Australia Post: Consolidated
Weighted Average Cost of Capital
17 August 2005
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Consolidated WACC
1
Executive Summary
The scope of this report is to evaluate the Consolidated WACC (Weighted Average Cost of
Capital) for Australia Post as a whole. This report reviews:
• The appropriate method to determine consolidated WACC;
• The application of the consolidated WACC; and
• Key assumptions and limitation in the application of the consolidated WACC.
In deriving the WACC, the risk of the overall business was determined with reference to the
Capital Asset Pricing Model (CAPM). The WACC was estimated under four different approaches
depending on the treatment of tax and imputation credits. The nominal WACC under each of the
four approaches is shown below.
Australia Post Consolidated
Asset Beta
Pre Corporate
Tax
Post Tax Classical
Post Tax Imputation
Vanilla WACC
0.52
10.3%
8.1%
7.2%
8.7%
We recommend adoption of the Vanilla-WACC method. We believe this method provides the
best estimate of the inherent business risk of the enterprise. The consolidated WACC under
other methods includes an adjustment for tax or imputation cashflows.
We note that the consolidated WACC has limitations when used for investment valuation
purposes and is, for the most part, a reference tool used to assess Australia Post’s current risk
position as a whole relative to other investments.
The Consolidated WACC may be used to assess the value of Australia Post as a whole in
particular circumstances. Where consolidated cashflows are discounted in a valuation model, the
Consolidated WACC may be applied. However, there is an implicit assumption that the business
mix will not change over time. Note when applying the Consolidated WACC there is an implicit
assumption that future projects are of similar nature and risk to that of Australia Post as it is
today. This is the case with any company.
Consolidated WACC
2
Table of Contents
1
1.1
1.2
1.3
1.4
1.5
1.6
1.7
1.8
Cost of Capital ........................................................................................................................ 4
Preface and Introduction ................................................................................................. 4
The Weighted Average Cost of Capital (WACC) ............................................................ 5
Definitions of the WACC and Net Cash Flows ................................................................ 6
Taxes and Imputation Tax Credits .................................................................................. 8
Parameters of the WACC and their Estimation ............................................................... 8
Risk and the Cost of Capital ............................................................................................ 9
CAPM and Risk ............................................................................................................. 11
Leveraging and De-leveraging Formulae in the Context of CAPM ............................... 13
2.1
2.2
2.3
2.4
2.5
Capital Asset Pricing Model (CAPM) Parameters ................................................................ 14
Risk Free Rate .............................................................................................................. 14
Determination of the Equity Beta .................................................................................. 14
Debt Betas and the Cost of Debt Capital in the WACC ................................................ 15
The Market Risk Premium (MRP) ................................................................................. 16
Security Market Line...................................................................................................... 17
3.1
3.2
3.3
3.4
3.5
Estimation of WACC ............................................................................................................. 19
Market and Fundamental Risk - Characteristics of Infrastructure Assets ..................... 19
WACC Estimation Process............................................................................................ 20
Australia Post Overview ................................................................................................ 21
Australia Post Consolidated Group WACC - Application .............................................. 23
Result ............................................................................................................................ 25
4.1
4.2
4.3
4.4
Application of WACC ............................................................................................................ 26
Application - Treatment of Cashflows ........................................................................... 26
Tax and Imputation Credits ........................................................................................... 28
Allowances for Specific Risk ......................................................................................... 29
Signals for Update of WACC ......................................................................................... 30
2
3
4
5
Conclusion and Summary ..................................................................................................... 31
6
6.1
6.2
6.3
Appendix A – Definitions of WACC....................................................................................... 32
Definitions ...................................................................................................................... 32
Before tax Cost of Capital ............................................................................................. 32
After tax Cost of Capital ................................................................................................ 33
7
Appendix B – Imprecision In Equity Beta and Regulatory Approach ................................... 35
8
Appendix C - Comparable Listed Post Offices ..................................................................... 38
9
Appendix D - Comparable Company Descriptions ............................................................... 39
10 Appendix E - Comparison to ACCC Methodology ................................................................ 42
10.1
Relationship of Post with the ACCC .............................................................................. 42
10.2
ACCC Determination of Efficient Pricing ....................................................................... 42
10.3
ACCC Calculation of WACC ......................................................................................... 43
10.4
Recent ACCC Decisions from Other Industries ............................................................ 43
Consolidated WACC
3
1 Cost of Capital
1.1
Preface and Introduction
The cost of capital for a consolidated entity largely reflects the same principles as that used for a
single purpose or “pure-play” entity. The key determinants and concepts to apply are:
- The notion of opportunity cost for the use of capital for equivalent purposes will determine
cost of capital and risk assessment;
- Assets, not liabilities (ie. debt and equity) determine risk;
- Determination of capital base (ie. what constitutes investable assets) is an important
component.
The discussion which follows details these concepts. Key areas of difference when considering a
consolidated WACC against WACC in a pure-play entity are noted.
Opportunity Cost Concept and Cost of Capital
The cost of capital is the cost of servicing the capital (referred to as the capital base) of an asset,
project or company (a collection of assets). The cost of capital is most commonly used as a
discount rate to capitalise net cash flows to give a present value. It is also used as a bench mark
rate of return, a regulatory rate of allowable returns to capital and as an ex-post measure of
performance.
Like all costs in economics, the cost of capital is an opportunity cost. It is the return that could be
obtained when investing the capital in the next best alternative use (in the same risk class) for
that capital. Further, because the value of an investment is dependent on future benefits (the
past is only relevant insofar as it reflects or is reflected in the future), the cost of capital when
used to capitalise net cash flows is an ex-ante or expected rate. As an ex-ante concept it should
be clearly distinguished from the ex-post concept which is typically referred to as the rate of
return on capital to distinguish it from the cost of capital.
At any point of time, the cost of capital is determined by the intersection of the demand and
supply curves for capital. The differences between investments’, projects’ or companies’ costs of
capital at any point of time reflect differences in their risk class; higher risk, requiring greater
compensation and therefore a greater cost of capital, and conversely. Across time, adjusting for
risk differences, the differences in rates reflect the “time rate of discount” or the “risk free rate”.
In a fully informed market, in equilibrium, it is the nature of the risk associated with the cash flows
generated by the assets and not the assets themselves nor the source of capital, which
determines the cost of capital. The source of capital simply determines the ordering of claims on
the cash flows and assets in the event of liquidation.
It is the assets (the Asset side of the Balance Sheet) or more accurately the cash flows generated
by those assets that distinguish the cost of capital between projects, investments or companies.
The source of capital (the Financial Obligations side of the Balance Sheet) simply determines the
“packaging” of the cash flows and associated risks amongst the providers of funds. The assets
generate these cash flows and their associated risks.
Consolidated WACC
4
Any definition or estimation of the cost of capital requires identification of the capital base for
which the cost of capital is the return or payment for the use of that capital. Capital simply reflects
a store of value and as such all assets whether physical or intellectual can be represented as
capital. However, whether they are part of the capital base for which a cost of capital is required
really depends on the nature of the decision or use of the capital. For example, the interest on
short term debt might be treated as an operating expense and the capital value of such debt
would not belong in the capital base. In contrast, the long term debt may belong in the capital
base and its interest becomes a component of the cost of capital. At an extreme we could even
capitalise labour and treat it in much the same way, that is, expense it as we would the interest on
debt with the liability becoming part of the capital base.
Typically, we would look to the financial obligations side of the balance sheet in order to
determine what might constitute the capital obligations of an entity or capital base and then
decide what is an appropriate definition of the cost of capital to service those obligations. The
reason for this is that we can only access the costs of capital from the Financial Obligations side
of the Balance Sheet and it is rare that a single source of capital is dedicated to and the sole
collateral of a specific asset or investment. In this process, care must be taken not to double
count certain costs in the valuation equation. For example, it is common to find trade creditors
listed in the balance sheet as a liability and yet we would rarely include the value of the trade
creditors as part of the capital base in assessing the cost of capital. This is because the cost of
servicing the trade creditors is typically incurred and accounted for in the cost of goods sold and
to include trade creditors in the capital base and attribute revenue to service those trade creditors
would be to double count that cost.
Although assets or, more accurately, the cash flows generated by assets determine differences in
the costs of capital we can only get a measure of this cost from the sources of capital (Financial
Obligations) and these are rarely dedicated to specific asset, instead they are usually backed by
a variety of assets (a “floating charge”). Therefore we must rely on an average, or more
accurately a weighted average, cost of capital, reflecting the average cost of capital for the assets
that support the various classes of capital and estimated as a weighted (by value) of the types of
capital.
1.2
The Weighted Average Cost of Capital (WACC)
The cost of various components of the firm's capital structure, in broad terms debt and equity,
weighted by the proportion of them to the firm's total assets is the firm’s weighted cost of capital.
It is simply defined as:
WACC = Re.
D
S
+ Rd.
V
V
… (1)
Where,
Re is the expected or required return on equity;
Rd is the expected or required return on debt;
S is the market value of equity;
D is the market value of debt; and
V=S+D is the value of the capital base.
The purpose in estimating a WACC is to estimate the cost of capital for the assets of Australia
Post. The WACC is often the only way to obtain such an estimate. The capital structure is only
relevant to the extent that we have to estimate the WACC via the “titles” (securities) to the assets.
The relationship of the firm's cost of capital with its capital structure is such that it is assumed that
the capital structure of the firm is optimal or does not affect the cost of capital. That is, we are
Consolidated WACC
5
assuming that the market-place expects that the firm will maintain the capital structure for which
we are deriving the cost of capital and moreover, there is no alternative capital structure that is
likely to make the firm more valuable.
It is important that the definition of the weighted average cost of capital (WACC) is consistent with
the net cash flows that are allowed as a return to capital.
The most obvious examples are where an after-tax definition of cash flows is to be used that an
after-tax definition, as distinct from a before-tax definition, of the cost of capital is used. However,
obvious inconsistencies are not the most common source of error amongst practitioners, the
more common errors are more subtle, insofar as there are a number of after-tax definitions of the
WACC that could be used and therefore a variety of definitions of net cash flow. The most
common error is to mix these definitions of the after-tax WACC with an inappropriate definition of
the after-tax net cash flow.
