ML18230A828
| ML18230A828 | |
| Person / Time | |
|---|---|
| Site: | Harris  |
| Issue date: | 03/23/1977 |
| From: | Currin H State of NC, Utilities Commission |
| To: | Office of Nuclear Reactor Regulation, State of NC, Utilities Commission |
| References | |
| Download: ML18230A828 (26) | |
Text
Decl(N@~
Coal 7 Date ~ of Qocume&n.
HMU TO YOOEKHFlLE BEFORE THE NORTH CAROLINA UTILITIES COMMISSION In the Matter of g EcE1vED gg ps m77 APPLICATIOH OF CH)EF CL"=RK CAROLIHA POWER AND LIGHT COMPANY )cw s~vES SP COaAlAlSS)OH FOR INCREASE IH RATES DOCKET NO. E-2, SUB 297 Testimony of H. Randolph Currin, Jr.
Senior Operations Analyst, Operations Analysis Section Division of Engineering Staff, North Carol ina Util i ties Conmissi on March 23, 1977
GENERAL Mould you please state your name, business address, and position with the North Carolina Utilities Comnission?
' A. My name i's H. Randol ph Curri n, Jr. My bus i ness address is One West 4 Morgan Street, Raleigh, North Carolina. I am presently employed as Senior Operations Analyst in the Operations Analysis Section of ..
the Engineering Division of the North Carolina Utilities Comnission.
8g. Would you please outline your educational background and experience?
9A. I graduated in 1972 from Duke University, Durham, North Carolina 10 with a Bachelor of Science degree in Electrical Engineering.
ll Upon graduation, I accepted employment with Duke Power Company 12 in Charlotte, North Carolina. I spent three montns in the 13 General 0 fice in Charlotte, developing a computer program 14 for Duke's Construction Management Program. Thereafter, I C
15 worked thirteen months in the Durham District as an Assistant 16 Engineer. My responsibilities there included large commercial and 17 industrial installations, coordination of circuit protective devices, system planning, new circui t design, analysis of circuit 19 voltage levels, supervision and instruction of student engineers, I 20 and emergency s~ tuation duty.
21 22 In August, 1973, I left Duke Power Company to enter. the Graduate 23 School of Industrial Administration at Carnegie-Mellon University 24 in Pittsbu-gh, Pennsylvania. During the surfer of 1974, I was 25 coordinator of a $ 5,000,000 project for a Burlington Industries
.26 plant in Romo, Georgia. Concurrent with my final year of studies
at Carnegie-Mellon, I undertook management consulting work for WRS 2 Motion Picture Laboratories and the University. In May, 1975 I 3 was award'ed a Master of Business Administration degree {or 4 Industrial Administration, as it is called there). My studies 5 there were concentrated in finance, corporate planning, and 6 management consulting. I joined the North Carolina Utilities 7 Commission on June 1, 1975.
gQ. What is the nature o your testimony in this docket?
10A. I shall testify as to the cost of capi.tal and fair rate of return of Carolina Power and Light Company.
12 13Q. Have you. previously offered testimony before this Commission?
1<A. Yes. I have testified as to the cost of capital and fair rate of 15 return in numerous cases before this Commission.
16 17Q. Are you generally familiar with the organization and operation of 18 CPSL?
19 A. Yes, I have reviewed the application of the Company to adjust its 20 rates for el ectri c power servi ce wi thin North Carol ina. I have 21 studied the information submitted by the Company with regard to 22 the information request of the Commission Staff. I have also 23 examined the testimony offered to the Commission by the witnesses 24 represent'ng the Company.
25 26Q. What sources of information did you employ in preparing your cost 27 of capital and fair rate of return analysis?
~
3 M lA. In addition to the data supplied by the applicant I gathered information from the following journals and news publications:
B IMIIB.J I,B,~MB'l l,dll ll 4 Investment Surve . I also referred to the North Carolina General 5 Statutes and a number of publications and texts in business and 6 finance.
