Download Table of Contents - Maryland Public Service Commission

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Table of Contents
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Description
Page No.
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Table of Contents
1
7
Introduction
3
8
Summary
5
9
Risks
9
10
The DCF Methodology
12
11
Capital Structure
16
12
Weighted Average Cost of Capital
18
13
Cost of Equity Capital
18
14
Comments
23
15
Appendix
16
Exhibits CAL-1 - 6
17
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BEFORE THE
MARYLAND PUBLIC SERVICE COMMISSION
Testimony of CHARLES A. LARSON
CASE NO. 8829
INTRODUCTION
Q.
12
PLEASE
STATE
YOUR
NAME,
OCCUPATION
AND
BUSINESS
a
financial
ADDRESS?
13
14
A.
My
name
is
Charles
A.
Larson.
I
am
15
analyst for the Rate Research and Economics Division,
16
Public Service Commission of Maryland
17
6 St. Paul Street, Baltimore, Maryland, 21202.
with offices at
18
19
Q.
20
PLEASE
OUTLINE
YOUR
EDUCATIONAL
BACKGROUND
AND
EXPERIENCE?
21
22
A.
From
the
University
of
Wisconsin
I
received
my
23
Bachelor of Science degree in electrical engineering
24
in
25
Administration with majors in public utility economics
26
and
27
completed my studies in advanced accounting (Masters
28
Equivalent)
29
completed my residence requirements for a Ph.D. degree
1948
and
management
in
my
in
Masters
1950.
1957.
At
At
3
degree
Denver
New
York
in
Business
University
University
I
I
1
in finance, economics, accounting and statistics in
2
1959.
3
natural
gas
and
petroleum
engineering
by
Professor
4
Botset,
who
was
Dean
the
of
Petroleum
5
Engineering at the University of Pittsburgh.
6
During the 1960’s I was privately tutored in
of
School
After serving three years in the U.S. Navy as an
7
air intelligence officer, air
controller, and watch
8
officer, I became a system planning engineer with the
9
Wisconsin Electric Cooperative in Madison, Wisconsin
10
in 1947.
11
for Middle West Service Company, a firm of management
12
consultants in Chicago, Illinois serving electric and
13
gas utilities.
14
Colorado working as a rate analyst for Public Service
15
Company
16
distribution company.
After that I worked two years
17
in
an
18
Electric
19
nation’s electric power companies.
Starting in 1959,
20
I
Economic
21
Associates (NERA), a firm of consulting economists in
22
New York City followed by four years working as a
23
consultant
24
Services, Inc., a firm of management consultants in
New
During 1950-4, I worked as a rate engineer
of
Colorado,
York
worked
Then I spent two years in Denver,
City
as
Institute,
ten
years
and
a
a
and
for
National
for
electric
the
association
President
4
gas
economist
trade
for
Vice
local
Edison
for
the
Research
Commonwealth
1
Washington, DC.
2
1970’s I was a consultant and Senior Vice President
3
with
4
engineering consultants in Washington, DC.
5
became President of Consulting Services Inc., a firm
6
of
7
Washington, DC continuing to make studies and testify
8
on rate of return and other matters.
9
retired working as the manager of a horse farm in
Zinder
economic
Then for about ten years during the
Companies,
and
firm
engineering
and
economic
consultants
In 1980, I
located
in
In 1990 I semi-
11
environmental consulting.
In 1995, I was employed at
12
my
Regulatory
13
specialties in Cost
14
and Depreciation Systems.
15
and experience is shown in Appendix A.
as
business
and
Edgewater,
position
doing
of
10
present
MD
a
appraising
Economist
and
with
of Capital, Financial Analysis,
My depreciation education
16
17
SUMMARY
18
19
Q.
20
WHAT IS THE PURPOSE OF YOUR TESTIMONY IN THE PRESENT
PROCEEDINGS?
21
22
23
A.
I will recommend a rate of return on rate base for
Baltimore Gas and Electric Company (BGE), and comment
5
1
on
the
testimony
2
sponsored by BGE.
and
exhibits
of
certain
witnesses
3
4
Q.
PLEASE EXPLAIN HOW YOUR TESTIMONY WILL BE PRESENTED.
A.
First, I will evaluate the financial, business, and
5
6
7
economic risks for BGE.
Second, I will describe the
8
DCF methodology which I employ.
9
structure will be analyzed.
Third, BGE's capital
Fourth, I will determine
10
BGE's weighted average cost of capital.