Moreover, there are some good arguments why the after-tax cash to compensate for the cost of
capital should be used and therefore an after-tax definition of the WACC instead of a before-tax
cost of capital. The effective tax rate is likely to vary between time periods because of
depreciation, investment allowances and other factors that often cause the actual tax applicable
to an investment to differ from the statutory tax rate. If a before-tax WACC is derived, this rate
has to be some form of average rate for the investment’s life unless a separate WACC is to be
estimated for each year. It is simpler and more accurate to add a component for tax in much the
same way as operating costs for the period and then compensate the capital on an after-tax
basis.
Consolidated WACC
The WACC derivation in (1) implicitly assumes we are dealing with a single-division or pure play
entity. That is, it assumes the cost of equity Re can be derived for the entity as a whole. Where
the Re cannot be observed directly for the consolidated entity, a consolidated WACC may be
derived from an amalgam of the divisional WACCs. This can be achieved in a number of ways.
Consolidated WACC = WACC1 * (Value1 / Total Value) +
WACC2 * (Value2 / Total Value) + . . .
WACCn * (Valuen / Total Value)
where WACC1, WACC2, … and WACCn represents the WACC of division 1, 2, … and n
respectively.
1.3
Definitions of the WACC and Net Cash Flows
As we have already indicated the cost of various components of the firm's capital structure, in
broad terms debt and equity, weighted by their proportion to the firm's total assets is the firm’s
weighted average cost of capital (WACC).
1.1.1 The “Vanilla” WACC
The definition of the WACC that is appropriate for net cash flows after company tax and whose
cash flows reflect the tax deductibility of interest is the simple or “Vanilla” WACC which was
defined above as Equation (1) and in Appendix A under 4. This definition of WACC weights the
required return to equity and debt by their respective value in the capital structure. In contrast to
Consolidated WACC
6
the more traditional after-tax definition of WACC found in most textbooks (and described below) it
does not include any tax effect of interest deductibility which is incorporated into the net cash
flows.
The precise definition of after-tax net cash flows appropriate for the “Vanilla” WACC can be found
in Appendix A but essentially it is the after tax income that accrues to shareholders plus the
interest cost of the debt. Equivalently, it is earnings before interest and taxes (EBIT) less the
effective amount of company tax that is paid. The effective company tax should not only include
deductions for depreciation, investment allowances and the like, it should include any value in the
franking credits because they can be deducted from personal tax liabilities they represent a
withholding of personal tax at the company level.
The absence of a tax parameter in the Vanilla WACC – taxes are taken account of in the
definition of cash flows – makes the equation less prone to error than alternative equations which
include some tax effects.
The effective tax rate is likely to vary between time periods because of depreciation, investment
allowances and other factors that often cause the actual tax applicable to an investment to differ
from the statutory tax rate. If a WACC equation is used other than the “Vanilla” WACC it will have
a tax parameter, moreover, this tax parameter will require a rate of tax that is some form of
average rate for the investment’s life unless a separate WACC is to be estimated for each year. It
is simpler and more accurate to add a component for tax in much the same way as operating
costs are treated in the net cash flows for the period and then compensate the capital on an aftertax basis.
Another advantage of the “Vanilla” WACC is that capital market rates are usually quoted on an
after company tax basis. Therefore, the values for the equation’s parameters are more readily
identified with market observations, easier to comprehend and less prone to any errors through
adjustments.
In summary, the reason for arguing that the "Vanilla" WACC is the most appropriate is that all the
adjustments for taxes, imputation credits and the like occur in the net cash flows. This has the
advantage of clearly identifying when taxes are paid (also, it clearly recognises the difference
between economic depreciation and tax depreciation). In addition, this simple WACC or “Vanilla
WACC” is much easier for lay people to understand because it bears a closer resemblance to
observable market rates.
1.3.1 The Traditional After-Tax Definition of WACC
The more traditional after-tax definition of WACC takes account of taxes in the WACC formula,
i.e.
WACC = Re.
D
S
+ Rd.
.(1-T(1- γ ))
V
V
… (2)
Where,
T is the corporate tax rate;
γ is the value attributed to franking credits; and
other terms are as defined above.
Consolidated WACC
7
The effect or value of tax credits is taken into account through γ ≤ 1.0. Where tax credits are
worthless ( γ =0.0), the equation reverts to the standard textbook (USA) equation reflecting a
classical tax system. The equation and its associated net cash flows are defined as 2. in
Appendix A. The net cash flows ignore the effect of gearing or interest deductibility from taxes, so
that the cash flows are effectively EBIT less taxes where the taxes reflect any value of the
franking credits.
The equation was adopted because it reflected the Modigliani and Miller Proposition that gearing
does not affect the value of the firm and the net cash flows are unaffected by gearing under this
definition which made it easier to estimate net cash flows. However, the WACC equation is
affected by gearing, moreover as we indicated above it requires a geometric mean estimate of
taxes taking account of gearing and deductions for depreciation which are extremely difficult to
measure accurately as a geometric mean. The equation and the associated estimate of net cash
flows are likely to lead to less accurate valuations than the “Vanilla” equation and its associated
net cash flows.
1.4
Taxes and Imputation Tax Credits
The amount of tax paid by a company reflects the tax assessable income and this is unlikely to
coincide with the net cash flows, and the “effective” tax rate. Under an imputation tax system not
all the tax collected from the company is really company tax. To the extent that part, or all, of the
tax collected is redeemable against personal tax liabilities it represents personal tax. The
company is collecting that proportion of the tax that is redeemable but it is tax that would
otherwise be paid by the shareholder as personal tax. Therefore the “effective” tax rate for the
company must take into account that amount of the tax paid by the company that is later
redeemed by shareholders as a payment of personal tax. The issue is to assess what proportion
of the tax collected from the company is not company tax but a pre-payment of personal tax.
In the case of Australia Post, we understand that the imputation tax credits are unable to be
utilized. Hence at an Australia Post level the value of them appears to be zero ( γ =0.0). In
effect, Australia Post faces a classical tax system. The after-tax definitions of WACC defined in
Appendix A when γ =0.0 cause the equations under 2. to be identical to those of a Classical Tax
System.
However, the key consideration in the estimation of WACC (and treatment of franking credits) is
the inherent risk of the opportunity cost of capital. This requires consideration at a broader level.
In this context, the opportunity cost for investments in Australia Post is that of a normal, public
commercial listed company. Hence franking credits should be valued. We consider a value of
50% to be appropriate (ie. γ =0.5). This reflects the approximate level of credits which are
accessible (paid by the average company) and the actual proportion which is utilised by investors.
Section 4 describes how this may be applied.
1.5
Parameters of the WACC and their Estimation
It is usual to estimate the WACC by separately estimating each of the components of the WACC
equation. An alternative method is to estimate the WACC as a whole by models such as the
Capital Asset Pricing Model. The WACC for an entity should be the same whatever approach is
used but there are subtle differences between the approaches which can lead to different values
for the WACC, we will explain this in the next section, and in this section we will explain the more
conventional estimation procedure.
Consolidated WACC
8
As the name implies, the WACC is an average cost of the capital, typically broken up into debt
and equity, that is used to finance the assets or capital of the company. The respective amount of
equity and debt are weighted by their respective proportions of the capital.
These proportions should reflect current or market values and so when the respective weights are
estimated S/V and D/V they should reflect the market value of equity (S) and debt (D) and their
sum (V) will reflect the market value of the firm’s assets.
The cost of the debt capital (Rd), following the above principle, should be the current cost or rate
of return (yield) required on debt of the “quality” (risk class) issued by the company. Care must be
taken to ensure all the costs of this debt are recognised, particularly in the case of hybrids or
mezzanine finance where part of the cost of the debt is often an option on equity. Because the
return or interest on the debt is set under the terms of the debt as a contractual rate, it is usually
relatively straight forward to estimate Rd. The same is not true for equity cost (Re)
The suppliers of equity capital are the residual claimants (after debtholders and government
through their tax claims) on the assets and the revenues of the company. The consequence is
that the equity cost is a non-contractual rate and it has to be estimated indirectly through models
such as the Capital Asset Pricing Model (CAPM), the most popular method of estimating the cost
of equity (Re) but by no means the only approach that could be used. The CAPM approach will
be discussed more fully in the next and subsequent sections.
The estimates of the above parameters of WACC are the same whichever definition of the WACC
is used. The same is not true of the remaining parameters: tax (T) and the associated value of the
tax credits ( γ ). The estimate of these parameters differs depending on which definition (equation
1 or 2 above) of WACC is adopted. If the “Vanilla” WACC definition is adopted the approach is
fairly straight forward. Insofar as the parameters T and γ do not appear in the WACC equation
the WACC is unaffected by their values. Instead, they are estimated as part of the net cash flows.
The definitions for estimating the net cash flows are given in Appendix A.
In contrast, if the WACC definition described by equation 2 is adopted, then rather than applying
the actual tax and credits for each period, an estimate of the average rate for these parameters
over the life of the assets or company must be made. Moreover, because the WACC is a
compounding variable, these averages are not simple averages but a geometric average
reflecting the effect of compounding rates. Inevitably, assumptions of constant rates are required
or implied to be able to easily estimate the values – assumptions which may be at odds with
reality.
1.6
Risk and the Cost of Capital
At any point in time risk usually distinguishes the relative cost of capital for different investments.
The cost of capital measures the degree of risk aversion for investors. In a pure fundamental
corporate finance framework, the risk aversion is a pure time-value-of-money (opportunity cost of
capital) concept represented simply by a risk premium over the risk free rate. The risk premium is
usually determined with respect to the average return in a broad, market-based portfolio of
securities. However, this does not capture specific risks to the project such as construction risk
or demand risk. Specific risks may be handled in one of two ways:
- The first is the textbook approach with adjustment to cashflows for the probability
weighted or “expected” value of cashflows after specific risks.
- The second is a market or short-hand approach using an all up risk premium all specific
risks added to the cost of capital.
