Download 9535 Testimony [Dave] - Maryland Public Service Commission

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TESTIMONY OF DAVID C. PARCELL
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I.
INTRODUCTION
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Q.
PLEASE STATE YOUR NAME, OCCUPATION, AND BUSINESS ADDRESS.
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A.
My name is David C. Parcell. I am Vice President and Senior Economist of Technical
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Associates, Inc. My business address is Suite 602, 1051 East Cary Street, Richmond,
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Virginia 23219.
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Technical Associates, Inc. is a consulting firm which, since 1970, has performed a
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wide array of services to both governmental and private clients. A primary component of
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these services has involved various aspects of public utility ratemaking. In connection with
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these studies, members of the firm have testified in well over 600 utility ratemaking
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proceedings throughout the United States and Canada.
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Q.
PLEASE DESCRIBE YOUR BACKGROUND AND EXPERIENCE.
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A.
I hold B.A. (1969) and M.A. (1970) degrees in economics from Virginia Polytechnic
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Institute and State University (Virginia Tech) and a M.B.A. (1985) from Virginia
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Commonwealth University. I have been continuously employed by Technical Associates
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and its predecessor companies since 1970. The large majority of my consulting experience
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has involved the provision of cost of capital testimony in utility ratemaking proceedings. I
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have previously testified in over 300 utility proceedings before approximately 30 regulatory
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agencies in the United States and Canada.
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Schedule 1 provides a more complete description of my background and experience.
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Q.
WHAT IS THE PURPOSE OF YOUR TESTIMONY IN THIS PROCEEDING?
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A.
I have been retained by the Maryland People's Counsel to evaluate the cost of capital aspects
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of the current filing of Chesapeake Utilities Corporation ("Chesapeake"). I have also
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performed independent studies and am making a recommendation of the current cost of
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capital for Chesapeake.
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Q.
HAVE YOU PREPARED AN EXHIBIT IN SUPPORT OF YOUR TESTIMONY?
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A.
Yes, I have prepared one exhibit comprised of 17 schedules, identified as Schedules 1
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through 17. This exhibit was prepared either by me or under my direction. The information
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contained in this exhibit is correct to the best of my knowledge and belief.
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Q.
HOW IS YOUR DIRECT TESTIMONY ORGANIZED?
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A.
My testimony is organized into thirteen parts as follows:
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I.
Introduction
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II.
Recommendations and Summary
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III.
Economic/Legal Principles and Methodologies
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IV.
General Economic Conditions
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V.
Chesapeake's Operations and Business Risks
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VI.
Capital Structure and Cost of Debt
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VII.
Selection of Comparison Group
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VIII.
Discounted Cash Flow Analysis
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IX.
Capital Asset Pricing Model Analysis
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X.
Comparable Earnings Analysis
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XI.
Return on Equity Recommendation
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XII.
Total Cost of Capital
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XIII.
Comments on Company Testimony
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II.
RECOMMENDATIONS AND SUMMARY
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Q.
WHAT ARE YOUR RECOMMENDATIONS IN THIS PROCEEDING?
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A.
My overall cost of capital recommendation for Chesapeake is as follows:
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Percent
Cost
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Long-term Debt
43.38%
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Common Equity
56.62
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Total Cost of Capital
Return
8.48%
10.50-11.50
100.00%
3.68%
5.95-6.51
9.62-10.19%
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The Company's application requests a total cost of capital of 11.07 percent, which
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incorporates a cost of common equity of 13.00 percent.
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Q.
PLEASE SUMMARIZE YOUR ANALYSES AND CONCLUSIONS.
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A.
This proceeding is concerned with the regulated gas utility operations of Chesapeake. My
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analyses are concerned with the Company's total cost of capital.
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performing these analyses is the development of the appropriate capital structure.
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Chesapeake's proposed capital structure is the proforma September 30, 1995 test period
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capital structure. I have utilized the capital structure proposed by the Company.
The first step in
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The second step in a cost of capital calculation is a determination of the embedded
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cost rate of long-term debt. I have also utilized the cost rate proposed by Chesapeake in my
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analyses.
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The third step in the cost of capital calculation is the estimation of the cost of
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common equity. I have employed three recognized methodologies to estimate the cost of
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equity for Chesapeake. Each of these methodologies is applied to a group of comparison
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companies selected as having similar risk and operating characteristics to Chesapeake, the
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group of Barometer companies utilized by Chesapeake cost of capital witness Paul R. Moul,
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Moody's Gas Distribution Group, and the DCF and comparable earnings techniques were
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applied to Chesapeake. These three methodologies and my findings are:
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Discounted Cash Flow
10.00 - 11.25%
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Capital Asset Pricing Model 10.25 - 10.50%
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Comparable Earnings
11.00 - 11.50%
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Based upon these findings, my recommendation of the fair cost of common equity for
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Chesapeake is a range of 10½ percent to 11½ percent, with a mid-point of 11 percent. My
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recommended range incorporates the upper end of each of the ranges developed in my three
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methodologies.
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Combining these three steps into a weighted cost of capital results in an overall rate
of return of 9.62-10.19 percent, with a mid-point of 9.90 percent.
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III.
ECONOMIC/LEGAL PRINCIPLES AND METHODOLOGIES
Q.
WHAT IS YOUR UNDERSTANDING OF THE ECONOMIC AND LEGAL
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PRINCIPLES WHICH UNDERLIE THE CONCEPT OF A FAIR RATE OF
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RETURN FOR A REGULATED UTILITY?
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A.
Regulated public utilities primarily have their rates established using the "rate base - rate of
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return"
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expenses, taxes and depreciation on a dollar-for-dollar basis, plus are granted an opportunity
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to earn a fair rate of return on the assets utilized (i.e., rate base) in providing service to its
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customers. The rate base is derived from the asset side of the utility's balance sheet as a
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dollar amount and the rate of return is developed from the liabilities/owners equity side of
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the balance sheet as a percentage. The rate of return is developed from the cost of capital,
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which is estimated by weighting the capital structure components (i.e., debt, preferred stock,
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and common equity) by their percentages in the capital structure and multiplying these by
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their cost rates. This is also known as the weighted cost of capital.
concept.
Under this method, utilities are allowed to recover their operating
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Technically, the fair rate of return is a legal and accounting concept which refers to
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an ex post earned return on an asset base, while the cost of capital is an economic and
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financial concept which refers to an ex ante expected or required return on a liability base.
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However, in regulatory proceedings, the two terms are often used interchangeably and are
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done so in my testimony.
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From an economic standpoint, a fair rate of return is normally interpreted to
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incorporate the financial concepts of financial integrity, capital attraction, and comparable
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returns for similar risk investments.
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financial theory and are generally implemented using financial models and economic
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concepts such as discounted cash flow (DCF), capital asset pricing model (CAPM), and
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comparable earnings.
These concepts are derived from economic and
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From a legal standpoint, two U.S. Supreme Court decisions are universally cited as
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providing the legal standards for a fair rate of return. The first is the Bluefield Water Works
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and Improvement Company v. Public Service Commission of the State of West Virginia
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(262 U.S. 679), which was decided in 1923. In this decision, the Court stated:
"What annual rate will constitute just compensation depends
upon many circumstances and must be determined by the exercise of
a fair and enlightened judgment, having regard to all relevant facts.
A public utility is entitled to such rates as will permit it to earn a
return on the value of the property which it employs for the
convenience of the public equal to that generally being made at the
same time and in the same general part of the country on investments
in other business undertakings which are attended by corresponding
risks and uncertainties; but it has no constitutional right to profits
such as are realized or anticipated in highly profitable enterprises or
speculative ventures. The return should be reasonably sufficient to
assure confidence in the financial soundness of the utility, and
should be adequate, under efficient and economical management, to
maintain and support its credit and enable it to raise the money
necessary for the proper discharge of its public duties. A rate of
return may be reasonable at one time, and become too high or too
low by changes affecting opportunities for investment, the money
market, and business conditions generally."
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This decision established the following standards for a fair rate of return: comparable
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earnings, financial integrity, and capital attraction. It also noted the changing level of
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returns over time.
