Financial Aspects

March 3, 2008
ECO 4934: Public Utilities Economics: International Infrastructure

The importance of Financial data

Regulators gather and study financial data to partially overcome the information asymmetry issue. Basically relies on financial statements. Reporting financial, operative and commercial data is mandatory in some countries. For financial data to be reliable it needs to be audited by an auditing firm before reporting it to the regulator The regulator may be allowed to perform some degree of auditing, usually on operating or commercial areas

The importance of financial data is that it is used to calculate the rate base and the rate of allowed return on a Cost of Service/Cost plus regulatory regime.

Some Observations Regarding Financial Aspects

Determining the earnings of the utilitys regulated operations involves the following controversial issues:
asset valuation, assessing the prudency and usefulness of the utilities' expenditures setting depreciation rates determining the treatment of unpaid bills customer or government provided capital imputed revenue.

When determining the earnings for regulated services, the regulator generally allows capital and operating expenses that are prudently incurred i.e. that are cost minimizing given the level of output and service quality required by the market and by regulation and used and useful to be covered by regulated prices (the purchased inputs are used for and needed in providing service). The regulator often allows amounts of unpaid bills to be reflected in prices if the amounts represent normal business experience. The utility generally does not expect all customers to pay their bills the lost of revenue must be recovered elsewhere. If the regulator believes that the operator is not exerting sufficient effort in collecting unpaid bills, they are disallowed.

Asset Valuation
With respect to valuating assets for regulated services (rate base), there are two basic approaches: 1) Cost-based approach (also called original cost or historical cost accounting): values assets at what the utility originally paid for the assets. This is the most common approach used for assessing returns to shareholders. Value-based approaches: approaches a) Fair-value: values the assets based on the profits they can generate for the shareholders. b) Current cost or replacement cost accounting: values assets each year at what it would cost to acquire them that year. year This approach is the most common used for determining economic costs for rate design.

2)

Capital Structure
Refers to the proportions of debt and equity that the utility uses to finance its operations. A firm capital structure varies among countries and industries. Because of tax advantages on debt issuance, it will be cheaper to issue debt rather than new equity. (this is only true for profitable firms, tax breaks are available only to profitable firms). At some point, however, the cost of issuing new debt will be greater than the cost of issuing new equity. This is because adding debt increases the default risk - and thus the interest rate that the company must pay in order to borrow money. By utilizing too much debt in its capital structure, this increased default risk can also drive up the costs for other sources as well. Management must identify the "optimal mix" of financing the capital structure where the cost of capital is minimized so that the firms value can be maximized.

Cost of Capital
How regulators determine whether the operators earnings on the regulated operations are sufficient to attract capital for future investments.
The cost of capital for a firm is calculated as a weighted sum of the cost of equity and the cost of debt (WACC). Firms finance their operations by external financing - issuing stock (equity) and issuing debt and Internal financing, by reinvesting prior earnings. Capital (money) used to fund a business should earn returns for the capital owner who risked their saved money. For an investment to be worthwhile the projected return on capital must be greater than the cost of capital. The cost of debt is composed of the rate of interest paid. In practice, the interest-rate paid by the company will include the risk-free rate plus a risk component, which itself incorporates a probable rate of default (and amount of recovery given default). For companies with similar risk (credit rating) the interest rate is largely exogeneous. \Cost of equity is more challenging to calculate as equity does not pay a set return to its investors. The cost of equity is broadly defined as the risk-weighted projected return required by investors. The cost of equity is therefore inferred by comparing the investment to other investments with similar risk profiles to determine the "market" cost of equity.

Capital Asset Pricing Model

This model is used in finance to determine a theoretically appropriate price of an asset such as a security. The return on an individual stock should equal its cost of capital. The investors would expect (or demand) to receive:

ER = Rf + s (RM-Rf)
ER Rf s RM (RM-Rf) The expected return on investment The risk free rate is taken from the lowest yielding bonds in the particular market The sensitivity to market risk () Expected market return The market premium (varies over time and place)

CAPM's starting point is the risk-free rate (Rf )- typically a 10-year government bond yield. To this is added a premium that equity investors demand to compensate them for the extra risk they accept. This equity-market premium consists of the expected return from the market as a whole less the risk-free rate of return. The equity risk premium is multiplied by a coefficient called beta which is unique for each beta firm/industry and depends on everything starting from management to business and capital structure. It can be estimated from past returns and past experience from similar firms/industries.

Weighted Average Cost of Capital

The Weighted Average Cost of Capital (WACC) is used in finance to measure a firm's cost of capital. The total capital for a firm is the value of its equity (for a firm without outstanding warrants and options, plus the cost of its debt. Notice that the "equity" in the debt to equity ratio is the market value of all equity, not the shareholders' equity on the balance sheet. Calculation of WACC is an iterative procedure which requires estimation of the fair market value of equity capital.

Kc= (1-)Ke+Kd
Where:

Kc Ke Kd D E

The firm weighted cost of capital The debt to capital ratio, D / (D + E) The cost of equity The after tax cost of debt The market value of the firm's debt. The market value of all equity

In writing:

WACC = (1 - debt to capital ratio) * cost of equity + debt to capital ratio * cost of debt

Net Present Value

NPV: The difference between the present value of cash inflows and the present value of cash outflows. NPV is an indicator of how much value an investment or project adds to the value of the firm. The utility uses it to make investment decisions and regulators use it to value cash flows. NPV analysis is sensitive to the reliability of future cash inflows that an investment or project will yield. NPV compares the value of a dollar today to the value of that same dollar in the future, taking inflation and returns into account. If the NPV of a prospective project is positive, it should be accepted.
T

NPV = C0 +
t =1

Ct (1 + r )t

r is the discount rate = the comparative value of a dollar at some future time and its present value; the rate of return that could be earned on an investment in the financial markets with similar risk. A firm's weighted average cost of capital (after tax), WACC, is often used. r represents both the time value of money and the project risk, in other words, r represents what the utility needs to pay both to debt holders and shareholders to obtain capital for this project.