Consolidated WACC
9
Used appropriately, both the methods above result in an equivalent answer. Here is an example
that illustrates our point:
Figure 1-1 Handling Risk – Adjustments to WACC and Probability Weighted Cashflows
Year
Assumptions
Construction Cost
Earnings
Predicted Cashflow
1
-100
Adjustments
Probability of Cost Overrun
Cost Overrun
Cashflow Adjustment
Adjusted Cashflows
2
3
-100
75
75
80
80
-15
-115
75
80
-100
1.18
(84.6)
75
1.40
53.7
80
1.65
48.4
75
80
50%
-30
Valuation Approach: Market Based Risk Premium
WACC
10%
Risk Premium for Construction Risk
8%
Cost of Capital
18%
Cashflows
Discount Factor
PV Predicted Cashflows
Net Present Value of Project
$
17.5
Valuation Approach: Cashflow Based Specific Risk Pricing
WACC
10%
Risk Premium for Construction Risk
0%
Cost of Capital
10%
Cashflows
Adjustment for Construction Risk
Discount Factor
PV Predicted Cashflows
Net Present Value of Project
-100
-15
1.10
(104.5)
$
1.21
62.0
1.33
60.1
17.5
The first approach using an additional risk premium is a commonly employed method as it is
relatively simple to apply. The discount rate is adjusted by a single factor for all risks (market and
diversifiable). The discount rate or risk premium is derived from examining the internal rate of
return of investments of comparable risk. This method makes the significant assumption that
projects are comparable. This is clearly not the case for unique assets – particularly many
infrastructure projects. Hence this method provides only a shorthand account for project risks.
It is in these circumstances that the "text book" approach of separately identifying the two broad
classes of risk - the non-compensated diversifiable risk and the compensated non-diversifiable
risk - comes into its own. Because it can quantify the risk and link the required return from one
risk class to another and therefore one investment to another, the "text book" approach has
greater universality.
Consolidated WACC
10
The principle arising out of these observations is that we recommend when there is a readily
available capitalisation rate from comparable investments use it because it is likely to incorporate
compensation for all the relevant risk e.g. in valuing investment in residential real estate.
However, when the investment is unique and no such "benchmarks” are available, typically, we
will have to resort to models of risk compensation in order to derive an appropriate cost of capital
or capitalisation rate e.g. the required or justifiable return for the provision of unique infrastructure
assets. This is further discussed in Section 4.3.
1.7
CAPM and Risk
As mentioned above, risk can be segmented into two basic types: non-diversifiable and
diversifiable risk. In the context of the CAPM and the “textbook” and regulator approach to pricing
and valuation the non-diversifiable risk is taken account of in the discount rate through estimating
the cost of capital in the context of CAPM whereas the diversifiable risk is taken into account in
the estimate of the expected net cash flows.
Non-diversifiable risk is also known as:
• systematic risk;
• market risk;
• covariance risk; and
• beta (β) risk.
Because the β risk is non-diversifiable it commands a risk premium, known as the market risk
premium (MRP), which is defined as [ E(Rm) – Rf ]. The MRP is the premium a market portfolio
of assets or securities (Rm ) is expected to earn above the risk-free rate (Rf).
The effect of non-diversifiable risk is captured through such models as the Capital Asset Pricing
Model (CAPM):
R
j
[E (R ) −
= R
f
+ β
= R
f
+ β j MRP
j
m
R
f
]
(3)
where:
Rj is the expected return on asset (security) j or its required return or cost of capital; and
βj is the non-diversifiable risk associated with asset j and because of the MRP this βj component
of risk increases the discount rate or cost of capital in an NPV analysis.
The CAPM is the standard approach to estimate the required return (Cost of Capital) of equity
(Re) where unlike debt there is no contractual rate set for the return. The risk occurs as β in the
above CAPM and this is non-diversifiable risk for which the capital market pays a market risk
premium MRP.
As we have mentioned, in the case of debt, we typically use the yield on debt to estimate the cost
of debt (Rd). Such a yield includes both non-diversifiable risk and diversifiable risk. The latter is
usually included when estimating a company’s WACC or asset cost of capital, although logically
the diversifiable risk should not be included but for major companies it is so low the bias is judged
to be not consequential.
Diversifiable risk is also known as:
• non-systematic risk;
• non-market risk;
• non β risk;
Consolidated WACC
11
•
•
•
idiosyncratic risk;
residual risk; and
insurable risk.
Diversifiable risk can be diversified away because it is uncorrelated with other risks or variations
in net cash flows and as such it does not command a premium in the sense that non-diversifiable
risk commands a premium. However, this does not mean that it has no effect on values or that it
can be ignored in a discounted cash flow analysis.
It has become almost conventional to use the CAPM for estimating a required or expected return
to equity. The CAPM is testimony to the adage that in finance and economics, in fact in all social
sciences, “models that are to be used but never to be believed”. There are far more academic
papers around showing the inadequacies of the CAPM as a means of estimating expected or
required returns to equity capital than there are papers illustrating its value. The problem is
finding a robust alternative to the CAPM. It just does not exist at the moment.
The severest critics of the CAPM are the academics. However, from a practical point of view
these critics take the assumptions underlying the derivation of the CAPM far too seriously. From
practitioners point of view all the CAPM needs to provide is a means of deriving an expected
return for the non-contractual financial obligations of the company. In this context, it is best
looked at as a base rate of return which is widely recognised (the surrogate for the risk free rate
e.g. a government bond rate) plus a risk premium which is provided by a readily identifiable risky
benchmark (the market index) which is then scaled (the β) by some measure of the relative (to
the index) risk of the asset or investment.
The theoretical support for the use of β can be readily derived using the market model, an
empirical surrogate of the CAPM, without many of the assumptions needed to derive the CAPM.
This scaling of market risk by a β or relative co-variance risk gives rise to the notion of nondiversifiable or systematic risk which earns a premium in the capital markets because it has to be
borne and cannot, by definition, be diversified.
If we set the cost of capital on the basis of systematic or non diversifiable risk then, of course, that
other component of risk that is diversifiable must be taken into account in the net cash flows as
an actuarial estimated expected net cash flow i.e. the probability of the alternative states of nature
that might occur by their outcomes.
All of the parameters of the CAPM have been subject to a great deal of investigation and criticism
in empirical investigations of the model. The problem has been to find an adequate substitute.
The simplicity of the model and the strong theoretical backing to β as a relative risk measure is
strong. Moreover, the ability to take such measures from one set of investments and apply them
to other investments gives a robustness and practical value to the model that is not apparent in
the results thrown up by "gross empirical studies". These are the studies that throw all the data
into a computer and look for empirical relationships between returns and various “factors”. The
use of neural networks is the most rampant expression of such an approach.
Developing pricing models from parameters such as size, price to book and sundry other
accounting variables has been of limited value to the practice of valuation because of a lack of
strong theoretical support for the relationships. Yet there is no doubt that CAPM is a very limited
model and really only supported by the relative returns of large companies in well developed
stock markets. This clearly limits the use of the CAPM in circumstances where the cost of equity
capital has to be estimated for companies or investments that are not traded under such
conditions.
The argument for using the model in the case of Australia Post, a large company but unlisted and
government-owned, rests on the concept of the opportunity cost of capital.
Consolidated WACC
12
Clearly, Australia Post could be readily listed and its securities would be expected to behave in a
manner similar to other companies’ securities of a comparable risk class. Therefore, the
opportunity cost of the funds to the government reflects a listed Australia Post.
1.8
Leveraging and De-leveraging Formulae in the Context of CAPM
We indicated above that the cost of capital and the WACC could be estimated as a whole in the
context of CAPM. For example, if we estimated the company’s β as a whole we could apply the
CAPM to estimate the company cost of capital which would be equivalent to the WACC.
Similarly, the arithmetic of the CAPM and β’s allows us to break this total β into equity and debt β.
The relationship enables us to correct for leveraging (gearing) effects on equity and debt returns
in the context of CAPM.
Adopting the Vanilla WACC definition (equation 1 above) and substituting for Re and Rd the
CAPM (equation 3) for these returns, i.e. Re = Rf + βe(MRP) and Rd = Rf + βd(MRP), we get the
equation:
S +β D
… (4)
β a = β e.
d
V
V
where,
βa is the beta of the assets or the company as a whole,
βe is the beta of equity, and
βd is the beta of debt.
The other variables have been previously defined. Alternatively, if we adopted the definition of
WACC under equation 2. the deleveraging formula becomes:
β a = β e.
S + β D (1-T(1-γ))
d
V
V
… (5).
It is our preference to reliever or delever using equation 4 above. This method is least prone to
errors in estimation. Tax terms may then be applied, if appropriate, to the cost of equity derived
from the beta estimate.
Derivation of the cost of equity or βe is discussed in the next section.
Consolidated WACC
13
2 Capital Asset Pricing Model (CAPM) Parameters
2.1
Risk Free Rate
There has been some debate about what is the appropriate risk free rate to use in the CAPM.
The debate has not concerned the source of the surrogate “risk free” rate which is a
Commonwealth Government Issued security. The debate, to the extent that it exists, concerns
the duration or term of such a security together with the sampling method used for determining an
estimate.
The CAPM is a single period model of no fixed duration and various governments securities from
government bills to long term government bonds have been used as a surrogate rate. In the
context of CAPM theory there is no reason to pick one duration over another. However, ideally
the duration of the CAPM should be the duration of the planning period for which the CAPM is to
be used to estimate an expected or required return. This means that if the planning horizon is a
long term investment then a long term government bond is the appropriate duration to use.
Further, it has been conventional in Australia to use 10 year Commonwealth Bond Yields as the
proxy of the risk free rate as it is a highly liquid security which provides a good reflection of the
expected yield on a long term government security. The data bases that have been assembled
typically use such a bond as the surrogate risk free rate and, therefore, measures of market risk
premium and the like are more readily available where a 10 year Commonwealth bond rate has
been used.
The date at which the yield on a government bond should be taken as the surrogate for the risk
free rate is the date closest to the date of the pricing decision since the yield is meant to reflect
the risk free rate that could be expected going forward.
Capital Partners consider the most recent yield on a government bond the best estimate of the
future rate and this is the yield that should be used to estimate the risk-free rate (Rf) in the CAPM.
The duration of the bond should ideally match the investment horizon. For long term investment
decisions, we recommend the 10 year government bond rate.
