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  • 1. Project Report - Cost of capital The concept of "cost of capital" is very important in financial management. It is weighted average cost of various sources of finance used by a firm may be in form of debentures, preference share capital, retained earnings and equity share capital. A decision to invest in a particular project depends upon the cost of capital of the firm or the cut off rate which is minimum rate of return expected by the investors. When a firm is not able to achieve cut off rate, the market value of share will fall. In fact, cost of capital is minimum rate of return expected by its investors. Every firm has different types of goals or objectives such as profit maximization, cost minimization, wealth maximization and maximum market share. If a firm’s main objective is wealth maximization then that firm earns a rate of return more than its cost of capital. The cost of capital is a term used in the field of financial investment to refer to the cost of a company's funds (both debt and equity), or, from an investor's point of view "the shareholder's required return on a portfolio company's existing securities".[1] It is used to evaluate new projects of a company as it is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet. Cost of debt
  • 2. 1. Cost of debt When companies borrow funds from outside or take debt from financial institutions or other resources the interest paid on that amount is called cost of debt. The cost of debt is computed by taking the rate on a risk free bond whose duration matches the term structure of the corporate debt, then adding a default premium. This default premium will rise as the amount of debt increases (since, all other things being equal, the risk rises as the amount of debt rises). Since in most cases debt expense is a deductible expense, the cost of debt is computed as an after tax cost to make it comparable with the cost of equity (earnings are after-tax as well). Thus, for profitable firms, debt is discounted by the tax rate. The formula can be written as (Rf + credit risk rate)(1T), where T is the corporate tax rate and Rf is the risk free rate. The yield to maturity can be used as an approximation of the cost of debt. 2. Cost of equity Cost of equity = Risk free rate of return + Premium expected for risk Cost of equity = Risk free rate of return + Beta x (market rate of return- risk free rate of return) where Beta= sensitivity to movements in the relevant market Where: Es The expected return for a security Rf The expected risk-free return in that market (government bond yield) βs The sensitivity to market risk for the security RM The historical return of the stock market/ equity market
  • 3. (RM-Rf) The risk premium of market assets over risk free assets. The risk free rate is taken from the lowest yielding bonds in the particular market, such as government bonds. An alternative to the estimation of the required return by the capital asset pricing model as above, is the use of the Fama–French three-factor model. Expected return The expected return (or required rate of return for investors) can be calculated with the "dividend capitalization model", which is Comments The models state that investors will expect a return that is the risk-free return plus the security's sensitivity to market risk times the market risk premium. The risk premium varies over time and place, but in some developed countries during the twentieth century it has averaged around 5%. The equity market real capital gain return has been about the same as annual real GDP growth. The capital gains on the Dow Jones Industrial Average have been 1.6% per year over the period 1910-2005. [2] The dividends have increased the total "real" return on average equity to the double, about 3.2%. The sensitivity to market risk (β) is unique for each firm and depends on everything from management to its business and capital structure. This value cannot be known "ex ante" (beforehand), but can be estimated from ex post (past) returns and past experience with similar firms. Cost of retained earnings/cost of internal equity Note that retained earnings are a component of equity, and therefore the cost of retained earnings (internal equity) is equal to the cost of equity as explained above. Dividends (earnings that are paid to investors and not retained) are a component of the return on capital to equity holders, and influence the cost of capital through that mechanism. Weighted average cost of capital Main article: Weighted average cost of capital The Weighted Cost of Capital (WACC) is used in finance to measure a firm's cost of capital.
