Estimated costs of equity for utilities are, like interest rates, very low by historical standards. A standard capital asset pricing model (CAPM) value might be 9 percent,1 although some analysts might argue for much lower values.2 Discounted cash flow (DCF) methods may produce a wider range of answers, due to variations in the growth rates selected, but many of those answers will be low by historical standards, too.3
These low findings are based in part on problems with the underlying models. For example, the CAPM long has been known to underestimate the cost of equity of low-beta stocks and to overestimate the cost of equity of high-beta stocks.4 However, often there is a more fundamental problem that rate regulation in North America usually overlooks: a material mismatch between the capital structure at which the cost of equity is estimated and the ratemaking capital structure to which it is applied.5 A material capital structure mismatch, which occurs frequently, can lead to material misestimates of the appropriate allowed return on equity, perhaps on the order of 2 percentage points. That is, a 9 percent estimate of the cost of equity can imply an allowed rate of return on equity of 11 percent.
Let's start with the basics. Companies raise money for investment by issuing securities. Different securities have different claims on the firm's earnings, and if necessary, on its assets. Debt has a senior claim on a specified portion of the earnings. Common equity, the most junior security, gets what's left after everyone else has been paid.
The company's overall risk depends on the business it's in. When a company uses (reasonable amounts of) debt, the company's overall risk falls on a fraction of its capital, the common equity.6 Since equity bears more risk, investors require a higher rate of return on equity than on debt. Except at extreme debt levels, the overall risk of the firm does not change materially due to the addition of debt. The various securities just divvy that risk up.
Modern models of the cost of equity assume risk consists of a stock's sensitivity to one or more economic factors that affect asset values generally. Suppose changes in some market-wide economic factor normally produce fluctuations in the market value of a company's assets of plus or minus (+/-) 2 percent. At 100 percent equity, these changes produce fluctuations of +/-2 percent of the market value of the company's equity, too. But at a 50-50 market-value, debt-equity ratio, the same asset-value fluctuations produce equity-value fluctuations of +/- 4 percent. At a 75-25 market-value debt-equity ratio, these fluctuations become +/- 8 percent of the market value of the company's equity. Figure 1 illustrates this point for debt-equity ratios of 0-100, 25-75, 50-50, and 75-25. Higher risk means a higher required rate of return, so the cost of equity goes up at an ever increasing rate as a company adds debt, which offsets the lower cost of debt. In short, there is no magic in financial leverage.
This result should be familiar to anyone who owns a home. When housing prices go up or down, the effect on the owner depends in part on how big the mortgage is. Figure 2 shows this effect for mortgages that are 0 percent, 20 percent, 50 percent, and 80 percent of the dwelling's initial purchase price. The figure assumes the purchase price of a home is $100,000, and that a year later housing prices in the area are expected to vary within a range of plus or minus 10 percent of today's price. The impact on the homeowner's net worth depends on the size of the mortgage. With no mortgage, a +/-10 percent change in the dwelling's price translates into a +/-10 percent change in the owner's equity. With a mortgage of 50 percent of purchase price, this range doubles to +/-20 percent. With a mortgage of 80 percent of purchase price, the +/-$10,000 in the home's value becomes +/-50 percent of the owner's initial $20,000 in equity.
Nearly half a century of financial research on the effects of capital structure on the value of the firm7 and the resulting literature have explored the effects of risk, corporate taxes, personal taxes, financial distress, the signals companies send investors through the ways they raise capital, and possible divergences of interests between managers and shareholders. We believe it is fair to say that no single theory has emerged as "the answer" to how capital structure affects the value of a firm.
Empirical as well as theoretical research has been done. For most industries, modest amounts of debt appear to add some value to the firm. However, companies display a wide range of intra-industry capital structures, and the most profitable firms in an industry tend to use the least debt, a finding that holds internationally as well as in the United States. The most profitable firms are the ones that could make best use of the corporate tax shields that interest expense provides,8 and presumably these firms tend to be the best managed (why else are they the most profitable?). The fact that these firms do not use more debt implies that the corporate tax advantage of debt must be offset by other costs. The upshot of such research is that the value of a firm is not very sensitive to the debt ratio over a broad middle range of capital structures.
What does this mean for the cost of capital? Standard practice uses the after-tax weighted-average cost of capital as the discount rate in determination of the value of a project or a firm.9 If the value of the project or the firm is independent of capital structure over a broad middle range, as the research demonstrates, so too must be its after-tax weighted-average cost of capital.10
The result is illustrated in Figure 3. Here the after-tax weighted-average cost of capital is shown essentially as flat between market-value capital structures of about 30 and 55 percent debt. If the overall cost of capital is essentially constant as the proportion of risk-bearing equity shrinks, the risk and cost of equity must rise at an ever-increasing rate-just what the risk discussion in the previous section predicted. But the finding that the after-tax weighted-average cost of capital essentially is flat tells us just how fast the cost of equity increases with debt. The figure shows this effect in the cost-of-equity curve.11
Market-value equity ratios typically are higher than book-value debt ratios for utilities today. Suppose an analyst examines a sample of firms in this industry and estimates a 9 percent cost of equity at the sample's 34 percent market-value debt ratio. Then (estimation errors aside) she would have found an 11 percent cost of equity had the sample had a 53 percent debt ratio, because the sample's equity holders would have been bearing much more financial risk at the higher debt ratio.12 That, in turn, means that if the capital structure used to set rates were 53 percent debt, the allowed rate of return on equity should be 11 percent, not 9 percent.
The finding that the after-tax weighted-average cost of capital is essentially flat for companies in the industry's middle range of capital structures provides a ready three-step procedure to use in rate hearings:
The result will be the cost of equity found by the analyst, estimation problems aside, if the sample's market-value capital structure had been equal to the ratemaking capital structure. That value is the appropriate allowed rate of return on equity at the ratemaking capital structure.
Differences between the market-value capital structures of the sample companies and the capital structure used to set rates can be large. If so, there will be equally large differences in the amount of financial risk-hence, the costs of equity at the different capital structures. Failure to take these differences into account is likely to lead to allowed rates of return on equity that are materially below the costs of equity that utility shareholders actually require.