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Rebuttal Testimony of Stephen G. Hill
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INTRODUCTION / SUMMARY
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Q. PLEASE STATE YOUR NAME, OCCUPATION AND ADDRESS.
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A. My name is Stephen G. Hill. I am self-employed as a financial consultant and principal of
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Hill Associates, a consulting firm specializing in financial and economic issues in
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regulated industries. My business address is P. O. Box 587, Hurricane, West Virginia,
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25526 (e-mail: [email protected]).
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Q. ARE YOU THE SAME STEPHEN HILL WHO TESTIFIED PREVIOUSLY IN THIS
PROCEEDING ON BEHALF OF THE MARYLAND PEOPLE’S COUNSEL?
A. Yes, I am.
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Q. WHAT IS THE PURPOSE OF YOUR TESTIMONY AT THIS TIME?
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A. I will respond to certain portions of the Direct Testimony of Commission Staff witness
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Eric Icart related to capital structure theory and the appropriate ratemaking capital
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structure for Washington Gas Light Company (WGL, the Company) in this proceeding.
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Q. WHAT ARE YOUR DISAGREEMENTS WITH MR. ICART WITH REGARD TO HIS
CAPITAL STRUCTURE RECOMMENDATION IN THIS PROCEEDING?
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A. With regard to the selection of the ratemaking capital structure in this proceeding, Mr.
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Icart and I are largely in agreement. The Staff witness has adopted the capital structure
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recommended by the Company in this proceeding. As I noted in my Direct Testimony, for
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the most part, I have also utilized the Company’s requested capital structure.
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However, I disagree with the amount of short-term debt included in the
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Company’s (and therefore Mr. Icart’s) forward-looking ratemaking capital structure.
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Those differences are relatively minor. For example, Mr. Icart recommends the use of the
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Company’s requested ratemaking equity ratio of 53.4% common equity, while my
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recommendation includes an equity ratio of 52.86%—about half a percent lower.
Rebuttal Testimony of
Stephen G. Hill
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Therefore, while there are differences in the technical aspects of the capital structure
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recommendations of the Staff and Maryland People’s Counsel (MPC), the rate impact of
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those differences is relatively small.
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More important, I believe, is our disagreement on theoretical grounds. Mr. Icart
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indicates at pages 8 through 10 of his Direct Testimony in this proceeding that a) the
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value of a firm is unaffected by its capital structure choices and b) capital structure has
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little impact on utility revenue requirements. With all due respect to the Staff witness, I
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believe Mr. Icart is incorrect on both counts. The selection of an appropriate ratemaking
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capital structure is an issue with which this Commission will be confronted again and
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again, and an important issue which deserves full and accurate explanation. Moreover, the
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selection of a particular capital structure does, indeed, have an impact on rates. Therefore,
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I will address in some detail the aspects of capital structure theory and the shortcomings
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in Staff’s position on that issue.
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I will first discuss the technical differences between Staff’s/WGL’s capital
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structure recommendation and that of Maryland People’s Counsel (MPC). Because I have
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previously set out my rationale for the use of a different amount of short-term debt in the
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ratemaking capital structure than that used by WGL/Staff in my Direct Testimony, I will
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only briefly summarize that position here. The more substantial portion of my Rebuttal
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will address the theoretical capital structure issues.
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Q. PLEASE BRIEFLY EXPLAIN WHY YOU BELIEVE THE AMOUNT OF SHORT-
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TERM DEBT INCLUDED IN THE COMPANY’S RATEMAKING CAPITAL
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STRUCTURE SHOULD BE HIGHER THAN THAT INCLUDED BY WGL OR
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STAFF.
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A. First, the Company’s use of a three-year average level of short-term debt biases
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downward the amount of debt to be included in a forward-looking capital structure, due
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to the lower-than-average usage in 1999 (when short-term debt costs were substantially
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higher than they are currently)1. Second, the Company’s capital structure adjustment to
1 DOD witness Crane and AOBA witness Oliver also mention this point in their Direct Testimony in this
proceeding.
Rebuttal Testimony of
Stephen G. Hill
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account for its unregulated investments (i.e., lowering the historical amount of short-term
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debt used and increasing the amount of pro-forma common equity to account for the same
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investment) effectively double-counts that investment. Accepting one of those
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adjustments (increasing common equity) calls for the elimination of the other (reducing
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the historical level of short-term debt).