  • 4. The total capital for a firm is the value of its equity (for a firm without outstanding warrants and options, this is the same as the company's market capitalization) plus the cost of its debt (the cost of debt should be continually updated as the cost of debt changes as a result of interest rate changes). Notice that the "equity" in the debt to equity ratio is the market value of all equity, not the shareholders' equity on the balance sheet.To calculate the firm’s weighted cost of capital, we must first calculate the costs of the individual financing sources: Cost of Debt, Cost of Preference Capital and Cost of Equity Cap. Calculation of WACC is an iterative procedure which requires estimation of the fair market value of equity capital Capital structure Main article: Capital structure Because of tax advantages on debt issuance, it will be cheaper to issue debt rather than new equity (this is only true for profitable firms, tax breaks are available only to profitable firms). At some point, however, the cost of issuing new debt will be greater than the cost of issuing new equity. This is because adding debt increases the default risk - and thus the interest rate that the company must pay in order to borrow money. By utilizing too much debt in its capital structure, this increased default risk can also drive up the costs for other sources (such as retained earnings and preferred stock) as well. Management must identify the "optimal mix" of financing – the capital structure where the cost of capital is minimized so that the firm's value can be maximized. The Thomson Financial league tables show that global debt issuance exceeds equity issuance with a 90 to 10 margin. The structure of capital should be determined considering the weighted average cost of capital. Introduction The cost of capital reflects the opportunity cost of funds for investment in companies. If their investments were expected to earn a return below their cost of capital, investors would have superior alternatives for their funds. They could find other projects with the same expected return but lower risk, projects with the same risk, but a higher expected return, or projects with a higher risk and a higher expected return which still made a better opportunity than airports. It may be worth noting that arguments are often made about risks affecting the cost of capital that on closer analysis are project cashflow risks and uncertainties. The expected cost of capital is often a critical issue in the regulation of capital-intensive utilities via RPI-X regulation where small changes in the cost of capital can have a major impact on the price cap. This is the case for airports. The cost of capital is also very important and relevant for incremental cost estimates. The CAA is not envisaging a formal consultation on this document but would welcome views, argument, analysis and evidence that would assist the CAA in coming to a final view on this issue. The CAA is conscious that where airport capacity is under heavy pressure and investment is the priority it will be important that the estimate used has a low risk of being too low rather than
  • 5. being too high. This balancing of risk is consistent with maximising regulatory certainty so as to provide a sound basis for long term investment in desired capacity. There remains intense debate on how several of the key components of the cost of capital should be estimated for regulatory purposes. The issue has been given considerable prominence in recent regulatory decisions, particularly the CC‟s decisions over the appeals by two water companies. The CAA proposes to draw on what we consider to be regulatory best practice in coming to a conclusion on the key issues affecting the generic elements of the cost of capital (the risk free rate and the equity risk premium). Our focus will be the framework provided by the capital asset 1 pricing model (CAPM) applied on a weighted average cost of capital basis (WACC) . We are not 2 proposing to use other techniques such as dividend growth or arbitrage pricing models, 3 although we have examined recent relevant literature . We would of course welcome any evidence based on these approaches that assists the CAA in coming to a final view on the appropriate cost of capital in this review. This is not a precise science and judgement will be needed in coming to a view on this issue as an integral part of the final regulatory decision given the CAA‟s statutory objectives. In this review the CAA will “model” the airport businesses with a view to forming the appropriate price cap on a cash-flow basis. In this framework the cost of capital takes its technically correct role (in the capital asset pricing model) as a discount rate (as opposed to a target rate of return). Estimating the cost of capital requires estimates or judgements on the following: • the return demanded on risk-free assets; • the equity risk premium; • airport company betas; • the debt premium; • gearing; • treatment of tax. We first cover the two generic components of CAPM: the risk free rate and the equity risk premium. The estimations are in real terms. The distinction between using a post-tax pre-financing cost of capital, using a post-tax, post-financing cost–of-capital and pre-tax cost of capital (and calculating a „tax wedge‟ in the cost of capital) is largely one of presentation provided they are handled consistently. shows an overview of approaches adopted in recent decisions of other regulators and the Competition Commission on the components of the cost of capital. 2. Risk free rate At the time of the water appeals the CC was aware that spot market rates were below longer term averages and that the index gilt historic averages were above those estimated from very long
