equity returns, from one hearing to the next, to reflect small changes in utility risk, while leaving deemed capital structure ratios unchanged - This one-variable-at-a-time adjustment procedure recognizes the direct trade-off relationship between debt ratios and k e, i.e., as debt ratio k eutility allowed ROE

8 DETERMINING k VERSUS ESTIMATING k Source of confusion On the one hand, a utility s k is largely determined by the business risk of its assets and investments hence, the uses to which it puts its funds, while... on other hand, the utility WACC formula which incorporates the costs associated with the utility s various sources of financing is used to estimate k The reconciliation Utility WACC is a valid k-estimation procedure if we assume the subject utility is targeting optimal financing policies Hence, if a board s deemed capital structure ratios approximate a utility s optimal ratios, regulators may reasonably estimate what a utility s k is by looking at the costs associated with its sources of funds, within the utility WACC framework, and If the above assumption holds, then the utility WACC approach is quite robust, in the sense that it can accommodate a wide variety of methods for estimating the firm s cost of equity (k e )

9 ESTIMATING k e THE DISCOUNTED CASH FLOW (DCF) METHOD Most heavily relied upon method in U.S. regulatory hearings because there are more publicly-traded utilities to provide data inputs Based on a stock valuation approach the constant dividend growth valuation model which postulates that a firm s current share price will equal the present value of all its future cash dividend payments and distributions Generic formula: k e = ( E(DPS) / P ) + g (all percentages) where: k e = estimate of utility s cost of equity for the test year E(DPS) = the utility s expected dividend-per-share payment over the next 12 months P = the current market price for the utility s common shares g = the single percentage value that most closely approximates what investors expect the average growth rate in the utility s earning power and dividend-paying power to be for the infinite future The term E(DPS)/P is known as the prospective dividend yield. Advantages of the DCF Method: (1) reflects investors expectations as embodied in the current share price (2) for publicly-traded companies, the dividend yield term is readily available/observable and relatively easy to forecast (3) assumptions necessary to validate the underlying valuation model are reasonable ones for most publicly-traded, regulated utilities

10 Disadvantages of the DCF Method: (1) Difficulty in forecasting utility s infinite future growth rate (g) - possible circular reasoning, as board s allowed ROE influences subsequent growth, which may influence future ROE awards - historical evidence may not be relevant for future - forecasting one number to infinity that encapsulates many varying growth and maturity phases use Two-Stage Gordon Valuation Model to get around this problem, but associated formula complex (2) non-traded shares for the regulated entity no direct evidence with respect to formula s input values - inferring input values from the average values for comparable co s or utilities abandons most of the distinctive value of DCF approach (3) relative risk comparisons cannot be directly reflected in DCF formula (4) some of the fundamental assumptions of the underlying stock valuation model seem at odds with the reality of the regulatory environment e.g., - constancy of k e over time - prevailing stock prices equal equilibrium prices based solely on risk and growth assessments all the time

11 ESTIMATING k e THE EQUITY RISK PREMIUM (ERP) METHOD Is the most heavily relied upon method at Canadian boards Motivating premise equity is riskier than government or utility debt - hence, risk-averse investors demand an extra expected return to hold equities instead of gov t or utility bonds - the extra return is called the equity risk premium (ERP) Generic formula: k e = r LTGOVT + ERP (all percentage values) where: k e = estimate of utility s cost of equity capital for test year r LTGOVT = forecast of the average level of long-term Canada bond yields for the test year ERP = estimate of the compensatory rate-of-return premium required to attract investors to invest in the subject utility s shares, over the same test year horizon Generic formula does not specify what kinds of risk are being compensated - could be year-to-year uncertainty of equity returns, or short-term bankruptcy risk, or long-term survival/viability risk, or any combination Beta risk or systematic market risk i.e., the degree to which a utility s equity returns are sensitive to, or synchronized with, the returns for the overall stock market is another risk candidate preferred by institution-al investors (because it is the only risk they cannot diversify away)

12 The ERP method relevant to institutional investors is called the Capital Asset Pricing Model (CAPM), where the ERP term in the generic formula is replaced by β MRP, and - β = forward-looking estimate of utility s index of systematic risk. - average Canadian utility betas have been in the range of 0.25 to 0.50 for the past decade. - MRP = market risk premium = forward-looking estimate of the expected return above government bond yields that investors require to invest in the stock market in general. - consensus estimates of the Canadian MRP have been in the range of 5.0% to 6.0% since 2010 (based on extensive annual survey data compiled by Fernandez et al from Spain s IESE Business School) - Implied CAPM-model-based k e for the typical Canadian utility for 2015: k e = r LTGOVT + β MRP = 2.3% + (0.50)(6.0%) = 5.3%. - Adding 0.50% to reflect flotation costs and to ensure that the utility s share price (if it were traded) would trade above its book value, implied fair return on equity (ROE) of about 6%. Reasons why CAPM alone may be inadequate for setting allowed ROEs: - some relevant risks not captured by beta (e.g., stranded asset risk and regulatory risks) - boards may wish to satisfy equity-return requirements of investors who do not hold widely-diversified portfolios, for whom risks beyond beta may be important

13 Alternative Generic ERP Approach Formula: k e = r BOND + ERP* (all percentage values) where: r BOND = forecast of the subject utility s senior bond yield for the test year ERP* = estimate of the compensatory rate-of-return premium, above the subject utility s senior bond yield, required to attract investors to invest in the utility s shares, over the same test year horizon Advantages of above generic ERP method over those based on gov t yields: - r BOND will reflect changes in utility s credit risk and some other financialmarket conditions from hearing to hearing - r BOND will not be depressed, to the same extent as r LTGOVT, by monetary policies General Advantages of the ERP method: (1) focuses squarely on relative risks (2) only method where the equity-risk impact of changing capital structure proportions can be explicitly accounted for (3) there is relative stability of individual-utility ERP (and ERP*) estimates from hearing to hearing, even if gov t and utility bond yields fluctuate significantly (4) data for forecasting test-year gov t (and utility) bond yields are widely available and publicly known (e.g., consensus forecasts)

14 General Disadvantages of the ERP method: (1) Historical ERPs often inferred from analysts estimates of historical k e s; but those estimates are contentious; process often involves circular reasoning and substitution of another k e model for the ERP method (2) disagreement among witnesses about the relevance of different risk concepts for gauging relative ERPs and how to estimate these values (3) disagreement about the usefulness of historical MRP and ERP estimates for forecasting their likely future values - however the Fernandez survey evidence should tempered disputes about MRPs in future years In Canada, over the past 20 years, boards have preferred the ERP method over the DCF approach, as shown by the adoption of formula-based, ROE adjustment procedures based on changing long-term Canada bond yield expectations by the NEB, the OEB, and most other Canadian boards. This makes sense since ERP method is likely to be more useful and reliable than the DCF approach, especially if the utility s risk profile is changing over time and the shares of the stand-alone regulated utility are not publicly traded.

2013, Study Session #11, Reading # 37 COST OF CAPITAL 1. INTRODUCTION

2013, Study Session #11, Reading # 37 COST OF CAPITAL 1. INTRODUCTION COST OF CAPITAL 1 WACC = Weighted Avg. Cost of Capital MCC = Marginal Cost of Capital TCS = Target Capital Structure IOS = Investment Opportunity Schedule YTM = Yield-to-Maturity ERP = Equity Risk Premium