Upload
european-copper-institute
View
5.708
Download
0
Embed Size (px)
Citation preview
Experience you can trust.http://www.leonardo-energy.org/training-module-electricity-market-regulation-session-5
Training on Regulation
A webinar for the European Copper Institute
Webinar 5: Cost of CapitalDr. Konstantin Petrov / Dr. Daniel Grote
14.12.2009
14.12.2009 2
http://www.leonardo-energy.org/training-module-electricity-market-regulation-session-5
Agenda
b) Weighted Average Cost of Capital (WACC)a) Concept and Regulatory Objectives
1. Definition of Cost of Capital
c) Cost of Debtd) Cost of Equity
2. Quantification of Cost of Capitala) 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
14.12.2009 3
http://www.leonardo-energy.org/training-module-electricity-market-regulation-session-5
1. Definition of Cost of Capital
a) Definition and Regulatory Objectives
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
Regulatory objectives
– Provide sufficient return to encourage investments
– Refer to capital market performance where it is possible
– Consider adequately the risk of regulated industry
– Provide incentives to employ optimal capital structure (minimal cost of capital)
14.12.2009 4
http://www.leonardo-energy.org/training-module-electricity-market-regulation-session-5
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
The cost of capital (allowed rate of return) is usually determined as the Weighted Average
Cost of Capital (WACC)
WACC comprises of cost of equity and cost of debt weighted by their shares
WACC may include corporate taxes
WACC is applied in almost all European jurisdictions and worldwide
14.12.2009 5
http://www.leonardo-energy.org/training-module-electricity-market-regulation-session-5
1. Definition of Cost of capital
b) Weighted Average Cost of Capital (WACC) (2)
Cost of Equity
No default riskNo reinvestment risk
+
Market risk measure
*
Base Equity Premium
Country Risk Premium
Risk-free rate + Debt premium
Risk-free rate Beta Risk Premium
Premium for averagerisk investment
Debt / Equity ratio
E = Equity D = Debt
Tax rateCost of Debt Gearing
T = Tax
DE+D WACC (post-tax) = Cost of equity + Cost of Debt (1-T)E
E+D* * *
14.12.2009 6
http://www.leonardo-energy.org/training-module-electricity-market-regulation-session-5
1. Definition of Cost of Capital
c) Cost of Debt
Calculated as sum of the risk free rate and debt risk premium (debt spread)
Availability of market data essential
Risk free rate
– Is the expected return on an asset which bears no risk at all, no default risk
– Estimated on the basis of appropriate long-term government bond yields
Debt risk premium
– Is the interest paid on corporate bonds over and above a comparable risk-free bond
– Can be obtained by observing published credit ratings that specialist credit rating
agencies assign to the company
14.12.2009 7
http://www.leonardo-energy.org/training-module-electricity-market-regulation-session-5
1. Definition of Cost of Capital
d) Cost of Equity (1)
Calculated as sum of the risk free rate and equity risk premium adjusted by beta coefficient
Availability of market data essential
Risk free rate
– Is the expected return on an asset which bears no risk at all
– Estimated on the basis of appropriate long-term government bond yields
Beta coefficient
– Is an attempt to examine how the return on the investment co-varies with the return on
the market portfolio
– Direct estimates are not possible unless a company is publicly traded
– An estimate of a company’s equity beta can be calculated from an estimate of its asset
beta (based on international experience)
Equity risk premium
14.12.2009 8
http://www.leonardo-energy.org/training-module-electricity-market-regulation-session-5
1. Definition of Cost of Capital
Equity risk premium
– The usual regulatory practice is to use historical data on national capital market returns and
arithmetic averages
Country Regulator Industry Range of Equity risk premium Last decision
Min Max Date Equity risk premium
ACCC TSO (electricity) 6.0% 6.0% 2005 6.0% Australia ESC DSO (electricity) 6.0% 6.0% 2005 6.0%
Belgium CREG DSO (gas) 3.5% 3.5% 2006 3.5% TSO (gas) 5.0% 5.0% 2004 5.0%
Finland EMA TSO (electricity) 5.0% 5.0% 2004 5.0%
Electricity generation 5.25% 5.25% 2005 5.25% Ireland CER
TSO/DSO (electricity) 5.25% 5.25% 2005 5.25% TSO (electricity) 4.0% 6.0% 2005 5.0% DSO (electricity) 4.0% 7.0% 2005 5.0% Netherlands DTe
DSO (gas) 4.0% 6.0% 2005 6.0% New Zealand Commerce Commission DSO (gas) 5.5% 7.5% 2005 7.0%
UK Ofgem DSO (electricity) 2.5% 4.5% 2004 4.5%
d) Cost of Equity (2)
14.12.2009 9
http://www.leonardo-energy.org/training-module-electricity-market-regulation-session-5
1. Definition of Cost of Capital
e) Capital Structure (gearing)
The regulators aim to approximate the optimal financing
(= minimisation of cost of capital)
of the regulated service providers
Usually standardised
Regulators set targets
Objective is to minimize cost of capital
Equity part usually between
40 % and 50 %
Cost of debt
WACC
Cost of capital
Cost of equity
Optimal cost of capital
Debt / equity ratio (gearing)
14.12.2009 10
http://www.leonardo-energy.org/training-module-electricity-market-regulation-session-5
1. Definition of Cost of Capital
f) Treatment of Taxes
Corporation tax is a charge on corporate profits
It may be incorporated in the assessment of cost of capital
Pre-tax WACC, corporate tax included in the equity return allowed via the WACC
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
14.12.2009 11
http://www.leonardo-energy.org/training-module-electricity-market-regulation-session-5
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
14.12.2009 12
http://www.leonardo-energy.org/training-module-electricity-market-regulation-session-5
2. Quantification of Cost of Capital
a) Capital Asset Pricing Model (CAPM)