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The second decision is the Federal Power Commission et. al. v. Hope Natural Gas
Company (320 U.S. 591). In its 1942 decision, the U.S. Supreme Court stated:
"The rate-making process under the (Natural Gas) Act, i.e.,
the fixing of 'just and reasonable' rates, involves a balancing of the
investor and consumer interests...From the investor or company
point of view it is important that there be enough revenue not only
for operating expenses but also for the capital costs of the business.
These include service on the debt and dividends on the stock. By
that standard the return to the equity owner should be commensurate
with returns on investments in other enterprises having
corresponding risks. That return, moreover, should be sufficient to
assure confidence in the financial integrity of the enterprise, so as to
maintain its credit and to attract capital."
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This case affirmed the primary standards of the Bluefield case, as well as the public interest
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standard.
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I believe the Bluefield and Hope decisions, as well as subsequent decisions which
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cite these decisions, have identified three economic parameters relevant to the determination
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of a fair rate of return:
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1)
comparable earnings,
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2)
financial integrity, and
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3)
capital attraction.
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It is apparent that these legal standards reflect the economic criteria encompassed in the
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"opportunity cost" principle of economics, which holds that a utility and its investors should
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be afforded an opportunity (not a guarantee) to earn a return commensurate with returns
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they could expect to achieve on investments of similar risk. The opportunity cost principle
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is consistent with the fundamental premise on which regulation rests, namely that it is
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intended to act as a surrogate for competition.
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Q.
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HOW CAN THESE STANDARDS BE EMPLOYED TO ESTIMATE THE COST
OF CAPITAL FOR A UTILITY?
A.
Neither the courts nor economic/financial theory have developed exact and mechanical
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mechanisms for precisely determining the cost of capital. This is the case since the cost of
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capital is an opportunity cost and is prospective looking, which indicates it must be
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estimated.
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There are several useful models which can be employed to estimate the cost of
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equity capital, which is the capital structure item that is the most difficult to determine.
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These include the discounted cash flow method (DCF), the capital asset pricing model
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(CAPM), the comparable earnings analysis and the risk premium technique. Each of these
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methods is based upon a distinct branch of economic or finance theory and each method has
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its own strengths and weaknesses.
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The comparable earnings method is oriented toward the "fairness" standard, whereas
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the CAPM, DCF and risk premium methods are oriented toward the "capital attraction"
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standard. The comparable earnings test measures returns on book equity or "vintaged"
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capital, while the other methods measure the return required per dollar of current purchasing
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power.
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Among the capital attraction models, the DCF method estimates a company's cost of
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equity directly (by utilizing expected cash flows and market prices), while the CAPM and
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risk premium methods estimate the cost of equity indirectly (by evaluating the relative risk
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and expected returns of alternative investments).
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In performing analyses of the cost of common equity, it is customary and
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appropriate to consider the results of several alternative methods. The analyst then must
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decide upon the appropriate weight to give the results of each method in the determination
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of the cost of common equity. This follows because each method requires judgment as to
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the reasonableness of its assumptions and inputs; each model has its own way of examining
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investor behavior; each model proceeds from different fundamental premises, most of
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which cannot be validated empirically; and each model may not at all times be
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representative of current investor behavior. Just as there is no uniformity as to which
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method is used by investors, there should not be a singular method exclusively used to
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estimate a utility's cost of common equity. At the very least, alternative methods should be
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used as a check on a primary or preferred method.
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Q.
WHICH METHODS HAVE YOU EMPLOYED IN YOUR ANALYSES OF THE
COST OF COMMON EQUITY?
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A.
I have utilized three methodologies in my testimony.
These are DCF, CAPM and
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comparable earnings. My ultimate recommendation gives weight to each of these three
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methodologies.
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IV.
GENERAL ECONOMIC CONDITIONS
Q.
WHAT IS THE IMPORTANCE OF ECONOMIC AND FINANCIAL CONDITIONS
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IN A DETERMINATION OF THE COST OF CAPITAL?
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The costs of capital, for both fixed-cost (debt and preferred stock) components and common
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equity, are determined in part by economic and financial conditions. At any given time, the
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level of economic activity, the stage of the business cycle, the level of inflation, and
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expected economic conditions have direct and significant influences on the cost rates of
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debt, preferred stock, and common equity.
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Q.
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WHAT INDICATORS OF ECONOMIC AND FINANCIAL ACTIVITY HAVE YOU
EVALUATED IN YOUR ANALYSES?
A.
I have examined several sets of economic statistics. In doing so, I have examined the period
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1975 to the present. I chose this period since it permits the evaluation of economic
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conditions over two full business cycles and thus makes it possible to assess changes in
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long-term trends. A business cycle is commonly defined as a complete period of expansion
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(recovery) and contraction (recession); a full business cycle is a useful and convenient
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period over which to measure levels and trends in capital costs.
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Q.
PLEASE DESCRIBE THE PAST TWO COMPLETE BUSINESS CYCLES AND
THE INITIAL PORTION OF THE CURRENT CYCLE.
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A.
The current expansion began in April of 1991 and is thus over four years old. Thus far in
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1995 the economy has slowed with the apparent realization of a "soft landing" (i.e., the
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economy moves to a lower growth track but does not slip into recession). The two prior
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complete cycles covered the following periods:
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Business Cycle Expansion Period
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1975-1982 cycle
Mar,1975-July,1981*
Aug,1981-Oct,1982
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1983-1991 cycle
Nov,1982-July,1990
Aug,1990-Mar,1991
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* there was a brief "mini-recession" in 1980
Contraction Period
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The current expansion has surpassed the average length of expansions in the post-
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World War II era. The 1982-1991 expansion was the longest peacetime expansion of this
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era.
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Q.
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PLEASE DESCRIBE RECENT ECONOMIC AND FINANCIAL CONDITIONS
AND THEIR IMPACT ON THE COSTS OF CAPITAL.
A.
Schedule 2 shows several sets of economic data. Page 1 contains general macro-economic
statistics, while Pages 2 and 3 contain financial market statistics.
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Page 1 of Schedule 2 shows that the initial stage of the current expansion was
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somewhat slower than the typical recovery period. This is indicated by the growth in real
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Gross Domestic Product, industrial production, and the unemployment rate. On the other
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hand, growth in 1994 was strong. As noted previously, economic growth has slowed in
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1995.
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The rate of inflation is also shown on Page 1. The Consumer Price Index (CPI) rose
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significantly during the 1975-1982 business cycle and reached double digit levels in 1979-
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1981. The rate declined substantially in 1991 and remained lower than 6.1 percent during
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each year of the 1983-1991 business cycle, as the CPI generally grew by about four percent
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annually from 1982-1989 (each year except one from 1982-1989 had a CPI rate between 3.8
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percent and 4.6 percent). Since 1991, the CPI has been 3.1 percent or lower and the 2.7
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percent rate in 1993 and 1994 is the lowest of the twenty year period.
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Q.
WHAT HAVE BEEN THE TRENDS IN INTEREST RATES?
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A.
Page 2 of Schedule 2 shows several series of interest rates. Rates rose sharply in 1975-1981
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when the inflation rate was rising and high. Rates then fell substantially throughout the
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remainder of the 1980's and into the 1990's. During the first two years of the current
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business cycle, rates continued to fall and in 1993 reached the lowest levels since at least
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1975. Rates generally rose in 1994 as the economy strengthened but have again declined in
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1995 in conjunction with reduced levels of economic growth and low inflation.
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Q.
WHAT HAVE BEEN THE TRENDS IN COMMON SHARE PRICES?
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A.
Page 3 of Schedule 2 shows several series of common stock prices and ratios. These
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generally indicate that share prices were generally stagnant during the high inflation/interest
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rate environment of the late 1970's and early 1980's. On the other hand, the 1983-1991
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business cycle and the current expansion have witnessed a significant upward trend in stock
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prices. Most of the recent stock indices have been at all-time highs.
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Q.
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WHAT IS THE SIGNIFICANCE OF THESE ECONOMIC AND FINANCIAL
TRENDS ON THE COSTS OF CAPITAL?
A.
There are a number of significant conclusions which are apparent from this review of
economic and financial trends:
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Inflation - rates declined substantially during the 1983-1991 business cycle to a four
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percent annual level and are even lower in the current expansion. This general decline is
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significant since anticipated inflation is a driving force in interest rates and security prices.
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Interest rates - both long-term and short-term rates declined significantly during the
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1983-1991 cycle. Long-term rates have declined even more during the current expansion.
