BOOTH CAMPUT 2015

Cost of Capital

Professor Laurence BoothCIT Chair in Structured FinanceRotman 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?

BOOTH CAMPUT 2015

Graham and Harvey (JFE 2001) Survey

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Estimating Opportunity Costs

 

MRPRK F

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Estimating the Market Risk Premium: Equities over Bonds

• Suppose we assume that the market risk premium is constant

• Have to mimimise estimation risk

• Do not trust any short term equity market risk premium estimate!

tMRPEMRP )(

Equities LTC Bonds2000 7.41 13.642001 -12.57 3.922002 -12.44 10.092003 26.72 8.062004 14.48 8.462005 24.13 15.052006 17.26 3.222007 9.83 3.302008 -33.00 13.652009 35.05 -4.262010 17.61 11.452011 -8.71 18.622012 7.19 4.542013 13.00 -8.42

BOOTH CAMPUT 2015

Annual Returns 1926-2013

Arithmetic is simple average; geometric is compound and OLS is the least squares estimate.Approximately Geometric Mean = Arithmetic Mean - .5*varianceFor example, US variance is about 4%, so AM and GM diverge by about 2%

Canadian and U.S. Risk Premium Data 1926-2013

US Risk Premium estimatesOverall OLS AM GM StdevEquity 10.97 12.05 10.08 20.18Bonds 5.32 5.81 5.41 9.45

Risk Premium 5.65 6.24 4.67

Canadian Risk Premium estimatesOverall OLS AM GM StdevEquity 10.32 11.20 9.56 18.66Bonds 6.01 6.43 6.08 8.92

Risk Premium 4.31 4.77 3.48

BOOTH CAMPUT 2015

US & Canadian Risk Premium

U.S. vs Canada “Risk Premium Estimates”

Equity Bond Risk PremiumAM Returns

US 12.05 5.81 6.24CANADA 11.20 6.43 4.77

Difference 0.84 -0.63 1.47

GM Returns

US 10.08 5.41 4.67CANADA 9.56 6.08 3.48

Difference 0.52 -0.67 1.19

BOOTH CAMPUT 2015

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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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

BOOTH CAMPUT 2015

Utility Risk

Union Actual vs Allowed ROE

8

9

10

11

12

13

14

15

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 over-earning 1.22%, or 2.34% while under settlement!

BOOTH CAMPUT 2015

EGDI Allowed vs Actual ROE

8

9

10

11

12

13

14

15

16

17

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

Utility Market Risk

Average Utility Betas

-0.100

0.000

0.100

0.200

0.300

0.400

0.500

0.600

Jan-

85

Jan-

86

Jan-

87

Jan-

88

Jan-

89

Jan-

90

Jan-

91

Jan-

92

Jan-

93

Jan-

94

Jan-

95

Jan-

96

Jan-

97

Jan-

98

Jan-

99

Jan-

00

Jan-

01

Jan-

02

Jan-

03

Jan-

04

Jan-

05

Jan-

06

Jan-

07

Jan-

08

Jan-

09

Jan-

10

Jan-

11

Jan-

12

Utility beta Utility (No TAU)

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Public Beta Estimates June 2015

Ticker RBC GoogleENBRIDGE ENB 0 -0.19TRANSCANADA TRP 0.23 0.1CANADIAN UTILITIESCU 0.15 0.09TRANSALTA TA 0.23 -0.11EMERA EMA 0.19 0.27FORTIS FTS 0.21 0.16VALENER VNR 0.38 0.21VERESEN VSN 0.4 0.16AVERAGE BETA 0.22 0.09

BOOTH CAMPUT 2015

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

Current RBC 2016 Forecast (June 2015) 3.5% for Canada and 4.25% for US

Canadian Yields since Jan 2008

0

1

2

3

4

5

6

7

8

9

10

1/1/

2008

4/1/

2008

7/1/

2008

10/1

/200

8

1/1/

2009

4/1/

2009

7/1/

2009

10/1

/200

9

1/1/

2010

4/1/

2010

7/1/

2010

10/1

/201

0

1/1/

2011

4/1/

2011

7/1/

2011

10/1

/201

1

1/1/

2012

4/1/

2012

7/1/

2012

10/1

/201

2

1/1/

2013

4/1/

2013

7/1/

2013

10/1

/201

3

1/1/

2014

4/1/

2014

7/1/

2014

10/1

/201

4

1/1/

2015

4/1/

2015

BBB A AA LTC

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Discounted Cash Flow (DCF)

• Implied required rate of return

• 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)