The most common model applied in practice (also for regulatory purposes) to determine a
theoretically appropriate required rate of return of an asset
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
Total risk of portfolio = specific risk + systematic risk
– specific (unsystematic) risk components uncorrelated with general market movements company specific individual risk, can be diversified away by investing in the market
– systematic risk common to all assets in the market (market risk) risk for being in the market cannot be reduced by diversification
stock owners only compensated for systematic risk
14.12.2009 13
http://www.leonardo-energy.org/training-module-electricity-market-regulation-session-5
2. Quantification of Cost of Capital
a) Capital Asset Pricing Model (CAPM) – Formula
or
E(Ra) = Rf + β ( E(Rm) – Rf ) + 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 ordiversifiable
risk
*
E(Ra) - Rf = β ( E(Rm) – Rf )
β (beta) times market premium=individual risk premium
*
14.12.2009 14
http://www.leonardo-energy.org/training-module-electricity-market-regulation-session-5
2. Quantification of Cost of Capital
a) Capital Asset Pricing Model (CAPM) – Security Market Line
Relationship between security returns and market returns– The Security Market Line (SML) describes a relation between beta and the asset's expected
rate of return
– The slope of the SML is equal to the market risk premium (E(Rm) – Rf ) and reflects the
investment’s degree of risk aversion at a given time
Relatively risky assetsMarket
portfolio
Relatively safe assets
Error term (ε)
risk-free rate of return
Expected rate of return
systematic risk (β)0
E(Rm)
1
Rf
Security Market Line (SML)
Expected return of
the market
High risk premium
Low risk premium
14.12.2009 15
http://www.leonardo-energy.org/training-module-electricity-market-regulation-session-5
2. Quantification of Cost of Capital
b) Fama-French 3-Factor Model (1)
Most popular alternative to CAPM in finance research (not yet much applied in the regulatory context)
Expands the CAPM with additional factors for firm size and book-to-market ratios found in a number of empirical studies
E(Ra) = Rf + β ( E(Rm) – Rf ) + 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
* * *
14.12.2009 16
http://www.leonardo-energy.org/training-module-electricity-market-regulation-session-5
2. Quantification of Cost of Capital
b) Fama-French 3-Factor Model (2)
Market risk
– β = 1 asset moves with the market
– β < 1 asset moves less than the market, less risk + lower than market return
– β > 1 asset moves more than the market, higher risk + higher than market return Size effect
– Empirical observation that investors have received additional returns by investing in stocks
of companies with a relatively small market capitalization (size premium)
– γ close to 0, large capitalization portfolio
– γ close to 1, small capitalization portfolio Value effect
– Empirical observation that investors have received additional returns for investing in stocks
of companies with high book-to-market values (value premium)
– δ close to 0, portfolio with low book-to-market ratio
– δ close to 1, portfolio with high book-to-market ratio
14.12.2009 17
http://www.leonardo-energy.org/training-module-electricity-market-regulation-session-5
2. Quantification of Cost of Capital
c) Arbitrage Pricing Theory (APT)
The Arbitrage Pricing Theory (APT) assumes that the expected return of a stock depends on
the fundamental macroeconomic factors influencing it The risk premium of a stock is associated with the stock’s sensitivity to each of these
macroeconomic factors 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) Possible factors to be considered are economic growth, interest rates, inflation, fuel prices,
consumer spending Open question: Which factors to include and how to weight them?
E(Ra) = Rf + βa1 ( F1 ) + βa2 ( 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
* *
14.12.2009 18
http://www.leonardo-energy.org/training-module-electricity-market-regulation-session-5
2. Quantification of Cost of Capital
d) Dividend Growth Model (DGM)
The Dividend Growth Model (DGM) or Dividend Discount Model values a stock with the
present value of the dividend stream from that stock
Requires forecasting of the future distribution of dividends
The company growth regarded as constant (in one stage specification of the model)
Usually used as supporting model to examine the accuracy of the CAPM results
Re = + gD1
P0
Cost of Equity
expected dividend
current share price
rate of growth in dividend
14.12.2009 19
http://www.leonardo-energy.org/training-module-electricity-market-regulation-session-5
2. Quantification of Cost of Capital
e) Comparable Earnings Model (CEM)
The Comparable Earnings Model (CEM) estimates the cost of capital from the historical
returns on equity for entities or industries of comparable risk
The cost of capital is related to the average rate of return over a historic period
It is based on accounting data which is affected by accounting policy
Difficult to select comparable company and appropriate period
14.12.2009 20
http://www.leonardo-energy.org/training-module-electricity-market-regulation-session-5
2. Quantification of Cost of Capital
f) Regulatory Precedents
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
Countries or companies from other sectors may not be comparable due to differences in:
– Regulatory regime
– Sector specifics
– Political and social environment
Decision dependent on the accuracy of decision making of other regulators
Experience you can trust.http://www.leonardo-energy.org/training-module-electricity-market-regulation-session-5
End of Webinar 5
KEMA Consulting GmbHKurt-Schumacher-Str. 8, 53113 BonnTel. +49 (228) 44 690 00Fax +49 (228) 44 690 99
Dr. Konstantin PetrovManaging ConsultantMobil +49 173 515 1946 E-mail: [email protected]