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The dramatic decline in long-term interest rates in 1993, coupled with the failure of the
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1994 increases to be sustained, indicates that long-term interest rates are relatively low and
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are not increasing. This finding is significant since utility stocks and utility costs of capital
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are interest-rate sensitive.
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Utility share prices - prices have increased significantly in the 1980's and 1990's,
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along with rising prices of other types of enterprises. This is significant since higher utility
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market-to-book ratios and lower yields are recognition that utilities are currently facing
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lower costs of capital in comparison to the past two business cycles.
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Economic prospects - it is anticipated there will be a continuation of moderate
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economic growth and a Federal Reserve monetary policy designed to avoid a return to
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recession and the maintenance of low inflation.
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In conclusion, there has been a fundamental shift between the 1975-1982 business
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cycle, the 1983-1991 business cycle, and the current cycle.
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characterized by lower inflation, lower interest rates, and higher stock prices. As a result,
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the cost of capital, for both debt and equity, is now lower in two ways. First, it is lower now
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than during the past business cycle. Second, it has declined during the current expansion.
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This shift has been
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V.
CHESAPEAKE'S OPERATIONS AND BUSINESS RISKS
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Q.
PLEASE SUMMARIZE CHESAPEAKE AND ITS OPERATIONS.
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A.
Chesapeake is a diversified utility company engaged in natural gas distribution and
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transportation, propane distribution and information technology services. The Company
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provides natural gas service in the Eastern Shore of Maryland, Delaware and Central
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Florida. The utility operations serve about 32,000 natural gas customers. A subsidiary,
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Eastern Shore Natural Gas Company, operates a 271-mile non open-access interstate
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pipeline which provides service from various points in Pennsylvania to the Company's
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distribution divisions in Maryland and Delaware, as well as to other utilities and customers
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in Delaware and the Eastern Shore of Maryland. In addition, the Company and its non-
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utility subsidiaries are engaged in computer and information technology services, and in the
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sale of propane to some 22,000 customers.
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Q.
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WHAT
ROLE
DOES
GAS
DISTRIBUTION
OPERATIONS
PLAY
IN
CHESAPEAKE'S TOTAL OPERATIONS?
A.
As the following table indicates, gas distribution operations account for about one-half of
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the revenues and operating income of Chesapeake's total operations. However, when the
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pipeline operations are considered, natural gas operations account for about three-fourth of
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total operations.
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Operating
Revenues
(000)
Operating
Income
Gas Distribution
$49,524
50%
$4,697
49%
$68,529
63%
$8,161
77%
Gas Transmission
$22,192
23%
$3,018
30%
$17,792
16%
$620
6%
Propane
$20,684
21%
$2,288
22%
$16,949
16%
$829
7%
$6,173
6%
$174
2%
$5,000
5%
$1,044
10%
$98,572
$10,177
$108,271
$10,653
Type of Operations
Information
Technology
Total
Assets
Capital
Expenditures
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This table further indicates that the gas distribution operations of Chesapeake are the fastest
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growing, as some 77 percent of 1994 consolidated capital expenditures were accounted for
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by gas distribution operations.
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Q.
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WHAT IS THE COMPETITIVE POSITION OF CHESAPEAKE'S GAS
DISTRIBUTION OPERATIONS IN MARYLAND?
A.
Discussion of Chesapeake's Maryland operations normally is done within the context of the
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Maryland-Delaware Delmarva Peninsula operations. The Company operates one division
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in Maryland and one division in Delaware; however, these two divisions both purchase their
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gas from Eastern Shore Natural Gas Company and discussions of these divisions in
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Company publications (e.g. Annual Report) combine the two division as "Delmarva".
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The Company management reports to stockholders that the Company is in a strong
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competitive position. For example, page 17 of the 1994 Annual Report (Management's
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Discussion and Analysis) stated:
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Competition
Historically, the Company's natural gas operations have successfully
competed with other forms of energy such as electric, oil and
propane. The principal considerations have been price and to a
lesser extent, accessibility. However, natural gas shows great
potential for increased sales as a vehicle fuel and for electric power
generation because of its environmentally superior qualities, its
production from domestic sources and endorsements received by
government officials. Since Eastern Shore has not elected to be an
"Open Access" pipeline, the Company is not subject to the
competitive pressures, on the Delmarva peninsula, of FERC Order
No. 636.
Both the propane distribution and the information technology
businesses face significant competition from a number of larger
competitors having substantially greater resources available to them
than the Company. In addition, in the information technology
business, changes are occurring rapidly which could adversely
impact the markets for the Company's products and services.
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This indicates that Chesapeake's natural gas operations (including gas distribution)
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are perceived to be in a strong competitive position. Its non-utility operations, on the other
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hand, are not perceived to be as strong competitively.
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The Company also noted (page 7 of 1994 Annual Report) "We believe that our
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natural gas operations and marketing staff have the knowledge and experience to compete
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in an Open Access environment when our northern distribution divisions are required to do
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so." It is my understanding that Eastern Shore Natural Gas had indicated its intention to file
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for approval to become an open-access pipeline. As the Company itself notes, however,
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this potential conversion is not expected to adversely affect Chesapeake's competitive
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position.
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Q.
IS THE LONG-TERM DEBT OF CHESAPEAKE RATED?
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A.
Chesapeake's long-term debt is not rated by either Moody's of Standard & Poor's. It appears
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that the Company's debt is privately placed.
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Chesapeake has not been an active issuer of long-term debt in recent years. The
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Company issued no long-term debt in 1992 and 1994, although it issued $10 million of 15-
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year senior notes in 1993 (part of which were used to repay existing debt). In fact,
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Chesapeake's current (June 30, 1995) $123.9 million level of long-term debt is less than any
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year-end amount (except 1991) since 1988, according to the Company's response to OPC
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Data Request No. 6, Question No. 6.
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VI.
CAPITAL STRUCTURE AND COST OF DEBT
Q.
WHAT IS THE IMPORTANCE OF DETERMINING A PROPER CAPITAL
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STRUCTURE IN A REGULATORY FRAMEWORK?
Q.
A utility's capital structure is important since the concept of rate base - rate of return
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regulation requires that a utility's capital structure be determined and utilized in estimating
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the total cost of capital. Within this framework, it is proper to ascertain whether the utility's
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capital structure is appropriate relative to its level of business risk and relative to other
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utilities.
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As noted in Section III, the purpose of determining the proper capital structure for a
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utility is to help ascertain the capital costs of the company. The rate base - rate of return
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concept recognizes the assets which are employed in providing utility services and provides
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for a return on these assets by identifying the liabilities and common equity (and their cost
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rates) which are used to finance the assets. In this process, the rate base is derived from the
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asset side of the balance sheet and the cost of capital is derived from the liabilities/owners
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equity side of the balance sheet. The inherent assumption in this procedure is that the
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capital structure and the rate base are approximately equal and the former is utilized to
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finance the latter.
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The common equity ratio is the percentage of common equity in the capital
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structure. This is the capital structure item which normally receives the most attention,
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since common equity: (1) usually commands the highest cost rate; (2) generates associated
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income tax liabilities; and (3) causes the most controversy since its cost cannot be precisely
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determined.
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Q.
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HOW
HAVE
YOU
EVALUATED
THE
CAPITAL
STRUCTURE
OF
CHESAPEAKE?
A.
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I first examined the five-year historic (1990-1994) capital structure ratios for Chesapeake.
These ratios are shown on Schedule 3.
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I have summarized below the common equity ratios for Chesapeake on two bases:
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Including S-T Debt
Excluding S-T Debt
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1990
49.6%
56.7%
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1991
49.0%
58.4%
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1992
51.9%
56.3%
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1993
49.3%
57.6%
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1994
52.5%
60.4%
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This indicates that Chesapeake's common equity ratio in 1994 is the highest of the period.
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Q.
HOW DO THESE CAPITAL STRUCTURE RATIOS COMPARE TO THE
NATURAL GAS DISTRIBUTION INDUSTRY?
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A.
I have prepared Schedule 4 to make this comparison. This schedule shows the 1989 -1993
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five-year (i.e., most recent five-year period available) capital structure ratios of the Moody's
3
Gas Distribution Group, which is a long-standing group of eight companies frequently
4
utilized to describe the gas distribution industry as a whole.