2.2
Determination of the Equity Beta
The standard method for estimating equity betas is an ordinary least squares (OLS) regression of
stock returns on market returns. Most commercial data sources use four or five years of monthly
stock returns and monthly returns on a broad stock market index portfolio. The slope coefficient
from a standard OLS regression of stock returns on market returns is then used as an estimate of
the equity beta.
As with any regression, the estimated coefficient is not a precise calculation, but simply an
estimate. The standard statistical (and legitimate) interpretation of the estimated coefficient from
any regression is that the true value of this parameter comes from a normal distribution with
mean equal to the parameter estimate and standard deviation equal to the standard error of the
estimate. That is, the regression approach does not compute the true beta, it merely narrows it
down to within some probabilistic range.
Consolidated WACC
14
The width and range of this distribution depends on how precisely the coefficient can be
estimated. It is the standard error of the regression estimate that measures the precision with
which it has been estimated. Typically equity beta estimates, computed by regressing stock
returns on market returns, have large standard errors. This means that they are imprecisely
estimated and single point estimates cannot be relied upon with any great confidence. Hence we
recommend that an industry average asset beta be applied. Appendix B provides further
discussion on the different approaches to handling imprecision in beta estimates and the historic
regulatory position.
Pure-Play or Single Division Beta Estimation
Capital Partners approach is to:
1. Identity the industry segment a company operates in.
2. Estimate individual equity betas of comparable listed companies in the industry. Whilst
we have a preference for long term (5 year monthly) betas, this may often not be practical
where operations change over time. Capital Partners use the average of the 3-year
weekly and 5 year monthly betas to derive an estimate of individual equity betas.
3. Estimate the unlevered beta for the industry segment
a. Unlever the equity beta for each comparable company using the leverage of
each company as per the formula described in 1.8.
b. Calculate the average of the unlevered betas. This is used as the estimate of the
industry asset beta. This is sufficient to estimate industry WACC directly and is
our preferred approach.
4. Where an equity beta is desired, as needed for the calculation of WACC in approaches
other than the Vanilla WACC, the industry asset beta should be relevered using the firm’s
market levels of debt and equity to derive the equity beta.
Consolidated or Multi-Divisional Beta
It is difficult to estimate a consolidated beta (and thus consolidated WACC directly). This is
because where an entity engages in multiple activities across different industries it is difficult to
identity truly comparable companies. The alternative choices are:
- Use a single point estimate of the consolidated company’s equity beta and unlever this.
This assumes the company is listed.
- Use a weighted average of appropriate asset beta estimates for different industries a
company operates in.
It is our preference to use the second approach. The weights should ideally be related to the
relative contribution or exposure to other industries. The weighted average asset beta may then
be relevered at the relevant gearing level as per a pure play firm above.
The consolidated WACC of a business is best derived from the value-weighted average of
comparable industry betas of a particular company or project will operate in.
2.3
Debt Betas and the Cost of Debt Capital in the WACC
The difference between the interest rate or yield on debt issued by the entity and the comparable
yield on the commonwealth government issued security of the same term is called the debt
margin. This margin will reflect the risk of the entity’s debt relative to the commonwealth debt’s
security. As we have already indicated the risk of the security can be divided up into diversifiable
and non-diversifiable risk both of which will reflect the default risk of the entity or borrower.
Clearly, the risk of the entity’s debt will be a function of the amount of asset backing to t he debt
or equivalently the degree of leverage or gearing that the entity has. The greater the debt to value
or debt to equity ratio of the entity, other things being equal, the greater the risk and therefore the
Consolidated WACC
15
greater the required return or debt margin. This effect is clearly shown in the deleveraging
equations (4) and (5). Similarly, the cost of equity will increase as the proportion of debt in the
capital structure increases but this does not imply the cost of capital for the entity’s assets
changes. The change in proportion of equity to debt can offset the relative increase in equity and
debt costs such that the WACC or asset cost of capital remains unchanged – this is an illustration
of the Modigliani Miller (MM) Proposition that “a company’s value is invariant with changes in its
capital structure”. As a practical proposition the so called MM hypothesis is valid within
reasonable ranges of debt/equity for most entities. The consequences are that in setting a debt
margin, we are implicitly setting a level of gearing. If the observed equity beta is used together
with a debt beta to derive an asset beta the assumptions employed will imply a particular level of
gearing.
When estimating a WACC it is usual to estimate the cost of debt using the contractual interest
rate on the debt as a measure of the required or expected return on such debt. To the extent that
the WACC is used to discount expected net cash flows and the redemption yield on the debt is
used as a measure of the cost of debt reflects both diversifiable and non-diversifiable risk will also
cause an over estimate in the debt component of the cost of capital. The same problem occurs
when we ascribe the full “debt margin” to the estimation of the beta of debt (βd).
Where expected cash flows are used in the numerator of the NPV model, diversifiable risk is
taken into account in the product of the probability of the various "states of nature" and the
outcomes, in much the same way as an insurance premium reflects the actuarial expected
outcomes. To include compensation for such risk in the WACC is to double count for this risk.
Nonetheless, the usual practice is to ignore such double counting or overestimate in debts
contribution to WACC on the grounds that for major issuers of debt, such as listed companies, it
is small and insignificant.
Capital Partners recommends Australia Post use a debt beta of 0.1 in calculating WACC. This is
roughly equivalent to the expected yield on an investment grade security with strong ability to
meet debt service. We recommend against the textbook practice of assuming debt beta of zero
for simplicity as only the risk free asset meets this criteria.
2.4
The Market Risk Premium (MRP)
As one of the CAPM parameters the MRP is common to all asset or securities, it reflects the
premium the beta or covariance risk of the asset or company must command. It is the premium
for an average unit of risk (β = 1.0).
The MRP is the stock market’s price of risk relative to a risk-free rate of return such as the yield
on 10-year Government bonds. The MRP is a real measure of risk as distinct from a nominal
measure. The rationale for using historical data as a measure of the ex-ante MRP is that
investors’ expectations will be framed on the basis of their past experience. Historically, the MRP
tends to be mean reverting but there have been 10-year periods when the returns from equities
have been below the yield of 10-year bonds.
A figure of 6% is commonly used in Australia and the US by regulators and academics, although
some market participants use more recent data and subjective measures to justify using a lower
MRP figure. When calculating ex-post MRP figures as a basis for determining the ex-ante MRP,
the use of arithmetic average stock returns is favored over the geometric measure because
arithmetic average returns are probably a closer proxy for what are expected by investors or how
the expectations are framed by investors. The Australian historical MRP data has been
reasonably consistent with that of the US, UK and New Zealand.
Consolidated WACC
16
Figure 2-1 and Figure 2-2 demonstrate a justification for a MRP of 6%. The ten year moving
average has a mean of about 6% although in any ten year period the average could be well
below or above this average but this does not mean expectations will be framed on any one ten
year period.
Figure 2-1: Ten Year MRP
1 6 .0 0
1 4 .0 0
1 2 .0 0
1 0 .0 0
8 .0 0
6 .0 0
4 .0 0
2 .0 0
0 .0 0
-2 .0 0
-4 .0 0
Source: Officer
The Exponential Moving Series is also trending towards 6%, such a series places greater weight
on more recent observations, the equation is defined as:
SMRP(t) = α.MRP(t)
+ (1-α).
α). SMRP(t-1)
α.
Figure 2-2: Simple Exponential Smoothing of the MRP, alpha=0.5
12
10
8
6
4
2
0
De c) 18 9 0
2.5
1900
1910
1920
1930
1940
1950
1960
1970
1980
1990
Security Market Line
The CAPM expresses risk and return on the Security Market Line which indicates the required
return for any asset relative to the risk free asset and the market portfolio (or average equity
investment). The SML is invariant to individual risk preferences.
Consolidated WACC
17
The SML is depicted below. Note all assets are of greater risk than the risk free instrument. That
is, there are no negative beta assets. At the low end of the spectrum are corporate bonds. The
market portfolio or average equity has, by definition, a beta of 1.0. As the average market
portfolio has debt, the average asset is of lower risk. As shown, when taking into account the
average market gearing, the average unlevered equity (ie. the average asset) has a beta of 0.7.
Figure 2-3 Security Market Line
Expected
Return
Average company
consolidated WACC
Market Risk
Premium
6.0%
Risk Free
Corporate
Debt
Average
Unlevered Equity
β = 0.7
Average
Equity
β=1
Beta
Source: Capital Partners for Illustrative Purposes Only
With different levels of gearing, any single investment can be virtually anywhere on the SML.
Hence it is more useful to compare where investments are on the SML at the asset (ungeared
level).
The beta for a particular investment will be derived by estimating the equity betas for all its
comparable companies, and then delevering these equity betas to derive an asset beta. The
average asset beta can then be used for the divisional WACC or regeared at an appropriate
gearing for that division to derive a divisional equity beta.
Consolidated WACC
18
3 Estimation of WACC
This section outlines the basis of how we conclude on the consolidated WACC of Australia Post.
Australia Post operates in a number of segments which span competitive to infrastructure-type
services. These segments clearly are of differing risk and hence the typical estimation methods
for examining pure-play companies are not valid for Australia Post. Further, it is impossible to
directly observe the consolidated WACC for Australia Post.
The consolidated WACC of Australia Post will be derived in a bottom-up approach by examining
a range of comparable businesses to the ones Australia Post operates in. As a reasonableness
test, this will be considered in light of the expected return behaviour for infrastructure assets.
3.1
Market and Fundamental Risk - Characteristics of Infrastructure Assets
Risk will be determined by the fundamental nature of the asset. It is our experience that care
needs to be taken in identifying the nature of infrastructure assets as some essential service
assets are often incorrectly perceived to be of low risk. Incorrect specification results in
substantial misallocation of resources. This is demonstrated below using the example of Horizon
Energy – a major Victorian coal-fired power generator – where 90% of equity investment was lost.
Power generation is an essential service often perceived as infrastructure but is in fact a
commodity market subject to competitive forces with little pricing power – hence it is of high risk.
Figure 3-1: Misclassification of Risk
Probability
Risk incorrectly identified and
cash flows over-estimated
Actual
cash
flows
lower
than
forecast
Incorrect
estimate of
high cash
flow
True Asset
Value
Investment Sunk Cost
Investment risk occurs when the value
of an asset is incorrectly specified.
