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The Fear Factor

Understanding power company volatility in the context of valuation theory.
Fortnightly Magazine - April 15 2002

industry and in the use of off-balance sheet structures as financing vehicles. Rating agencies responded by downgrading and threatening to downgrade gencos issuing new debt, raising the specter of gencos being required to post hundreds of millions in collateral for their trading operations. From mid-November until mid-December, the cost of genco debt increased in pretax terms anywhere from 40 percent for investment-grade rated debt to as much as 100 percent for non-investment-grade debt. This effectively foreclosed the ability of gencos to issue debt as a means of raising capital, leaving equity as the only option.

At the same time, the cost of issuing equity became prohibitive as genco stock prices declined. Compounding the problem was the fact that new equity investors would have required a premium return in excess of the predicted returns recognizable at the market equity price. The unfortunate effect was that gencos' marginal cost of capital skyrocketed at the very moment these companies needed capital most.

In terms of our DCF analysis, an increase in the WACC from 8 percent to 11 percent or more (accounting for the constrained liquidity situation) would reduce considerably the already battered enterprise and equity values of our hypothetical genco. Considering the effect of leverage, the reduction in the equity value is magnified more than twice, since (we assume) the face value of debt obligations remained constant over the course of the year. In fact, the chart demonstrates that the genco index fell another 40 percent between mid-November and mid-December as liquidity issues threatened to bury the sector.

Although important issues not discussed here certainly played some part, much of the extreme volatility in genco equities over the course of the past year can be explained in the context of the DCF model. As liquidity concerns begin to fade and genco WACCs fall in response, one can hope that the theory behind the DCF approach will hold and that genco equity values will continue to recover.

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