5
Schedule 4 indicates that the Moody's Gas Distribution Group has maintained the
6
following common equity ratios over the five year period:
7
8
Year
9
1989
49.5%
52.0%
10
1990
49.7%
53.0%
11
1991
48.0%
50.1%
12
1992
49.4%
53.6%
13
1993
49.6%
53.0%
14
In comparison to Chesapeake, these common equity ratios are generally lower,
15
Including S-T Debt
Excluding S-T Debt
especially since 1992.
16
17
Q.
18
19
WHAT COMMON EQUITY RATIO HAS CHESAPEAKE REQUESTED IN THIS
PROCEEDING?
A.
The Company's Application requests use of the following capital structure:
20
Capital Item
21
Long-term Debt
Percent
43.38%
23
1
Common Equity
56.62%
2
3
4
Q.
5
6
WHAT CAPITAL STRUCTURE DO YOU PROPOSE TO USE IN THIS
PROCEEDING?
A.
I will also employ the pro-forma test period capital structure as proposed by Chesapeake. I
7
note, however, that use of this capital structure, which contains a higher common equity
8
ratio than the gas distribution industry in general, has the effect of lowering the financial
9
risk of Chesapeake. I also note that the pro-forma test period capital structure contains no
10
short-term debt (the lowest cost component of the capital structure) even though it appears
11
the Company has consistently utilized short-term debt (see Schedule 3).
12
13
Q.
14
15
WHAT IS THE COST OF LONG-TERM DEBT IN THE COMPANY'S
APPLICATION?
A.
16
The Company has revised its long-term debt cost to be 8.48 percent, which is represented to
be the pro-forma test period embedded cost of debt. I also use this cost rate in my analyses.
17
18
Q.
19
20
21
CAN THE COST OF COMMON EQUITY BE DETERMINED WITH THE SAME
DEGREE OF PRECISENESS AS THE COST OF DEBT?
A.
No. The cost rate of debt is largely determined by interest payments, issue prices, and
related expenses.
Even though alternative methodologies exist for determining the
24
1
embedded cost rate, the cost rate for debt is generally agreed to, at least within a relatively
2
small range.
3
4
The cost of common equity, on the other hand, is not susceptible to specific
5
measurement, primarily because this cost is an opportunity cost. There are, however,
6
several models which can be employed to estimate the cost of common equity. Three of the
7
primary methods - DCF, CAPM, and comparable earnings - are developed in the following
8
sections of my testimony.
9
25
1
2
VII.
SELECTION OF COMPARISON GROUP
Q.
HOW HAVE YOU ESTIMATED THE COST OF COMMON EQUITY FOR
3
4
5
6
CHESAPEAKE?
A.
Chesapeake is a publicly-traded company that is diversified into non-utility operations. As
7
a result, it is not appropriate to consider the Company's market cost of equity (i.e., DCF and
8
CAPM) as the exclusive methodology to estimate the fair cost of equity for the Company's
9
utility operations. This follows since its stock price reflects its consolidated operations, not
10
just its utility operations.
11
Another alternative is to select a group of comparison gas distribution companies. I
12
have selected such a group for comparison to Chesapeake. In my analyses, I have also
13
conducted studies of the cost of equity for the Moody's Gas Distribution group, as well as
14
the group of 14 barometer companies utilized by Chesapeake witness Moul as a proxy for
15
Chesapeake.
16
17
Q.
HOW HAVE YOU SELECTED A GROUP OF COMPARISON COMPANIES?
18
A.
I have selected a group of nine comparison companies based upon several criteria which
19
were employed to screen for companies which are publicly-traded and are covered by Value
20
Line, but are smaller than the larger gas distribution companies. In doing so, I selected gas
21
distribution companies based upon the following criteria:
26
1
2
3
1)
1994 Revenues of $200 million to $1 billion
4
2)
1994 Net Plant of $200 million to $1 billion
5
3)
1994 common equity ratio of 40% to 60%
6
4)
Value Line Safety Rank of "2"
7
Schedule 5 identifies the nine comparison companies, along with the criteria. I am aware
8
that these companies are somewhat larger than Chesapeake, but I note that even smaller
9
companies do not have the same degree of financial data and forecasts with which to apply
10
models such as DCF and CAPM.
11
27
1
VIII. DISCOUNTED CASH FLOW ANALYSIS
2
3
Q.
4
5
WHAT IS THE THEORY AND METHODOLOGICAL BASIS OF THE
DISCOUNTED CASH FLOW MODEL?
A.
The discounted cash flow (DCF) model is one of the oldest, as well as the most commonly
6
used models for estimating the cost of common equity for public utilities. The DCF model
7
is based on the "dividend discount model" of financial theory, which maintains that the
8
value (price) of any security or commodity is the discounted present value of all future cash
9
flows. When applied to common stocks, the dividend discount model describes the value of
10
a stock as follows:
Install Equation Editor and doubleclick here to view equation.
11
12
where: P = current price
13
D1 = dividends paid in period 1, etc.
14
K1 = discount rate in period 1, etc.
15
n = infinity
16
This relationship can be simplified if dividends are assumed to grow at a constant
17
rate of g. This variant of the dividend discount model is known as the constant growth or
18
Gordon DCF model. In this framework, the price of a stock is determined as follows:
19
28
1
Install Equation Editor and doubleclick here to view equation.
3
where: P = current price
4
D = current dividend rate
5
K = discount rate
6
g = constant rate of expected growth
7
This equation can be solved for K (i.e, the cost of capital) to yield the following
8
formula:
Install Equation Editor and doubleclick here to view equation.
9
This formula essentially states that the return expected or required by investors is
10
comprised of two factors: the yield (current income) and expected growth (future income).
11
12
Q.
PLEASE EXPLAIN HOW YOU HAVE EMPLOYED THE DCF MODEL.
13
A.
I have utilized the constant growth approach to the DCF model. In doing so, I have
14
combined the current dividend yield for each group of gas distribution companies described
15
in the previous section with several indicators of expected growth.
16
17
18
Q.
HOW DID YOU DERIVE THE DIVIDEND YIELD COMPONENT OF THE DCF
EQUATION?
19
29
1
A.
There are several methods which can be used for calculating the yield component. These
2
methods generally differ in the manner in which the dividend rate is employed, i.e., current
3
vs. future dividends or annual vs. quarterly compounding of dividends. I believe the most
4
appropriate yield component is a quarterly compounding variant which is expressed as
5
follows:
Install Equation Editor and doubleclick here to view equation.
6
This yield component recognizes both the timing of dividend payments and
7
dividend increases.
8
The Po component in my yield calculation is the average (of high and low) stock
9
price for each company for the most recent three month period (June - August, 1995). The
10
Do component is the current annualized dividend rate. The g component is the average of
11
the five growth indicators analyzed (as described below).
12
13
Q.
14
15
HOW HAVE YOU ESTIMATED THE GROWTH COMPONENT OF THE DCF
EQUATION?
A.
The growth rate component of the DCF model is usually the most crucial and controversial
16
element involved in using this methodology. The objective of estimating the growth
17
component is to reflect the growth expected by investors which is embodied in the price
18
(and yield) of a company's stock. As such, it is important to recognize that individual
19
investors have different expectations and consider alternative indicators in deriving their
30
1
expectations. A wide array of techniques exist for estimating the growth expectations of
2
investors. As a result, it is evident that no single indicator of growth is always used by all
3
investors. It therefore is necessary to consider alternative indicators of growth in deriving
4
the growth component of the DCF model.
5
I have considered five indicators of growth in my DCF analyses. These are:
6
1)
1990-1994 (5-year average) earnings retention, or fundamental growth;
7
2)
1990-1994 (5-year average) of historic growth in earnings per share (EPS),
8
dividends per share (DPS), and book value per share (BVPS);
9
3)
1998-2000 projections of earnings retention growth;
10
4)
1993-1999 projections of EPS, DPS, and BVPS; and
11
5)
5 year projections of EPS growth as reported in I/B/E/S.
12
I believe this combination of growth indicators reflects a representative and
13
appropriate set with which to estimate investor expectations.
14
15
Q.
PLEASE DESCRIBE YOUR DCF CALCULATIONS.
16
A.