• 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

MRPgPdRDCFCAPM F 1

BOOTH CAMPUT 2015

Negative real bond yields

Very high real bond yields

Difference between Naive DCF and Risk Premium estimates for the Market

-8.00

-6.00

-4.00

-2.00

0.00

2.00

4.00

6.00

8.00

10.00

12.00

1956

M01

1957

M10

1959

M07

1961

M04

1963

M01

1964

M10

1966

M07

1968

M04

1970

M01

1971

M10

1973

M07

1975

M04

1977

M01

1978

M10

1980

M07

1982

M04

1984

M01

1985

M10

1987

M07

1989

M04

1991

M01

1992

M10

1994

M07

1996

M04

1998

M01

1999

M10

2001

M07

2003

M04

2005

M01

2006

M10

2008

M07

2010

M04

2012

M01

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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

Adjustments: A Spreads

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

Default Spreads Since Dec 1979

0

50

100

150

200

250

300

350

400

450

500

12

/31

/19

79

12

/31

/19

80

12

/31

/19

81

12

/31

/19

82

12

/31

/19

83

12

/31

/19

84

12

/31

/19

85

12

/31

/19

86

12

/31

/19

87

12

/31

/19

88

12

/31

/19

89

12

/31

/19

90

12

/31

/19

91

12

/31

/19

92

12

/31

/19

93

12

/31

/19

94

12

/31

/19

95

12

/31

/19

96

12

/31

/19

97

12

/31

/19

98

12

/31

/19

99

12

/31

/20

00

12

/31

/20

01

12

/31

/20

02

12

/31

/20

03

12

/31

/20

04

12

/31

/20

05

12

/31

/20

06

12

/31

/20

07

12

/31

/20

08

12

/31

/20

09

12

/31

/20

10

12

/31

/20

11

12

/31

/20

12

12

/31

/20

13

12

/31

/20

14

AA A BBB

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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.

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Preferred Shares

• Importance:• Tax effects• Pre-tax spread with long Canadas

• Source: BMO Preferred Share Statistics May 31, 2004

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US Operation Twist started August 2011A spreads and preferred share spreads were about the same beforeAfter A spreads the same, but preferred spreads increased

Operation Twist

Preferred and A Spreads

100

150

200

250

300

350

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

/201

011

/1/2

010

12/1

/201

01/

1/20

112/

1/20

113/

1/20

114/

1/20

115/

1/20

116/

1/20

117/

1/20

118/

1/20

119/

1/20

1110

/1/2

011

11/1

/201

112

/1/2

011

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

/201

211

/1/2

012

12/1

/201

21/

1/20

132/

1/20

133/

1/20

134/

1/20

135/

1/20

136/

1/20

137/

1/20

138/

1/20

139/

1/20

1310

/1/2

013

11/1

/201

312

/1/2

013

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

/201

411

/1/2

014

12/1

/201

41/

1/20

152/

1/20

153/

1/20

154/

1/20

155/

1/20

156/

1/20

15

Pref A

BOOTH CAMPUT 2015

Pref-A Spread

-100

-50

0

50

100

150

200

1/1/

2010

3/1/

2010

5/1/

2010

7/1/

2010

9/1/

2010

11/1

/201

0

1/1/

2011

3/1/

2011

5/1/

2011

7/1/

2011

9/1/

2011

11/1

/201

1

1/1/

2012

3/1/

2012

5/1/

2012

7/1/

2012

9/1/

2012

11/1

/201

2

1/1/

2013

3/1/

2013

5/1/

2013

7/1/

2013

9/1/

2013

11/1

/201

3

1/1/

2014

3/1/

2014

5/1/

2014

7/1/

2014

9/1/

2014

11/1

/201

4

1/1/

2015

3/1/

2015

5/1/

2015

Preferred shares are equities and taxed the same Unlike Canada bonds they have not been affected by monetary policy to the same degree

BOOTH CAMPUT 2015

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 CheckInvestment and Speculative TSX Returns back to 1987

ROE Spec TSX1987 11.19 -5.31 5.881988 12.97 -1.89 11.081989 11.79 9.58 21.371990 7.48 -22.28 -14.801991 3.53 8.48 12.021992 1.56 -2.99 -1.431993 3.69 28.86 32.551994 6.57 -6.75 -0.181995 9.55 4.98 14.531996 10.29 18.06 28.351997 10.86 4.12 14.981998 8.83 -10.42 -1.581999 9.82 21.90 31.712000 10.92 -3.51 7.412001 7.41 -19.98 -12.572002 5.68 -18.12 -12.442003 9.64 17.08 26.722004 11.62 2.86 14.482005 12.70 11.43 24.132006 13.96 3.30 17.262007 12.86 -3.03 9.832008 9.44 -42.44 -33.002009 8.06 26.99 35.052010 9.90 7.71 17.612011 9.60 -18.31 -8.712012 10.28 -3.09 7.19

Average 9.24 0.28 9.52volatility 3.07 16.32 16.68

BOOTH CAMPUT 2015

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?