CALCULATION THE REVENUE

REQUIREMENTS

prof. Vidmantas Jankauskas

honorary ERRA member

Budapest, March 6, 2013

Contents

Pricing principles

Revenue requirement (RR) formula and data sources

Cost evaluation

Valuation of the regulatory asset base

(RAB)

Ownership vs lease of assets

Depreciation

Cost of capital

Pricing principles

• consumers want low prices and high

quality

• energy companies want to maximize

their profits

• politicians want low prices (especially

for residential consumers –

voters) but also want to protect

companies – sponsors of election

campaigns

• regulators want fairness – balance

interests of all

Different interests in pricing

Pricing objectives

• least cost

• cost reflection

• cost recovery

• stability of revenues and tariffs

• simplicity and public acceptability

• fairness (no discrimination)

• no cross-subsidies

The regulator should set regulated tariffs for the regulated companies so that the regulated tariffs allow the companies to earn a revenue that covers the “justified

costs” of their operation, that is the costs that are necessary and

unavoidable to provide the regulated service at a predefined level of quality

The main principle of the price

regulation

More principles of tariff regulation

V.Jankauskas 7

• Prices should not endanger financial viability

of regulated companies. All justified costs must be

covered, including opportunity cost of capital assets.

• Price regulation should stimulate more

efficient functioning. Productive and allocative

efficiency are also aimed – incentive price regulation.

• Price regulation should be transparent and

consistent. Simplicity of price structures can establish

trust the regulation.

• Frequent and unexpected interventions

should be avoided. Regulators are always in an

imperfectly informed position.

Cost coverage

• The prices / tariffs set by the regulator

should (just) allow for the recovery of the

justified cost of the activities that fall under

price regulation

• A pre-defined level of service quality

should be guarantied

• Vertically integrated industry: end

customer tariffs should cover the

aggregate justified costs of the whole

value chain (production + net imports +

networks + storage + retail + taxes) 8 V.Jankauskas

Pricing in a competitive market

Wholesale:

Bilateral,

PX

System

use

charges:

Network

use

System

operation

Cross-

border

capacity

use

Retail

margin:

Risk mana-

gement

services

(wholesale,

credit risk)

Final

purchase

price

taxes

+ + =

+

regulated

9 V.Jankauskas

Pricing is a two step procedure

1. Regulator determines the revenue requirements for the regulated company

2. Regulator chooses a tariff structure which allows the company to obtain enough revenues to cover its cost and earn a reasonable return

alternatively

Regulator revises a tariff structure proposed by the company

1.Regulator determines revenue requirements for the regulated company

2.Revenue requirement is spread among the various consumer classes and services that the company sells

3.Actual tariffs charged to consumers are developed

Sometime it is seen as

a three step procedure

An average tariff

V.Jankauskas 12

Average tariff = Revenue requirement

Consumption volume

Both numerator and denominator are forecasted values

Calculation of the revenue requirement

V.Jankauskas 13

Calculating the revenue requirement

V.Jankauskas 14

• Revenue Requirement - total (annual) revenue

which covers the operating expenses (including

depreciation and taxes) of supplier(s) of a given

service or product and ensures (them) a fair rate of

return on assets utilized.

• Setting revenue requirement (RR) can

substantially affect the profitability of the firm as well

as the costs of ratepayers.

• Calculating RR is usually the first step of each

well-known price regulation methodology (cost-plus

regulation, incentive price regulation methods etc).

The main formula

V.Jankauskas 15

Typical formula of revenue requirement (RR) is the

following:

RR = O + D + T + r*B where

RR = Revenue Requirement

O = Operating Expenses

D = Depreciation

T = Taxes

r = allowed rate of return

B = rate base (or regulatory asset base – RAB)

Data collection and analysis: 3 goals

V.Jankauskas 16

• Collection of information (input data) for tariff-setting

• Control and feedback of existing tariffs (support of „on the run” price regulation: X-factor, profit cap, individual cost review)

• Possession of up-to-date data for ongoing issues (debates with firms, questions of politicians and/or consumers, publications)

Financial Statement (annual report) of

a regulated company contains

V.Jankauskas 17

- Balance sheet - statement of the book

value of the company at a particular

date (end of the fiscal year)

- Income statement (profit and loss account):

records revenue and expenses over a

specified period of time

- Cash-flow (CF) statement: refers to the amounts

of cash being received and spent during a

defined period of time

Balance sheet

V.Jankauskas 18

• The only statement which applies to a single point in time, instead of a period of time (also called „snapshot” of the company’s financial condition).