Schedule 6 presents my DCF analysis. Page 1 shows the calculation of the "raw" (i.e., prior
17
to adjustment for growth) dividend yield. Pages 2-4 show the growth rate proxies described
18
above. Page 5 shows the DCF calculations, which are presented on several bases: average,
19
mid-point, and range of low/high values. These results can be summarized as follows:
20
31
1
Mid-Point
Average
Range
2
Comparison Group
9.6%
9.8%
8.1-11.1%
3
Moody's Group
9.1%
9.4%
8.0-10.2%
4
Moul Barometer Group
10.0%
10.0%
8.7-11.3%
5
Chesapeake Utilities 9.2%
9.0%
8.5-9.9%
6
7
I wish to emphasize that these results are numeric calculations and should not be
8
interpreted to be my DCF findings prior to analysis and interpretation.
9
10
Q.
11
12
HAVE YOU ALSO CALCULATED INDIVIDUAL DCF COSTS FOR THE
COMPANIES CONTAINED IN EACH OF THE GROUPS?
A.
Yes, I have.
These are shown in Schedule 7.
This presentation reflects a similar
13
combination of yield and growth rates to those of the prior schedule, except that DCF
14
calculations are shown for each company. The average DCF calculations for the individual
15
companies are seen to be very similar to the average composite DCF calculations for each
16
group of companies.
17
18
Q.
WHAT IS YOUR CONCLUSION OF YOUR DCF ANALYSES?
19
A.
Based upon my analyses, I believe 10 - 11¼ percent represents the current DCF cost of
20
equity for Chesapeake.
21
calculations for each group examined in the previous analysis. I have focused on the high
This range is approximated by the upper ends of the DCF
32
1
end of the DCF calculations since current financial conditions (low interest rates and high
2
market-to-book ratios for utilities) have the effect of driving DCF results to low levels by
3
historic standards.
4
33
1
IX.
CAPITAL ASSET PRICING MODEL ANALYSIS
2
3
Q.
4
5
PLEASE DESCRIBE THE BASIS OF THE CAPITAL ASSET PRICING
MODEL.
A.
The Capital Asset Pricing Model (CAPM) is a version of the risk premium
6
technique.
7
investment risk and its market rate of return. The CAPM was developed in the 1960's and
8
1970's as an extension of modern portfolio theory (MPT), which studies the relationships
9
among risk, diversification, and expected returns.
The CAPM describes and measures the relationship between a security's
10
11
Q.
HOW IS THE CAPM EMPLOYED?
12
A.
The general form of the CAPM is:
Install Equation Editor and doubleclick here to view equation.
13
where: K = cost of equity
14
Rf = risk free rate
15
Rm = return on market
16
 = beta
17
Rm-Rf = market risk premium
18
As noted previously, the CAPM is a variant of the risk premium method. I believe the
19
CAPM is generally superior to the simple risk premium method because the CAPM
34
1
specifically recognizes the risk of a particular company or industry, whereas the simple risk
2
premium method does not.
3
4
Q.
HOW IS RISK MEASURED IN THE CAPM?
5
A.
Beta is an indicator of investment risk; it is a measure of the expected amount of change in a
6
security's return that results from a change in general security market returns. As such, beta
7
indicates the security's variability of return relative to the return variability of the overall
8
capital market. It is beta which distinguishes the CAPM from the simple risk premium
9
method since it specifically recognizes the risk of individual securities or groups of
10
securities.
11
Beta, the indicator of a security's investment risk, serves as a measure by which the
12
security's market return requirements can be identified. Securities with high betas require
13
relatively higher returns because these securities exhibit a greater volatility than do
14
securities with relatively lower market betas. A high beta security, when combined with a
15
portfolio of other securities, will increase the portfolio's market variability. This causes a
16
high beta security to be less desirable and consequently, a higher return is required to attract
17
investor capital to a high beta security than to a low beta security.
18
19
20
Q.
WHAT GROUPS OF COMPANIES HAVE YOU UTILIZED TO PERFORM CAPM
ANALYSES?
35
1
A.
I have performed CAPM analyses for the groups of gas distribution companies evaluated in
2
my DCF analyses. I did not perform a CAPM for Chesapeake since Value Line does not
3
follow the Company and assign it a beta.
4
5
Q.
WHAT RATE DID YOU USE FOR THE RISK-FREE RATE?
A.
The first term of the CAPM is the risk free rate (Rf). The risk-free rate reflects the level of
6
7
8
return which can be achieved without accepting any risk.
9
In reality, there is no such thing as a riskless asset. In CAPM applications, the risk-
10
free rate is usually recognized by use of U.S. Treasury securities. This follows since
11
Treasury securities are default-free owing to the government's ability to print money and/or
12
raise taxes to pay its debts.
13
Two types of Treasury securities are often utilized as the Rf component - short-term
14
U.S. Treasury bills and long-term U.S. Treasury bonds.
15
calculations using three-month averages (June-August 1995) for:
16
Yields
17
90 day Treasury bills
18
30 year Treasury bonds
5.43%
6.72%
19
20
Q.
WHAT BETAS DID YOU EMPLOY IN YOUR CAPM?
36
I have performed CAPM
1
A.
I utilized the most current Value Line betas for each company in the groups of comparison
2
companies. These are shown on Schedule 9 and are seen to be within a range of 0.45 to
3
0.75 (the beta for the entire market is 1.00).
4
5
Q.
HOW DID YOU ESTIMATE THE MARKET RETURN COMPONENT?
6
A.
The market return component (Rm) represents the expected return from holding the entire
7
market portfolio. In the CAPM, this term technically reflects the return from holding the
8
weighted combination of all assets (i.e., stocks, bonds, real estate, collectibles, etc.).
9
However, the traditional use of CAPM in utility rate proceedings focuses on Rm as the
10
return on common stocks.
11
Alternative methods have been prepared with which to estimate Rm. As was the
12
case in the DCF analysis concerning investors' expectations of growth, investors do not
13
universally share the same expectations of the return on the overall market. My analysis of
14
the Rm focuses on various returns for the Standard & Poor's 500 Composite - a well-
15
recognized index of the overall stock market. Two measures of return for the S&P 500
16
have been performed and are shown in Schedule 8.
17
18
Page 1 shows the return on equity for the S&P 500 over the period 1978-1994 (all
available years reported by S&P). Several averages were evaluated:
19
20
1978-1994
(all available years)
21
1985-1994
(last 10 years)
14.1%
14.1
37
1
1983-1991
(last complete business cycle)
2
1986-1994
(time period of last business cycle)
3
1990-1994
(last 5 years-length of average
4
13.4
business cycle)
14.4
14.3
5
6
7
Page 2 shows the total return, as tabulated by Ibbotson Associates, on both
arithmetic and geometric means. Again, several averages were evaluated:
8
9
10
11
Arithmetic
12
1926-1994
13
14
15
16
17
18
19
20
21
22
(all available years)
1969-1994
(last 25 years)
Geometric
12.2%
11.3
10.2%
10.1
1984-1994
(last 9 years)
15.1
14.4
1990-1994
(last 5 years)
9.3
8.7
23
24
In estimating Rm, I considered all of the period averages described above. As I
25
indicated previously, since investors do not share universal beliefs and expectations, it is
26
proper to consider alternative time periods and information in estimating the collective
38
1
expectations of investors. Collectively, these indicate a range of returns of 8.7 percent to
2
15.1 percent. The average is 12.4 percent, the median is 13.4 percent, and the mid-point is
3
11.9 percent. I use 13 percent as Rm in my CAPM analysis since this generally represents
4
the middle of these types of averages. I believe a 13 percent Rm for the market is very
5
reasonable and may overstate investor expectations.
6
7
Q.
PLEASE DESCRIBE THE RESULTS OF YOUR CAPM ANALYSIS.
8
A.
Schedule 9 shows my CAPM results. Page 1 employs 90 day Treasury bill yields as Rf and
9
Page 2 uses 30 year Treasury bond yields as Rf. The results are as follows:
10
11
12
T-bills
T-bonds
13
Comparison Group
9.7%
10.3%
14
Moody's Group
9.7
10.3
15
Moul Barometer Group
9.8
10.4
16
17
Q.
18
WHAT IS YOUR CONCLUSION CONCERNING THE CAPM COST OF EQUITY
FOR CHESAPEAKE?
