Problems in Cost of Capital Estimation:
Illustrations from the Gas Industry
Kevin Davis
Colonial Professor of Finance
Department of Accounting and Finance
The University of Melbourne
k.davis@ecomfac.unimelb.edu.au
Ph: 03 9344 8015
http://www.ecom.unimelb.edu.au/accwww
fax: 03 9349 2397
Overview


Significance of the Cost of Capital
Alternative Cost of Capital Measures
 pre versus post tax
»


imputation considerations
 nominal versus real
 equity versus entity (WACC)
Estimating components of the WACC
 betas; leverage; tax rates; franking credit
valuation;
Dealing with non-systematic risk
Why is the Cost of Capital Relevant?




Evaluation of new projects
 Net Present Value (NPV) techniques
Performance measurement of existing business
 Economic Value Added (EVA)
Pricing Policy
 Access provisions
Financing Choice
 Optimal Capital Structure
Problems in Determining the Cost of Capital

Cost of Equity capital not directly observable

Interest Rate quoted on debt finance not
necessarily equal to rate of return expected by
providers of debt finance

Hybrid securities often involve option
characteristics which have a cost which needs
to be evaluated
The Regulatory Model for Access Pricing


A net revenue stream which equals the required
rate of return on written down book value plus
depreciation each period means that the initial
investment is zero NPV
Initial book value of assets established as DORC
value
 Depreciated Optimised Replacement Cost
The Regulatory Model


Determine target revenue stream for 5 year horizon, based
on
 Projections of volume
 Revenue to cover (efficient) operating costs, return
on capital, return of capital (depreciation)
 Initial price determined from year 1 target revenue
and volume projections
 Subsequent prices for 5 year horizon set using CPI –
X rule, where X set to give Present Value of resulting
revenue stream equal to that of target revenue stream
Note: approximately 50% of target revenue is return on
capital
Background (continued)


Access prices should mimic a (hypothetical) competitive
outcome
 Market value of business should be close to
replacement value of assets
Privatization sale prices were over twice the replacement
value of assets
 Cannot be explained by potential operating efficiency
gains or synergy
 Unlikely to be largely due to “winner’s curse”
 Unlikely to be due to underestimation of asset
replacement value
 Indicative of use of excessively high cost of capital in
regulatory determination
The Building Block Approach


Target Revenue
=
Operating Costs
+
Return of Capital
+
Return on Capital
Fundamental Decisions
 real versus nominal (is inflation reflected in
return of or return on capital?)
 post tax versus pre tax (is tax component of
target revenues implicit in (pre tax) return
on capital or identified explicitly from (post
tax) return on capital?)
 entity versus equity (is focus on return to all
providers of funds or only owners?)
Consistency Issues



Any number of different approaches can be
shown to be equivalent
 provided that “correct” input parameter
values are used
Unfortunately, correct values aren’t known and
errors lead to wealth transfers
Approach adopted should aim to enhance:
 Accuracy of estimation of key parameters in
each approach
 Transparency of the process
 Ease of interpretation
Real versus Nominal Approach


Either real (CCA depreciation) or nominal
(historical cost depreciation) approach can be
used
 no effect on NPV of target revenue stream
 first cash flow and X factor may be affected
Real pre tax approach requires derivation of real
pre tax cost of capital
 no simple conversion formula to get real pre
tax from nominal post tax cost of capital
 real pre tax concept not commonly used
Imputation Implications

Gas Industry approach commenced with a nominal WACC
formula which
 started with “partially grossed up” cost of equity (re),
available from CAPM
 adjusted this to be applicable to cash flows after
company tax (ie not including franking credits in
cash flows)
E
(1  T )
D
r  re .
 rd . .(1  T )
V (1  T (1   ))
V
i
o

Then adjusted for tax and inflation to apply to real pre
tax cash flows
Imputation Implications



Problems
 What is value of  ?
 What is appropriate value of T ?
Alternatives
“Entity Basis”
 cash flows to all capital providers after tax
»
»

tax as levered or unlevered entity?
Add value of franking credits into cash flows
“Equity Basis”
 cash flows (plus value of franking credits) to
equity providers after tax
The Regulatory Problem

Cost of capital “built up” from component parts
 many “unknowns”
»
»


CAPM parameters, tax issues, leverage & debt
costs
real, pre tax WACC figure required (not well
understood)
“cherry picking” of parameter estimates by
participants in process
bias towards overstatement of WACC by
participants
Effective
Company Tax
Rate
Company Tax Rate
Leverage
Equity B
Asset b
Real
Pre Tax
WACC
Nominal
Post Tax
WACC
“Comparables”
Equity b
Market Risk
Premium
Nominal
Post Tax
Cost of
Equity
Valuation
of Franking
Credits
Real Risk
Free Rate
Dividend Policy
Risk Free Rate
Cost of Debt
Credit Rating
Inflation
Estimating CAPM parameters

