Cost of Capital
Professor Laurence Booth
CIT Chair in Structured Finance
Rotman School of Management
University of Toronto
BOOTH CAMPUT 2015
Overview
•
Can not mechanically do much in finance
• Markets constantly changing
• History “constrains” reasonable values
•
Three iron laws of finance
• Time value of money
• Risk value of money
• Tax value of money
•
Business cycle effects
• Bond and money market spreads
• Equity risk “betas”
•
Government intervention
• Financial principles are “absent a government”
• Fixed income markets have been dominated by the
“global policy maker” (monetary policy) since 2008
• What is the impact on equity markets?
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Graham and Harvey (JFE 2001)
Survey
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Estimating Opportunity Costs
•
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K  RF  MRP
Estimating the Market Risk
Premium: Equities over Bonds
•
Suppose we assume that
the market risk premium is
constant
MRP  E ( MRP )  t
•
•
Have to mimimise
estimation risk
Do not trust any short
term equity market risk
premium estimate!
BOOTH CAMPUT 2015
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
Equities LTC Bonds
7.41
13.64
-12.57
3.92
-12.44
10.09
26.72
8.06
14.48
8.46
24.13
15.05
17.26
3.22
9.83
3.30
-33.00
13.65
35.05
-4.26
17.61
11.45
-8.71
18.79
7.19
4.45
13.00
-8.26
10.55
15.48
Annual Returns 1926-2014
US Risk Premium estimates
Overall
OLS
AM
Equity
10.96
12.06
Bonds
5.37
6.00
Risk Premium
5.59
6.06
GM
10.61
5.85
4.76
Stdev
20.07
9.70
Canadian Risk Premium estimates
Overall
OLS
AM
Equity
10.30
11.20
Bonds
6.07
6.57
Risk Premium
4.24
4.62
GM
10.04
6.52
3.52
Stdev
18.56
8.98
Arithmetic is simple average; geometric is compound and OLS is the least squares estimate.
Approximately Geometric Mean = Arithmetic Mean - .5*variance
For example, US variance is about 4%, so AM and GM diverge by about 2%
BOOTH CAMPUT 2015
US & Canadian Risk Premium
Equity
Bond
MRP
AM Returns
US
Canada
Difference
12.06
11.20
0.87
6.00
6.57
-0.58
6.06
4.62
1.44
GM Returns
US
Canada
Difference
10.61
10.04
0.57
5.85
6.52
-0.67
4.76
3.52
1.24
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Instead of Canadian long term bond yields and returns being
0.63% higher than the US, forecast yields are 0.75% lower.
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Currency Composition of Major Country Reserve Fund Holdings
http://www.imf.org/external/np/sta/cofer/eng/index.htm
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•
Currently outstanding government of Canada
treasury bills and bonds outstanding (June 2015)
is $543.2 billion so foreign government official
holdings are about 22% of the total.
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•
Source June 2015 Financial System Review, Bank
of Canada
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Fernandez Survey
.
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Fernandez 2015 Survey
Survey indicates lower Canadian yields are being offset
by higher Canadian MRP
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Distribution of Market Return
Estimates
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Utility Business Risk
•
Short run
• Ability to earn the allowed ROE
• Return on capital
•
Long run
• Stranded asset risk
• Return of capital
• “I want my money back!” (Greece!)
• More important in low interest
rate environment
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Utility Risk
Union Actual vs Allowed ROE
15
14
13
12
11
10
9
8
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Allow ed
Actual
Weather normalised actual ROE: average overearning 1.22%, or 2.34% while under settlement!
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EGDI Allowed vs Actual ROE
17
16
15
14
13
12
11
10
9
8
1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Allowed
Actual
Like Union Gas this is weather normalised
BOOTH CAMPUT 2015
Utility Business Risk
•
Very little business risk as they almost
always earn their allowed ROE
• Forward test year
• Annual rate hearings
• Deferral accounts
•
•
•
Removal of commodity charge
Weather deferral accounts (FEI, GMI, ATCO)
Major business risk for most utilities is long
run capital recovery:
• Can they recover their investment in rate
base?