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Third, the level of short-term debt included in the Company/Staff recommended
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capital structure is below the amount used historically and below the amount projected to
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be used in the future and is, thus, likely to be unrepresentative of the manner in which the
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Company is actually capitalized in the future. Fourth, short-term debt costs are at
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historically low levels and a reduction in short-term debt usage, given that fact, would not
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serve to most cost-effectively capitalize the Company.
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For these reasons, a higher amount of short-term debt should be included for
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ratemaking purposes than that included in the Company’s/Staff’s recommended
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ratemaking capital structure. As I note in my Direct Testimony an amount of short-term
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debt of $110 Million is appropriate for ratemaking purposes in this proceeding, rather
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than the $94.2 Million amount included in WGL/Staff’s recommended capital structure.
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Q. AT PAGE 9 OF HIS DIRECT TESTIMONY, MR. ICART INDICATES THAT WGL’S
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REQUESTED CAPITAL STRUCTURE IS SIMILAR TO THE SAMPLE GROUP OF
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GAS COMPANIES USED BY COMPANY WITNESS OLSON IN THIS CASE. IS
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THAT CORRECT?
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A. No. The common equity ratio data shown on Mr. Icart’s EI-2a (drawn from Value Line)
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do not take short-term debt into account. In order to be comparable, the common equity
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ratio in WGL/Staff’s recommended capital structure—absent consideration of short-term
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debt—should be compared to the Value Line averages for the other gas companies. Using
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Mr. Icart’s Exhibit EI-2B, WGL’s equity ratio (absent consideration of short-term debt) is
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approximately 57% (56.98%). That amount of common equity is considerably higher than
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the 51.2% average for the sample group of gas companies shown on Mr. Icart’s Exhibit
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IE-2A. WGL’s ratemaking capital structure contains higher-than-average common equity
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and is, thus, considerably less financially risky than that of other gas companies.
Rebuttal Testimony of
Stephen G. Hill
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Alternatively, we can compare WGL/Staff’s common equity ratio
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recommendation (53.4%) with the equity ratio of Mr. Olson’s sample companies which
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includes the consideration of short-term debt. CA Turner’s Utility Reports June 2002
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edition indicates that the average common equity ratio of Mr. Olson’s six gas companies
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averages 46%. The verdict is the same—the ratemaking common equity ratio
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recommended by the Company and the Staff in this proceeding is not similar to that of
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other gas companies, as Mr. Icart indicates. Rather, WGL’s common equity ratio is
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substantially higher than that of other gas companies and the Company is considerably
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less financially risky for that reason.
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Q. MR. ICART ALSO TESTIFIES THAT THE COMMISSION SHOULD NOT BE
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CONCERNED ABOUT UTILITY FINANCIAL CROSS-SUBSIDIZATION OF WGL
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HOLDINGS UNREGULATED OPERATIONS, BECAUSE VALUE LINE REPORTS
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WGL HOLDINGS COMMON EQUITY RATIO TO BE 56%, WHILE THE
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RATEMAKING EQUITY RATIO RECOMMENDED BY STAFF IS LOWER—53.4%.
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WHAT ARE YOUR COMMENTS?
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A. Again, Mr. Icart does not take into account the fact that Value Line common equity ratios
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are reported without consideration of short-term debt. Therefore, the 56% equity ratio for
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WGL Holdings reported by Value Line is not comparable to Staff’s recommended
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common equity ratio of 53.4% because the former does not include consideration of
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short-term debt, while the latter does. As I noted in my Direct Testimony at page 23, the
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March 31, 2002 balance sheet data filed with the Securities and Exchange Commission
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indicate that WGL Holdings (which is operationally riskier than WGL’s gas utility due to
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the parent’s unregulated operations) is capitalized with a common equity ratio lower than
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that utilized by WGL. The common equity ratio of the riskier entity—WGL Holdings—
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should be higher than that of WGL, not lower.
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Therefore, I believe there is reason for this Commission to be concerned with
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regard to the risk of WGL Holdings’ unregulated operations and how they are capitalized.
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While, as I noted in Direct, those operations remain relatively small today, the
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Stephen G. Hill
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Company’s intent to expand its unregulated operations (especially its gas marketing
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activities) calls for the Commission to be vigilant about those issues.