• Classifies company’s worth in two ways: according to time of use (current or fixed assets) and way of finance (shareholders’ equity and liabilities).

• Fixed assets + Current assets = Shareholders’ Equity + Liabilities

Balance sheet of the distribution company VST

as of December 31, 2011

Assets MLTL Liabilities and

equity

MLTL

Fixed assets 2164 Equity 1445

Current assets 188

inventories 10 Liabilities

account

receivables

102 long term 544

securities 62 short term 464

Prepaid expenses 13

TOTAL ASSETS 2454 TOTAL

LIABILITIES and

EQUITY

2454

V.Jankauskas 19 1 € = 3.4528 LTL

Income statement

V.Jankauskas 20

• Income statement records revenue and expenses over a specified period of time

• It indicates how revenue is transformed into net income (result after all revenues and expenses have been accounted for).

• Income statement is a non-cash approach of reporting company’s result

Income statement of the distribution company

VST as of December 31, 2011 Revenues and expenditures MLTL

Total sales 1156

Other revenues 5

Cost of purchased electricity (831)

Labour cost (79)

Depreciation (231)

Other expenses (26)

Operating profit (65)

Financial profit/loss (5)

Profit before taxes (70)

Taxes 13

Net profit (57) V.Jankauskas 21

Cash-flow statement

V.Jankauskas 22

• CF refers to the amounts of cash being received

and spent during a defined period of time. It is used to

determine problems with liquidity.

• Shortage of cash can happen even while company

is profitable (and vice versa)!

• Operational CF: result of the company’s core

business

• Investment CF: result of investments and

acquisitions

• Financing CF: result of financial activities (receiving

or paying loans, issuing stock, paying dividends etc.)

Why is Financial Statement (FS) useful

for regulators?

V.Jankauskas 23

• FS is prepared in accordance with general

accounting rules, enacted by law. Thus reports of

different companies are comparable

• FS is audited by accountants

• FS is not made directly for the regulator, annual

report can be regarded as a real and reliable

publication

• Publicly available for everybody who is interested

in the financial performance of the company

• FS disclose overall picture on economic

performance of the companies

What are the problems with Financial

Statement?

V.Jankauskas 24

• Within general accounting rules companies

are free to evaluate their assets and liabilities

(accounting policies). Thus comparability is

limited.

• FS refers to the whole, usually vertically

integrated company, regulated activities are not

separated.

• FS is prepared and published once a year.

• Regulator’s price regulation policies are not in

line with companies’ internal accounting policies

(problem of reasonable costs and assets).

Therefore Regulator asks for additional

data supplies

• Financial Statement is appropriate for

continuous economic monitoring, and – as a

starting point – for price regulation as well

• Regulator usually asks for additional data

supplies from the regulated companies

• Some balance between the necessity to

understand of operation of the company and not

missing in insurmountable volumes of data

• Regulator should not manage the regulated

company!

V.Jankauskas 25

Example: Lithuanian NCC requires

• Electricity distribution company (distribution

licence holder) should submit the following

reports:

– Quarterly reports

• general

• on quality of service (interruptions, disconnections, etc.)

– Annual reports on

• general activities

• connection of new customers

• connection of renewable generators

• consumer complaints

V.Jankauskas 26

More problems with data

• Shared and centralized services within the

vertically integrated holding (IT, legal services,

accounting etc.)

• Regulatory tasks and competences concerning

outsourcings

• Market-based pricing of outsourced services

and acceptance by the Regulator

• Tariff-increase because of structural changes?

