Rate of Return Capital Structure

Transcription

1 Rate of Return Capital Structure Roger A. Morin, PhD, Distinguished Professor of Finance Professor of Finance for Regulated Industry Center for the Study of Regulated Industry College of Business, Georgia State University Chairman & C.E.O. Utility Research International 1

2 Outline Risk Environment Summary of testimony Methods Results ROE Formulas S & P Release Dr. Kalymon s Recommendations 2

3 Risk Environment 3

4 Investment Risk Business Risk Above average Regulatory Risk Average + Financial Risk Below Average TOTAL Average + 4

5 Cost of Capital and Regulatory Risk Cost of Debt Cost of Equity Capital Structure Weights Weighted Average Cost of Capital Allowed Rate of Return 5

6 Cost of Capital and Financial Risk Cost of Debt Cost of Equity Capital Structure Weights Weighted Average Cost of Capital Allowed Rate of Return 6

7 Capital Structure Cost of Capital AAA AA A BBB Bond Rating, Debt Ratio 7

8 Summary of Testimony: Methods & Results 8

9 Cost of Equity Measurement 4 Principal Methodologies 1. Comparable Earnings 2. Risk Premium 3. Capital Asset Pricing Model ( CAPM ) 4. Discounted Cash Flow ( DCF ) 9

10 1. Comparable Earnings Test Measures the ROE of equal risk nonregulated companies Intended to provide a measure of past earnings of comparable companies to use as a proxy for future utility returns 10

11 2. Risk Premium Method Estimates the necessary premium over risk free rate to attract investors: Equity return = Risk-Free + Risk Premium 11

12 Risk and Return Return on Capital Markets Average Stock Equity Risk Premium R f R f = Risk-free rate Government Bonds Average Stock Risk 12

13 Utility Risk Premium Return Average Stock Utility Risk Premium R f R f = Risk-free rate Government Bonds Electric Utility Average Stock Risk 13

14 Risk Premium Method Example Long-Term Canada Bonds 6.0% Risk Premium 5.0% Return on Equity = 6.0% + 5.0% = 11.0% 14

15 Risk Premium Estimates Study Result Electric utility historical 5.7% Natural gas utility historical 6.1% Allowed risk premium Canada 4.4% Allowed risk premium U. S. 5.1% 15

16 3. CAPM Method Return = Risk free rate + Risk premium Return = Risk free rate + Beta (Market Price of Risk) = R f + β(r m -R f ) 16

17 CAPM Risk-Return Relationship Return R M R NP Market Portfolio R f β NP 1.0 Risk 17

18 Beta Estimates Sample Result Canadian energy utilities 0.60 Natural gas distribution utilities 0.64 U. S. Electric utilities 0.70 Natural gas transmission 0.65 Unlevered-levered beta Regulatory betas Canada Regulatory betas U. S AVERAGE

19 Market Risk Premium Estimates Study Result Hist. Hatch-White 6.9% Hist. Cdn. Inst. Actuaries 5.7% Hist. Ibbotson Associates Canada 5.5% Hist. Ibbotson Associates U.S. 7.5% Prosp. Value Line Canada 6.8% Prosp. Value Line U.S. 7.6% AVERAGE 6.7% 19

20 CAPM Results Risk-Free Rate = 6.0% Beta = 0.67 Market Risk Premium = 6.7% K = R f + β(r m -R f ) = 6% x 6.7% = 6% + 4.5% = 10.5% 20

21 Return Theoretical vs Empirical Estimate of the CAPM Theory Observed R f Low betas High betas Beta 21

22 Risk Premium Estimates Summary STUDY RISK PREMIUM CAPM 4.5% ECAPM 5.0% Electric Utility Historical 5.7% Natural Gas Utility Historical 6.1% Allowed Risk Premium 4.4% Allowed Risk Premium 5.1% RANGE 4.5% - 5.0% 22

23 Rate of Return Conclusion Long-Term Canada Bonds 6.0% Risk Premium 4.5% - 5.0% Return on Equity 10.5% % 23

24 4. DCF Method Return = Dividend Yield + Growth K = D 1 /P + g 24

25 DCF Example Dividend Yield = 6.0% Expected Growth = 5.0% Return = 6.0% + 5.0% = 11.0% 25

26 DCF Test Problems Assumes constant growth forever Erratic Historical growth performance Difficult to estimate investor long-term growth expectations Scarcity of pure-play companies in Canada 26

27 DCF Checks U. S. Elec & Gas Utilities Return 8 6 Growth Dividend Yield Combin Gas & Elec Gas LDCs 27

28 ROE Proposal 10.5% % 45% Common Equity Ratio 28

29 ROE Formulas 29

30 ROE Formula Amendments Risk-free rate: Actual Consensus Forecast Going-in risk premium 4.75% Retain 80% elasticity 3-Year review 30

31 S & P Release 31

32 S&P Release Concerns with weak capital structures, low allowed ROEs Reevaluation U.S. experience Opt for caution, prudency, financial stability in capital structure decision Fortis NP Harmonization safeguards Non-recourse debt First Mortgage Bonds S&P & DBRS rating A Stand-alone approach Board policy 32

33 Dr. Kalymon s Recommendations 33

34 Dr. Kalymon s Proposals 8.5% - 9.0% 40% Common Equity Ratio 34

35 Comments on Dr. Kalymon: Common Sense Reactions Lowest allowed ROE in North America Impact on financial ratios, interest coverage Bond rating implications Adding fuel to S&P fire 35

36 Rating System AAA AA A BBB BB B CCC D(efault) Investment Grade 36

37 Rating System AAA AA A BBB BB B CCC D(efault) Actual Investment Grade 37

38 Financial Interrelationships ROE Interest Coverage Common Equity Ratio 38

39 Comments on Dr. Kalymon: Conceptual Aspects Long-term 10-year Canada 5% vs 30-year 6% Market risk premium 2.5% - 3.0% Short-period Geometric vs arithmetic mean Implied Beta = 1.0 Check: 4.6% - 6.0%; Beta = 0.40 Inconsistencies Beta = 0.40 utilities Beta = 0.67 industrials Beta = 1.0 Market-to-Book Ratio adjustment DCF Results unreliable Dividend vs earnings growth 39