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Q. TURNING NOW TO THE THEORETICAL DIFFERENCES BETWEEN YOUR
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POSITION AND THAT OF STAFF REGARDING CAPITAL STRUCTURE, MR.
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ICART INDICATES, AT PAGES 9 AND 10 OF HIS TESTIMONY THAT HIS
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POSITION THAT CAPITAL STRUCTURE DECISIONS ARE IRRELEVANT IS
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BASED ON THE THEORETICAL WORK OF MILLER AND MODIGLIANI. WHAT
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ARE YOUR COMMENTS?
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A. Miller and Modigliani (MM) published two articles regarding capital structure theory;
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Mr. Icart cites only the first article, published in 1958. As the Staff witness correctly
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notes, according to MM, in a world without taxes the value of a firm is unaffected by the
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mix of capital selected to finance the firm. Unfortunately, no corporation exists in such a
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rarified no-tax theoretical environment. Therefore, in 1963 MM published a second
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article regarding capital structure theory which considers corporate taxes. The conclusion
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of that second article (which witness Icart fails to mention) is that the selection of the type
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of capital used to finance the corporation does matter. In that latter paper MM posit that
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due to the tax deductibility of interest expense, the value of the firm is maximized (and
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capital costs minimized) as debt leverage is increased.
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“MM’s original work, published in 1958, assumed zero
taxes. In 1963, they published a second article which
included corporate taxes. With corporate income taxes, they
concluded that leverage will increase a firm’s value—
because interest on debt is a tax-deductible expense, more
of a leveraged firm’s operating income flows through to
investors, hence the value of the firm is higher.” (Brigham,
Gapenski, Intermediate Financial Management, 5th Ed.,
Dryden Press, Fort Worth TX, 1996, p. 368)
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Therefore, Mr. Icart’s focus on MM’s first paper as support for his claim that the
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selection of the mix of capital “is not relevant” in this proceeding does not, I believe,
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accurately convey the theoretical background on this subject. WGL, or any other utility
Rebuttal Testimony of
Stephen G. Hill
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under the purview of this Commission, is certainly subject to taxes and, as MM posit, for
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a firm which experiences corporate taxes, capital structure does matter and the use of debt
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capital can reduce capital costs and increase firm value.
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Q. IN OTHER WORDS, THE FIRST MM ARTICLE (WITHOUT TAXES) INDICATES
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THAT CAPITAL STRUCTURE IS IRRELEVANT TO THE VALUE OF A FIRM, AND
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THE SECOND ARTICLE (WITH TAXES) EFFECTIVELY INDICATES THAT AN
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ALL-DEBT CAPITAL STRUCTURE WOULD MAXIMIZE FIRM VALUE,
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CORRECT?
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A. Correct.
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Q. NEITHER ONE OF THOSE CONCLUSIONS SOUNDS VERY REALISTIC; HOW
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DOES THE ACADEMIC COMMUNITY RATIONALIZE THOSE TWO EXTREMES
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OF CAPITAL STRUCTURE THEORY?
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A. While the abundance of leveraged buy-outs and debt-financed mergers occurring over the
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past twenty years in all facets of the U.S. economy lend support to the validity of the
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second MM paper (the use of debt maximizes firm value), the most widely accepted view
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of capital structure theory today is called the “trade-off model.” Intuitively, we understand
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that the use of debt will lower a firm’s capital costs and help to increase its valuation. We
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also understand that the use of too much debt—i.e., a level of debt so high that it creates a
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high probability that the firm would not be able to meet interest payments—can create
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serious problems for a firm and its investors. Those “problems” created by the use of
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excessive amounts of debt are costs related to financial distress (bankruptcy costs,
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efficiency declines, monitoring costs) which increase the cost of debt and reduce the
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value of the firm’s equity.
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In other words, as the use of debt is increased and the use of equity reduced,
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beyond some point (and well before the firm is capitalized with 100% debt) the cost of
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debt will rise rapidly and the value of the firm will be diminished, not increased.