V.Jankauskas 27

Asymmetry of information

28

Regulator Regulated

company

Decisions to be

made on the basis

of best available

information

Distort information

in order to serve the

profitability

objective

(shareholders

interest) V.Jankauskas

Cost (operating expenses)

evaluation

V.Jankauskas 29

Operating expenses

V.Jankauskas 30

• Operating expenses (costs) (O) are related to operating and maintaining the utility plant and providing the utility services

• Main items are:

- Fuel (generation)

- Purchased power (wholesale and retail supply)

- Maintenance (generation, transmission- distribution)

- Labour costs (staff expenses).

- Services

Cost allocation

V.Jankauskas 31

• Operating expenses(O) are related to

operating and maintaining the utility plant and

providing the utility services

- O&M (Operations and Maintenance) costs

can be directly assigned to particular

operating functions

- A&G(Administrative and General) costs

have to be distributed among operating

activities –indirect costs

Cost of network losses

• Technical losses – losses associated with

the transmission and distribution of

electricity

• Non-technical (commercial) losses –

losses due stealing energy and losses due

to accidents

• Influencing factors:

– quantity (or percentage)

– average price of electricity

V.Jankauskas 32

Example: electricity distribution losses in

Hungary

0

2

4

6

8

10

12

14

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

set by HEO

real

V.Jankauskas 33

Necessary costs

• Regulator will accept only reasonable and

necessary costs in calculation of the Revenue

Requirement

• How to know if certain costs are reasonable and

necessary?

• Benchmarking if there are several similar

companies (e.g. electricity distribution)

• International benchmarking may give some

comparison, but due to different legal

background it could also mislead

V.Jankauskas 34

Historic data

• Historic data is very useful for understanding the

costs’ levels as also their development

• But one should ask if company was managed

and operated efficiently

• When setting tariffs regulator needs to evaluate

the future costs, therefore some forecasts should

be calculated

• The forecasts should evaluate the historic trends,

current developments and make comparisons

with such costs elements of similar companies

V.Jankauskas 35

Normative values

• Some regulators are trying to give a scientific

justification to almost all cost elements –

theoretical values are calculated based on

complicated formulas and assumptions

• Though it is rather popular, especially in the CIS

countries, one should understand that theory

may significantly differ from reality

• Therefore, theoretical normative values may be

used as benchmarks only

• Price regulation is more art than science

V.Jankauskas 36

RAB calculation

V.Jankauskas 37

• RAB usually refers to the measure of the net

value of a company’s regulated assets used in

price regulation

• RAB drives two of the fundamental building

blocks that make up the company’s revenue

requirements:

– the return on capital (i.e. the return on the RAB) and

– the depreciation allowance

• RAB is a key determinant of prices that may be

charged for regulated services in the future

V.Jankauskas 38

Regulatory asset base (RAB)

RAB initial value

V.Jankauskas 39

RAB is compilation and summation of the

assets used in providing the regulated service

• generally only includes those assets funded with

investor money

• regulators do not generally recognise intangible

assets such as goodwill

• RAB should include the assets used for the

provision of the regulated services only

• excludes customer contributed assets

RAB is the investment base upon which the

provider is permitted to earn a reasonable

return

Fair value of RAB

V.Jankauskas 40

provision of certainty for investors

provision of incentives for investors

fairness - including:

• sharing benefits between investors

and customers

• continuity of initial price level for social

reasons

provision of correct price signals for

consumption, investment etc.

interpretation of the regulatory ‘contract’ - in

what state are assets expected to be kept?

RAB calculation

V.Jankauskas 41

Opening

value

Prudent

capital

expen-

ditures

Asset

disposals

or retire-

ments

Regul.

accumu-

lated

depre-

ciation

Net

asset

balance + - - =

RAB calculation: net approach

V.Jankauskas 42

The regulatory asset base for the year t is calculated according to the

following formula:

CB = OB + Inv - D - AD - DC + DWC

where: OB - opening value of regulatory assets for year t of the

regulatory period;

Inv - investment (capital expenditures) for year t of the

regulatory period;

D - depreciation for year t of regulatory period;

AD - assets disposal for year t of regulatory period;

DC - annual change over year t in the value of assets funded

by capital contributions;