11
cost
12
DCF/IRR
13
certain statements made by certain witnesses of BGE.
of
equity
will
methodology.
be
determined
Finally,
I
Fifth, BGE's
employing
will
the
comment
on
14
15
Q.
16
PLEASE
SUMMARIZE
YOUR
CONCLUSIONS
CONCERNING
THE
climate,
the
REQUIRED RATE OF RETURN FOR BGE.
17
18
A.
Considering
the
present
economic
19
financial condition and position of BGE vis-a-vis the
20
national and state financial and economic markets, I
21
conclude that a reasonable overall rate of return on
22
BGE's 1999 rate base should be in the range of 8.2% to
23
9.2%.
24
because, at this time, expected inflation is zero or
25
negative.
I
am
recommending
the
lower
range
of
8.2%
This 8.2% overall rate of return is based,
6
1
in
part,
on
a
recommended
adjusted
market
cost
2
equity capital of 10.3% as shown in Exhibit CAL-1A.
of
3
4
Q.
5
CAN
YOU
QUICKLY
EXPLAIN
THE
DERIVATION
OF
YOUR
RECOMMENDED 8.2% OVERALL RATE OF RETURN ON RATE BASE?
6
7
A.
Yes.
As shown in Exhibit CAL-1, the overall cost of
8
capital for BGE is 8.7%
However, deducting 100 basis
9
points from BGE’s market cost of equity capital of
10
11.3% results in a recommended 10.3% cost of equity.
11
This lower cost of equity results in an overall rate
12
of return on rate base of 8.2% as shown in Exhibit
13
CAL-1A.
14
15
The
downward
16
points reflects BGE’s Rider 8 Monthly Rate Adjustment,
17
which
18
predictable.
19
Company its allowed revenues, plus the revenues from
20
the addition of new customers.
21
revenue
22
Rider 8, reduces BGE’s risks and makes its stock more
23
valuable.
24
similar
makes
adjustment
BGE’s
Rider
uncertainty
to
gas
from
market
revenues
8
highly
effectively
and
by
100
basis
stable
and
guarantees
the
The elimination of
volatility,
as
a
result
of
The reduced risk for BGE stockholders is
the
spreads
7
between
bonds
of
different
1
ratings.
BGE
is
unique
in
this
regard
2
investor recognizes BGE’s much lower risks.
and
the
3
4
Additionally,
5
adjustment of 20 –30 basis points to BGE’s cost of
6
equity
7
interruptible customers.
8
not
9
recommend such an adjustment at this time.
be
if
I
BGE
considered
is
implemented
granted
making
demand
a
downward
rates
for
its
However, since this rate may
for
several
years,
I
do
not
10
11
Q.
12
PLEASE
EXPLAIN
THE
BASIS
FOR
THE
UPPER
RANGE
OF
REASONABLENESS FOR BGE’S OVERALL COST OF CAPITAL.
13
14
A.
BGE investors have subjected themselves to the risks
15
of
inflation.
16
fairly compensate BGE’s investors for this exogenous
17
risk that I will discuss infra.
18
Commission believes that there will be 3% inflation
19
during
20
consider allowing BGE the upper range of 9.2% rate of
21
return on its investment.
the
next
Accordingly,
three
or
the
four
Commission
should
For example, if the
years,
they
should
22
23
24
Q.
WOULD A 3% ESTIMATE OF INFLATION BE REALISTIC AT THIS
TIME?
8
1
2
A.
No.
That
was
how
a
the
hypothetical
upper
range
situation
of
9.2%
that
3
demonstrates
might
be
4
achieved.
5
percent inflation factor might be realistic because it
6
would reflect the current inflation rate.
7
one-half
8
reflective of an overall rate of return on rate base
9
of 8.7%.
However, a one percent or one and one-half
percent
rate
of
future
A one and
inflation
would
be
10
11
RISKS
12
13
Q.
14
PLEASE
EXPLAIN
WHAT
FINANCIAL
RISKS
SHOULD
BE
CONSIDERED FOR THE FUTURE.
15
16
A.
Financial risks for the most part should be considered
17
in light of the national and international money and
18
investment markets.
19
are falling, an analyst
20
how intensely the regulated company can avail itself
21
to such future market conditions.
For example, if interest rates
should determine if, when and
22
23
24
Q.
PLEASE EXPLAIN WHAT ECONOMIC RISKS SHOULD BE EVALUATED
BY THE FINANCIAL ANALYST.
9
1
A.