7THE COST OF CAPITAL APPROACH As a theor tical proposition, how should the cost of capital and 9 the fair rate of return be determined?
lOA. The cost of capital is the price a firm must pay to "rent" money from those who are willing and able to supply it, just as the cos of renting an operations center is the amount paid by the utility to the owner of the building. Since uncertainty exists as to the actual return that a firm will realize from its operations, the return expected by investors will vary among the different forms of capital !bonds, preferred stock, and conmon equity) to allow l7 for temporal and risk differentials. The overall cost of capital to a particular firm can be derived from the weiqhted average of l9 the cost rates and capital structure proportions of the different 2O sources of capital. This is, in essence, the cost of capital approach.
22 23 A determination of the cost rate of bonds and prefer red stock i s a simple exercise because the prices paid for these sources of 25 capital are fixed when they are initally supplied to the firm.
M 26
-4 1 A determination of the cost rate for common equity is a far more 2 complex and controversial problem since there is no guaranteed 3 return by'he firm to the stockholder. A potential shareholder 4 only provides capital to the firm when his ~ex ected returns are 5 sufficiently high to induce him to invest in the particular firm 6 rather than some other risk-return alternative. Thus, an analysis 7 of the cost of equity capital is actually an analysis of the 8 expectations of potential investors.
log. How is the fair rate of return related to the cost of capital?
llA. With regards to the regulation of public utilities, the fair rate 12 of return can only be determined by giving recognition to the 13 costs of. the Company incurred in serving its customers. The simul-14 taneous equitable treatment of bvth the Company's stockholders and 15 customers demands that the company be granted rates which will 16 yield an amount equal to operating costs and capital costs. As 17 public utilities are very capital intensive, the capital costs 18 will comprise a substantial percentage of the total service costs.
19 20 Should the Company be allowed a rate of return in excess of its 21 cost of cap.'tal, the investor will earn monopoly profits .through the unreasonably high rates. This excessive return'ould unfairly 23 redistribute income from the consumer to the investor. Hy the 24 same token, should the company be granted a rate of return below 25 its cost of capital, the value of equity shares would decline,
,26 which w'ould, in effect, allow the consumers to confiscate a
1 por tion of the shareholder's investment. This level of return 2 would also have a deleterious long-run effect on the consumer, 3 because the Company would be unable to attract sufficient capital 4 to maintain or improve the quantity and quality of future service.
6 Consequently, a total dollar return based on the operating expenses and 7 the cost of capital will allow the company to meet its service and 8 financial obligations and to establish a suff'iciently sound repu-g tation to attract future investors. Thus, there is one, and only 1O one, rate of return that is fair in terms of effi cient resource 11 allocatior. and distributional justice. That fai r rate of return 12 is the cost of capital.
13 149. How do you define the cost of equity capi tal?
lSA. From the perspective of the Company, the cost of equity is the 16 supply price of equity, the rental rate the Company must pay in 17 the equity market. Thus, the cost of equity capital is the 18 ~ex ected retu'rn which the investor requires before he is willing 19 to lend capital to the Company. Why his expected rate of return?
20 Unlike the holder of bonds or preferred stock, the equity investor 21 has no contractural agreement with the Company as to the rate of 22 return, if any, he will recei ve. Accordingly', the purchase of an v
23 equity interest is riskier than the purchase of a fixed interest 24 security. The investor makes the decision to purchase co+non 25 stock based upon his expectations of the Company's future earnings.
26 Only if the investor perceives his expected return from a stock to
be large enough to compensate him for the apparent, risk involved, will he be willing to rent his capital to the Company.
4g. What, considerations are involved in determining an investor's re-quired rate of return?
6A. The investor must anticipate the cost incurred by him in supplying his capital to a particular firm. The cost is the exp cted return forfeited by not purchasing the stocks of alternative companies of 9 similar risk. Thi s i s the economi c concept of opportuni ty cost.
10 When an inves".,or purchases the common equity of a particular company, he is saying, in effect, that his expected return exceeds or equals the cost incurred by not purchasing a different stock of 13 similar risk.
14 159. What technique did you employ to estimate the cost of equity capital 16 to CPSL?