DWC - annual change over year t in working capital;

CB - closing value of regulatory assets for year t of the

regulatory period

RAB calculation: gross approach

V.Jankauskas 43

The closing value of the RAB for year t of

regulatory period might be expressed by the

following formula:

CB = CFA - CCC – CWC

where:

CFA = OFA + Inv - D - AD

CB - closing value of regulatory assets for year t of

regulatory period;

CFA - closing value of fixed assets for year t of

regulatory period;

CCC - closing value of capital contribution;

CWC - closing value of working capital

• Capital contributions comprise of:

– grants obtained from international institutions and/or

the government and

– direct payments by the user of a specific service for

an asset, e.g. connection payments

• The assets financed by the capital contributions

should be excluded from the RAB

• Therefore, it is necessary to disclose the values

of capital contributions (for existing assets and

for new investments) in order to ensure

transparency of the process

V.Jankauskas 44

Capital contributions

Regulators should require that

V.Jankauskas 45

The net asset value of capital contributions

and the relevant accumulated depreciation

should be shown separately on the balance

sheet for each energy activity;

Capital contributions should be split into those

associated with grants, connection

contributions and other capital contributions;

Where exact splits cannot be identified the

regulated companies should provide estimates

as well as an explanation of the methodology

adopted and why it is considered appropriate

• To the extent that the time at which a particular

cost is incurred is not matched with its recovery

(via tariff revenues), then capital is required to

cover the time lag – working capital

• An investment in working capital is a necessary

part of conducting a regulated business

• In addition, there is also place for a return on the

working capital similar to the requirement for a

return on capital assets

V.Jankauskas 46

Working capital

• There are different approaches for working

capital treatment in the regulatory price control

• In general, regulators want to give companies an

incentive to manage working capital well

• The USA regulatory practices use cash cycle

method called lead-lag approach.

• Some Eastern European (Bulgaria, Romania)

regulators allow working capital allowance set

equal to 1/8 of the revenue requirements

V.Jankauskas 47

Working capital – regulatory

treatment

• Most of the regulators think that new capital

expenditure should be introduced in the RAB on

the basis of actual costs incurred up to the point

at which the assets become operational

• Some regulators include construction work in

progress in the RAB when construction is to be

completed within a relatively short period of time,

e.g. in one year

• There is also the question of prudent investment

when considering whether the full cost of new

investment should be added to the RAB

V.Jankauskas 48

Construction work in progress

(CWIP)

• Different type of investments

– extension investments: all investments needed for

meeting the change of load and generation patterns

in the future

– replacement investments: all investments related to

replacement of aged (technically or economically)

equipment

– exceptional investments: investment resulting from

e.g. new legal obligations.

• Some investments could be both for network

extension and for replacement reasons (e.g.

replacement of an old transformer with a new

one but more powerful) V.Jankauskas 49

New investments

• Information asymmetry – company always

knows better than the Regulator

• The regulator will not accurately know the

appropriate amount of capital expenditure

required by the regulated service providers

• In this case there may be incentives for the

regulated entity to inflate the reported capital

expenditure relative to the true cost

• Investments may be examined from two

perspectives: ex-ante and ex-post

V.Jankauskas 50

Regulatory asymmetry

Ex-post assessment of investments

• Ex-post assessment may be undertaken to supplement the ex-ante investment reviews

• Regulators aim to identify differences between the

capital expenditures allowed in the ex-ante review

and the actual investments undertaken by the

regulated company

• Regulatory ex-post checks can also be undertaken

without any previous ex-ante approval of the

investments

• In this case, the companies are confronted with the

uncertainty of whether the undertaken investments

will be recognised by the regulator ex-post.