Economic
risks,
like
financial
risks,
are
mostly
2
exogenous meaning that they are usually imposed on a
3
company rather than being initiated by
4
Thus, if the country is experiencing high inflation,
5
the financial analyst should study the impact of such
6
economic factors on the regulated company.
7
hand,
8
increase faster than its costs.
9
inflation is compounding the growth in net income as
inflation
may
cause
a
a company.
company’s
On the one
revenue
to
In that situation
10
the company grows.
11
is also being impacted by that inflation.
12
other hand, if the impact of inflation is primarily on
13
the
14
slowing down, diversifying or otherwise attempting to
15
avoid a direct and heavy impact from inflation.
operating
However, the company’s net income
costs,
the
company
On the
should
consider
16
17
Q.
18
PLEASE
EXPLAIN
WHAT
YOU
MEAN
WHEN
YOU
REFER
TO
BUSINESS RISKS.
19
20
A.
One of the major business risks today is that from
21
competition.
A
22
competitive
advantage
23
share
24
uncontrollably
of
the
company
it
market.
must
has
When
in
maintain
order
market
to
shares
whatever
keep
its
decline
the business is inexorably headed for
10
1
disaster.
2
management of a company.
3
allows
4
company could be forced out of business for lack of an
5
adequate
6
regulated
7
business shielded from competition.
8
to
9
future.
be
Also, business risks can be caused by the
its
a
operations
return
on
utilities
For instance, if a company
to
its
become
investment.
have
distribution
inefficient,
a
major
monopolist
Of
part
the
course,
of
their
BGE will continue
for
the
forseeable
10
11
Q.
WHAT IS AN EXAMPLE OF OTHER RISKS?
A.
A good example of other risks today would be the risks
12
13
14
from
government
regulation
15
example, the the Clean Air Act, although endorsed by
16
business interests, can strain an individual company’s
17
resources
18
financial
19
which
20
adversely.
under
analysts
might
some
restrictions.
applications.
must
affect
and
a
be
aware
company’s
For
Accordingly,
of
any
future
conditions
earnings
21
22
Also, if regulatory lag can be ameliorated risks will
23
be reduced.
24
11
1
DCF METHODOLOGY
2
3
Q.
WHAT IS YOUR APPROACH TO THE DETERMINATION OF A FAIR
4
AND REASONABLE RATE OF RETURN ON COMMON EQUITY CAPITAL
5
FOR BGE?
6
7
A.
As
has
been
generally
accepted
in
the
field
of
8
government regulation, I employ the discounted cash
9
flow rate of return model in order to ascertain what
10
would
be
a
fair
and
reasonable
11
common equity capital for
rate
of
return
on
BGE.
12
13
Q.
WHAT
IS
THE
GENERAL
THEORY
IN
SUPPORT
OF
THE
14
DISCOUNTED CASH FLOW METHOD OF DETERMINING A RATE OF
15
RETURN ON EQUITY CAPITAL FOR REGULATED UTILITIES?
16
17
A.
The general theory is that the investor expects that
18
the earnings on his/her investment in the near-term
19
future after discounting cash receipts
20
time will be
21
considering the most likely risks and uncertainties of
22
that investment.
23
know how much cash dividends or their equivalent can
24
be
expected
to the present
equal to his/her desired cost of capital
in
Specifically, the investor wants to
the
future
12
and
how
much
capital
1
appreciation can be expected when that investment is
2
sold.
3
past record in order to forecast the future.
4
record of a company is a good starting point for such
5
a determination.
6
request
7
financial track record of a prospective investment.
8
That review will encompass at a minimum the company’s
9
dividend and stock price data for a number of past
Accordingly, the investor examines the stock’s
of
a
The past
Thus, the financial analyst at the
potential
investor
will
examine
the
10
years both as to level and trend.
11
also
12
dividends as well as to estimate the probabilities of
13
enhanced stock value during the period (horizon) that
14
the investor plans to hold the stock.
analyze
the
company’s
The analyst will
potential
for
paying
15
16
Q.
17
WHAT IS THE MATHEMATICAL FORMULA FOR THE TRADITIONAL
DCF METHOD?
18
19
A.
The mathematical formula traditionally used is shown
20
below:
The formula
is from page 178 of the text
21
entitled
22
Westerfield & Jordan, Irwin, 1995.
Fundamentals of Corporate Finance
23
13
by Ross,
1
K0
2
K1
3
Where,
=
=
4
5
(D0
(1+g)/ P0
K0
K0
g
(1 + f)
=
K1
=
7
adjusted
8
payout.