A classic example was in the case of
Horizon Energy (formerly 25% owners
of Loy Yang Power Partnership).
An excessive price was paid on
acquisition. Risk was underestimated
and cashflow was overestimated.
- Long term electricity prices were
overestimated (median should be
left of investment sunk cost)
- Volatility was greater as power
generation is not true infrastructure.
Source: Capital Partners for Illustrative Purposes Only
As noted, the consolidated WACC will be built up from a review of different enterprises. Our
sensibility check will be a determination of whether components represent the risk profile of a true
infrastructure asset or are commercial in nature.
Consolidated WACC
19
Infrastructure assets are essential services which normally exhibit monopoly or monopoly-like
characteristics. They exhibit ability to control or influence prices over relatively identifiable
demand. True infrastructure assets have little correlation with the market and hence are
expected to have low asset betas.
In Figure 3-2 below, those divisions which are expected to possess infrastructure like
characteristics are expected to be within the green shaded area (ie. lower risk and return). The
competitive business units are expected near the blue areas (ie. average market risk and return).
Figure 3-2 Security Market Line
Expected
Return
Market Risk
Premium
6.0%
Risk Free
Corporate
Debt
Infrastructure Avg. Unlevered Average
Asset
Equity
Equity
β
between
β = 0.7
β=1
0.2 & 0.5
Beta
Source: Capital Partners for Illustrative Purposes Only
3.2
WACC Estimation Process
As noted, the consolidated WACC will be built up from a number of comparable entities. We note
that at some point, a subjective judgement needs to be made on where to disaggregate the
behaviour of Australia Post. The WACC is estimated under four methods as below. All of these
methods are before personal taxes.
1. Pre Corporate Tax: Suitable where tax is not calculable e.g. for internal divisional
analysis.
Consolidated WACC
20
2. Post-Tax – Classical: An after-corporate tax WACC based on a classical tax system i.e.
where no imputation credits are generated. Suitable for situations where franking credits
are not paid or are attributed zero value.
3. Post-Tax – Imputation: An after-corporate tax WACC based on an imputation tax
system. Tax effects are incorporated in the discount rate.
4. Vanilla WACC: An after-corporate tax WACC that can be used under any tax system. All
tax effects are accounted for in the cash flows.
The cash flows applicable to each WACC are shown in Table 4-1 in Section 4, along with the
formulas for calculating each WACC.
The average asset beta is sufficient to calculate WACC under the Vanilla-WACC approach.
Vanilla WACC is the preferred method as it is least prone to error and explicitly recognises tax in
the cashflows rather than the discount rate. However, for estimation of WACC using the
alternative methods discussed, it is necessary to estimate the average equity beta.
Equity beta is derived by relevering the average asset beta using CAPM parameters as
discussed in Section 2. An optimal gearing of 70% equity/30% debt has been assumed. We
note that each time levering or unlevering is conducted, there is additional risk of estimation error.
A summary of key assumptions is below.
Table 3-1: Capital Partners’ Assumptions
Capital Partners
Assumption
Ten year Risk Free Rate (Rf)
Market Risk Premium (MRP)
Corporate Tax Rate (T)
Value Attrbuted to Franking Credits (γ)
Debt Beta
Gearing (D/V)
3.3
5.56%
6.00%
30%
0.5
0.1
30%
Australia Post Overview
Australia Post’s main business segments are characterised by high volume, low margin
transactions. Significant upfront investment is required and critical mass is essential to ensure
the business operates effectively. Management and operating risk appear low relative to the
average industrial company. However, as key functions are increasingly automated, there is less
scope to vary costs with volume and operating leverage will increase. This profile is not dissimilar
to many other key infrastructure assets. The key business segments we have considered in the
determination of consolidated WACC are:
• Financial Services
• Reserved Letter Services (“Letters”)
• Property Development
• Logistics
The key divisions and components of Australia Post’s risk are described below.
Consolidated WACC
21
Table 3-2 Components of Australia Post’s Risk
Division
Type of Risk
Description
Financial
Services
Retailing
Financial Services is a mix of retailing and infrastructure
services. Key comparables are retailers and transactional
services such as stock exchanges.
Transactional
The Financial Services division provides processing facilities
for financial payments and retail services. Financial Services
does not incorporate banking services such as deposit taking
and lending.
The nature of the business is twofold:
1. One side is a processing facility characterised by
high volume transactions of low value;
2. The second part of the business is retail sales.
Reserved
Letter
Services
(“Letters”)
Partial
monopoly
Letters is an infrastructure asset with some demand risk
which should primarily be recognised in cashflow forecasts.
However, Letters does not possess a monopoly where mail is
not delivered to individual households.
Distribution
This division still operates under a protected environment
where local “Reserved Letter” services apply for addressed
mail under 250g. However, even without this protection,
addressed mail can be considered a natural monopoly in the
sense that a large, single supplier of the service is the most
optimal outcome. Letters provides an essential service where
the expense of replicating letter boxes, post offices, sorting
and the postal distribution network is an inherent barrier.
Property
Development
Property
market
The Property Development division is responsible for
preparing post offices for sale and lease back. Post’s
Property Development division is a small component of the
overall business and earns little external revenue and hence
bears little relevance to the consolidated WACC.
Logistics
Transport and
Distribution
Logistics is responsible for delivery of packages and parcels
which do not fall under the services provided by Letters.
Larger parcels are often delivered by third-party contractors
and smaller ones by postal staff. Logistics also provide
warehousing and distribution services on a commercial basis
to larger customers such as Coles On-line.
Consolidated WACC
22
3.4
Australia Post Consolidated Group WACC - Application
Whilst detailed valuation methodology is beyond the scope of this report, it is necessary to
consider the context in which WACC may be employed. In our view, the consolidated WACC for
Australia Post is not truly applicable in a valuation context. It is unlikely that any individual
investment project Australia Post undertakes will replicate this profile.
The consolidated WACC may be used to estimate the value of Australia Post as a whole from
consolidated ungeared cashflows. However, there is a high risk of estimation error should the
consolidated WACC be applied in this manner. We recommend against this method of valuation
except as a short-hand valuation only.
Using the consolidated WACC for valuing the whole entity implicitly assumes the consolidated
WACC is equally applicable to all future cashflows. This is beyond the scope of this report but we
consider this unlikely given the changing nature of Australia Post’s business.
Figure 3-3 below provides an example of the estimation error over time when a business takes on
different types of projects. Assuming a business of three projects with different risk profiles, the
initial estimation of consolidated WACC will prove to be conservative. This is because the higher
risk project is expected to earn a higher return and hence the higher risk division’s relevance will
increase over time. In the example below, all else equal, the consolidated WACC will increase
from 10.8% to 11.3%. Therefore, use of a static consolidated WACC of 10.8% may overestimate
value.
Figure 3-3 Consolidated WACC Example of Estimation Error Over Tme
Year 10 Value = $284
Consolidated WACC = 11.3%
60%
Market risk
WACC = 13%
Year 1 Value = $100
Consolidated WACC = 10.8%
50%
25%
23%
17%
Moderate risk
WACC = 10%
Infrastructure risk
WACC = 7%
25%
Source: Capital Partners for illustrative purposes only.
Consolidated WACC
23
The consolidated WACC is expected to increase over time to reflect the relatively higher
expected return and faster growth of more risky projects. The consolidated WACC therefore
requires ongoing review.
An additional danger arises where the Consolidated WACC is applied as a single hurdle rate for
all projects within Australia Post. This will result in the following:
- Potential rejection of low risk, positive NPV projects;
- Potential acceptance of high risk negative NPV projects; and
- An increase in the average risk of the firm.
Note this will be the case where any single company-wide hurdle rate is applied in a firm with
projects of varying risk. Take for example the case of Telstra. Telephony lines are inherently low
risk businesses. If the expected return for a telephony line were used to assess the merits of
acquiring a software development company such as Solution 6, which is of higher risk, this would
lead to poor investment decision making. This is demonstrated in Figure 3-4 where projects
above the upward sloping Required Return are value accretive and projects below are value
destroying. As shown, a flat hurdle rate results in sub-optimal investment decisions.
Figure 3-4 Investment Risk from Consolidated WACC as a Hurdle Rate
Required
Return
Accept higher risk
value destroying
projects
Reject potentially
valuable low risk
projects
Required Return
Hurdle Rate Original
Consolidated
WACC
Market
risk
Moderate
Infrastructure
risk
Infrastructure
risk
Consolidated
WACC
Market
Risk
Source: Capital Partners for illustrative purposes only.
The consolidated WACC is mostly useful for assessing the overall position of Australia Post in a
risk return context – providing investors with the ability to decide if, as a whole, it meets their own
risk preferences. In the example shown, the risk of the example firm is between that of an
infrastructure asset and a competitive asset.
Consolidated WACC
24
3.5
Result
The consolidated WACC for Australia Post has been calculated under four different methods as
below. Capital Partners preferred method is to use the Vanilla WACC.
Table 3-3: Australia Post Consolidated WACC
Australia Post Consolidated
Consolidated WACC
Asset Beta
Pre Corporate
Tax
Post Tax Classical
Post Tax Imputation
Vanilla WACC
0.52
10.3%
8.1%
7.2%
8.7%
25
4 Application of WACC
This section defines how cashflows should be constructed under each of the WACC methods.
The construction of WACC is relatively straightforward when compared to the estimation of
cashflow.
The critical issue is confusion over accounting identities and actual cashflows to owners of the
business. It is cashflows that determine the value of an investment rather than profits. In the
estimation of cashflows, confusion usually occurs in the treatment of different stakeholder claims
(debt service, equity and net taxes), changes to working capital, capital expenditure, and
determination of the “most likely case” or mean estimate of future cashflows. As discussed in
Section 1.6, adjustments are required for idiosyncratic risk or Specific Risk Pricing. This is
discussed briefly below in Section 4.3.
Appropriate construction of expected cashflows requires significantly more detailed explanation
than is within the scope. However, the cashflow treatment and derivation from accounting values
is relatively formulaic and is shown below in Section 4.2.
