The time-honored discounted cash flow method for determining appropriate utility returns falls short when interest rates are low. Inadequate ROEs ultimately increase cost of capital and wipe away...
Volatile markets call for alternative financial models.
explained above, due to lack of consistency, it would be inappropriate to use this as the cost of debt. The Merton model estimates the default component to be close to 2.5 to 3 percent, which indicates a true cost of debt in the 9 to 9.5 percent range.
Once the cost of equity and the cost of debt have been determined, calculating the after-tax WACC is a simple exercise. Figure 3 summarizes the results of the utility and the merchant class analysis, using both the DCF and the CAPM methodologies. Note that these numbers are purely illustrative and based on best efforts to create cost-of-capital estimates using empirical data.
The analysis projects an increase of 1 percent or less in the cost of capital using the CAPM for both utilities and merchants. The DCF model estimates a higher change—more than 1 percent for utilities and a greater than 3 percent change for merchants. Most of the change in the cost of capital (especially in the DCF case for merchants) is driven by cost-of-equity changes, although changes in debt costs also are a significant contributing factor.
As the results indicate, the CAPM methodology is relatively less responsive to fluctuations in market capitalizations over a limited historical period due to its reliance on longer-term historical data and other offsetting risk parameters. On the other hand, the DCF methodology, by construct, is highly responsive to the changes in stock prices and market capitalizations and provides a more dynamic estimate of change in cost of capital due to recent market fluctuations. The significantly greater change in the cost of capital for merchants as compared to utilities is partly explained by the relative drop in stock prices, with the decrease in stock prices for the merchants far exceeding the drop for utilities.
Neither model is perfect—DCF focuses highly, perhaps too much, on the near term, while the CAPM might over-emphasize the long term and might not take current conditions sufficiently into account. Hence, using an average of the two approaches is more prudent and might provide a better sense for relative changes in the cost of capital. Also, while the CAPM approach frequently is used for both utilities and merchants, the DCF approach seldom is used for merchants, though it is commonly applied to utilities. Given the current volatility of the credit and the equity markets, it’s critical to consider the appropriate approach to establishing a long-term view of the cost of capital.
The credit markets clearly are in a state of substantial flux, and the availability and cost of capital—to utilities, merchants and others—will depend on how quickly credit can start flowing again. The public-private partnerships structures recently announced by President Obama and Treasury Secretary Tim Geithner are intended to enable troubled banks to off-load toxic assets from their balance sheets through equity participation from the federal reserve and private banks in conjunction with leverage from the Federal Deposit Insurance Corporation (FDIC). The clear intent is to lower the overall riskiness of financial markets and hence the cost of capital, though it’s unclear whether