9
P
10
12
+
The cost of capital for common equity
capital.
6
11
)
The rate of return on common equity capital
for
=
D0 =
the
cost
of
flotation
The most recent stable stock
g
=
The
short-term
represented by earnings per share.
15
f
=
and
stock
future
14
18
price.
related to P0 .
dividends
17
price
flotation
costs
growth
appreciation
adjusted
for
payout.
Example:
D0
=
$6 per share
19
P0
=
$100 per share
20
g
=
Assume that:
=
( 6 x 1.04/ 100)
23
=
6.24
24
=
10.24%
4%
21
22
dividend
The annual dividends per share most closely
13
16
and
Then,
K0
14
+
4
+ 4
rate
for
usually
dividend
1
2
PROOF
Discount
Discount
Future
Discounted
Year
Factor@4%
Fac.10.24%
Dividends
Dividends
1
1.0400
1.1024
$6.24
$5.66
2
1.0816
1.2153
6.49
5.34
3
1.1249
1.3397
6.75
5.04
Total present value of
dividends to the Year 3 $16.04
3
Present value of stock sold in Year3
4
TotalPresentValue
83.96
100.00
5
Stock value in 3 years at 4% growth is
112.49
6
The above proof of the DCF formula shows that
7
investor would realize his/her 10.24% cost of capital
8
if the three-year growth in dividends and stock value
9
were 4% related to the investment of $100 with an
an
10
initial $6 annual dividend.
It should be pointed out
11
that the above traditional DCF methodology is only
12
reliable when the dividend and stock price growth
13
rates are the same and are reflective of the stock
14
being analyzed.
15
constraint.
16
employed the traditional DCF methodology in this
17
proceeding.
18
DCF/IRR methodology wherein only dividends and stock
19
prices are forecast.
This is a very significant
Because of this constraint, I have not
Instead, I have used the "horizon" or
Under this methodology, the DCF
15
1
return is the internal rate of return or discount rate
2
that makes the net present value of an investment zero
3
(See Id. Ross,et al., p.209).
4
procedure will be explained when I discuss the
5
derivation of the cost of equity capital.
The details of this DCF
6
7
Q.
DOES THE TYPICAL INVESTOR IN A REGULATED FIRM CONSIDER
8
THE INVESTMENT CRITERIA
9
LANDMARK HOPE NATURAL GAS
10
BY
ESSENTIALLY PROCLAIMED IN THE
CASE SO FREQUENTLY QUOTED
JUDGES AND COMMISSIONS?
11
12
A.
Yes.
In Federal Power Commission v. Hope Natural Gas
13
320 U.S. 591, 603 (1944) the Supreme Court stated that
14
the return to the equity owner should be commensurate
15
with
16
having
17
expected
18
sufficient
19
integrity of the enterprise in order to maintain its
20
credit and to attract capital.
returns
on
investments
corresponding
investors'
to
risks
and
return
on
assure
in
other
enterprises
uncertainties.
investment
confidence
in
the
should
CAPITAL STRUCTURE
23
Q.
WHAT IS AN APPROPRIATE CAPITAL STRUCTURE FOR BGE?
24
16
be
financial
21
22
The
1
A.
An appropriate capital structure for BGE is one which
2
optimizes the low cost debt structure of BGE without
3
exposing it to extreme leverage and the consequential
4
loss of financial integrity, i.e., the debt ratio of
5
BGE
6
financial
7
average
8
comparable firms with similar risks and uncertainties.
must
not
be
so
jeopardy
cost
of
high
nor
that
so
capital
the
low
is
Company
that
not
its
is
in
weighted
competitive
with
9
10
Q.
ASSUMING THAT BGE HAS AN OPTIMUM CAPITAL STRUCTURE,
11
WOULD AN INCREASE IN ITS EQUITY RATIO INCREASE THE
12
WEIGHTED AVERAGE COST OF CAPITAL FOR BGE?
13
14
A.
No.
There is no reason to conclude that the overall
15
risks of BGE would change because of a hypothetical
16
increase in its equity ratio.
17
to conclude that the overall risks of BGE would be
18
unaffected
19
Furthermore,
two
20
and
Miller,
21
irrelevant to a company's total value how that company
22
chooses to arrange its finances.
23
& Jordan, Fundamentals of Corporate Finance, Richard
24
D. Irwin, Inc., 1995, page 479)
Merton
by
changes
Nobel
to
Indeed, it is logical
its
laureates,
state
17
that
capital
Franco
it
is
structure.