17A. I used the Discounted Cash Flow valuation model. The model states 18 that the price of a share of stock is a result of all future returns 19 (known or expected) to the investor, discounted at th investor's 20 opportunity cost of capital, or his capitalization rate. The 21 discounting process is required since returns tomorrow are less 22 valuable than returns today. Given a flow of'returns, the investor's 23 capitalization. rate can be precisely derived if there is market information on the price of the asset. The efficient market for 25 equity issues provides this market information.
26
The DCF model states that the market value of the equity of the firm is equal to the discounted future cash flows received by 3 the investor in each time period, t.
4 Price =
Dt t 1 Dt 2 -1
~1+K) ~1+K ~1+KK1 ~1+K 4 5
where D is the dividend and K is the capitalization rate. If we 7 assume that dividends grow at a constant rate, gD, in the limit, 8 K = D + gyp or p
9 1O the capitalization rate equals the current dividend yield plus the expected growth in dividends (assuming that the price of the stock will appreciate at ihe same rate, gD, as the dividends).
13 Thus, the investor can realize his required return from a combination of current yield and price appreciation.
15 Although the DCF model is a theoretically precise method of determining the cost of capital to a growing firm, the model can not be implemented empirically with mathematical precision because 19 the future cash flows to the investor can not be known with certainty.
2p This is not tc say we are completely ignorant of the future. Since investor expectations are formed from past company performance and informed projections of the future, the analyst can approximate 23 investor behavior by careful ly studying the same expectation-forming information.
25 26 THE COST OF EQL'ITY CAPITAL TO CAROLINA POWER AND LI"~HT COMPANY
The applica .ion of the DCF technique requires the use of estimates 2 of the dividend yield and growth rate. The dividend yield is 3 observable in the daily market transactions in a company's stock, 4 but the dividend yield determined from one daily pr".'ce may be 5 misleading if the price fluctuates. An average dividend yield 6 figured over some period of time is preferable to the choice of 7 any single daily yield figure, but the time period used for averaging should not be so long as to obscure changes in the cost 9 of equity in the capital markets.
10 The est~mates of future growth are somewhat more difficult to 12 , obtain. Investors are looking to the future, and there is always 13 some uncertainty associated with any estimation of the future.
14 It is generally reasonable, however, to postulate that a major 15 determinant of expected future growth is past realized rates of 16 growth.
17 18 0 Specifical iy, how did you calculate the dividend yield?
19 A. As illustrated in Currin Exhibit 1, first, I calculated weekly 20 dividend yields for the six months September 1976 - February 1977.
21 Then I averaged the weekly yields to obtain monthly yields. Finally, 22 I calculated a weighted average of the monthly average yields, weighting the most recent month the heaviest. The resultant yield 24 was 7.57%.
26/. How did you c'alculate the growth rate?
1 A. As shown in Currin Exhibit No. 2, I used company data to calculate 2 the growth rates in earnings and dividends per share for the peri-3 ods 1966-1967 to 1975-1976. Then I ca1culated a weighting average of the yearly average growth rates, weighting the most recent period the heaviest. I then averaged the weighted average earn-ings and dividends growths. The resultant growth rate is 4.61$ .
8 g. What is the bare cost of equity capital to Caro1ina Power and Light Company as 'indicated by the DCF technique?
10 A. 12.1GX, which results from adding the growth rate to the dividend yield.
12 g. Is this the cost of equity for Carolina Power and Light that 13 you employ in subsequent calculations?
14 A. No. To enable the company to net book value on a common stock sale, an increment must be added to the bare cost of equity to allow for issuance expenses and market pressure, if any.
18 g .. Wl>at allowance, then, did you make for i s suances expenses?
19 A. The issuance expenses in Carolina Power and Light's two most 20 recent common stock sales have been 3.695 and 2.70 . I used the 21 average ((3.69 + 2.70)/2 = 3.20) of these two numbers as a reason-22 able representation of what the company might experience in its 23 next sale of cordon stock.
259. What allowance did you make for market pressure?
26A. I made a study of market pressure based on Carolina Power and
Light's most recent common stock sal.e. On September 16, 1976, a registration statement was filed with the Securities and Exchange Corrmission. On October 20, 1976, three million shares of corrmon stock were sold.