• TransCanada 2011/12 Mainline hearing
• Go back to regulator if unanticipated events
(risk) and risk may then be reallocated as
long as there is underlying demand?
BOOTH CAMPUT 2015
Market Risk: Betas
•
Beta measures the extent to which a security
moves with the market.
• Low beta means it is low risk as its risk is mainly
diversifiable
• High beta means it moves much more than the
market both up and down
•
Individual estimates are volatile
• They reflect what happened over the estimation
period
• They change as the impact of special events pass out
of the estimation window
•
•
Always easy to “poke holes” in individual
estimates, which is why we look across time and
use averages
Everyone “adjusts” to get forward estimates, but
no mechanical adjustment works for utilities
BOOTH CAMPUT 2015
-0.2
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Gamma
Beta2
-0.4
Beta1
Gamma is the interest rate sensitivity of utilities. Beta
the market sensitivity
12/31/2013
12/31/2012
12/31/2011
12/31/2010
12/31/2009
12/31/2008
12/31/2007
12/31/2006
12/31/2005
12/31/2004
12/31/2003
12/31/2002
12/31/2001
12/31/2000
12/31/1999
12/31/1998
12/31/1997
12/31/1996
12/31/1995
12/31/1994
12/31/1993
12/31/1992
Utility Market Risk
Utility Betas (new index data)
1
0.8
0.6
0.4
0.2
0
Public Beta Estimates June 2015
Ticker
ENBRIDGE
ENB
TRANSCANADA
TRP
CANADIAN UTILITIES
CU
TRANSALTA
TA
EMERA
EMA
FORTIS
FTS
VALENER
VNR
VERESEN
VSN
AVERAGE BETA
RBC
“average” risk firm has a beta of 1.0
BOOTH CAMPUT 2015
0
0.23
0.15
0.23
0.19
0.21
0.38
0.4
0.22
Google
-0.19
0.1
0.09
-0.11
0.27
0.16
0.21
0.16
0.09
Summary on CAPM Fair ROE
•
•
Current near term forecast LTC bond yields
about 3.0%
Canadian market risk premium
• Typical range 5-6% currently higher due to low
LTC yields
•
Utility risk
• Very low business risk for utilities
• Typical betas are usually in a range 0.45-0.55
•
•
•
•
Add flotation cost to get stock price above book
value: 0.50%
Overall current fair ROE about 6.25%
Current allowed ROEs in the 8.2-8.8% range
(except OEB)
Special factors?
BOOTH CAMPUT 2015
BOOTH CAMPUT 2015
BBB
A
AA
4/1/2015
1/1/2015
10/1/2014
7/1/2014
4/1/2014
1/1/2014
10/1/2013
7/1/2013
4/1/2013
1/1/2013
10/1/2012
7/1/2012
4/1/2012
1/1/2012
10/1/2011
7/1/2011
4/1/2011
1/1/2011
10/1/2010
7/1/2010
4/1/2010
1/1/2010
10/1/2009
7/1/2009
4/1/2009
1/1/2009
10/1/2008
7/1/2008
4/1/2008
1/1/2008
Canadian Yields since Jan 2008
10
9
8
7
6
5
4
3
2
1
0
LTC
Current RBC 2016 Forecast (June 2015) 3.5% for Canada and 4.25% for US
Discounted Cash Flow (DCF)
•
Implied required rate of return
𝒅
• 𝑲=𝑷+𝒈
• Dividend yield plus growth in stock price
(earnings/dividends)
•
•
•
Dividend yield is easily estimated but what
is the forecast growth rate?
By looking at DCF we can check the CAPM
fair ROE
Easiest done by looking at the market:
growth expectations constrained in terms of
growth by GDP!