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“The addition of financial distress and agency costs to the
MM tax model results in a trade-off model of capital
Rebuttal Testimony of
Stephen G. Hill
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structure. In such a model, the optimal capital structure can
be visualized as a trade-off between the benefit of debt
financing (the interest tax shelter) and the costs of debt
financing (financial distress and agency costs).” (Brigham,
Gapenski, Intermediate Financial Management, 5th Ed.,
Dryden Press, Fort Worth TX, 1996, p. 382)
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Therefore, as debt is added to the capital structure of a firm, the overall cost of capital
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declines. As more debt is added, the capital cost continues to decline until the amount of
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debt in the capital structure begins to endanger the viability of the firm. At that point, the
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cost of debt and equity begins to increase more rapidly and, due to that additional cost,
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continuing to add debt will no longer continue to lower overall capital costs. Instead, at
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that point, the continued addition of debt will increase the firm’s overall cost of capital,
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not lower it, and, thus, begin to diminish the value of the firm rather than increase it.
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The result of this practical application of the MM theory is an overall cost of
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capital which declines as debt is added up to a point at which the addition of more debt
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will increase rather than decrease the overall cost of capital. The capital structure mix
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which exists at that point where the overall cost of capital of a firm is minimized is the
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firm’s “optimal capital structure.” Here again, the most widely accepted view in the
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financial literature arrives at the conclusion that capital structure does matter and can
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have an important impact on the cost of capital and the value of the firm.
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Q. HOW SHOULD THE COMMISSION INTERPRET THIS OPTIMAL CAPITAL
STRUCTURE CONCEPT?
A. A capital structure which contains too little debt (too much common equity) is not
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optimal or economically efficient for rate setting purposes because it is too expensive.
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That is, the firm has not taken sufficient advantages of its debt carrying capacity and has
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not, therefore, sufficiently lowered its cost of capital. If, for example, an energy utility
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firm came before this Commission expecting to set rates for its utility operations with a
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60% common equity ratio, this Commission should have serious questions regarding the
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propriety of setting rates on such an expensive capital structure.
Rebuttal Testimony of
Stephen G. Hill
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On the other hand, a capital structure which contains too much debt (too little
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common equity) is not optimal or economically efficient for ratesetting purposes because
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it also is too expensive. A heavily leveraged capital structure runs the risk of financial
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trouble for the company. As this Commission is aware, I made just such an argument in
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the recent Baltimore Gas & Electric corporate re-organization case. In that instance, I was
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concerned that the separation of the generation assets from the distribution utility
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concurrent with leaving the attendant debt capital at the utility level unnecessarily
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increased the distribution utility’s leverage. In that instance the utility equity ratio had
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been reduced to approximately 25% of total capital. I recommended that the Commission
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require the utility to re-capitalize its operations by buying down debt and increasing its
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common equity ratio.
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Therefore, in principle, an appropriate ratemaking capital structure is one which
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balances the operational and financial risk of the firm, minimizing overall capital costs. In
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some instances that may mean that the ratemaking common equity ratio should be higher
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or lower than that actually used by the Company, or, in the alternative, the allowed return
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on common equity adjusted to account for capital structures which are outside the
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established norms in the utility industry.
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Q. HOW IS AN OPTIMAL CAPITAL STRUCTURE IDENTIFIED?
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A. The determination of a particular optimal capital structure for a particular firm is a
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difficult technical matter and cannot be accomplished with precision because the
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variables at play cannot be explicitly defined throughout the capital structure continuum.
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Nevertheless, the manner in which utilities are capitalized on average can provide the
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Commission an indication of how most utility managers elect to capitalize their
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operations. While industry-average capital structures may not be optimal capital
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structures and, thus, applicable in every instance, they do provide the Commission some
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indication as to what might constitute a reasonable ratemaking capital structure.
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As I noted in my Direct Testimony (Exhibit_(SGH-1), Schedule 2, page 2) the
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average common equity ratios in the gas industry today range from about 37% to 44% of
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total capital. As it turns out, the average common equity ratios for the electric industry are
Rebuttal Testimony of
Stephen G. Hill
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in roughly the same range. This is in contrast to unregulated industrial firms, which have
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a more volatile income stream than utilities and are capitalized with about 60%-62%
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common equity2 as a percent of total capital. Therefore, from these data and based on my
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experience, I believe equity ratios for energy utilities ranging from 35% to 50% for utility
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operations are reasonable for ratesetting purposes.
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That is not to say that ratemaking capital structures with common equity ratios
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outside that range could not be used for setting rates, only that common equity ratios in
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that range could be considered to be generally similar to industry averages and, thus,
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normal for utility operations. Indeed, in this instant case I recommend rates be set for
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WGL using a capital structure with a common equity ratio outside that 35%-50% range,
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but I also recommend that WGL’s relatively high common equity ratio be accounted for
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with a lower allowed return on equity.
