Electricity Markets Regulation - Lesson 5 - Cost of Capital

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The weighted average cost of capital (WACC) methodology is a widely accepted method for calculating the allowed rate of return. Regulators use different models to set the allowed cost of capital. This section explains the models and their practical application.
· Definition of cost of capital
o WACC
o Cost of equity
o Cost of debt
o Capital structure (gearing)
o Treatment of taxes
· Quantification of cost of capital
o CAPM (Capital Assets Pricing Model)
o Price Arbitrage Theory
o Dividend Growth Model
o Comparable Earnings Model
o “Precedent Case” Approach
· Financial Analysis

Electricity Markets Regulation - Lesson 5 - Cost of Capital

  1. 1. Training on Regulation A webinar for the European Copper Institute Webinar 5: Cost of Capital Dr. Konstantin Petrov / Dr. Daniel Grote 14.12.2009
  2. 2. Agenda b) Weighted Average Cost of Capital (WACC) a) Concept and Regulatory Objectives 1. Definition of Cost of Capital c) Cost of Debt d) Cost of Equity 2. Quantification of Cost of Capital a) Capital Asset Pricing Model (CAPM) c) Arbitrage Pricing Theory (APT) d) Dividend Growth Model (DGM) e) Comparable Earnings Model (CEM) e) Capital Structure (gearing) f) Treatment of Taxes f) Regulatory Precedents b) Fama-French 3-factor Model
  3. 3. 1. Definition of Cost of Capital a) Definition and Regulatory Objectives <ul><li>Cost of capital is a measure of the financial return that investors seek for the risk they are taking on by investing in the company </li></ul><ul><li>Regulatory objectives </li></ul><ul><ul><li>Provide sufficient return to encourage investments </li></ul></ul><ul><ul><li>Refer to capital market performance where it is possible </li></ul></ul><ul><ul><li>Consider adequately the risk of regulated industry </li></ul></ul><ul><ul><li>Provide incentives to employ optimal capital structure (minimal cost of capital) </li></ul></ul>
  4. 4. 1. Definition of Cost of Capital b) Weighted Average Cost of Capital (WACC) (1) Cost of Equity Cost of Debt Equity Share Debt Share Taxes WACC <ul><li>The cost of capital (allowed rate of return) is usually determined as the Weighted Average Cost of Capital (WACC) </li></ul><ul><li>WACC comprises of cost of equity and cost of debt weighted by their shares </li></ul><ul><li>WACC may include corporate taxes </li></ul><ul><li>WACC is applied in almost all European jurisdictions and worldwide </li></ul>
  5. 5. 1. Definition of Cost of capital b) Weighted Average Cost of Capital (WACC) (2) Cost of Equity No default risk No reinvestment risk + Market risk measure * Base Equity Premium Country Risk Premium Risk-free rate + Debt premium Risk-free rate Beta Risk Premium Premium for average risk investment Debt / Equity ratio E = Equity D = Debt Tax rate Cost of Debt Gearing T = Tax D E+D WACC (post-tax) = Cost of equity + Cost of Debt (1-T) E E+D * * *
  6. 6. 1. Definition of Cost of Capital c) Cost of Debt <ul><li>Calculated as sum of the risk free rate and debt risk premium (debt spread) </li></ul><ul><li>Availability of market data essential </li></ul><ul><li>Risk free rate </li></ul><ul><ul><li>Is the expected return on an asset which bears no risk at all, no default risk </li></ul></ul><ul><ul><li>Estimated on the basis of appropriate long-term government bond yields </li></ul></ul><ul><li>Debt risk premium </li></ul><ul><ul><li>Is the interest paid on corporate bonds over and above a comparable risk-free bond </li></ul></ul><ul><ul><li>Can be obtained by observing published credit ratings that specialist credit rating agencies assign to the company </li></ul></ul>
  7. 7. 1. Definition of Cost of Capital d) Cost of Equity (1) <ul><li>Calculated as sum of the risk free rate and equity risk premium adjusted by beta coefficient </li></ul><ul><li>Availability of market data essential </li></ul><ul><li>Risk free rate </li></ul><ul><ul><li>Is the expected return on an asset which bears no risk at all </li></ul></ul><ul><ul><li>Estimated on the basis of appropriate long-term government bond yields </li></ul></ul><ul><li>Beta coefficient </li></ul><ul><ul><li>Is an attempt to examine how the return on the investment co-varies with the return on the market portfolio </li></ul></ul><ul><ul><li>Direct estimates are not possible unless a company is publicly traded </li></ul></ul><ul><ul><li>An estimate of a company’s equity beta can be calculated from an estimate of its asset beta (based on international experience) </li></ul></ul><ul><li>Equity risk premium </li></ul>