19
20
21
A.
The CAPM results collectively indicate costs of about 10¼ to 10½ percent for the groups of
gas distribution companies. In making this determination, I have placed primary reliance on
39
1
the long-term Treasury bond yield as the risk free rate. As I indicated in my DCF analyses,
2
current financial market conditions cause me to focus on the long-term rate.
3
4
40
1
X.
COMPARABLE EARNINGS ANALYSIS
Q.
PLEASE DESCRIBE THE BASIS OF THE COMPARABLE EARNINGS
2
3
4
5
METHODOLOGY.
A.
The comparable earnings method is derived from the "corresponding risk" standard of the
6
Bluefield case. This method is based upon the economic concept of opportunity cost. As
7
noted previously, the cost of capital is an opportunity cost: the prospective return available
8
to investors from alternative investments of similar risk. If, in the opinion of those who
9
save and commit capital, the prospective return from a given investment is not equal to that
10
available from other investments of similar risk, the available capital will tend to be shifted
11
to the alternative investments. Through this mechanism, opportunity-cost-driven pricing
12
signals direct capital to its most productive uses; thus, a free enterprise system promotes an
13
efficient allocation of scarce resources.
14
The comparable earnings method is designed to measure the returns expected to be
15
earned on the original cost book value of similar risk enterprises. Thus, this method
16
provides a direct measure of the fair return, since it translates into practice the competitive
17
principle upon which regulation rests.
18
The comparable earnings method normally examines the experienced and/or
19
projected returns on book common equity. The logic for returns on book equity follows
20
from the use of original cost rate base regulation for public utilities which uses a utility's
21
book common equity to determine the cost of capital. This cost of capital is, in turn, used as
41
1
the fair rate of return which is then applied (multiplied) to the book value of rate base to
2
establish the dollar level of capital costs to be recovered by the utility. This technique is
3
thus consistent with the original cost rate base methodology used to set utility rates.
4
It can be maintained that the comparable earnings standard is easy to calculate and
5
the amount of subjective judgment required is minimal. The method avoids several of the
6
subjective factors involved in other cost of capital methodologies. For example, the DCF
7
method requires the determination of the growth rate contemplated by investors, which is a
8
subjective factor. The CAPM requires the specification of several expectational variables,
9
such as market return and beta. In contrast, the comparable earnings approach makes use of
10
simple readily available accounting data. In fact, investors are provided with accounting
11
data (i.e., annual reports, Form 10-Ks, prospectuses) on a more frequent basis than market
12
data.
13
In addition, this method is easily understood and is firmly anchored in regulatory
14
tradition (i.e., Bluefield and Hope). Furthermore, this method is not influenced by the
15
regulatory process to the same extent as market-based methods such as DCF and CAPM.
16
The base to which the comparable earnings standard is applicable is the utility's book
17
common equity, which is much less vulnerable to regulatory influences than stock price
18
which is the base to which the market-based standards are applied.
19
20
21
Q.
HOW
HAVE
YOU
EMPLOYED
THE
METHODOLOGY IN YOUR TESTIMONY?
42
COMPARABLE
EARNINGS
1
2
A.
I have conducted the comparable earnings methodology by examining realized and
3
projected returns on equity for several groups of companies and evaluating the investor
4
acceptance of these returns by reference to the resulting market-to-book ratios. In this
5
manner, it is possible to assess the degree to which a given level of return equates to the cost
6
of capital. It is generally recognized for utilities that market-to-book ratios of greater than
7
one (i.e., 100%) reflect a situation where a company is able to attract new equity capital
8
without dilution (i.e., price above book value). As a result, one objective of a fair cost of
9
equity is the maintenance of stock prices above book value.
10
I would further note that the comparable earnings analysis, as I have employed it, is
11
based upon market data (through the use of market-to-book ratios) and is thus essentially a
12
market test. As a result, my comparable earnings analysis is not subject to the criticisms
13
occasionally made by some who maintain that past earned returns do not represent the cost
14
of capital. In addition, my comparable earnings analysis uses prospective returns and thus is
15
not strictly backward looking.
16
17
Q.
18
19
WHAT TIME PERIODS HAVE YOU EXAMINED IN YOUR COMPARABLE
EARNINGS ANALYSIS?
A.
My comparable earnings analysis first considers the experienced equity returns of
20
Chesapeake and the groups of gas distribution companies for the period 1983-1994 (i.e., last
21
12 years). I have examined a relatively long period of time in order to determine trends in
43
1
earnings over at least a full business cycle. In estimating a fair level of return for a future
2
period, it is important to examine earnings over a diverse period of time in order to avoid
3
any undue influence by unusual or abnormal conditions that may occur in a single year or
4
shorter period. Therefore, in forming my judgment of the current cost of equity I have
5
focused on three periods: the period 1990-1994 (last five years), the period 1983-1991 (last
6
complete business cycle), and the period 1986-1994 (the most recent period encompassing
7
the time frame of the recent business cycle).
8
9
Q.
PLEASE DESCRIBE YOUR COMPARABLE EARNINGS ANALYSIS.
10
A.
Schedules 10 through 12 contain summaries of experienced returns on equity for several
11
groups of companies, while Schedule 13 presents a risk comparison of utilities versus
12
unregulated firms.
13
14
Schedule 10 shows the earned returns on average common equity for Chesapeake
and the three groups of gas distribution companies. These can be summarized as follows:
15
16
17
Group
Historic
ROE
Prospective
M/B
ROE
18
Comparison Group
11.2-12.4%
135-162%
11.2-12.1%
19
Moody's Group
11.4-13.4%
132-164%
10.7-12.3%
20
Moul Barometer Group
13.4-13.9%
150-168%
11.0-11.8%
21
Chesapeake Utilities
10.8-15.0%
140-165%
N/A
22
44
1
These results indicate that historic returns of 11-14 percent have been adequate to
2
produce market-to-book ratios of 132-169 percent for the three groups of proxy companies.
3
I note, further, that over these periods, returns on equity have generally declined while
4
market-to-book ratios have increased. This reflects a decreasing cost of common equity
5
over recent years.
6
Furthermore, projected returns on equity for 1995, 1996 and 1998-2000 are within a
7
range of 10.7 percent to 12.3 percent for the gas distribution groups. These relate to 1994
8
market-to-book ratios of 165 percent and higher.
9
10
Q.
HAVE YOU ALSO REVIEWED EARNINGS OF UNREGULATED FIRMS?
11
A.
Yes. As an alternative, I also examined a group of largely unregulated firms. I have
12
examined the Standard & Poor's 500 Composite group, since this is a well recognized group
13
of firms that is widely utilized in the investment community and represents an indication of
14
the competitive sector of the economy. Schedule 11 presents the earned returns on equity
15
and market-to-book ratios for the S&P 500 group over the past twelve years. As this
16
schedule indicates, over the three periods this group earned average returns ranging from
17
13.3-14.4 percent and with market-to-book ratios of 187-265 percent. This information
18
shows that although annual earnings have fluctuated substantially, the period averages are
19
fairly constant. On the other hand, over the past ten years market-to-book ratios have
20
increased, reflecting a decline in the return levels required by investors. The years 1989
45
1
through 1994, in particular, have had market-to-book ratios over 220 percent and were 298
2
percent and higher in 1993 and 1994.
3
Schedule 12 shows further evidence that earnings declined from their 1977-1981
4
highs and remained relatively low through 1987. From the latter half of 1988 to the first
5
half of 1989, earnings levels increased somewhat before declining again through 1992.
6
Since 1992, earnings have increased again.
7
8
Q.
9
10
HOW CAN THE ABOVE INFORMATION BE USED TO ESTIMATE THE COST
OF EQUITY FOR CHESAPEAKE?
A.
The recent earnings of the gas distribution and S&P 500 groups can be utilized as an
11
indication of the level of return realized and expected in the regulated and competitive
12
sectors of the economy. In order to apply these returns to Chesapeake, however, it is
13
necessary to compare the risk levels of this industry with those of the competitive sector. I
14
have done this in Schedule 13 which compares several risk indicators for the S&P 500
15
group, the gas distribution groups, and Chesapeake.
16
The information in this schedule indicates that the S&P 500 group is more risky
17
than the gas distribution industry in general. Chesapeake is not followed by Value Line, so
18
that it is difficult to compare to the gas distribution industry.