5 Given that the SEC registration marked the firs': instance that the "public" had knowledge of CP&L's specific stock sale plans, it is reasonable to assume that there might have been some 9 downward pressure on CP&L's stock price immediately following 10 the registration announcement. Accordingly, I looked at the closing pri:es of CPKL's common stock for a period of 10 trading 12 days immediately before registration and 10 trading days immed-13 iately after registration. For the same time period, I a'iso 14 looked at the closing values of the Standard and Poors Utilities 15 Index for a frame of reference. Obviously, a 5Ã drop in CP&L's 16 stock during the week after registration would not indicate market pressure if the Index declined 10/ over the same time period.
19 20 A visual inspection of the graph in Currin Exhibit No. 3 does 21 not indicate any apparent market pressure during the registration 22 period. This is confirmed by calculating the net change in the 23 relationship between the average price of CP&L's stock vs. the 24 average S&P Utilities Index for the 10 days prior to registration 25 to the appropriate ratio for the 10 days subsequent to registration.
26 As shown in Currin Exhibit No. 4, CP8L experienced a net gain of
1.64Ã over the Index after registration. Clearly there was no market pressure on CPSL's stock from the registration.
The second date about which I attempted to measure market pres-sure was the date of the co+ron stock sale. Using the same methodology as with the registration date, Currin Exhibits No. 5 and 6 show the results. CPKL experienced a decline of .53K relative tc the Index in the period after the common stock sale.
10 In further comparison of CPAL vs. the SEP Utilities Index for the 10 days prior to registration with the 10 days subsequent 12 to sale indicates that there has been more than the .53Ã market 13 pressure which occurred during the sale period. Currin Exhibit No. 7 shows this gradual decline in CPGL's relationship with the 15 Index to the 2.45K.
16 17 g. What, then, is the total allowance for issuance expenses and 18 market pressure which you deem to be reasonable?
19 A. I found the sum of issuance expenses and market pressure to 20 be 5.65K.
21 229. What is the resultant cost of equity to Carolina Power and Light 23 Company?
24A. As shown in Currin Exhibit No. 8, I found CPRL's adjusted cost of 25 equity to be 12.91<.
1 g. >Ihat did you find to be the total cost of capita') to CP&L?
2A. Using 12.91" as the cost of equity, and 7.71K and 8.01~ as the 3 costs of debt and preferred stock, I calculated ihe weighted cost of capital to CP&L to be 9.21K This is shown in Currin 5 Exhibit i'~o. 9.
6 In your analysis of the cost of capital for CP&L, did you perform any other studies other than those already discussed?
9A. Yes, I did. As a check on the results of my application of the
]D DCF formv')a to CP&L, I made the same calculations for Duke Power Company. Though there are many similarities between Duke and CP&L, 12 it should be almost universally recognized that an investment in 13 Duke is rot as risky as an investment in CP&L. Duke is larger, has a better bond rating, has lower plant construction costs, more efficient plants, etc. Accordingly, the cost of capital, debt and equity, is lower for Duke than CP&L.
17 18 Using the OCF formula in exactly the same manner for Duke as CP&L, 19 I calculated Duke's bare cost of equity. As shown in Currin Exhibits 2p 10 and ll, the dividend yield of 7.37K and the growth rate of 4.47K add to indicate a bare cost of equity for Duke of 11.84~. This 22 compares i!ith 12.18~ for the same number for CPAL.. hi) ile this 23 doesn '
verify my findings for CP&L, it does show that the DCF formula does yield consistent, and not obviously unreasonable results.
25 2g. Does this conclude your testimony?
27A. Yes, it does.