  8. 8. 1. Definition of Cost of Capital <ul><li>Equity risk premium </li></ul><ul><ul><li>The usual regulatory practice is to use historical data on national capital market returns and arithmetic averages </li></ul></ul>d) Cost of Equity (2)
  9. 9. 1. Definition of Cost of Capital e) Capital Structure (gearing) <ul><li>The regulators aim to approximate the optimal financing </li></ul><ul><li>(= minimisation of cost of capital) </li></ul><ul><li>of the regulated service providers </li></ul><ul><li>Usually standardised </li></ul><ul><li>Regulators set targets </li></ul><ul><li>Objective is to minimize cost of capital </li></ul><ul><li>Equity part usually between </li></ul><ul><li>40 % and 50 % </li></ul>Cost of debt WACC Cost of capital Cost of equity Optimal cost of capital Debt / equity ratio (gearing)
  10. 10. 1. Definition of Cost of Capital f) Treatment of Taxes <ul><li>Corporation tax is a charge on corporate profits </li></ul><ul><li>It may be incorporated in the assessment of cost of capital </li></ul><ul><li>Pre-tax WACC, corporate tax included in the equity return allowed via the WACC </li></ul><ul><li>Post-tax WACC, corporate tax included as a separate item in the allowed revenue, tax shield effect incorporated in the debt return allowed via the WACC </li></ul>
  11. 11. 2. Quantification of Cost of Capital Overview Quantification Models Capital Asset Pricing Model (CAPM) Arbitrage Pricing Theory (APT) Dividend Growth Model (DGM) Regulatory Precedents Comparable Earnings Model Fama-French 3-factor model
  12. 12. 2. Quantification of Cost of Capital a) Capital Asset Pricing Model (CAPM) <ul><li>The most common model applied in practice (also for regulatory purposes) to determine a theoretically appropriate required rate of return of an asset </li></ul><ul><li>Discussion in finance about the theoretically exact model, but to date CAPM remains the basic model that provides a fairly good representation (rough proxy) of the real world </li></ul><ul><li>Total risk of portfolio = specific risk + systematic risk </li></ul><ul><ul><li>specific (unsystematic) risk </li></ul></ul><ul><ul><ul><li>components uncorrelated with general market movements </li></ul></ul></ul><ul><ul><ul><li>company specific individual risk, can be diversified away by investing in the market </li></ul></ul></ul><ul><ul><li>systematic risk </li></ul></ul><ul><ul><ul><li>common to all assets in the market (market risk) </li></ul></ul></ul><ul><ul><ul><li>risk for being in the market </li></ul></ul></ul><ul><ul><ul><li>cannot be reduced by diversification </li></ul></ul></ul><ul><li> stock owners only compensated for systematic risk </li></ul>
  13. 13. 2. Quantification of Cost of Capital a) Capital Asset Pricing Model (CAPM) – Formula or E(R a ) = R f + β ( E(R m ) – R f ) + ε Expected return on individual capital asset a Risk-free rate of interest sensitivity of asset returns to market returns Expected return of the market Risk-free rate of interest market premium or equity risk premium Error term systematic or non-diversifiable risk specific or diversifiable risk * E(R a ) - R f = β ( E(R m ) – R f ) β (beta) times market premium = individual risk premium *
  14. 14. 2. Quantification of Cost of Capital a) Capital Asset Pricing Model (CAPM) – Security Market Line <ul><li>Relationship between security returns and market returns </li></ul><ul><ul><li>The Security Market Line (SML) describes a relation between beta and the asset's expected rate of return </li></ul></ul><ul><ul><li>The slope of the SML is equal to the market risk premium (E(R m ) – R f ) and reflects the investment’s degree of risk aversion at a given time </li></ul></ul>Relatively risky assets Market portfolio Relatively safe assets Error term ( ε ) risk-free rate of return Expected rate of return systematic risk ( β ) 0 E(R m ) 1 R f Security Market Line (SML) Expected return of the market High risk premium Low risk premium
  15. 15. 2. Quantification of Cost of Capital b) Fama-French 3-Factor Model (1) <ul><li>Most popular alternative to CAPM in finance research (not yet much applied in the regulatory context) </li></ul><ul><li>Expands the CAPM with additional factors for firm size and book-to-market ratios found in a number of empirical studies </li></ul>E(R a ) = R f + β ( E(R m ) – R f ) + γ (SMB) + δ (HML) + ε Expected return on individual capital asset a Risk-free rate of interest Sensitivity of returns of asset a to market returns Expected return of the market Error term Risk-free rate of interest Expected returns of small minus big (SMB) stocks Expected returns of high minus low book-to-market (HML) stocks Sensitivity of returns of asset a to returns of small over big stocks Sensitivity of returns of asset a to returns of high over low book-to-market stocks * * *