Note that it is implicitly assumed that future projects are of similar nature and risk as Australia
Post is as a whole. In other words, the cost of capital depends on the nature of an individual
project rather than the source of capital.
4.1
Application - Treatment of Cashflows
The calculation of cash flows depends on the WACC formula used. The appropriate cash flows
for each WACC are presented in Table 4-1 (continued on the next page), along with the formulae
for calculating the WACC.
Table 4-1: WACC Formulas and Cash Flows
Pre Corporate Tax WACC
Cash Flows
Net cash flows to equity
+ net cash flows to debt
+ tax payments.
(Approximately EBITDA)
Cash Flow s
to Equity
Debt Tax
Shield
Cash Flow s
to Gov't
Cash Flow s
to Debt
WACC
Consolidated WACC
WACC =
re
S
D
+ rd .
(1 − T (1 − γ ) V
V
.
26
Post Corporate Tax WACC – Classical Tax System
Cash Flows
Net cash flows to equity
+ net cash flows to debt
(Approximately EBITDA
Tax)
–
Debt Tax
Shield
Cash Flow s
to Equity
Cash Flow s
to Gov't
Cash Flow s
to Debt
WACC
WACC = re .
S
D
+ rd . (1 − T )
V
V
Post Corporate Tax WACC – Imputation Tax System – Tax Effects in Discount Rate
Cash Flows
Net cash flows to equity
(excluding value of franking
credits)
+ net cash flows to debt
Debt Tax
Shield
Cash Flow s
to Equity
Cash Flow s
to Gov't
Cash Flow s
to Debt
WACC
WACC = re .
S
(1 − T )
D
.
+ rd . (1 − T )
V (1 − T (1 − γ ))
V
Post Corporate Tax “Vanilla” WACC – Imputation with Tax Effects in Cash Flows
Cash Flows
Net cash flows to equity
(including value of franking
credits)
+ net cash flows to debt
Cash Flow s
to Equity
Debt Tax
Shield Value of
Franking
Credits
Cash Flow s
to Debt
WACC
WACC = re .
Cash Flow s
to Gov't
S
D
+ rd .
V
V
Capital Partners valuations incorporate the Vanilla WACC in a DCF framework, which requires an
estimate of asset cash flows, net of tax and franking credits.
Consolidated WACC
27
This structure enables Capital Partners to take a reported operational performance measure
(EBITDA) and convert the result into a format that is a suitable for a WACC-based DCF model
(Un-geared Post Tax Post Franking Cash Flow). Table 4-2 shows the calculation of cash flows to
be used with the Vanilla WACC using Australia Post data from the 2004 Annual Report.
Table 4-2: Calculation of Net Cash Flow for use with Vanilla WACC
Profit From Ordinary Activities Before Tax
Add: Borrowing Costs Expense
Add: Depreciation and Amortisation
EBITDA
Less: Purchase of PP&E
Less: Purchase of Intangibles
Add: Decrease in Debtors
Less: Decrease in Creditors
Less: Increase in Inventory
Less: Income Tax Paid
Add: Value Attributed to Franking Credits
Ungeared Free Cash Flow
4.2
2004
521.1
32.1
204.1
757.3
(197.9)
(12.0)
12.7
(70.4)
(8.3)
(179.4)
89.7
391.7
Tax and Imputation Credits
The optimal manner in which tax and imputation credits are treated is also critical in the
determination of the best WACC estimation method. It is our preference to avoid confusing a
cashflow term (taxes and imputation credits) with a risk measure.
Capital Partners preferred approach is to build taxation, including imputation, into the cash flows
rather than in the discount rate. This is an additional reason for preference for the Vanilla WACC
as recently adopted by the ACCC. The Vanilla WACC leads to a valuation result that is postcorporate tax, but pre-personal tax where:
• There is no need for a corporate tax term (Tc) in the discount rate, because the effects of tax
and franking credits are included in the cash flows
• There is no need for a personal tax term (Tp) in the discount rate – the valuation is invariant to
this.
Australia has what is known as a full imputation taxation system. This was adopted in Australia in
1987. This removed the impact of double-taxing of dividends, at both the company and the
personal level. Tax at the corporate level effectively became personal witholding tax for
shareholders who were Australian residents. However, not all of the franking credits are available
or utilised.
Analysis undertaken by Officer and Hathaway reveals that the value of franking credits can vary
according to the type of company. In the case of Australia Post, our two key considerations are
the likely franking credits available and an estimate of the proportion of shareholders who are
able to take advantage of credits – in the context of Australia Post as a normal commercial entity.
Consolidated WACC
28
In this vein, we are mindful of the fact that both Telstra and Commonwealth Bank were unable to
transfer all franking credits on privatisation. However, sufficient amounts or warranties were
made available such that all retained earnings in the period immediately following privatisation
were virtually guaranteed to be fully franked. Hence we consider it appropriate to apply a level of
franking similar to that of other comparable commercial enterprises (as discussed in 1.4). For
Australia Post we recommend a level of 50%.
4.3
Allowances for Specific Risk
The value of an investment is a function of the cashflows generated and the risks associated with
those cashflows. The forecast cashflows represent the expectation of the most likely case.
These cashflows are then discounted to allow for systematic risk in the investment.
However, as discussed, in Section 1.6 it is necessary to consider idiosyncratic or specific risks
which are not captured in our estimation of beta. The forecast cash flows are adjusted to allow
for specific risks relevant to the investment in order to determine the expected or probabilityweighted cash flows.
Examples of specific risks include, but are not limited to:
• Technology involvement;
• Project scale;
• Construction cost overruns;
• Management inexperience;
• Liquidity; and
• Macroeconomic conditions.
The normal practice is to incorporate a risk premium in the discount rate for these specific risks.
Capital Partners recommends against this practice as it confuses cashflow forecasting risk
against the inherent risk of the asset. Furthermore, a risk premium inappropriately penalises all
future cashflows for a specific event.
For example, to value a development that faces the possibility of a cost over-run during
construction, we would first estimate the probability of a cost over-run and the approximate
impact on cash flows. If we estimate that there is a 10% chance of a delay that will cost an
additional $5m, then the expected cost of delays is $0.5m. This is included in the cash flow
forecasts.
Accounting for specific risk in this way is simpler and more transparent than attempting to adjust
the discount rate of the project.
Capital Partners recommend that specific risks are expressly priced and included in the cash flow
forecasts rather than allowed for by adjusting the cost of capital.
Value = (Forecast “Base Case” Cashflows @ Discount Rate) - Value of Specific Risks.
Consolidated WACC
29
4.4
Signals for Update of WACC
There are two factors that can be expected to change the WACC of Australia Post:
•
•
Change in interest rates; and
Change in the risk profile of the business.
Interest Rates: An increase in interest rates increases the cost of capital for every asset in the
economy due to the increase in the risk free rate. The 10-year bond rate varies continuously so it
is prudent to review the WACC on a regular basis e.g. quarterly, or before each investment
decision. An appropriate signal to reconsider the WACC is an announcement of a change in the
short term target cash rate by the Reserve Bank of Australia Such announcements generally also
signal a change in long term rates.
Business Risk: A change in the business risk of Australia Post would bring about a change in
the asset beta, thus affecting the WACC. Business risk could be altered by establishment of a
new line of business or a change in the weightings of the existing divisions due to a change in
their size relative to each other.
Other Causes for Review of WACC: It would also be appropriate to review the WACC if new
evidence emerges in the form of new listed comparables which could facilitate a more accurate
estimation of the asset beta.
Consolidated WACC
30
5 Conclusion and Summary
The key consideration for Australia Post is the opportunity cost of alternative and equivalent uses
of funds for owners and investors in Australia Post. Despite government ownership, we consider
that the opportunity cost of capital for Australia Post is that of a normal (listed) commercial
enterprise.
Capital Partners has estimated the consolidated WACC of Australia Post using the CAPM under
four different methodologies. These are shown below.
Table 5-1: Consolidated WACC
Australia Post Consolidated
Asset Beta
Pre Corporate
Tax
Post Tax Classical
Post Tax Imputation
Vanilla WACC
0.52
10.3%
8.1%
7.2%
8.7%
Capital Partners recommends use of the Vanilla WACC. This method provides the purest
representation of the inherent business risk of the enterprise. Tax and imputation impacts are not
related to the risk of the enterprise but are cashflow impacts. The Vanilla WACC requires project
assessment using post-tax, post-franking cashflows with only time-value-of-money consideration
in the discount rate.
We consider this method least prone to estimation error. This method is consistent with the
ACCC’s most recent approach on WACC for other regulated assets. We recommend this be
done at an assumed value of franking credits of 50% per dollar of tax.
We suggest caution in the application and interpretation of the consolidated WACC. The
consolidated WACC provides a measure of the relative risk of the enterprise and is most useful
as a point of reference to gauge the performance of Australia Post as a whole. In our view,
Australia Post is of moderately higher risk than the average infrastructure asset but of significantly
lower risk than the average listed security.
The consolidated WACC is a static number reflecting the current business mix of Australia Post.
Over time, organic growth is expected to see riskier divisions contribute a larger share of value.
Hence the consolidated WACC is likely to change over time. This makes the consolidated WACC
less reliable as a valuation tool. It should only be used to provide a broad approximate valuation
of the enterprise. When valuing specific projects, those projects should be of similar risk to that of
the entire enterprise.
We note the CAPM based risk measures above do not incorporate a premium for non-systematic
or specific risk events for Australia Post. These will require specific review on a case basis. This
is beyond the scope of this report. However, we broadly recommend that specific risks are not
incorporated as a premium to WACC but are considered as an adjustment to forecast cashflows.
Consolidated WACC
31
6 Appendix A – Definitions of WACC
There are a variety of WACC that could be used and the most commonly used formulae for the
WACC and the appropriate definition of net cash flows, given the WACC, are given below. The
proof of these definitions can be found in Officer, R.R. [1994], “The Cost of Capital of a Company
Under an Imputation Tax System”. Accounting and Finance, Vol. 34, No. 1, pp. 1-17.
6.1
Definitions
X0
represents operating net cash flows, i.e. the net cash flows that are distributed to
shareholders, debt holders and the government through taxation i.e.