CURRIN EXHIBIT NO NCUC DOCKET NO. E-2, SUB 297 Carolina Power and Light Company Dividend Yield September 3 7.9 October 1 7.3 November 5 8.0 10 7.7 8 7.8 12 7;9 7.6 7.9
'.7 17 15 19 24 7.4 22 8.0 26 7.4 29 7.9 Average 7.65 Average 7.. 78 Average 7.75 December 3 7.4 January 7 7.5 February 4 7.4 10 7.2 14 7.7 11 7.6 17 7.1 21 7.8 18 7.7 24 7.2 28 7.4 25 7.8 31 F 1 Average 7.20 Average 7.60 Average 7.63 Weighted Average Dividend Yield =
(l(7.65)+2(7.'~8)+3(7.75)+4(7.20)+5(7.60)+6(7.63))/21 =
7.57K
CURRIN EXHIBIT iVO, 2 NCUC DOCKET NO. E-2, SUB 297 Carolina Power and Light Company Growth Yield Earnings Per Share Dividends Per Share 1966 $ 1.87 $ 1.30 1967 '1. 91 1.35 1968 1.98 1.39 1969 2.05 1.43 1970 1.56 1.45 1971 1.97 1.46 1972 2.86 1.48 1973 2.58 1.56 1974 2.21 1.60 1975 2.70 1.60 1976 2.74 1.69 Growth 66-67 2.14 x 1 = 214 3.85 x 1 = 3.85 67-68 3.66 x 2 = 7+33 2.96 x 2 = 5.93 68-69 3.54 x 3= 1061 2.88 x 3 = 8.63 69-70 -23.90 x 4 = -95.61 2.10 x 4 = 8.39 70-71 26.28 x 5 = 131.41 Ox 5 = 0 71-72 45.18 x 6 = 271.07 1.37 x 6 = 8.22
-9.79 x 7 = -68.53 5.41 x = 37.84 72-73 7
-14.34 x 8 =-114.73 2.56 x 8 = 20.51 73-74 74-75 22.17 x 9 = 199.55 Ox 9 = 0 x 10 = 14.81 5.63 x 10 = 56.25 75-76 1.48 358.04/55 = 6.51 149.62/55 = 2.72 Average Growth Y'ield = (6.51 + 2.72)/2 = 4.61%
CURRIN EXHIBIT NO. 3 NCUC DOCKET NO. E-2. SUB 297 CP&L Common Stock Price Ys. S&P Utilities Index 9/l/76 - 9/30/76 aa ao b! b!
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CURRIN EXHIBIT NO. 4 NCUC DOCKET NO. E-2, SUB 297 PAGE 1 OF 2.
Market Pressure Analysis Registration Period CPLL SEP Utilities Index
$ 21. 75 49.30
- 21. 50 49.28
- 21. 875 49.58 22.375 5G.03 22.25 50.2 22.25 50.3 22.25 50.58 22.75 50.60 22.875 50.56 22.75 50.53 REGISTRATION 22.625 50.79 22.625 51.19 22.875 51.29 22.875 51. 56 23.125 51. 46 23.125 51.22 23.125 51.04 23.50 51. 20 23.25 50. 99
.23.25 50.79 23.25 50.71
CURRIN EXHIBIT NO. 4 NCUC DOCKET NO. E-2, SUB 297 PAGE 2 OF 2 Market Pressure Analysis Registration Period Ten Trading Days Prior CPEL Average SBP Utilities Index Average CPL/SRP UI 22.26 50.10'4444 Ten Trading Days Subsequent CPGL Average SAP Utilities Index Average CPL/SKP UI 23.10 51.15 .4517 Net Change in CPSL-S&P UI Relationship
= .4517-.4444 x 1005
,4444
= +1.64%
CURRIN EXHIBIT NO. 5 HCUC 00CKET NO. E-2, SUB 297 CP&L Collmlon Stock Price Vs. S&P Utilities Index 10/6/76 - 11/4/76 QO ~ ~ ~ ~
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CURR'N EXHIBIT NO. 6 NCUC DOCKET NO. E-2, SUB 297 PAGE 1 OF 2 Harket Pressure Analysis Sal es Peri od CP5L SEP Utilities Index
$ 22.25 50.74 22.125 50.91 22.00 50.76 22.00 50.47 22.125 50.32 22.25 50.65 22.125 50.48 21.75 50.09
- 21. 75 50.12 21.50 49.99 SALE 49.89
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51 21.625 49.63 21.375 49.25 21.375 49.26 21.375 49.41 21.625 49.57
- 21. 875 49.81
- 21. 75 50.29 21." 875 50.44 21.375 50.01 21.50 50.07
CURRIN EXHIBIT NO. 6 NCUC DOCKET NO. E-2, SUB 297 PAGE 2 OF 2 Market Pressure Analysis Sales Period Ten Trading Days Prior CPSL Average SAP Utilities Index Average CPF'L/SAP UI
- 21. 99 50.45 .4358 Ten Trading Days Subsequent CPSL Average SAP Utilities Index Average CPSL/S&P UI, 21.58 49.77 .4335 Net Change in CP5L-S8P UI Re1ationship
.4335-.4358 x 100~+
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= -.53fe
CURRIN EXHIBIT NO. 7 NCUC DOCKET NO. E-2, SUB 297 Harket Pressure Analysis Ten Trading Days Prior To Registration CP8L Average SEP Utilities Index Average ~C EL/SEP UI 22.26 50.10 .4444 Ten Trading Days Subsequent To Sale CP&L Average S&P Utilities Index Average CP&L/S&P UI 21 .58 49.77 .4335 Net Change in CPSL-SSP UI Relationship
= .4335-.4444 x 100Ã
~ 4444.
