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
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". 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
Cost of debt
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.
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
The expected return for a security
The expected risk-free return in that market (government bond yield)
The sensitivity to market risk for the security
The historical return of the stock market/ equity market
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
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.
The expected return (or required rate of return for investors) can be calculated with the "dividend
capitalization model", which is
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.  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
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.
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
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.
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
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
pricing model (CAPM) applied on a weighted average cost of capital basis (WACC) . We are not
proposing to use other techniques such as dividend growth or arbitrage pricing models,
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;
• 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
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
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
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
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
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
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
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 year holding). CSFB in a recent publication estimated that the real average return since 1869 was
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
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
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
working paper present evidence that dividend yields are unable to predict stock returns. Bansal
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
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
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
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
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
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
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
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
the corporation tax can be regarded as a withholding tax . While the top marginal personal tax
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
Risk free rate
Post tax cost
Dividend tax credit
Pre-tax cost of equity
Risk free rate
Cost of debt
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.
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.