Modigliani
completely
(Ross, Westerfield,
1
2
WEIGHTED AVERAGE COST OF CAPITAL
3
4
Q.
WHAT IS BGE'S WEIGHTED AVERAGE COST OF CAPITAL?
A.
BGE's
5
6
weighted
average
cost
of
capital
or
required
7
rate of return on rate base is 8.2% % as shown in
8
Exhibit CAL-1A.
9
reported by BGE is 5.340%.
The cost of BGE's short-term debt as
10
is shown to be 6.467%.
11
is 7.240%.
12
discussed supra.
Its cost of long-term debt
Its cost of preference stock
BGE's cost of common equity is 10.3% as
13
14
COST OF EQUITY CAPITAL
15
16
Q.
HOW DID YOU DETERMINE BGE'S COST OF EQUITY CAPITAL ?
17
18
A.
19
I determined BGEs cost of equity capital from a target
group of seven comparable utility companies.
20
21
22
Q.
PLEASE DESCRIBE BGE'S COST OF EQUITY CAPITAL BASED ON
COMPARABLE ELECTRIC UTILITY COMPANIES.
23
18
1
A.
Exhibit CAL-2, page 1, shows a DCF/IRR analysis of
2
seven companies comparable to BGE.
3
selected by Goldman Sachs as being comparable to BGE
4
as
5
Statement prepared for the merger between PEPCO and
6
Baltimore
7
February
8
Securities
9
seven
stated
on
Gas
9,
page
and
1996
and
electric
38
of
Constellation's
Electric
as
a
Company
part
Exchange
The companies were
of
Form
Commission.
utilities
are
and
Proxy
filed
on
S-4
with
the
The
following
included
in
10
Sachs' "Selected Utility Companies."
11
1.
Allegheny Power System, Inc.
12
2.
Conectiv
13
3.
Dominion Resources, Inc.
14
4.
GPU, Inc.
15
5.
Philadelphia Electric Company
16
6.
Pennsylvania Power & Light Company
17
7.
Public Service Electric & Gas Company
Goldman
18
19
Starting with the 1999 stock price, which is known to
20
the investor, I have discounted Value Line's forecast
21
of
22
value.
23
forecast stock price from the year 2003 back to the
24
present
annual
dividends
per
Additionally,
value
year
share
I
1999.
19
to
the
discounted
For
each
1999
present
the
average
company,
the
1
discount factor is the rate of return which will make
2
the sum of the cash flows equal to zero as described
3
on
4
company costs of equity capital are shown in Exhibit
5
CAL-2, page 1.
6
the seven-company group employing the future average
7
range
8
However,
9
adjustment for Rider 8 lowerd the effective cost of
10
pages
9
-
prices
as
12
of
my
testimony.
The
individual
The average cost of equity capital for
forecast
discussed
by
Value
supra,
the
Line
100
is
11.3%.
basis
point
equity for BGE to 10.3%.
11
12
13
Q.
14
WHAT IS THE COST OF EQUITY CAPITAL IN THE COMPETITIVE
ARENA AT THIS TIME?
15
16
A.
One of the best guides to what is being earned in the
17
competitive market is measured by Standard & Poor's
18
500 common stocks.
19
20
Exhibit CAL-3 shows an analysis of the cost of equity
21
capital employing the DCF/IRR methodology for S & P's
22
500 Common Stocks for a 5-year horizon, to the year
23
2004.
24
stock prices and dividends to the year 2004 is 11.1%.
The cost of equity based on DRI's forecast of
20
1
2
3
Q.
PLEASE EXPLAIN EXHIBIT CAL-3.
A.
Exhibit CAL-3's upper half shows in columns A - D the
4
5
6
S & P stock price index, earnings and dividend payout
7
as forecast by DRI/McGraw-Hill for the 5-year horizon
8
ending with the year 2004.
9
forecast index is converted to a unity stock price of
10
$100 per share and dividends per share are derived
11
from forecast earnings per share and percent payouts.
In columns E - G the
12
13
The lower half of Exhibit CAL-3 shows the cash flow
14
during the 5-year horizon.
15
purchased at a cash outflow of $100.
16
investor realizes dividends per share of $1.44.
17
the investor realizes dividends per share in Years 2,
18
3 and 4 of $1.55, 1.68, $1.80 and $1.92, respectively.