Xo = Xe + Xd + Xg
Xe
Xd
Xg
T
is the net cash flows that are attributable to shareholders
is the net cash flows that are attributable to debt holders
is the net cash flows that are attributable to government through taxation
is the effective tax rate
is the value of imputation tax credits as a proportion of the tax credits paid
is the required return to equity holders
is the required return to debt holders
is the value of shares or equity
is the value of debt
is the value of the assets of the company
γ
re
rd
S
D
V=S+D
6.2
Before tax Cost of Capital
Definition of cash flows:
X
0
= X
e
+ X
d
+ X
g
Cost of capital:
r0 =
re
(1 − T (1 − γ )
Consolidated WACC
.
S
D
+ rd .
V
V
32
6.3
After tax Cost of Capital
1. Definition of cash flows:
X
0
(1 − T )
Cost of capital:
ri = re .
S
(1 − T )
D
.
+ rd .
(1 − T )
V (1 − T (1 − γ ) )
V
2. Definition of cash flows:
X
0
(1 − T (1 − γ ) )
Cost of capital:
S
D
+ rd ( 1 − T ( 1 − γ ) ) .
V
V
rii = re .
3. Definition of cash flows:
X 0 (1 − T ) + γ . T ( X 0 − X d )
Cost of capital:
riii = re .
S
D
+ rd .
. (1 − T )
V
V
4. Definition of cash flows:
X
0
− X
'
g
= X
0
− T(X
0
− X
d
) (1 − γ )
Cost of capital (the "Vanilla" WACC):
r iv = r e .
S
D
+ rd .
V
V
Is there a best WACC?
It is our preference to adopt the definition for the WACC as in equation 4 above. The appropriate
definition of cash flows, reordering the equation above is:
x o − x 'g = x o − T(x o − x d ) + γT(x o − x d )
where:
xo = economic operating profit (≡ earnings before interest and taxes)
T(xo-xd) = company tax with interest xd as a tax deduction
γ.T(xo-xd) = the value of franking credits added back because these are really a witholding of
personal taxes at the company level.
Consolidated WACC
33
This definition of net cash flows is also closer to what most would consider net of taxes cash to
providers of capital insofar as it includes the effect of the tax shield afforded by debt.
The WACC is a simple weighted average cost of debt and equity i.e.
r iv = r e .
S
D
+ rd .
V
V
is less prone to error and confusion relative to other equations or formulae.
Also the values are more readily identified with observations of capital market rates and therefore
easier to comprehend.
Further, the absence of a tax parameter in the WACC-- taxes are taken account of in the
definition of cash flows -- makes the effect of taxes less prone to error. As I have mentioned
conventional WACC with tax included in the formula require an estimate of some sort of average
tax rate for the entire life of the asset or the period of analysis. Such estimates are difficult to
determine with any accuracy.
The “Vanilla” WACC is also more accurate for finite life investments than alternative formulations
because of the tax effect and cross product effects of taxation and depreciation.
Finally, taxes can be accurately identified when they occur in the net cash flows. Their effect is
not ignored, although who has to bear the taxes or changes in taxes is still a problem the
Regulator has to solve.
In summary, the reason for arguing that equation 4 is the most appropriate is that all the
adjustments for taxes, imputation credits and the like occur in the net cash flows. This has the
advantage of being able to clearly identify when these taxes are paid (also, it clearly recognises
the difference between economic depreciation and tax depreciation). In addition, this simple
WACC or “Vanilla WACC” is much easier for lay people to understand and bears a closer
resemblance to market rates which they can observe.
Consolidated WACC
34
7 Appendix B – Imprecision In Equity Beta and Regulatory
Approach
The imprecision in beta estimates has been noted by Australian regulators. The imprecision of
equity beta estimates has also long been recognised in the academic literature and in practice.
For example, the Centre for Research in Finance (CRIF) at the Australian Graduate School of
Management computes OLS betas as well as Scholes-Williams betas. The Scholes-Williams
procedure provides a statistical correction for non-trading. This correction is designed to account
for the fact that a particular stock may trade more or less frequently than the average stock in the
index. The AGSM-CRIF Explanatory Notes explain that, “OLS can only be used when the data
used satisfies the assumptions which underlie the regression analysis. One assumption, which is
of potential importance in the Australian environment, is that the company and index rates of
return should be measured contemporaneously; that is, over exactly the same time intervals.
Since we are using monthly data, this is equivalent to assuming that all stocks have a trade
(establishing the current price) right at the end of each month. While this might be the state of
affairs for BHP, it is not so for many of the companies listed by the ASX. In fact, some listed
companies exhibit infrequent trading to the point where they do not trade even at regular monthly
intervals.”
In fact, the problem is more severe than this – many of the stocks that are included in the index
also trade infrequently. Therefore, even if we are trying to estimate the beta of a stock that is
large and liquid and trades continuously, there is still a mismatch with the trading frequency of the
index. The index likely contains stock prices from its smaller constituents. The CRIF Explanatory
Notes also recognise this: “This thin trading phenomenon may introduce biases into the OLS
estimates. A number of statistical methods exist for estimating beta in the presence of the thin
trading phenomena. The CRIF betas are computed using a version of the method first suggested
by Scholes and Williams (1977), this technique adjusts for thin trading inherent in both the stock
and the market index”. However, we cannot simply rely on these Scholes-Williams betas for at
least three reasons:
They tend to be estimated with even less precision than standard OLS betas (i.e., they are
designed to correct for non-trading bias, not statistical imprecision); the Scholes-Williams
technique is only one of many statistical adjustments to OLS betas that have been proposed (see
below); and the Scholes-Williams technique often produces extreme results, at least relative to
standard OLS betas, but there is no consistent relationship between the two. For example, in the
recent CRIF report (March, 2004), the Scholes-Williams beta is no different from the OLS beta for
Envestra, 30% higher for Alinta, and 8 times as large for AGL.
Another reputable data source, Bloomberg, provides a different statistical adjustment. Blume
adjusted betas, as provided by the Bloomberg service as follows:
β e adjusted = 0.67 × β e raw + 0.33 × 1.
Three substantial pieces of work that document other variations in the way that betas are
estimated in the Australian context are the ACG’s report for the ACCC (2002), the NERA (2002)
response to this report and the research monograph by Brailsford, Faff and Oliver (1997). These
sources document more than 20 alternative statistical approaches that have been proposed to
estimate equity betas.
Clearly, there is no single consensus approach for estimating equity betas. The very existence of
so many alternative approaches is evidence that none is satisfactory, accurate, or robust. In this
Consolidated WACC
35
context it is worth looking at some of the regulatory issues surrounding WACC and the estimates
of equity β’s.
By construction, the equity beta of the average Australian firm is 1.0. This is equivalent to noting
that the average Australian firm is expected to require a return on equity that matches that of the
market portfolio. Thus, an equity beta of 1.0 is, by construction, the starting point or null
hypothesis when estimating the beta for a particular firm. Only when there is sufficient evidence
to depart from this null hypothesis should a different value be used. Indeed, in the financial
economics literature it is quite standard to construct “market adjusted returns” by assuming that
all firms have an equity beta of 1.0. Brown and Warner (1980) demonstrate that, in many
settings, assuming the equity beta of all firms is 1.0 produces more consistent and reliable results
than if betas are statistically estimated for each firm. Conceptually, a particular firm may have a
beta different from 1.0 if the business in which it operates has low systematic risk or if it has
different gearing than the average firm. However, these effects are difficult to quantify precisely
such that a maintained assumption that equity beta equals 1.0 is often superior. This is
particularly true in cases where the two effects work in opposite directions. For example,
regulated energy distribution firms are likely to have lower than average systematic risk but much
higher than average (assumed) gearing. To the extent that these effects are difficult to quantify
and tend to cancel each other, substantial evidence should be required before departing from an
equity beta of 1.0.
The issue has recently been addressed in some detail by the Productivity Commission (PC), the
Supreme Court of Western Australia and the Australian Competition Tribunal. For example, the
Productivity Commission’s Review of the National Access Regime recognises that the effects of
too little infrastructure investment are far more severe than those associated with too much (or
too early) investment. The PC states (p. xxii) that “Given that precision is not possible, access
arrangements should encourage regulators to lean more towards facilitating investment than
short term consumption of services when setting terms and conditions” and that “given the
asymmetry in the costs of under- and over-compensation of facility owners, together with the
informational uncertainties facing regulators, there is a strong in principle case to ‘err’ on the side
of investors”.
The PC goes on to quote from a submission to the review by NECG, which stated that “In using
their discretion, regulators effectively face a choice between (i) erring on the side of lower access
prices and seeking to ensure they remove any potential for monopoly rents and the consequent
allocative inefficiencies from the system; or (ii) allowing higher access prices so as to ensure that
sufficient incentives for efficient investment are retained, with the consequent productive and
dynamic efficiencies such investment engenders. There are strong economic reasons in many
regulated industries to place particular emphasis on ensuring the incentives are maintained for
efficient investment and for continued productivity increases. The dynamic and productive
efficiency costs associated with distorted incentives and with slower growth in productivity are
almost always likely to outweigh any allocative efficiency losses associated with above-cost
pricing. (sub. 39, p. 16)”
The PC Review highlighted the need to modify implementation of the regime and made 33
recommendations to improve its operation. In particular it identified as a “threshold issue, the
need for the application of the regime to give proper regard to investment issues” and “the need
to provide appropriate incentives for investment.”
This view is supported by the Commonwealth Government, which has resolved to amend the
Trade Practices Act in this regard. In particular, the access regime will be modified to include a
clear objects clause: “The objective of this part is to promote the economically efficient operation
and use of, and investment in, essential infrastructure services thereby promoting effective
competition in upstream and downstream markets…”
Consolidated WACC
36
In addition, a set of pricing principles will be included that requires “that regulated access prices
should: (i) be set so as to generate expected revenue for a regulated service or services that is at
least sufficient to meet the efficient costs of providing access to the regulated service or services;
and (ii) include a return on investment commensurate with the regulatory and commercial risks
involved…”
We believe that these views are consistent with the notion that a higher standard of evidence
should be required to adopt an equity beta estimate below 1.0 than is required to adopt an
estimate above 1.0.