19
20
21
Q.
WHAT RETURN ON EQUITY IS INDICATED BY THE COMPARABLE
EARNINGS ANALYSIS?
46
1
A.
Based on the recent earnings and market-to-book ratios, I believe the comparable earnings
2
analysis indicates that the cost of equity for gas distribution companies is no more than 11
3
to 11½ percent. Recent returns of 11-14 percent have resulted in market-to-book ratios of
4
132 or over. Prospective returns of 10½-12½ percent have been accompanied by market-to-
5
book ratios of over 160 percent. As a result, it is apparent that returns below this level
6
would result in market-to-book ratios of well above 100 percent. An earned return of 11 to
7
11½ percent or less should thus result in a market-to-book ratio of at least 100 percent.
8
47
1
XI.
RETURN ON EQUITY RECOMMENDATION
Q.
PLEASE SUMMARIZE THE RESULTS OF YOUR THREE COST OF EQUITY
2
3
4
5
6
ANALYSES.
A.
My three methodologies collectively indicate a range of 10 percent to 11¾ percent for the
gas distribution industry, as summarized below:
7
Discounted Cash Flow
8
Capital Asset Pricing Model 10¼-10½%
9
Comparable Earnings
10-11¼%
11-11½%
10
My overall conclusion for these groups is a range of 10½-11½ percent, which focuses on
11
the upper ends of these findings.
12
13
48
1
XII.
TOTAL COST OF CAPITAL
3
Q.
WHAT IS THE TOTAL COST OF CAPITAL FOR CHESAPEAKE?
4
A.
This is shown on Schedule 14 which shows the total cost of capital for the Company using
2
5
the proposed capital structure and cost of debt along with my cost of common equity
6
recommendation. The resulting total cost of capital is a range of 9.62-10.19 percent (9.90
7
percent mid-point).
8
9
Q.
DOES YOUR COST OF CAPITAL RECOMMENDATION PROVIDE THE
10
COMPANY WITH SUFFICIENT EARNINGS LEVELS TO MAINTAIN ITS
11
FINANCIAL INTEGRITY?
12
A.
Yes, it does. Schedule 15 shows the pre-tax coverage that would result if Chesapeake
13
earned the mid-point of my cost of capital recommendation. As this indicates, the mid-
14
point of my recommended range would produce a coverage level which is within the
15
benchmark range for an A rated gas distribution utility.
16
17
In addition, the debt ratio in my recommendation is 43 percent. This is in the "A"
benchmark range.
18
49
1
2
XIII. COMMENTS ON COMPANY TESTIMONY
3
4
Q.
DO YOU WISH TO COMMENT ON PORTIONS OF MR. MOUL'S TESTIMONY?
5
A.
Yes. I will comment on each of Mr. Moul's four methods he utilizes to determine the cost
6
of equity for Chesapeake, namely comparable earnings, DCF, risk premium, and CAPM. I
7
also have some comments on Mr. Moul's perceptions of the change in risks of the gas
8
distribution industry.
9
10
Q.
PLEASE SUMMARIZE MR. MOUL'S COMPARABLE EARNINGS METHOD.
11
A.
Mr. Moul's comparable earnings analysis examines the historic and forecast return for eight
12
non-utility companies which he selected as being of similar risk to his barometer group. He
13
calculated a five-year historic median return on equity of 12.1 percent and a 3-5 year
14
forecast median return of 14.5 percent, which average 13.3 percent (his recommendation).
15
I note, first that the mere equivalence of timeliness, beta, safety, financial strength,
16
price stability and technical rank (the six indicators used by Mr. Moul to compare risk
17
between utilities and non-utilities) does not indicate that the required or expected earnings
18
are the same. For example, the projected 3-5 year returns for the non-utilities is 14.5
19
percent in Mr. Moul's Attachment PRM-6, whereas the projected returns for Mr. Moul's
20
barometer group is 11.8 percent (see my Schedule 10). Thus, utilities are able to maintain
21
similar Value Line rankings even though their expected earnings are lower. This indicates
50
1
that the required earnings are greater for the non-utilities that for utilities such as
2
Chesapeake. I note that the eight non-utility companies, who have historic equity returns of
3
12.1 percent and forecast returns of 14.5 percent, have 1995 market-to-book ratios of 276
4
percent (Schedule 16). The clearly demonstrates that an expected return of 13.3 percent is
5
well above the required cost of equity for these companies.
6
7
Q.
8
9
PLEASE SUMMARIZE YOUR UNDERSTANDING OF MR. MOUL'S DCF
ANALYSIS.
A.
10
Mr. Moul performs DCF analyses for a barometer group of fifteen natural gas utilities. His
results are as follows:
11
Barometer Group
12
Yield
6.46%
13
Growth
5.50%
14
M/B
1.025%
15
DCF
12.26%
16
17
Q.
18
19
WHAT COMMENTS DO YOU HAVE CONCERNING MR. MOUL'S GROWTH
RATE RECOMMENDATION?
A.
Mr. Moul recommends a 5.50 percent growth rate for his barometer group. It is evident that
20
these exceed investor expectations and are not supported by Mr. Moul's analyses. As is
21
indicated on Mr. Moul's Attachments PRM-8 and PRM-9, both the historic and projected
51
1
growth rates of EPS, DPS, BVPS and cash flow per share (CFPS) are below his
2
conclusions. Only one of nine historic growth rates are as high as 5.5 percent and none of
3
the eight long-term projected growth rates are as high as 5.5 percent. Mr. Moul's conclusion
4
can only be derived by relying exclusively on the highest estimators, namely the short-term
5
projections. I do not regard this to be a realistic interpretation of the actual growth rate
6
indicators and Mr. Moul offers no evidence that investors focus only on the most optimistic
7
and only short-term estimators. In addition, the DCF model is based upon a long-run
8
perspective of investor expectations, which also makes Mr. Moul's short-term focus
9
improper.
10
I also disagree with Mr. Moul's 0.5 percent increment for "market-wide factors to
11
the growth rate shown by Company-specific variables". There is no justification for adding
12
this increment. In fact Mr. Moul acknowledged, in response to OPC Data Request No. 5,
13
Question 8, that he knows of no studies which support such an adjustment. All of the
14
factors listed on pages 40-41 of Mr. Moul's testimony should be known by investors and
15
therefore already incorporated in the stock prices and therefore DCF results. This follows
16
since the stock market is widely accepted to be one of the most efficient markets in the
17
world, which implies that all relevant information is reflected in stock prices.
18
19
20
Q.
WHAT COMMENTS DO YOU
HAVE CONCERNING MR. MOUL'S
FLOTATION COST ADJUSTMENT?
21
52
1
A.
Mr. Moul multiplies his DCF (as well as risk premium and CAPM results) result by 1.025
2
as a flotation cost adjustment. Chesapeake has not had a public offering of common stock
3
since at least 1990 (see response to Question No. 5 of OPC Data Request No. 6). As a
4
result, no flotation cost adjustment is necessary since to do so would permit the recovery of
5
costs which cannot be shown to have been incurred. Even if a flotation cost adjustment
6
were justified, Mr. Moul's proposed adjustment is excessive. Application of his 0.3 percent
7
(30 basis points) adjustment to the cost of equity increases his total cost of capital by 0.17
8
percent (17 basis points, or 56.62% common equity ratio times 0.3% cost of equity
9
increment). This cost of capital increment, if applied to an approximate rate base of
10
Chesapeake's gas distribution operations of $40 million, results in a revenue requirement of
11
$68,000, plus the tax effect (which approximately doubles this result).
12
increment of some $140,000 is a windfall to Chesapeake's stockholders, since it represents
13
expenses which have not been incurred.
This annual
14
In addition, there is no need to make a market/book adjustment, as Mr. Moul
15
recommends. As my Schedule 10 indicates, his barometer group has 1994 market-to-book
16
ratios of 166 percent.
17
18
Q.
PLEASE SUMMARIZE MR. MOUL'S RISK PREMIUM ANALYSIS.
19
A.
Mr. Moul performs a risk premium analysis by combining the "prospective long-term debt
20
cost rate for a public utility with an A bond rating" (8.00 percent) with a 5.00 percent risk
53
1
premium to derive a 13.00 percent cost of equity. To this he adds a 0.30 percent "market-
2
to-book modification factor" to get a 13.30 percent risk premium result.