  • 6. term time series. Arguably, therefore, the CC has set a conscious precedent and little has changed subsequently. Ofwat, Ofgem and ORR have opted for a more forward looking basis in their recent reviews. The CAA continues to be attracted to using historical data for the purposes of the risk free rate given short term volatility and the long term investment focus of the current review. The CAA is therefore minded to adopt the most recent published CC decision for the purposes of this review. Given the historical data this seems to be the view that minimises the prospect of too low a cost of capital and the risks that entails. This represents a reduction from the last airport review where a range of 3.5% to 3.8% was used. This has been the source of controversy in the recent periodic reviews. The most recent CC decisions 4 used a (real) risk free rate range of 2.75%-3.25% with a mid-point of 3.0% . This followed previous MMC conclusions in relation to BAA (1996), Manchester Airport (1997) and Northern Ireland Electricity (1997) and Cellnet-Vodafone (1999) where the real risk free rate was assumed to be 3.5%5 6 3.8%. Recent conclusions by Ofgem, Ofwat and ORR use a risk free rate in the range 2.25%-3.0%. Ofgem‟s paper on Transco (February 2001) is suggesting a range with a slightly lower mid-point than this. The reason for the difference is that the regulators have generally focused on current market rates on index linked UK government stocks, which are currently lower than in recent years, while the CC has focused more on longer term averages of index linked gilts. It should be noted that the CC‟s conclusions are based upon data on UK government index linked gilts‟ yields estimated by the Bank of England covering the period for which index linked stocks have been available, 1982. It is not, therefore, a (very) long term average of the type often used in estimating the 7 risk-free rate and the equity risk premium (see below). However, the return on index linked gilts since the mid-80s has been higher than ex post returns on government bonds over the twentieth century as a 8 9 whole. In the very long run, the CC recognises, the risk free rate has been lower. Jenkinson (1999 ) calculates that the real return on Treasury Bills from 1919-98 was 1.7% (average annual) to 2.1% (average 10 10 year holding). CSFB in a recent publication estimated that the real average return since 1869 was 11 1.8%. The LBS Millennium Book estimates a lower return of 1.0% p.a. over the century. This is consistent with US data. These are lower than the Ofwat/Ofgem estimates. 3. Equity risk premium The difference between the CC and recent regulators‟ analyses is less than for the risk free rate. Both are on the low side of long-term time series estimates. In Cellnet-Vodafone the MMC opted for an ERP of 3.5%-5.0%. The lower end of this range is below the upper bound of the regulators‟ ranges. In the water cases the CC used a central estimate of 4%, 0.25% below that for Cellnet12 Vodafone. This was 50 basis points higher than Ofwat‟s central estimate and Ofgem (2001) suggests that even 3.5% is high. The ERP has been the subject of enormous academic study. The ERP, which is forward looking, cannot be directly measured or observed (unlike the risk free rate). The ERP has typically been estimated using long run historical measures of the ex post real returns on equities compared with those on bonds. These time series tend to suggest ERP for the UK in the range 4.5%-6.5% (Millennium book, table 15 and 16). This depends on whether average or geometric means are
  • 7. used and whether short term or long term bonds are used in the calculation. (Estimates for the world‟s largest capital market, the US, suggest an ERP roughly 100 basis points higher.) The CC in the Sutton decision included a calculation synthesising the arithmetic mean – geometric mean debate to suggest numbers towards the top end of their range as representing the best unbiased 13 estimators . Regulators and the CC have advanced arguments that these estimates may be overstated as the best indicator of the forward-looking ERP because of the very high returns over the last two decades. Surveys of current market expectations are also drawn on to suggest that some shaving of these estimates is required. It is also worth reiterating that the estimated risk free rate used as the basis for historic estimates of the ERP was significantly below that assumed by the CC and other regulators (see table 1 above). Consider a company with a beta of 1, a debt premium of 0.5%, and 50% gearing. The real post tax WACC using long term averages for both the risk free rate (2%) and the ERP (5.5%) would be 5.0%. Using