Consolidated WACC
37
8 Appendix C - Comparable Listed Post Offices
The Netherlands: TPG
The Netherlands post office was partially privatised and listed on the Amsterdam Stock Exchange
in 1994 – the first postal system in the world to be listed. TPG also owns global express parcel
delivery and supply chain management businesses TNT Express and TNT Logistics. The Dutch
mail market is expected to be deregulated by 2007. The Dutch government owns 19% of TPG.
Germany: Deutsche Post
Deutsche Post was privatised and listed in 2000. In 2002, it acquired global express parcel
delivery business DHL. Deutsche Post also operates a logistics business and Postbank, a retail
bank that operates from post retail outlets. The German government owns 63% of Deutsche Post.
Singapore: SingPost
SingPost was a division of Singapore Telecommunications (SingTel) until it was spun off in an
IPO in 2003. SingTel has exclusive rights over basic mail in Singapore until 2007 and also
operates a global express parcel business and a logistics business. It has also entered a JV with
GE money to provide personal loans. SingPost is 31% owned by SingTel, which is 65% owned by
the Singapore government.
Australia
Post
TPG
Deutsche
Post
SingPost
Local Letters Monopoly
Local Express Parcels
Global Express Parcels
Logistics
Transactions Processing
Personal Banking
Consolidated WACC
38
9 Appendix D - Comparable Company Descriptions
Description
Market
Cap
A$m
Listed Postal Services
TPG
Deutsche Post
Singapore Post
National postal service in the Netherlands, international postal services,
global express parcel delivery, freight and logistics.
German national postal service, international postal services, global
express parcel delivery, freight and logistics, electronic transactions,
personal banking.
Singapore national postal service, international postal services, logistics,
electronic transactions.
17,235
33,533
1,334
Express Parcel Delivery
FedEx Corp
United Parcel Service
Blue Dart Express
Worldwide express parcel delivery, transportation, freight, supply chain
management, ecommerce.
Package and document delivery, logistics, supply chain management
The Indian agent for FedEx, offers a package and document courier
service and delivery within India and worldwide.
41,026
110,959
243
Australian Infrastructure
Australian Infrastructure Fund
Hills Motorway
Transurban Group
MIG
Envestra
Investment in unlisted transport infrastructure assets, primarily airports
and railways.
Ownership and operation of the M2 Motorway in Sydney.
Ownership and operation of tollroads in Melbourne in Sydney.
Ownership and operation of tollroads, primarily in Canada, the UK and
Australia.
Natural gas distribution and ownership of transmission pipelines in South
Australia, Queensland and the Northern Territory.
698
1,952
4,003
7,750
854
Australian Logistics
CTI Logistics
K & S Corporation
Toll Holdings
Wridgways Australia
Courier services, warehousing, logistics, container freight forwarding,
container packing and unpacking.
Transportation, warehousing, fuel distribution, freight forwarding.
Express rail, land and sea freight transport, logistics, warehousing and
distribution, port operations, recycling.
Furniture removal, storage, import and export services.
16
213
4,306
32
International Logistics
D. Logistics A.G.
Wincanton
TDG
Theil Logistics
Hub Group
Consolidated WACC
Supply and warehousing services for airports, manufacturers, chemical
companies and hospitals.
Logistical services, fleet management services, design and procurement
of warehouse storage systems.
Distribution, storage, supply chain management
Global logistics and business services
Container freight transportation and logistics
127
771
447
900
707
39
Market
Cap
Description
A$m
Stock Exchanges
Australian Stock Exchange
Honk Kong Exchange
Euronext Exchange
London Stock Exchange
Australia's primary stock exchange and derivatives market
Hong Kong stock exchange
A pan-European stock exchange
The UK's primary stock exchange
Transactions Processing
Baycorp Advantage
Paychex Inc.
Deluxe Corporation
Equifax Inc
Coinstar Inc.
iPayment Inc.
Supply of credit reference information
Payroll and human resources services
Electronic transactions and paper payments
Transaction processing, direct marketing
Self-service coin counting machines
Electronic transaction processing
700
16,382
2,466
5,298
762
889
Retail
Woolworths
Coles Myer
Foodland Associated
Brazin
Miller's Retail
Colorado Group
Food, liquor, discount and specialty retailing
Food, liquor, apparel and discount retailing
Food retailing, wholesaling and distribution
Specialty retailing
Discount retailer
Specialty clothing retailer
15,621
11,674
2,757
287
247
490
Property Development
Westfield Holdings
Peet & Co
Australand
FKP Property Group
Port Bouvard
Development and management of shopping centres
Residential property development
Residential and commercial property development and ownership
Residential and commercial property development and mangement
Residential property development
2,267
3,613
5,585
3,446
8,831
493
1,567
685
81
Comparable Companies Omitted from Analysis due to Insufficient Data
Company
Salmat
Bill Express
Geodis S.A.
Peet & Co
Just Group
Osaka Securities Exchange
Nasdaq Stock Exchange
Singapore Stock Exchange
New Zealand Stock Exchange
Newcastle Stock Exchange
Consolidated WACC
Industry
Direct marketing and delivery
Transactions processing
Global shipping and postal services, parcel and express delivery
Property development
Retail
Transactions processing (stock exchange)
Transactions processing (stock exchange)
Transactions processing (stock exchange)
Transactions processing (stock exchange)
Transactions processing (stock exchange)
40
Financial Services Devision - Comparable Companies
Traditional financial services businesses (such as Banking and Insurance) do not provide an
accurate comparison as these incorporate financial market risk. Financial Services is an
amalgam of general retailing and transactional service industries.
A number of listed retail
companies are available for comparison to the retail element. For the transactional element,
analogies may be drawn to stock exchange services and other data processing businesses
where high volumes of relatively similar transactions are processed at a set rate. Capital
Partners has assumed the risk is divided evenly between the two services.
Consolidated WACC
41
10 Appendix E - Comparison to ACCC Methodology
The ACCC’s methodology in the most recent Letters pricing determination in October 2002 is
slightly at odds with Capital Partners preferred Vanilla WACC approach. However, more recent
pricing decisions by the ACCC relating to other industries have incorporated the Vanilla WACC
and the 10-year bond yield, which are consistent with Capital Partners’ methodology.
10.1 Relationship of Post with the ACCC
Under the Australian Postal Corporation Act (1989), carriage of addressed letters weighing less
than 250 grams is reserved for Australia Post. The Reserved Letter service is considered a
notified service under Section 95X of the Trade Practices Act (1974).
Post is required to notify the ACCC of any proposed price increase of the Reserved Letter
service. The ACCC has the authority to object to proposed increases. The decision on whether
to object to a proposed price increase is based on the ACCC’s calculation of an appropriate aftertax return on capital. The ACCC performs this role only for the Reserved Letters business and
has no direct involvement with the other divisions of Post.
10.2 ACCC Determination of Efficient Pricing
The ACCC has two objectives in reviewing the prices of the Reserved Letters business:
• To allow Post to earn an efficient rate of return on the capital invested in the Reserved
Letters business; and
• To prevent Post from exploiting its monopoly position by increasing prices above an
economically efficient level.
To determine whether proposed prices will lead to an efficient rate of return, the ACCC estimates
the efficient costs of the division and its cost of capital. The following formula is applied in order
to estimate the revenue the division would require in order to earn an efficient return on capital
(the formula was obtained from the ACCC Australia Post Price Notification Decision October
2002). This revenue figure is divided by forecast volume to obtain an estimate of the efficient
price level.
RR = O&M + D + ROC + T
Where RR = required revenue
O&M = operating and maintenance expenditure
D = depreciation or return of capital
ROC = return on capital = WACC * WDV
WACC = weighted average cost of capital (post-tax);
WDV = written down (depreciated) average value of the asset base
T = corporate tax, less benefit of dividend imputation
Consolidated WACC
42
10.3 ACCC Calculation of WACC
The revenue and price calculation described above requires an estimate of the after-tax WACC of
the Reserved Letters business. In its most recent Letters pricing determination in October 2002,
the ACCC applied the WACC determined by Professor Kevin Davis. Professor Davis estimated
Post’s WACC by applying the following equation, which has been referred to throughout this
report as the “Post Tax – Imputation” WACC:
S
(1 − T )
D
WACC = re . .
+ rd . (1 − T )
V (1 − T (1 − γ ))
V
… (6)
All terms are as defined in Appendix C and in the report.
Table 10-1: ACCC Assumptions from October 2002 Letters Decision
ACCC Assumption
Rationale
S/V
70%
Consistent with Post assumption
D/V
30%
Consistent with Post assumption
T
30%
Australian corporate tax rate
γ
0.5
Consistent with previous decisions
Rf
40-day average of 5-year
Commonwealth bond rates
Term corresponds with length of regulatory
period
Debt margin
0.3%
Based on AAA credit rating
ße
0.55
Consistent with international listed delivery
companies and regulated businesses in
Australia.
MRP
6%
Consistent with previous decisions
10.4 Recent ACCC Decisions from Other Industries
The ACCC has made pricing determinations for other industries more recently than the last
review of Letters pricing in October 2002. The methodology used by the ACCC in its most recent
pricing determinations is different from the methodology applied to Letters in 2002 and consistent
with Capital Partners’ “Vanilla” WACC approach.
In the Background Paper “Statement of principles for regulation of the electricity transmission
revenues” dated 8 December 2004, the ACCC details its approach to calculating WACC. The
process described is the Vanilla WACC detailed above in Section 1.4.1.
The generic assumptions made by the ACCC in its December 2004 Background Paper on the
Electricity Transmission Industry are as shown below.
Consolidated WACC
43
Table 10-2: ACCC Assumptions from December 2004 Electricity Transmission Background
Paper
ACCC Assumption
Rationale
T
30%
Australian corporate tax rate
γ
0.5
Consistent with previous decisions
Rf
5 to 40-day average of 10year Commonwealth bond
rates
10 year rate consistent with original calculation of
the MRP
MRP
6%
Consistent with previous decisions and historical
measures
Consolidated WACC
44
Contact Details
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Sydney
Level 8, Aurora Place
88 Phillip Street
SYDNEY NSW 2000
Australia
Ph +61 2 8274-5900
sydney@cp2.com
www.cp2.com
Consolidated WACC
45