BOOTH CAMPUT 2015
DCF Checks
•
Equality for the market (beta equals 1.0)
d
CAPM  DCF  RF  1
•
•
P
 g  MRP
We can accurately estimate the LTC bond
yield and the dividend yield on the TSX
Suppose we plug in average real growth of
3.5% and the actual inflation rate and an
average market risk premium of 4% for
naïve estimates for the market
BOOTH CAMPUT 2015
-2.00
-4.00
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-6.00
-8.00
Negative real bond yields
Very high real bond yields
2012M01
2010M04
2008M07
2006M10
2005M01
2003M04
2001M07
1999M10
1998M01
1996M04
1994M07
1992M10
1991M01
1989M04
1987M07
1985M10
1984M01
1982M04
1980M07
1978M10
1977M01
1975M04
1973M07
1971M10
1970M01
1968M04
1966M07
1964M10
1963M01
1961M04
1959M07
1957M10
1956M01
Difference between Naive DCF and Risk Premium estimates for the Market
12.00
10.00
8.00
6.00
4.00
2.00
0.00
Insights
•
•
•
•
DCF estimates exceed risk premium
estimates during high inflation periods or
low real bond yield periods
CAPM estimates exceed DCF estimates
during high real bond yield periods
CAPM may under-estimate fair ROE if you
use current forecast LTC yields, but not as
bad as a year ago
Fernandez indicates that survey
respondents use rates higher than the 10
year forecast rate for their return estimates
BOOTH CAMPUT 2015
BOOTH CAMPUT 2015
AA
A
BBB
A bond yields are just over 1.50% over LTC yields, normally about 1.0%
Credit spreads directly reflect the business cycle, plausibly changes in risk
premiums and the change in the yield on government bonds
12/31/2014
12/31/2013
12/31/2012
12/31/2011
12/31/2010
12/31/2009
12/31/2008
12/31/2007
12/31/2006
12/31/2005
12/31/2004
12/31/2003
12/31/2002
12/31/2001
12/31/2000
12/31/1999
12/31/1998
12/31/1997
12/31/1996
12/31/1995
12/31/1994
12/31/1993
12/31/1992
12/31/1991
12/31/1990
12/31/1989
12/31/1988
12/31/1987
12/31/1986
12/31/1985
12/31/1984
12/31/1983
12/31/1982
12/31/1981
12/31/1980
12/31/1979
Adjustments: A Spreads
Default Spreads Since Dec 1979
500
450
400
350
300
250
200
150
100
50
0
Bank of Canada Research
60% of spread change for A bonds was driven by liquidity and market making
changes. I use 50% of change in credit spreads as a change in the risk premium
conditional on the state of the markets.
BOOTH CAMPUT 2015
Preferred Shares
•
Importance:
• Tax effects
• Pre-tax spread with long Canadas
•
Source: BMO Preferred Share Statistics May 31,
2004
BOOTH CAMPUT 2015
1/1/2010
2/1/2010
3/1/2010
4/1/2010
5/1/2010
6/1/2010
7/1/2010
8/1/2010
9/1/2010
10/1/2010
11/1/2010
12/1/2010
1/1/2011
2/1/2011
3/1/2011
4/1/2011
5/1/2011
6/1/2011
7/1/2011
8/1/2011
9/1/2011
10/1/2011
11/1/2011
12/1/2011
1/1/2012
2/1/2012
3/1/2012
4/1/2012
5/1/2012
6/1/2012
7/1/2012
8/1/2012
9/1/2012
10/1/2012
11/1/2012
12/1/2012
1/1/2013
2/1/2013
3/1/2013
4/1/2013
5/1/2013
6/1/2013
7/1/2013
8/1/2013
9/1/2013
10/1/2013
11/1/2013
12/1/2013
1/1/2014
2/1/2014
3/1/2014
4/1/2014
5/1/2014
6/1/2014
7/1/2014
8/1/2014
9/1/2014
10/1/2014
11/1/2014
12/1/2014
1/1/2015
2/1/2015
3/1/2015
4/1/2015
5/1/2015
6/1/2015
Operation Twist
Preferred and A Spreads
350
300
250
200
150
100
Pref
BOOTH CAMPUT 2015
A
US Operation Twist started August 2011