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Q. STAFF WITNESS ICART ALSO TESTIFIES THAT CAPITAL STRUCTURE CHOICE
DOES NOT IMPACT RATES TO CUSTOMERS. DO YOU AGREE?
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A. No. The choice of a particular ratemaking capital structure definitely does have an impact
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on the utility’s overall cost of capital and, therefore, affects the rates charged to utility
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customers. Schedule 1 of Exhibit_(SGH-2) attached to this testimony shows that making
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simple and plausible assumptions regarding capital cost increases as debt is added to the
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capital structure of a utility, the overall cost of capital declines. Then, as predicted by the
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trade-off theory of capital structure discussed above, as more debt is added the pre-tax
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overall cost of capital begins to rise again, confirming the existence of a lowest-cost,
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optimal capital structure.
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Page 1 of Schedule 1 shows a hypothetical utility which has a common equity
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ratio of 60%, a debt ratio of 40%, a cost of common equity of 9.50%, and for which the
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cost of debt is 300 basis points less than the cost of equity. With a combined 40% Federal
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and State income tax rate, the pre-tax overall cost of capital of our hypothetical utility
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would be 12.10%. Further, it is assumed that for every 1% decrease in the common equity
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ratio between 60% and 40%, the cost of common equity increases 0.04% (4 basis points),
2 The Value Line Investment Survey, Selection and Opinion, p. 3814, Value Line Industrial Composite.
Rebuttal Testimony of
Stephen G. Hill
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and for every 1% decrease in the common equity ratio between 40% and 30%, the cost of
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common equity increases 0.10% (10 basis points)3.
Under those assumptions, the pre-tax overall cost of capital (the cost of capital
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used for ratemaking purposes) declines as more debt is added, indicating that the capital
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costs borne by ratepayers decline as debt is added. Again, capital structure is shown to
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have an impact on the capital costs borne by ratepayers. Page 1 of Schedule 1 also shows
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that as more debt is added beyond a certain point, overall pre-tax capital costs begin to
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increase.
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Page 2 of Schedule 1 attached to this testimony provides a graphical
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representation of the numerical results shown on page 1 of that Schedule. Page 2 of
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Schedule 1 shows that the pre-tax overall cost of capital (the bold line on the graph)
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declines as the amount of common equity in the capital structure declines, even though
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the cost rates of equity and debt are rising. In addition, the pre-tax overall cost of capital
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declines until the equity ratio is 40% and the rate of increase in the cost of equity and debt
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rises—after that point, as debt is added to the capital structure, the overall cost of capital
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rises.
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While this graph appears to provide a very definite determination of the least-cost
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(optimal) capital structure for our hypothetical utility, it is important to understand that
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the assumed parameters affecting the cost of equity and debt and the changes in those
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costs as the amount of equity declines are not so well-defined in the real world.
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Therefore, while it is reasonable to believe that the overall cost of capital is a U-shaped,
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or bowl-shaped function which has a low point signifying the least-cost capital structure
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(i.e., the optimal capital structure), that function would be far less defined than that which
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appears on page 2 of Schedule 1.
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In other words, the minimum cost point (the optimal capital structure) would not
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be so well-defined in reality as it appears to be on page 2 of Schedule 1. Nevertheless, in
3 Staff witness Icart references a study which assumes that for every 1% change in common equity ratio, the
cost of equity increases 12 basis points. My own studies of the subject and my experience indicate that
assumption substantially overstates the nominal change in the cost of capital, and 4 to 5 basis points is a
more realistic figure for normal utility capital structures. The higher 10 basis point amount for capital
structure changes between 40% and 30% common equity is designed to recognize the additional financial
risk and agency costs associated with more highly leveraged capital structures.
Rebuttal Testimony of
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Stephen G. Hill
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my view, the assumptions on which the example set out above are based are reasonable
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and the graph on page 2 of Schedule does 1) provide a reliable illustration of the impact
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of the use of debt on the overall cost of capital and 2) shows that, contrary to the
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testimony of Staff witness Icart, capital structure does matter to ratepayers—and should
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be of concern to this Commission.
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Q. DOES THIS CONCLUDE YOUR REBUTTAL TESTIMONY, MR. HILL?
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A. Yes, it does.
Rebuttal Testimony of
Stephen G. Hill
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