Electricity Markets Regulation - Lesson 5 - Cost of Capital

Training on Regulation A webinar for the European Copper Institute Webinar 5: Cost of Capital Dr. Konstantin Petrov / Dr. Daniel Grote 14.12.2009

Agenda b) Weighted Average Cost of Capital (WACC) a) Concept and Regulatory Objectives 1. Definition of Cost of Capital c) Cost of Debt d) Cost of Equity 2. Quantification of Cost of Capital a) Capital Asset Pricing Model (CAPM) c) Arbitrage Pricing Theory (APT) d) Dividend Growth Model (DGM) e) Comparable Earnings Model (CEM) e) Capital Structure (gearing) f) Treatment of Taxes f) Regulatory Precedents b) Fama-French 3-factor Model

1. Definition of Cost of Capital a) Definition and Regulatory Objectives ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object]

1. Definition of Cost of Capital b) Weighted Average Cost of Capital (WACC) (1) Cost of Equity Cost of Debt Equity Share Debt Share Taxes WACC ,[object Object],[object Object],[object Object],[object Object]

1. Definition of Cost of capital b) Weighted Average Cost of Capital (WACC) (2) Cost of Equity No default risk No reinvestment risk + Market risk measure * Base Equity Premium Country Risk Premium Risk-free rate + Debt premium Risk-free rate Beta Risk Premium Premium for average risk investment Debt / Equity ratio E = Equity D = Debt Tax rate Cost of Debt Gearing T = Tax D E+D WACC (post-tax) = Cost of equity + Cost of Debt (1-T) E E+D * * *

1. Definition of Cost of Capital c) Cost of Debt ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object]

1. Definition of Cost of Capital d) Cost of Equity (1) ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object]

1. Definition of Cost of Capital ,[object Object],[object Object],d) Cost of Equity (2)

1. Definition of Cost of Capital e) Capital Structure (gearing) ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],Cost of debt WACC Cost of capital Cost of equity Optimal cost of capital Debt / equity ratio (gearing)

1. Definition of Cost of Capital f) Treatment of Taxes ,[object Object],[object Object],[object Object],[object Object]

2. Quantification of Cost of Capital Overview Quantification Models Capital Asset Pricing Model (CAPM) Arbitrage Pricing Theory (APT) Dividend Growth Model (DGM) Regulatory Precedents Comparable Earnings Model Fama-French 3-factor model

2. Quantification of Cost of Capital a) Capital Asset Pricing Model (CAPM) ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object]

2. Quantification of Cost of Capital a) Capital Asset Pricing Model (CAPM) – Formula or E(R a ) = R f + β ( E(R m ) – R f ) + ε Expected return on individual capital asset a Risk-free rate of interest sensitivity of asset returns to market returns Expected return of the market Risk-free rate of interest market premium or equity risk premium Error term systematic or non-diversifiable risk specific or diversifiable risk * E(R a ) - R f = β ( E(R m ) – R f ) β (beta) times market premium = individual risk premium *

2. Quantification of Cost of Capital a) Capital Asset Pricing Model (CAPM) – Security Market Line ,[object Object],[object Object],[object Object],Relatively risky assets Market portfolio Relatively safe assets Error term ( ε ) risk-free rate of return Expected rate of return systematic risk ( β ) 0 E(R m ) 1 R f Security Market Line (SML) Expected return of the market High risk premium Low risk premium

2. Quantification of Cost of Capital b) Fama-French 3-Factor Model (1) ,[object Object],[object Object],E(R a ) = R f + β ( E(R m ) – R f ) + γ (SMB) + δ (HML) + ε Expected return on individual capital asset a Risk-free rate of interest Sensitivity of returns of asset a to market returns Expected return of the market Error term Risk-free rate of interest Expected returns of small minus big (SMB) stocks Expected returns of high minus low book-to-market (HML) stocks Sensitivity of returns of asset a to returns of small over big stocks Sensitivity of returns of asset a to returns of high over low book-to-market stocks * * *

2. Quantification of Cost of Capital b) Fama-French 3-Factor Model (2) ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object]

2. Quantification of Cost of Capital c) Arbitrage Pricing Theory (APT) ,[object Object],[object Object],[object Object],[object Object],[object Object],E(R a ) = R f + β a1 ( F1 ) + β a2 ( F2 ) + … + ε Risk-free rate of interest Expected return on individual capital asset a Sensitivity of returns of asset a to factor 1 Factor 1 Sensitivity of returns of asset a to factor 2 Factor 2 Error term Additional factors * *

2. Quantification of Cost of Capital d) Dividend Growth Model (DGM) ,[object Object],[object Object],[object Object],[object Object],R e = + g D 1 P 0 Cost of Equity expected dividend current share price rate of growth in dividend

2. Quantification of Cost of Capital e) Comparable Earnings Model (CEM) ,[object Object],[object Object],[object Object],[object Object]

2. Quantification of Cost of Capital f) Regulatory Precedents ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object]

End of Webinar 5 ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object]

Electricity Markets Regulation - Lesson 5 - Cost of Capital

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Electricity Markets Regulation - Lesson 5 - Cost of Capital