= -2.45'A
CURRI N EXHIBIT NO NCUC DOCKET NO. E-2, SUB 297 CPGL Cost of Equity Adjustments for Market Pressure and Issuance Expenses Bare Cost of Equity = 12.18%%d Pressure 5 Issuance Expenses = 5.65%
t Adjusted Cost of Equi ty = 12.18~~
1 00 001o 5, 65%%d
CURRIN EXHIBIT NO. 9 NCUC DOCKET NO. E-2, SUB 297 Carolina Power and Light Company Cost of Capi ta1 (12-31-76)
Meighted Amount Fraction Cost Cost .
Debt $ 1, 103,463,000 .4517 7.71 3.48 Preferred Stocf; 336,018,000 .1376 8.01 1.10 Comnon Equity 875,967,000 .3586 12.91 4.63 Cost-Free Capital 'I27 151,000 .0521 0 Total $ 2,442,609,000 1.0000 9.21K
CURRIN EXHIBIT NO. 10 NCUC DOCKET NO. E-2, SUB 297 Duke Power Company Dividend Yield September 3 7.3 October 1 6.9 November 5 7.5 10 7.1 8 6.9 12 7.4 17 7.0 15 7.1 19 7.4 24 6.9 22'.5 26 7.2 29 7.6 Average 7.08 Average 7.20 Average 7.38 December 3 10 17
'.07.2 7.1 January 7 14 21 7.5 7.3 7.2 February 4 11 18 7.3 7.7 7.8 24 7.4 ,28 7. 2 25 7.8 31 73 Average 7.20 Average 7.30 Average 7.65 Weighted Average Dividend Yield =
(1(7.08)+2(7.20)+3(7.38)+4(7.20)+5(7.30)+6(7.65))/21 =
7.37K
CVRRIN EXHIBIT NO. 11 NCVC DOCKET NO. E-2, SVB 297 Dvke Power Company Growth Yield Ear nings Per Share Dividends Per Share 1966 1.72 1.10 1967 1.85 1.20 1968 1. 91 1. 30 1969 2.05 1.40 1970 1 . 57 1.40 1971 1. 88 1.40 1972 1.69 1.40 1973 1.87 1.40 1974 1.80 1.40 1975 1.84 1.40 1976 2.40 1.53 Growth 66-67 7.56 x 1 7.56 9.09 x 1 9.09 67-68 3.24 x 2 = 6.48 8.33 x 2 '. 5.67 68-69 7.33 x 3 = 21.99 7.69 x 3 23.08 69-70 -23.41 x 4= -93.64 Ox 4 0 70-71 19.75 x 5 = 98.75 Ox 5 0 71-72 -10.11 x 6= -60.66 0 x 6 0 72-73 10.65 x 7 = 74.55 Ox 7 0 73-74 -3.74 x 8"- -29.92 0 x 8 0 74-75 2.22 x 9 = 19.98 0 x 9 0 75-76 30.43 x10= 304.35 9.29 x 10 92.86 349.44/55 = 6.35 141.70/55 = 2.58 Average Growth Yield = (6.35 + 2.58)/2 = 4.47'5