  16. 16. 2. Quantification of Cost of Capital b) Fama-French 3-Factor Model (2) <ul><li>Market risk </li></ul><ul><ul><li>β = 1 asset moves with the market </li></ul></ul><ul><ul><li>β < 1 asset moves less than the market, less risk + lower than market return </li></ul></ul><ul><ul><li>β > 1 asset moves more than the market, higher risk + higher than market return </li></ul></ul><ul><li>Size effect </li></ul><ul><ul><li>Empirical observation that investors have received additional returns by investing in stocks of companies with a relatively small market capitalization (size premium) </li></ul></ul><ul><ul><li>γ close to 0, large capitalization portfolio </li></ul></ul><ul><ul><li>γ close to 1, small capitalization portfolio </li></ul></ul><ul><li>Value effect </li></ul><ul><ul><li>Empirical observation that investors have received additional returns for investing in stocks of companies with high book-to-market values (value premium) </li></ul></ul><ul><ul><li>δ close to 0, portfolio with low book-to-market ratio </li></ul></ul><ul><ul><li>δ close to 1, portfolio with high book-to-market ratio </li></ul></ul>
  17. 17. 2. Quantification of Cost of Capital c) Arbitrage Pricing Theory (APT) <ul><li>The Arbitrage Pricing Theory (APT) assumes that the expected return of a stock depends on the fundamental macroeconomic factors influencing it </li></ul><ul><li>The risk premium of a stock is associated with the stock’s sensitivity to each of these macroeconomic factors </li></ul><ul><li>If the price of an asset deviates from its expected price based on the influencing factors, investors will sell or buy the asset and bring the price back in line with the returns expected by the model (arbitrage) </li></ul><ul><li>Possible factors to be considered are economic growth, interest rates, inflation, fuel prices, consumer spending </li></ul><ul><li>Open question: Which factors to include and how to weight them? </li></ul>E(R a ) = R f + β a1 ( F1 ) + β a2 ( F2 ) + … + ε Risk-free rate of interest Expected return on individual capital asset a Sensitivity of returns of asset a to factor 1 Factor 1 Sensitivity of returns of asset a to factor 2 Factor 2 Error term Additional factors * *
  18. 18. 2. Quantification of Cost of Capital d) Dividend Growth Model (DGM) <ul><li>The Dividend Growth Model (DGM) or Dividend Discount Model values a stock with the present value of the dividend stream from that stock </li></ul><ul><li>Requires forecasting of the future distribution of dividends </li></ul><ul><li>The company growth regarded as constant (in one stage specification of the model) </li></ul><ul><li>Usually used as supporting model to examine the accuracy of the CAPM results </li></ul>R e = + g D 1 P 0 Cost of Equity expected dividend current share price rate of growth in dividend
  19. 19. 2. Quantification of Cost of Capital e) Comparable Earnings Model (CEM) <ul><li>The Comparable Earnings Model (CEM) estimates the cost of capital from the historical returns on equity for entities or industries of comparable risk </li></ul><ul><li>The cost of capital is related to the average rate of return over a historic period </li></ul><ul><li>It is based on accounting data which is affected by accounting policy </li></ul><ul><li>Difficult to select comparable company and appropriate period </li></ul>
  20. 20. 2. Quantification of Cost of Capital f) Regulatory Precedents <ul><li>The costs of capital of regulated firms is benchmarked against decisions of other regulatory authorities in other countries or for other sectors in the same country </li></ul><ul><li>Countries or companies from other sectors may not be comparable due to differences in: </li></ul><ul><ul><li>Regulatory regime </li></ul></ul><ul><ul><li>Sector specifics </li></ul></ul><ul><ul><li>Political and social environment </li></ul></ul><ul><li>Decision dependent on the accuracy of decision making of other regulators </li></ul>
  21. 21. End of Webinar 5 <ul><ul><ul><li>KEMA Consulting GmbH </li></ul></ul></ul><ul><ul><ul><li>Kurt-Schumacher-Str. 8, 53113 Bonn </li></ul></ul></ul><ul><ul><ul><li>Tel. +49 (228) 44 690 00 Fax +49 (228) 44 690 99 </li></ul></ul></ul><ul><ul><ul><li>Dr. Konstantin Petrov </li></ul></ul></ul><ul><ul><ul><li>Managing Consultant </li></ul></ul></ul><ul><ul><ul><li>Mobil +49 173 515 1946 E-mail: konstantin.petrov@kema.com </li></ul></ul></ul>

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