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
Outline Risk Environment Summary of testimony Methods Results ROE Formulas S & P Release Dr. Kalymon s Recommendations 2
Risk Environment 3
Investment Risk Business Risk Above average Regulatory Risk Average + Financial Risk Below Average TOTAL Average + 4
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
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
Capital Structure Cost of Capital AAA AA A BBB Bond Rating, Debt Ratio 7
Summary of Testimony: Methods & Results 8
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
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
2. Risk Premium Method Estimates the necessary premium over risk free rate to attract investors: Equity return = Risk-Free + Risk Premium 11
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
Utility Risk Premium Return Average Stock Utility Risk Premium R f R f = Risk-free rate Government Bonds Electric Utility Average Stock Risk 13
Risk Premium Method Example Long-Term Canada Bonds 6.0% Risk Premium 5.0% Return on Equity = 6.0% + 5.0% = 11.0% 14
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
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
CAPM Risk-Return Relationship Return R M R NP Market Portfolio R f β NP 1.0 Risk 17
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 0.63-0.81 Regulatory betas Canada 0.60-0.70 Regulatory betas U. S. 0.64-0.80 AVERAGE 0.67 18
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
CAPM Results Risk-Free Rate = 6.0% Beta = 0.67 Market Risk Premium = 6.7% K = R f + β(r m -R f ) = 6% + 0.67 x 6.7% = 6% + 4.5% = 10.5% 20
Return Theoretical vs Empirical Estimate of the CAPM Theory Observed R f Low betas High betas 0 1.0 Beta 21
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
Rate of Return Conclusion Long-Term Canada Bonds 6.0% Risk Premium 4.5% - 5.0% Return on Equity 10.5% - 11.0% 23
4. DCF Method Return = Dividend Yield + Growth K = D 1 /P + g 24
DCF Example Dividend Yield = 6.0% Expected Growth = 5.0% Return = 6.0% + 5.0% = 11.0% 25
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
DCF Checks U. S. Elec & Gas Utilities 14 12 10 6.5 7.1 Return 8 6 Growth Dividend Yield 4 4.8 4.5 2 0 Combin Gas & Elec Gas LDCs 27
ROE Proposal 10.5% - 11.0% 45% Common Equity Ratio 28
ROE Formulas 29
ROE Formula Amendments Risk-free rate: Actual Consensus Forecast Going-in risk premium 4.75% Retain 80% elasticity 3-Year review 30
S & P Release 31
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
Dr. Kalymon s Recommendations 33
Dr. Kalymon s Proposals 8.5% - 9.0% 40% Common Equity Ratio 34
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
Rating System AAA AA A BBB BB B CCC D(efault) Investment Grade 36
Rating System AAA AA A BBB BB B CCC D(efault) Actual Investment Grade 37
Financial Interrelationships ROE Interest Coverage Common Equity Ratio 38
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 1981-2000 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