the shorter term estimates of the risk free rate of 3.0%, and the CC‟s ERP of 4.0%, would give a real post tax WACC of 5.25%, not dissimilar. The CAA continues to be drawn towards the historical averages as the basis for estimating the ERP. We have found it difficult to evaluate the forward-looking studies including the dividend-growth studies. The recent Fama-French paper, summarised at attachment 2, based on a dividend growth model suggests that the unconditional expected equity risk premium is much lower than the realised number over the last fifty years, 7.4%. However Ang and Bekart in a recent NBER 14 working paper present evidence that dividend yields are unable to predict stock returns. Bansal 15 and Yaron suggest that concerns that historic estimates of the premium of approximately 6.5% are too high, are addressed when the long term effects of new information on expected earning growth rates are allowed for. Other regulators and the CC will have studied these issues intensively. Accordingly, and given the observation that the Debt premium Financial markets demand a premium on corporate debt over equivalent gilts to allow for the greater risk of default on corporate debt. This premium will vary depending on perceived risk with gearing being a major factor. According to OXERA the current premium on BAA debt is 1.40%-1.45%. This is higher than the range used by the MMC for BAA‟s regulated business in 1996 which was 0.3%-0.8%. At the last review MA advised the MMC that their premium was 17 0.8% . Excluding the higher risk non-regulated business should lower the current premium. However we note that recent regulatory decisions have used estimates in the 1.5%-2% range. For example, the CC in the Sutton case used a premium of 1.5% with gearing of 25%, rising to 1.9% with a gearing of 50%. We note, however, that Sutton is a much smaller company than BAA. We also note that OXERA calculates that BAA‟s economic gearing is around 23%. It has been argued that the debt premium should incorporate an adjustment for inflation risk. The debt premium is by definition a premium over the risk free rate. The risk free rate has been estimated using yields on index linked bonds, which are largely insulated from inflation risk (timings of adjustments may leave some residual inflation risk). However, the debt premium has been estimated using comparisons on yields on corporate debt with nominal gilts. If the risk of inflation differing from expectations is not diversifiable, nominal gilt yields may be subject to a degree of systematic risk. The standard method of measuring the cost of debt would not allow
  • 8. for this. There are the usual problems of measurement of market expectations of inflation here. The CAA also note that there may be other explanations for any premium on nominal gilts over index linked gilts, such as differential tax treatment. CAA believes this is relevant to the assessment of the pre-tax cost of capital „tax wedge‟, but is not inclined to allow an inflation premium on the debt premium. Our starting point will be the range used in the last review, allowing the regulated companies to make cases that their risk has changed. We will need to ensure that only the risks of the regulated firms are considered and that risks associated with diversification are excluded. At various stages BAA has indicated to us that its investment programme may cause gearing and risk to rise significantly. MA no doubt will also wish to make submissions on this point also. Gearing and tax The cost of tax is closely associated with the cost of capital: • corporation tax is a charge on corporate profits which, for a price regulated company, are largely determined by the regulatory assessment of the cost of capital; • timing differences between the liability to tax and the recognition of accounting profits are generally associated with capital transactions; • the liability to corporation tax is significantly influenced by the capital structure of the company, notably by the mix of debt and equity; • the tax position of shareholders is, in principle, influential in determining the cost of equity and debt with firms being price takers in respect of capital in competitive international capital markets. In practice, taxation can be considered an integral part of the overall cost of capital: the scale of operating profits required to sustain the ability of the company to finance new investment. There are, conventionally, two ways of measuring the cost of capital: • as the weighted average of the cost of debt and the cost of equity, treating corporate tax as a tax shelter benefiting debt (the post-tax approach, used by Ofwat); • as the weighted average of the cost of debt and the cost of equity “grossed up” by the corporate tax rate (the pre-tax approach, used by other regulators and the CC). The post-tax approach is used by Ofwat to assess the cost of capital for water and sewerage companies so that the effects of different tax and investment circumstances can be taken explicitly into account. The pre-tax approach is used by other regulators such as ORR and Ofgem, generally applying a relatively simple adjustment to the cost of capital: “grossing up” the post-tax cost of equity by the corporation tax rate. Provided the two approaches are handled appropriately there 18 should be no difference between them . Effective versus statutory tax rates Because of timing differences between the tax and statutory accounting rules effective and statutory tax rates can differ. The effect of inflation on the real value of capital allowances does reduce the impact of this deferral in present value terms. On the other hand, the existence of inflation