3
4
Q.
WHAT ARE YOUR COMMENTS ON MR. MOUL'S DEBT COST RATE?
5
A.
Mr. Moul's 8.00 percent cost rate of public utility debt over-states the current cost rate of A-
6
rated debt. As my Schedule 2, page 2, indicates, the yield on A-rated utility debt has been
7
lower than 8.00 percent since May of 1995 and was 7.83 percent in August.
8
9
Q.
PLEASE COMMENT ON MR. MOUL'S 5.0 PERCENT RISK PREMIUM.
10
A.
Mr. Moul's risk premium conclusion of 5.00 percent is developed by computing total
11
returns (dividends/interest income plus capital gains/losses) for various classes of securities
12
over various periods of time dating back to 1928. I do not regard this historic happenstance
13
to accurately and singularly measure the risk premium which investors currently expect.
14
Mr. Moul's Attachment PRM-12 provides a demonstration of this. The total return
15
of the S&P public utility stock index is 8.78 percent (geometric mean return) or 10.98
16
percent (arithmetic mean return) over the 1928-1993 period. If this is the return on equity
17
which investors expect, this is a contradiction of Mr. Moul's 13.3 percent conclusion and
18
affirms my recommendation of 10½ percent to 11½ percent. Even though these results can
19
be viewed as confirming my recommendation, I remain convinced that the total return
20
concept is not well-suited to estimate the cost of equity for a public utility.
21
54
1
2
3
Q.
PLEASE SUMMARIZE MR. MOUL'S CAPM METHODS.
4
A.
Mr. Moul's CAPM methods have the following results:
5
Rf
+

6
(Rm-Rf)
=
k
+
adj.
=
K
"Traditional" CAPM
7
7.00% .52
7.92%
8
11.12%0.30%
11.42%
"Zero Beta" CAPM
9
10.89%
.52
3.98% 12.96%
0.30%
13.26%
10
11
Q.
WHAT ARE YOUR COMMENTS ON MR. MOUL'S RISK FREE RATE?
12
A.
Mr. Moul's "traditional" risk-free rate (Rf) reflects the yield on 30 year Treasury bonds.
13
Currently yields on 30 year Treasury bonds are well below the 7 percent level he utilizes.
14
For the first nine months of 1995, 30 year Treasury bond yields have been:
15
Jan
7.85%
16
Feb
7.61%
17
Mar
7.45%
18
Apr
7.36%
19
May
6.95%
20
Jun
6.57%
21
Jul
6.72%
55
1
Aug
6.86%
2
Sep
6.55%
3
Current yields are well below 7 percent, in the 6.5 percent area.
4
5
Q.
PLEASE COMMENT ON MR. MOUL'S RISK PREMIUM.
6
A.
Mr. Moul's "traditional" 7.92 percent risk premium (Rm - Rf) is developed by estimating the
7
total market forecast return for the 1,700 stocks followed by Value Line, as well as the
8
1926-1993 risk premium based upon the Ibbotson Associates total return. I have the same
9
concerns about the total return concept as I expressed in my risk premium comments.
10
In addition, the 14.9 percent market return (Rm) implicit in Mr. Moul's analyses (i.e.,
11
solving the traditional CAPM equation for Rm) is clearly excessive. My Schedule 8
12
demonstrates that the S&P 500 group (which is used in Ibbotson Associates studies) has an
13
expected return of about 13 percent, not 14.9 percent as implied in Mr. Moul's analyses. If
14
Mr. Moul's CAPM were properly performed with a 13.0 percent market return (even
15
assuming no change in Rf to reflect current yields), the following returns result:
16
Rf
17
7.0%
+

(Rm-Rf)
.52
(13.0%-7.0%)10.1%
=
K
18
19
20
Q.
DO YOU HAVE ANY ADDITIONAL COMMENTS ABOUT MR. MOUL'S RISK
PREMIUM AND CAPM ANALYSES?
56
1
A.
Yes, I do. Mr. Moul's risk premium method reaches a 13.26 percent conclusion while his
2
"traditional" CAPM method reaches a 11.42 percent conclusion. There are quite divergent
3
results, especially considering that the CAPM is a form of the risk premium method. Stated
4
differently, the risk premium method is a CAPM with an assumed beta of 1.0. The higher
5
result of Mr. Moul's risk premium method is a demonstration that this analysis fails to
6
recognize the lower risk which regulated gas distribution utilities face vis a vis non-
7
regulated firms.
8
9
Q.
10
11
DO YOU HAVE ANY ADDITIONAL COMMENTS REGARDING MR. MOUL'S
ASSESSMENT OF THE RISKS OF THE GAS DISTRIBUTION INDUSTRY?
A.
Yes. Mr. Moul claims that the gas distribution industry now encounters more risk than it
12
did in recent years. In support of this he cites the impact of FERC Order 636 which
13
restructured the pipeline industry. I disagree with Mr. Moul's contentions. First, as noted
14
by Standard & Poor's in its April 25, 1994 CreditWeek:
15
16
17
18
19
20
21
22
23
24
25
26
27
28
"Industry Well Positioned - S&P delayed announcing these
business positions until now so that an evaluation could be made
regarding each company's operating performance in the Federal
Energy Regulatory Commission Order 636 environment. Order 636
unbundled pipeline rates and services and thrust greater gas supply
responsibilities on the distributors. This past winter has proven to be
an excellent test. The industry performed without any problems, that
is, without a shortfall of natural gas. While one winter does not
constitute a complete test, it appears the distributors in S&P's ratings
universe contracted for adequate gas supply and pipeline capacity for
a cold winter. Still a better understanding of the industry's gas
supply and transmission strengths and weaknesses will come after
several winters.
57
1
2
3
4
5
6
7
8
9
10
Nevertheless, S&P is still not overly concerned about the
risks thrust upon gas distributors by Order 636. Pipelines have been
unbundling their services and distributors have been managing their
own gas supplies since Order 436 was implemented in 1985. The
industry is far up the learning curve in this regard. All the S&P-rated
gas distributors, which comprise the 60 largest distributors in the
country (including combination companies), are believed to be of
significant size and to possess the management talent to handle the
gas supply role efficiently."
11
12
In addition, it must be remembered that risk is a relative concept, as virtually all
13
industries have changing risk characteristics. In this regard it is apparent that, on a relative
14
basis, the gas distribution industry's risk has not increased. This is demonstrated on
15
Schedule 17, which compares several risk indicators of Value Line and Standard & Poor's
16
in 1990 (pre-Order 636) and 1995. As this indicates, the relative risk of both the Moody's
17
gas distribution group and my comparison group have not changed appreciably.
18
19
Q.
DOES THIS CONCLUDE YOUR PRE-FILED TESTIMONY?
20
A.
Yes, it does.
58
Exhibit___(DP-1)
Schedule 15
CHESAPEAKE UTILITIES
PRE-TAX COVERAGE
PERCENT
Long-Term Debt
43.38%
Common Equity
56.62
Total
WEIGHTED PRE-TAX
COST
COST
8.48%
11.00
100.00%
Pre-Tax Interest Coverage
1/
COST
RATE
=
=
3.68%
3.68%
6.23
9.58 1/
9.91%
13.26%
13.26/(3.68)
3.60x
Post-Tax weighted cost divided by .65 (1-.35 tax rate)
Standard & Poor's Benchmark Guidelines for Gas Distribution Companies:
AA
A
BBB
3.75x
4.25
--
3.00x
3.75
4.25x
2.00x
2.75
3.25
46%
41%
--
51%
46%
42%
58%
53%
49%
Pretax Interest Coverage
Above Average Business Position
Average Business Position
Below Average Business Position
Total Debt to Total Capital
Above Average Business Position
Average Business Position
Below Average Business Position
BEFORE THE MARYLAND
PUBLIC SERVICE COMMISSION
CHESAPEAKE UTILITIES CORPORATION
CASE NO. 8707
DIRECT TESTIMONY
OF
DAVID C. PARCELL
TECHNICAL ASSOCIATES, INC.
ON BEHALF OF
MARYLAND PEOPLE'S COUNSEL
OCTOBER 16, 1995