• Regulator needs to consider whether the

company’s assets are sufficient to carry the

regulated activity

• On the other hand, if a regulated company has

excessive number of assets the regulator may

decide not to include these assets into the RAB

• Although the assets are being “used” the

question is whether they are actually “useful”

V.Jankauskas 52

Used and useful concept

Asset valuation

V.Jankauskas 53

Asset valuation options

V.Jankauskas 54

Asset valuation

Economic

valuation Market valuation Book valuation

Historic cost

Current

cost Current

Re-

valued

initial

Net

present

value

Indexed

historic

value

Modern

equivalent

asset

• The historic cost methodology values

assets at their original purchase price

• It has several advantages:

– it is administratively efficient and can be easily

audited because the data should be available

from financial statements;

– it is relatively inexpensive since it does not

require experts to determine costs;

– and it is objective because it relies on actual

data rather than judgements

V.Jankauskas 55

Historic cost

• Historic costs may understate asset prices in

times of high inflation and overstate asset prices

in times of technological change

• this method may lead to unstable prices (e.g.

prices may rise when new, more expensive

assets replace existing assets)

• data may be inadequate (especially for assets

that have been acquired a long time ago) and

returns may also be inadequate to support the

funding of new investments

V.Jankauskas 56

Historic cost - disadvantages

• This is the procedure for adjusting the

value of the asset base for the effect of

inflation

• Indexation should measure movements in

the current replacement cost of the assets

• Consumer price index or industrial price

index?

• A set of industry-based indices would be

more accurate but too complex

V.Jankauskas 57

Indexation

• Calculates the cost of replacing an asset

with another asset (not necessarily the

same) that will provide the same services

and capacity as the existing asset

• The assets are valued based on what it

would cost to replace them today

• Replacement costs reflect the price that a

firm with a certain service requirement

would pay for existing assets in preference

to replicating the assets

V.Jankauskas 58

Replacement cost

Replacement cost advantages and

disadvantages Advantages

• provide an incentive for

efficient investment

decisions as it allows the

regulator to reduce the

value of the assets once it

becomes aware that a more

efficient low cost alternative

asset is available

• this reduces the risk of

economically inefficient

duplication of infrastructure

• replacement cost

valuations entail a

degree of estimation and

judgment

• the information is more

expensive to collect than

historic cost data

because it may require

expert advice

V.Jankauskas 59

Disadvantages

• Sum of the prices that would be obtained

from selling each of the assets in a

competitive market

• What a third party would pay in an arm’s

length transaction

• Difficult if no active market, especially for

large, specialised items

• Romanian example

V.Jankauskas 60

Fair market value

• Sum of the discounted cash flows

associated with each asset

• Predict the cash flows expected to be

generated, then discount it back to present

values using appropriate risk-adjusted

discount rate

• Discount rate is often a key determinant of

the result

V.Jankauskas 61

Net present value

• In many CEE countries assets of the energy

companies were not properly valued, historic

cost was very low

• Indexations were not sufficient and many

countries introduced the replacement cost

principle for re-evaluation

• E.g. in Romania asset value of the distribution

companies after the re-evaluation increased

from 3 to 7 times

• But it was impossible to put it into the revenue

requirement V.Jankauskas 62

Valuation of assets in the CEE

countries

Bad example: Lithuania

• One of the two distribution companies (0.7 million customers) was privatised in 2003 by the local biggest retailer

• Competitive process, good price, but…

• Law on Electricity was amended after the privatisation, in 2004

• Assets were re-valued in 2004, increasing their value by factor 3

• Consequently tariffs were raised

• Result: consumers complaining that the private investor caused such an increase of tariffs

Privatisation of the distribution utilities in

Bulgaria, Romania and Macedonia has shown

that

– necessary to increase the asset value before the

privatisation as it was usually kept too low

– could be too painful to switch to the replacement

value of assets

– therefore it is important to agree on the re-

valuation of assets before the privatisation and on

their further regulatory treatment

– Romania agreed on the market value

V.Jankauskas 64

Lessons from the CEE countries

Example: RAB calculation in some

CEE countries

Country CWIP

included

CC included Assets

value

Revaluation

Bulgaria no yes historic yes

Croatia yes no historic no

Estonia no no historic yes

Hungary no no replacement yes

Lithuania no no replacement yes

Serbia yes no historic yes

Slovakia yes no replacement yes

65

Ownership vs lease of the assets

V.Jankauskas 66

• Companies often choose to lease long-

term assets rather than buy them for a

variety of reasons:

– the tax benefits are greater to the lessor than

the lessees

– leases offer more flexibility in terms of

adjusting to changes in technology and

capacity needs and so on

V.Jankauskas 67

Lease of the assets

Ownership of the assets

Advantages

• Outright asset ownership

• Assets can be modified at

any stage to suit

changing business

requirements

• Asset can be replaced or

disposed of at any time

Disadvantages

• Major capital outlay up-

front

• Entity incurs maintenance

and repairs costs which

typically increase as

assets age

• Entity incurs costs for the

replacement or disposal

of assets at the end of

their useful lives

V.Jankauskas 68

Lease of the assets

Advantages

• Cash-flow effective method

for gaining access to assets

as no major capital outlay

up-front

• Assets may be replaced

more frequently, allowing

the entity access to latest

technology for no additional

cost

• Possible access to

knowledge, purchasing

power and discounts offered

by the lessor

Disadvantages

• Assets may not be able to

be modified and replaced

to suit changing business

requirements without

lessor approval and

attracting fees

• Potential capital outlay at

the end of the lease term

if purchasing the asset at

the end of the lease

V.Jankauskas 69

• The decision to either lease an asset or

purchase it requires an analysis of the

financial implications of the decision also

• Financial parameters, such as the interest

rate as well as the implied opportunity cost

of using the entity's own cash resources,

may have a significant impact on the lease

versus purchase decision

V.Jankauskas 70

Financial implications

Depreciation

V.Jankauskas 71

• The normal usage of assets involves a reduction in

their ability to provide a service

• This “consumption” of the asset’s value should be

reflected in the operating costs and capital value of

the company

• When determining a depreciation charge there are

similar objectives to those for the RAB

• Is also a desire for equity - consumers should pay a

fair cost for the assets that they are consuming

• However, since assets often have a longer life than

the consumers there may be a strong inter-

generational equity question

V.Jankauskas 72

Depreciation

• Options to consider include:

– current cost depreciation;

– historic cost depreciation;

– depreciation of the initial RAB plus separate

depreciation of new investment; and

– an infrastructure renewals charge

• Each option effectively impacts on the allocation

of depreciation charges between existing and

future assets since it alters the level of assets

that are presumed to be kept in perpetuity

V.Jankauskas 73

Approaches to depreciation

• Yearly value of depreciation depends on

company’s depreciation policy

• Straight line (linear), non-linear, normal,

extraordinary, time proportionate, performance

related types of depreciation are available

• Accounting, taxation and regulatory depreciation

requirements usually deviate from each other

• All assets should be depreciated with the

exception of land and construction work in

progress

V.Jankauskas 74

Depreciation value

Asset group Life time of a new asset

(years)

High voltage lines

35

Medium voltage lines 30

Low voltage lines 25

Transformers 25-30

Buildings 50

Vehicles 8

V.Jankauskas 75

Example: useful life times for calculation

depreciation

Rate of return

V.Jankauskas 76

• The forecast level of profit (rate of return)

that a company should be able to earn

depends on:

– the value of the company (the RAB) and

– the forecast rate of return (weighted average

cost of capital)

• Is needed whether using incentive-based

or rate of return type regulation

V.Jankauskas 77

Required profit

• Rate of return (r) is the expected yield from the

company (industry), taking into account the

costs of financing the business (cost of capital)

• The cost of capital is usually measured as the

Weighted Average Cost of Capital (WACC)

• The r sets the return that can be earned on:

– existing assets and

– net investment

• This is a mixture of debt and equity

V.Jankauskas 78

Rate of return

Rate of return

V.Jankauskas 79

Equity Debt

Equity holders are

„residual claimants”

on the revenues – the

rest after all payment

obligations are

allocated to them

Debt providers

require a fixed

interest rate on

their investments

Returns of other possible

investments with similar risks

(opportunity cost)

Interest

expenses

Capital gearing ratio

• It is a financial ratio that compares some form

of owner's equity (or capital) to borrowed funds

• Gearing is a measure of financial leverage,

demonstrating the degree to which a firm's

activities are funded by owner's funds versus

creditor's fund

• The share of borrowed funds my differ from

30% in the Czech Republic to 70% in Austria

(by assumptions of national regulators)

