Introduction to Rate Cases and Rate Design David G. Loomis, Ph.D.

Introduction to Rate
Cases and Rate
Design
David G. Loomis, Ph.D.
Executive Director, Institute
for Regulatory Policy Studies
Cost of Capital
Fundamental Rate-of-Return
Equation

Revenue Requirement = OC + T + d + r(V-D)
 OC = Operating Costs
 T = Taxes
 d = Annual depreciation
expense
 r = Rate of return
 V = Value of physical and financial
 D = Accumulated depreciation
capital
is called the “return portion” and V-D is called
“rate base”
 r(V-D)
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Rate Base Versus Rate of Return

Numerical Example




2% increase in the rate of return yields $14 M increase in
revenue requirements.
To have the same effect on revenue requirements, the
rate base would have to increase by $ 140 M



.10 x $700 M = $70 M
.12 x $700 M = $84 M
.10 x $700 M = $70 M
.10 x $840 M = $84 M
A 20% increase in rate base is needed to justify the
same requirement as a 2% increase in the rate of return
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Determining r

Utility needs a fair rate of return that is sufficiently high to
attract new investment for new projects. To economists,
this is known as the opportunity cost of capital.

Important court case - Hope Natural Gas (1944) stated
that return "should be commensurate with return on
investments in other enterprises having corresponding
risks." And "should be sufficient to assure confidence in
the financial integrity of the enterprise so as to maintain
its credit and to attract capital."
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Capital Structure



Debt - Includes outstanding mortgage bonds,
debentures, advances from associated
companies and notes
Preferred Stock - Capital stock to which
preferences or special rights attach,
particularly as to dividends and/or proceeds.
Common Equity - The funds invested in the
business by the residual owners whose
claims to income and assets are subordinate
to all other claims
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Capital Structure Ladder
Higher Risk
Common Equity
Preferred Stock
Long Term Debt
Intermediate
Term Debt
Lower Risk
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Short Term Debt
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Process for determining the rate of
return

Determine capital structure (% of common
equity, preferred stock and bonds)

Determine average cost of debt (interest
rate)

Determine return on equity (ROE)

Calculate weighted average cost of capital
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Return on Equity
Methodologies
ROE Determination
Methodologies
Discounted Cash Flow
 Risk Premium
 Capital Asset Pricing Model (CAPM)
 Comparable Earnings

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Discounted Cash Flow
Discounted Cash Flow (DCF) is based on
the assumption that the price of a common
share equals the present value of the sum
of all future income to be received from the
share.
 Also assumes that the dividend payout,
earnings price ratio and growth rate
remain constant over time.

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Discounted Cash Flow
ROE =
D
+ g
P
Where: ROE = Expected return on equity
d = Dividend per share
p = Price of the stock
g = Expected annual growth in
dividend or market price of
the stock
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DCF Estimation

The components of the DCF model can be
estimated as follows:
 the
dividend yield (D/P) can be calculated as
of a particular date (e.g., end of a test year) or
as an average for a period of time (e.g.,
average during the test period), and
 the dividend growth rate can be calculated
using a log-linear regression analysis.
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Numerical Example
ROE =
D
+ g
P
D=Annual Dividend = $2.50
P=Price of Stock = $20
g=growth rate = 3%
ROE = (2.50/20) + .03 = .125 + .03=15.5%
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Risk Premium Approach
The risk premium approach is based on
the theory that the required rate of return
is higher for equity than for debt.
 The differential between the cost of equity
and debt is the required premium for
enticing investors to accept the greater
risk associated with equity.

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Risk Premium Approach
ROE = CD + RP
Where: ROE = Expected return on equity
CD = long term cost of debt
RP = risk premium
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Capital Asset Pricing Model

The Capital Asset Pricing Model (CAPM) is
based on modern investment portfolio theory.
Return on investment consists of two parts:
a
risk free return
 an additional return to compensate for risk.

Risk is measured by comparing the volatility of
return on a utility’s stock with the return in the
market as a whole.
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Capital Asset Pricing Model
ROE = rf +  (rm - rf )
Where: ROE = Expected return on equity
rf = the risk free return
rm = the return on the stock
 = the utility’s beta
coefficient (the utility’s
market risk)
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CAPM Graph
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Comparable Earnings

Also known as comparable industry or
comparable risk

Select a sample of firms believed to be of
comparable risk

Calculate average ROE for this sample of
firms
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Weighted Cost of
Capital
Revenue Requirement
Allowed Rate of Return - example
Common
Equity
Preferred
Stock
Long Term
Debt
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% of
Capitalization
Rate of
Return
Weighted
Return
50%
15%
7.5%
10%
12%
1.2%
40%
8.25%
3.3%
Allowed Rate of Return
12.0%
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Weighted Cost of Capital
Capital
Structure
Rate of
Return
Weighted
Cost
Common Stock
45%
12%
5.40%
Preferred
5%
8%
0.40%
Debt
50%
7%
3.50%
100%
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9.30%
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Gross Up for Taxes
Tax Gross Up

Because the utility must pay state and
federal income taxes on its net earnings,
net earnings must be "grossed-up" for
state and federal taxes so that
shareholders have the opportunity to
earn the allowed rate of return after
corporate income taxes have been paid
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Tax Gross Up Example
Return on equity = 12%
State and federal taxes combined = 42%
Before-tax return on equity =
[.12 / (1-0.42)] = 20.7%
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Weighted Cost of Capital
Grossed Up for Taxes
Capital
Structure
Common Stock
45.00%
Preferred
5.00%
Debt
50.00%
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Rate of Weighted
Return
Cost
20.70%
9.32%
8.00%
0.40%
7.00%
3.50%
13.22%
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Questions?