  • 9. means that airports will receive tax relief not just for the real cost of debt imputed in the CAPM model, but also on the inflation element of nominal interest payments. This is a real tax benefit. The combined effect of accelerated capital allowances and the tax treatment of interest would reduce the effective tax rate for airports over the investment cycle, reducing the size of the taxwedge necessary to ensure that the pre-tax cost of capital covers the cost of debt, normal equity returns and the cost of tax. Our financial modelling will aim to project the actual stream of tax payments along with other cash disbursements, pre-financing, so this issue will be addressed in this way. In the last regulatory decision on airports the MMC and CAA used the statutory corporation tax rate in the cost of capital calculations. In the water cases the CC used the effective tax rate calculated from their financial modelling. The CAA is reluctant to change existing regulatory practice for airports without careful analysis and modelling supporting such a change. It would seem that such a move requires a careful assessment by the regulator of optimal versus actual gearing including the tax liability management policy of the regulated firm. This would seem to be more intrusive than is desirable given the CAA statutory duties. Thus the CAA would propose to use statutory corporation tax rates in the cost of capital calculation. Convention to date seems to have allowed for full or near-full adjustment of the cost of capital by the tax benefit given by the deductibility of interest payments at the corporate level. It can be argued that the relevant tax rates that are “incorporated” in the pricing of capital assets in competitive capital markets must also take account of personal tax rates. This is particularly the case where 19 the corporation tax can be regarded as a withholding tax . While the top marginal personal tax 20 rate is higher than corporate tax rates in the UK and the US, the concessions in respect of the tax treatment of capital gains may mean the relevant effective personal tax rate is lower than the corporate rate any way. Plausible estimates of the relevant effective tax rates imply that the true tax shelter given by the deductibility of debt at the corporate level may be much smaller or nonexistent. For the purpose of calculating a cost of capital our initial range will be from allowing a full tax shield to allowing no tax shield. cost of capital estimates 7.1 Taking the estimates and assumptions specified above, the CAA has estimated a range for the cost of capital. The low case and high case are set out in Table 2 below. Table 2: Estimates of the real cost of capital Current Estimates low Last Review high low high Asset Beta 0.60 0.77 0.58 0.75 Gearing 0.30 0.20 0.30 0.30 Risk free rate 2.75% 3.25% 3.50% 3.80% Equity risk premium 3.50% 4.50% 4.00% 5.00%
  • 10. Equity beta Post tax cost of equity 0.70 0.90 0.70 0.90 5.20% 7.30% 6.30% 8.30% Dividend tax credit 0.80 5.04% Pre-tax cost of equity 0.80 6.64% Risk free rate 2.75% 3.25% 3.50% 3.80% Debt premium 0.30% 0.80% 0.30% 0.80% Cost of debt 3.05% 4.05% 3.80% 4.60% Post tax WACCa 4.28% 6.65%b 5.55%c 7.19%c Pre taxWACCa 6.12% 9.15% 6.41%c 8.32%c Corporation tax rate 30.00% 30.00% 33.00% 33.00% Incremental costs estimates and the cost of capital The cost of capital is a key parameter in the calculation of the incremental costs of airports. The CAA has emphasised the importance of these calculations for this review. We consider that the cost of capital estimates using the above parameters should be ones used for incremental cost calculations supplemented by sensitivity analysis. The one parameter that we would envisage could be varied would be the beta, if after careful analysis, it was considered that the beta for a specific project differed significantly from the estimated regulated business beta. We are open to argument, analysis and evidence on this point. Conclusion The cost of capital is a key parameter for this review. Given the importance of getting the best possible investment incentives for desired airport development, particularly in the South-east, we judge that in setting this parameter it is critically important not to set it too low. The adverse consequences of it being set too high are, in comparison, lower. The CAA is adopting a pragmatic approach to this issue drawing as much as possible of best practice followed by other regulators and the CC in terms of approach, analysis and data. This note lays out our proposed approach and current data sources as transparently as possible. We welcome analysis and evidence that will assist us in coming to an overall view that is most likely to contribute to achieving our statutory objectives.