V.Jankauskas 80

Weighted average cost of capital

V.Jankauskas 81

𝑾𝑨𝑪𝑪 = 𝒓𝒆𝑬

𝑬 + 𝑫+ 𝒓𝒅(𝟏 + 𝒕)

𝑫

𝑬 + 𝑫

where

re = required rate of return on equity

rd = rate of return on debt

E = equity

D = debt

t = corporate tax rate

Different tax rates in the EU countries

0

5

10

15

20

25

30

35

40

2009

V.Jankauskas 82

%

Example: Hungarian WACC, distribution network tariffs, 2009

V.Jankauskas 83

Before tax

WACC = (8,92 % * 0,55) + (6,4 % * 0,45) =

= 7,79 %

C.Kovacs

Example: Armenian WACC, distribution network tariffs, 2011

V.Jankauskas 84

Before tax

WACC = (17 % * 0,50) + (7 % * 0,50) = 12 %

A.Arshakyan

0

1

2

3

4

5

6

7

8

9

10

%

V.Jankauskas 85

WACC of some European TSOs

• This is the cost of borrowing funds for the

company from the debt markets

• Could be estimated by considering the

Eurobond markets

• May not be available to most of the companies,

but is the key market for determining the cost of

funds

• The cost of debt is defined as a risk-free rate

plus a company premium

• Reality check is to consider the actual cost of

borrowing and determine financial indicators V.Jankauskas 86

The cost of debt

• The cost of equity (re) is usually is

determined with the Capital Asset Pricing

Model (CAPM)

re = rf + β(rm-rf)

where

re = required rate of return on equity

rf = risk free rate of return (e.g. treasury bills)

β = Beta, the relative volatility of the specific

stock to the market

rm = market risk

V.Jankauskas 87

The cost of equity

Beta (β)

V.Jankauskas 88

• Beta is a measure of the relative riskiness of the

company, with respect to unavoidable risk

• So, beta is a scalar applied to the equity risk

premium

• The value used in the calculation is the equity beta

• This measures:

– underlying business risk (referred to as the asset beta); and

– financial risk (arising from the debt-equity structure)

• So, although two companies have the same business

risk, if they have different gearing levels then the

equity beta will be different

• Political risk factors

– existence of special taxes, restriction on fund transfers,

protection of local firms, etc.

– bureaucracy

– corruption

• Financial risk factors

– interest rate

– inflation

– exchange rate

– economy growth

• To every factor corresponding rating and weight are

assumed

V.Jankauskas 89

The country risk calculation

Example: Hungarian WACC, distribution network tariffs, 2009

V.Jankauskas 90

After tax

re = 4,6 + 0,43 * 5,9 = 7,14 %

Before tax

re = 7,14/(1-0,2) = 8,92 %

C. Kovacs

Hungarian example

V.Jankauskas 91

Compo-

nents

1997-

2000

2001-2004 2005-2008 2009-2012

Market

model

Single

buyer

Single

buyer/

hybrid

Hybrid/

Compe-

titive

Compe-

titive

Pricing

model

Cost plus

and price

cap

Cost plus

and price

cap

Cost plus

and price

cap

Cost plus

and price

cap

Rate base Equity Book value Replace-

ment value

Replace-

ment value

Rate of

return

8% 9,8% 7,1% 7,8%

V.Jankauskas 92

Development of price regulation in

Hungary

P.Kaderjak

Compo-

nents

1997-

2000

2001-2004 2005-2008 2009-2012

Calcu-

lation of r

Internat.

bench-

mark

Risk free +

premium

WACC

WACC

Depreci-

ation

Law on

Taxation

Law on

Taxation

Useful life

time

Useful life

time

Inflation IPI*k CPI*k CPI-k CPI-k

k 0,85-0.95 0,7-0,9 1,8-2,2 0,7-2,3

Network

losses

12% 10,8% 8,7% 8,3%

V.Jankauskas 93

Development of price regulation in

Hungary

P.Kaderjak

Thank you for your attention