19
In Year 5 the investor sells the stock for $158.75 as
20
forecast by DRI which I show in Column E for the year
21
2004.
22
as shown in Column G, Year 2004, to the selling price
23
resulting in a cash flow for Year 5 of $160.67.
In the Year 0 the stock is
In Year 1 the
And
I add the Year 5 dividends per share of $1.92
24
21
1
Finally, I calculate the internal rate of return (IRR)
2
or cost of equity to be 11.1% based on the cash flow
3
described above.
4
5
Q.
6
HAVE YOU MADE AN ANALYSIS OF THE COST OF EQUITY FOR A
COMPARABLE GROUP OF GAS DISTRIBUTION COMPANIES?
7
8
A.
9
Yes.
Exhibit CAL-4 shows a comparable group of seven
gas companies selected by MOODY’S UTILITY MANUAL.
The
10
companies were analyzed for their cost of equity as of
11
December
12
future stock prices.
13
these seven comparable companies is 13.1%.
24,
1999
employing
Value
Line’s
estimated
The resultant cost of equity for
14
15
Q.
SHOULD MUCH WEIGHT BE GIVEN TO THIS 13.1% COST OF
16
EQUITY IN LIGHT OF THE STOCK MARKET CORRECTION FOR GAS
17
UTILITIES?
18
19
A.
No.
This
is
a
temporary
price
correction
in
the
20
market.
21
back
22
Accordingly, I give this 13.1% cost of equity little
23
weight at this time.
at
Value Line expects gas utility stocks to come
a
higher
level
24
22
than
where
they
are
now.
1
Q.
MR. LARSON I WISH TO ASK YOU A HYPOTHETICAL QUESTION
2
IN REGARD TO BGE’S COST OF EQUITY CAPITAL.
3
THAT A BGE INVESTOR REQUIRED A 10.3% RATE OF RETURN ON
4
HER/HIS BGE EQUITY STOCK.
WHAT CASH PAYMENTS WOULD
5
BGE
STOCKHOLDER
6
ASSURE A 10.3% RATE OF RETURN ON EQUITY?
HAVE
TO
MAKE
TO
THAT
IN
ASSUME
ORDER
TO
7
8
A.
If BGE were to continue to pay dividends of $1.68 per
9
share, and if its stock would sell for 15% more or
10
$33.35 per share in three years, compared with its
11
approximate present price of $29.00 per share, the BGE
12
investor would earn a 10.3% rate of return on equity
13
capital as shown in Exhibit CAL-5.
14
capital appreciation for the investor is 15%.
That resulting
15
16
Q.
ON THE OTHER HAND, WHAT WOULD HAVE TO BE THE CAPITAL
17
APPRECIATION
IF
THE
COMMISSION
WERE
TO
18
REQUESTED 12.75% RATE OF RETURN ON EQUITY?
ALLOW
BGE’S
19
20
A.
A 12.75% rate of return on equity would require a
21
capital appreciation of almost 23%.
22
appreciation for a utility would be unprecedented.
23
24
COMMENTS
23
Such a capital
1
2
Q.
3
BASICALLY, HOW DID MR. MOUL DETERMINE HIS RECOMMENDED
COST OF EQUITY CAPITAL FOR BGE?
4
5
A.
First, Mr. Moul determined “Barometer” companies based
6
on
his
specious
four
criteria,
namely,
(1)
the
7
companies must all be listed on the New York Stock
8
Exchange, (2) they must be evaluated by Value Line,
9
(3) they must pay dividends, and (4) they must be
10
located in the Northeast or Southeast.
11
criteria bias for his seven "Barometer” companies is
12
suspect,
13
cross-examination
14
performance vis-à-vis Mr. Moul’s “Barometer” group was
15
far superior (Hearing Tr. Vol.2, pp. 210-216).
16
it should be noted, his “Barometer” group represents
17
gas companies (not combination utilities) (Hearing Tr.
18
Vol.2, pp. 218-9).
at
the
least.
it
Indeed,
was
during
disclosed
Clearly, his
Mr.
Moul’s
that
BGE’s
Also,
19
20
Second, Mr. Moul applied his four approaches in order
21
to
22
“Barometer” companies.
23
discounted cash flow (DCF), (2) risk premium (RP), (3)
evaluate
the
cost
of
equity
for
his
seven
His four approaches are (1)
24
1
capital
assets
pricing
2
comparable earnings (CE).
model
(CAPM),
and
(4)
3
4
Q.
ARE ALL OF HIS APPROACHES VALID?