A spreads and preferred share spreads were about the same before
After A spreads the same, but preferred spreads increased
BOOTH CAMPUT 2015
-50
-100
Preferred shares are equities and taxed the same
Unlike Canada bonds they have not been affected by
monetary policy to the same degree
5/1/2015
3/1/2015
1/1/2015
11/1/2014
9/1/2014
7/1/2014
5/1/2014
3/1/2014
1/1/2014
11/1/2013
9/1/2013
7/1/2013
5/1/2013
3/1/2013
1/1/2013
11/1/2012
9/1/2012
7/1/2012
5/1/2012
3/1/2012
1/1/2012
11/1/2011
9/1/2011
7/1/2011
5/1/2011
3/1/2011
1/1/2011
11/1/2010
9/1/2010
7/1/2010
5/1/2010
3/1/2010
1/1/2010
Pref-A Spread
200
150
100
50
0
Current CAPM Adjustments
•
“A” Spread Adjustment
• Used by many boards
• Add 50% of the change in the A spread to
adjust the utility risk premium
• Adds about 0.30% at the moment
•
Operation Twist
• I use a minimum LTC forecast yield of 4.0%
• Currently adds about 0.80% to the very low
forecast LTC yields.
• Explicitly accepted by BCUC and
Newfoundland PUB
BOOTH CAMPUT 2015
Checks
•
TD Economics October 19, 2012
•
Typical pension fund estimates
Add 1.5% to convert long run (geometric) to
arithmetic and equity market return is about
8.50%: limits the fair ROE for a utility to less than
8.50%
If a DB pension fund could earn the current utility
allowed ROE we wouldn’t have a pension problem
in Canada!
•
•
BOOTH CAMPUT 2015
“The most the owners in aggregate can earn between
now and judgment day is what their businesses in
aggregate earn.(italics in original) True by buying
and selling that is clever or lucky, investor A may
take more than his share of the pie at the expense of
investor B. And yes, all investors feel richer when
stocks soar. But an owner can exit only by having
someone take his place. If one investor sells high,
another must buy high. For owners as a whole,
there is simply no magic - no shower of money from
outer space – that will enable them to extract
wealth from their companies beyond that created by
the companies themselves.”
Warren Buffet
BOOTH CAMPUT 2015
Final Check
Investment and Speculative TSX Returns back to 1987
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Average
volatility
BOOTH CAMPUT 2015
ROE
11.19
12.97
11.79
7.48
3.53
1.56
3.69
6.57
9.55
10.29
10.86
8.83
9.82
10.92
7.41
5.68
9.64
11.62
12.70
13.96
12.86
9.44
8.06
9.90
9.60
10.28
9.24
3.07
Spec
-5.31
-1.89
9.58
-22.28
8.48
-2.99
28.86
-6.75
4.98
18.06
4.12
-10.42
21.90
-3.51
-19.98
-18.12
17.08
2.86
11.43
3.30
-3.03
-42.44
26.99
7.71
-18.31
-3.09
0.28
16.32
TSX
5.88
11.08
21.37
-14.80
12.02
-1.43
32.55
-0.18
14.53
28.35
14.98
-1.58
31.71
7.41
-12.57
-12.44
26.72
14.48
24.13
17.26
9.83
-33.00
35.05
17.61
-8.71
7.19
9.52
16.68
Conclusions
•
Can not mechanically do much in finance
• Markets constantly changing
• History “constrains” reasonable values
•
Three iron laws of finance
• Time value of money
• Risk value of money
• Tax value of money
•
Business cycle effects
• Bond and money market spreads
• Equity risk “betas”
•
Government intervention
• Financial principles are “absent a government”
• Fixed income markets have been dominated by the
“global policy maker” (monetary policy) since 2008
• What is the impact on equity markets?
BOOTH CAMPUT 2015