Risk free rate
 Theory suggests short term rate
 Practitioners use long term rate
 Compromise: use current long term rate
less historical “long - short” risk premium to
get expected long run average of short term
rate
 Does “duration” of activity matter?
 Should current day rate or historical average
be used?
The Market Risk Premium



“Conventional Wisdom” suggests MRP of 6-8
per cent
Theory and the “Equity Premium Puzzle”
 6-8 per cent not compatible with “normal”
risk aversion parameters
What is historical evidence?
 For Australia post WW2, arguably < 6% p.a.
»

compare return on equity with risk free rate for
same holding period
How is return on market (and thus MRP)
measured post imputation?
»
Partially/ fully grossed up?
Estimating Beta




Directly - regression of past returns on particular
stock against past returns on market
Purchase estimates
Accounting information / cash flow analysis
Comparables - identify similar risk companies
and adapt the beta estimates for those
 systematic risk needs to be the same
»
»

is “market” portfolio the same
how does regulation affect risk
leverage adjustment needs to be made
»
“unlever” and “relever” beta
Delevering - Levering



Equity beta reflects
 underlying asset (unlevered) beta
 leverage
To calculate beta for similar company(ie similar
business risk) with different leverage
 calculate asset beta (ie delever) and then
relever to get equity beta for desired
leverage
Issues
 tax adjustments and appropriate formula
 beta of debt
The GAS WACC Model
E
(1  T )
D
r  re .
 rd . .(1  T )
V (1  T (1   ))
V
i
o



re is a “partially grossed up” cost of equity
WACC proposed is applicable to nominal cash flows
calculated after tax but before interest (ie as if unlevered)
Implicit assumptions
 perpetuity cash flow
 returns take form of 100% franked dividends
» hence company in full tax paying position
 franking credits not fully valued
 capital gains taxed equivalently to other income
An Alternative (Monkhouse) WACC model
k  r f  b [ E( Rm )  r f ]   D t f
c
e
d
re  k   D t f  r f  b [ E( Rm )  r f ]
E c D
c
k w  k e  rd (1  T )
V
V
c
e





'
d
'
kec is return measured excluding value of franking credits
re is return measured including value of franking credits
kwc is WACC to apply to cash flows
Rm is partially grossed up market return
Equivalent to proposed model if returns only take form of
100% franked dividends
Notation






re expected return, rf is the risk free rate
E(Rm) is the expected return on the market –
inclusive of the value of franking credits
d utilization rate of distributed imputation
credits (equivalent to Officer’s 
D’ is the grossed up dividend yield
tf is the level of franking
 0 in the case of an unfranked dividend
 T (co tax rate) for a fully franked dividend).
D’ = d/[P(1-T)] where d is the cash dividend and P
is the share price.
Monkhouse’s CAPM under imputation




No preferential tax treatment of capital gains
Investors have different valuations of franking
credits (from 0 to 100%)
Investors do not shift between firms according
to tax characteristics of returns (franked /
unfranked etc)
Retained franking credits may add some value
(but assumed zero in version presented here)
Comparing Approaches
Risk Free Rate
Market Risk Premium
Beta
Grossed Up div yield
Cost of Equity (re)
cf Cost of Equity (ke)
%Equity (E/V)
Cost of Debt (rd)
% Debt (D/V)
Gamma ()
Tax Rate (T)
re [ (1-T)/(1-T(1- ))][E/V]
Officer(1)
8.00%
6.50%
1.08
na
15.02%
0.4
8.75%
0.6
0.25
0.36
0.053
Officer(2) Monkhouse(1) Monkhouse(2)
6.00%
8.00%
6.00%
6.00%
6.50%
6.00%
0.60
1.08
0.60
na
6.00%
6.00%
9.60%
15.02%
9.60%
14.48%
8.52%
0.7
0.4
0.7
6.75%
8.75%
6.75%
0.3
0.6
0.3
0.50
0.25
0.50
0.36
0.36
0.36
0.052
ke[E/V]
rd[1-T][D/V]
ro
na
na
0.058
0.060
0.034
0.013
0.034
0.013
8.63%
6.54%
9.15%
7.26%
Non systematic risk and the cost of capital




CAPM only prices systematic risk
Resulting cost of capital should be used in
conjunction with expected cash flows
Practitioners often add a “fudge factor” to CAPM
estimate to compensate for non systematic risk
 but such risk involves both upside and
downside!
A significant problem is that cash flow figures
used are often those viewed as most likely
(modal), and cash flow distribution is skewed
such that “expected” (mean) figure is lower
 solution - adjust cash flows for “insurance”
cost of downside risk