A.
No, not the way he applies them.
5
6
For instance, his CE
7
approach is based on book value, which is meaningless.
8
He should have employed market value.
9
value or an earnings/price ratio would result in a
However, market
10
return on equity unacceptably low for Mr. Moul.
11
the
12
discredited
13
because its coefficient of correlation is so low that
14
the beta is a meaningless number.
beta
in
the
as
a
CAPM
approach
useful
has
been
statistical
Also,
thoroughly
tool,
largely
15
16
Q.
17
THAT LEAVES THE RP AND DCF APPROACHES.
HAS MR. MOUL
DEVIATED IN APPLYING THOSE APPROACHES?
18
19
A.
Yes.
Exhibit
has
CAL-6
been
clearly
declining
shows
and
is
that
now
the
in
risk
20
premium
the
21
neighborhood of 1.5%.
22
5.70% risk premium (Testimony, page 41, line 7) is
23
obviously way out of line and should be rejected out
24
of hand.
Hence, Mr. Moul’s recommended
25
1
2
Furthermore, others have recognized the decline in the
3
risk premium.
4
of The Economist it states. “. . . the risk premium
5
had fallen by half to 2 ½%. . . “ (page 13).
6
For example, in the August, 1997 issue
Q.
IS MR. MOUL’S DCF APPROACH VALID?
A.
No.
7
8
9
Mr. Moul has violated the two Commission-adopted
rules in applying his DCF approach.
First, he has
10
used past data, not forward-looking data.
Second, he
11
has used book data, not market-oriented data.
12
13
Q.
HAS MR. MOUL MADE OTHER EGREGIOUS ERRORS?
A.
Yes.
14
15
Mr. Moul has used arthmetic growth rates rather
16
than
the
proper
geometric
(compound)
17
His DCF approach requires that compound growth rates
18
be employed.
19
and relied on IBES forecasts which grossly overstate
20
his results by about 200 basis points (Moul’s Exhibit,
21
Schedule 11, page 1).
Q.
rates.
However, he has ignored this requirement
22
23
growth
HAS MR. MOUL COMMITTED OTHER ERRORS?
24
26
1
A.
Yes.
He has failed to include short-term debt in his
2
recommended capital structure for BGE.
Traditionally,
3
this Commission has required that short-term debt be
4
included in the capital structure.
5
6
Q.
7
DID YOU REVIEW THE UPWARD 100 BASIS POINT ADJUSTMENT
THAT MR. MOUL MADE TO HIS 11.17% DCF RESULT?
8
9
A.
Yes.
Q.
PLEASE COMMENT ON THAT ADJUSTMENT.
A.
Mr.
10
11
12
13
Moul
reasons
(Direct,
p.
34)
as
a
company
14
increases its debt and debt risk, its equity costs
15
increase as its weight decreases proportionately.
Mr.
16
Moul
has
17
contradicted the Modigliani and Miller (M&M) theory
18
which states that the overall risks of a company do
19
not change with a change in its capital structure.
20
Second,
21
operation to achieve his 100 basis point increase to
22
his 11.17% DCF result.
23
highly
24
results meaningless.
is
wrong
his
for
three
adjustment
unreliable
beta
reasons.
is
an
First,
obvious
he
bootstrap
Third, his reliance on the
(discussed
27
supra)
makes
the
1
2
Q.
3
PLEASE
EXPLAIN
MR.
MOUL’S
CONTRADICTION
OF
THE
M&M
THEORY.
4
5
A.
I
will
show
you
an
example
of
his
contradiction.
6
Assume a capital structure of 50/50 debt/equity ratio
7
at the following costs.
8
9
Weighted
Capital
10
Percent
Cost
Cost
%
%
%
11
Debt
50
6.0
3.0
12
Equity
50
10.0
5.0
13
Total
100
8.0
14
15
Now assume, as Mr. Moul has, that the cost of equity
16
increases
17
decreases, and that debt increase in volume and cost
18
due to leverage.
19
that the cost of both debt and equity will increase
20
because risks for both have increased.
21
scenario results.
as
its
share
of
the
capital
Mr. Moul explains (Direct, p. 34)
22
23
24
structure
The following
Weighted
Capital
Percent
Cost
Cost
%
%
%
28
1
Debt
60
7
4.2
2
Equity
40
12
4.8
3
Total
100
9.0
4
5
Note that the overall cost of capital has increased
6
from
7
contradiction of the M&M theory.
8
the
9
point
10
8.0%
M&M
to
9.0%,
theory,
cost
of
Mr.
or
by
Moul
equity
100
basis
in
Thus, contrary to
bootstraps
adjustment
points
to
his
his
100
basis
11.17%
DCF
result.
11
12
In the above example, risks have not increased, but
13
Mr.
14
capital has increased by 100 basis points.
15
100 basis point adjustment is totally unsupported in
16
theory or common sense.
Moul
would
have
us
believe
that
the
cost
of
Mr. Moul’s
17
18
Q.
19
HAVE
YOU
ANY
COMMENTS
IN
DEPRECIATION TESTIMONY?
20
21
A.
Yes, just one.
Q.
PLEASE STATE THAT COMMENT.
22
23
24
29
REGARD
TO
MR.
AIKMAN’S
1
A.
Mr. Aikman explains that his 33% depreciation rate for
2
PC’s is based on a three-year phase-in from owning to
3
leasing.
4
relationship
5
proper write-off period for the non-recurring cost.
This
is
a
between
non-sequitur.
the
phase-in
There
period
is
and
no
the
6
7
Q.
WHAT WRITE-OFF PERIOD DO YOU RECOMMEND?
A.
I recommend a write-off period of eight years for two
8
9
10
reasons.
First, it coincides approximately with the
11
present rate which means no disruption to the overall
12
cost of service and, therefore, no large burden in
13
rate
14
recurring costs happen all the time and are usually
15
written off over a long period, such as 5 – 10 years,
16
that would cause little disruption to the customers’
17
bills.
design
for
the
customers.
Second,
such
non-
18
19
Additionally, Mr. Aikman admitted (Hearing Tr. Vol. 4,
20
p.
21
procedures would have to be taken in order not to have
22
a
23
were allowed and BGE does not have a depreciation case
24
for five years.
600)
during
mismatch
of
his
cross-examination,
revenue
if
30
a
three-year
that
special
amortization
1
2
Q.
DOES THAT COMPLETE YOUR TESTIMONY?
A.
Yes.
3
4
However,
I
reserve
the
right
to
file
5
supplemental testimony after the Company has responded
6
to
7
requests, and has fully provided actual data for the
8
entire test year.
outstanding
data
requests,
9
31
including
transcript
1
2
3
4
5
6
7
8
9
Appendix A
SPECIFIC DEPRECIATION EXPERIENCE AND QUALIFICATIONS OF
Charles A. Larson
Mr. Larson studied depreciation accounting and tax
10
accounting at Denver University's Graduate School of
11
Business.
12
numerous occasions.
13
employed as a Senior Vice President of Zinder Companies, he
14
was associated with the late Robley Winfrey who is known as
15
the father of the "Iowa Curves".
16
He has testified on depreciation matters on
For ten years, while Mr. Larson was
He was a System Planning Engineer with the Wisconsin
17
Electric Cooperative
18
materials and labor specifications for plant expansions,
19
prepared bidding lists, and assisted with the bidding
20
process with engineering analyses, technical assistance as
21
well as advice regarding unit costs.
22
Service Company he prepared system planning least cost
23
reports of project expansions dealing largely with steam
24
power plants.
25
where he prescribed the equipment,
At Middle West
Mr. Larson is a business appraiser who has taken into
26
account how depreciation and tax accounting affect the fair
27
market value of companies.
For the fiscal year 1994-95, he
32
1
was President of the Maryland Chapter of the American
2
Society of Appraisers.
3
4
5
Some of his clients for which he prepared depreciation
studies are shown below.
6
7
Gas Distribution Companies
8
Southern Indiana Gas and Electric
9
Public Service Company of Colorado
10
Western Kentucky Gas
11
Anchorage Natural Gas
12
Gas Transmission Companies
13
United Gas Pipeline
14
Sea Robin Pipeline
15
Plaquemine Pipeline
16
Questar
17
Electric Power Companies
18
Tucson Electric Power
19
Southern Indiana Gas and Electric
20
Central Power & Light
21
Texas Utilities
22
Public Service Company of Colorado
23
24
Telecommunications Companies
Alberta Government Telephone
33
1
Northern Telephone
2
Mesick Telephone
3
Greenville, WI, REA
4
5
Steam Companies
6
Cleveland Electric Illuminating
7
Upper Peninsular Power
8
Indianapolis Power & Light
9
Public Service Company of Colorado
10
Water Utility Companies
11
City of Richmond, VA.
12
Princess Anne Utilities
13
14
34