ML20003E990
| ML20003E990 | |
| Person / Time | |
|---|---|
| Site: | Comanche Peak  |
| Issue date: | 12/31/1979 |
| From: | Luftig M TEXAS POWER & LIGHT CO. |
| To: | |
| Shared Package | |
| ML19240B984 | List:
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| References | |
| NUDOCS 8104170637 | |
| Download: ML20003E990 (45) | |
Text
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-;0 Docke+ No. Sool 1
2 3
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8 DIRECT TESTIMONY OF 9
10 11 MARK D. LUFTIG 12 13 14 FOR 15 16 17 TEXAS POWER & LIGHT COMPANY 18 19 20 DECEMBER 1979 21 l
22 23 24 25 26 2
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810.4170 M 7 l
28 TEXAS POWER & LIGHT COMIRNY
B Luftig PAGE l of 29 1
DIRECT TESTIMONY OF MARK D. LUFTIG 4
2 Q.
PLEASE STATE YOUR NAME AND BUSINESS ADDRESS.
3 A.
My name is Mark D. Luf tig. My business address is One New York Plaza, New 4
York, New York 10004.
5 Q.
BY WHOM ARE YOU EMPLOYED AND IN WHAT CAPACITY?
6 A.
I am Vice President and Manager of the Utility Group in the Stock Research 7
Department at Salomon Brothers.
8 Q.
PLEASE DESCRIBE BRIEFLY YOUR EDUCATION AND YOUR BUSINESS 9
EXPERIENCE.
10 A.
I obtained my Bachelor of Arts degree (major in Economics) from Columbia 11 University in 1958.
Upon graduation, I undertook simultaneous programs in 12 business and law.
I obtained my Master's degree in business from Columbia 13 Graduate School of Business in 1961 where I ma,:ored in accounting and a 14 doctorate degree in law from Columbia Law School in 1962. From 1962 to 1968 I 15 was engaged in the private practice of law. During that time, among other things, 16 I participated in the formation and management of an investment advisory 17 company and a mutual fund. I became associated with New York Telephone 18 Company in 1968, and between 1968 and 1975 I served as Attorney, General 19 Attorney-Rates and Regulatory Matters and as a member of the Company's 20 Finance Committee. I also lectured on rate of return and participated in the 21 preparation and trial of several general rate proceedings, as well as in a 22 proceeding involving the investigation of the Bell System's capital structure.
23 These cases, lectures, and my daily work were concerned with the performance of 24 the utility industry as viewed by the financial commmunity. I joined Salomon 25 Brothers in 1975 and became a Vice President in 1977.
26 Q.
PLEASE DESCRIBE BRIEFLY THE BUSINESS OF SALOMON BROTHERS.
27 A.
Salomon Brothers is an investment banking firm with offices throughout the 28 United States, an office in Hong Kong and a subsidiary in England. We are TEXAS POWER & I.IGIIT COMPANY
Luftig PAGE 2 of 29 I
1 underwriters and brokers in addition to making markets at our own risk in all 2
security markets. Because of our varied activities, we are in daily touch with 3
thousands of analysts, portfolio managers and traders from banks, corporations, 4
insurance companies, mutual funds, and others. This activity gives us an up-to-5 the-minute awareness of their thinking. We also give advice to corporations as to 6
financial matters and with respect to the best ways to raise capital.
7 Q.
WHAT IS THE VOLUME OF SECURITIES HANDLED BY SALOMON BROTHERS?
8 A.
During its fiscal year, ended September 30, 1978, Salomon Brothers managed or 9
co-managed 180 public offerings of corporate securities with a total value of 10
$11.8 billion.
Recent figures disclose that Salomon Brothers rankad first or 11 second in total underwritings managed for 1978. Our firm is also a leader in the 12 field of private placements.
During fiscal 1978, tne firm placed privately, 13 securities aggregating $2.9 billion. We are also among the largest managers of 14 new debt issues in the United States. During our 1978 fiscal year, we managed or 15 co-managed 35 utility debt issues aggregating $2.9 billion. Our net worth at the 16 close of our last fiscal year was over $200 million, ranking us second in size 17 among all United States securities firms. During our 1978 fiscal year, we handled 18 over $500 billion in purchase and sales of securities.
19 We also have investment banking relationships with a number of utilities and 20 at any given time maintain positions in the various debt and equity issues of those 21 utilities. This gives us an unusual insight into investors' current attitudes toward 22 utility securities.
23 Q. PLEASE DESCRIBE THE FUNCTIONS OF AN UNDERWRITER.
24 A.
An underwriter or underwriting syndicate buys a security issue from an issuing 25 company and then resells it to the investing public at an " offering price" fixed by 26 the underwriter. The difference between the purchase price and the offering 27 price must compensate the underwriter for its costs and services in marketing the 28 issue, as well as for the risk it assumes. If the issue cannot be completely resold
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h TEXAS IOWER & LIGHT Colt 1%NY
Luftig PAGE i nf 79 1
at the offering price fixed by the underwriter, it is the underwriter, rather than 1
2 the issuing company, who bears the full measure of any loss.
3 Q. WHAT OTHER SERVICES DOES SALOMON BROTHERS PERFORM?
4 A.
We provide a broad range of bond market, money market, and equity research, and 5
advisory services for investors in, and issuers of securities. One of our specialties 6
in this area is public utility stocks and bonds.
7 Q.
WHAT ARE YOUR DUTIES WITH SALOMON BROTHcRS?
8 A.
As Vice President and Manager of the Utility Group, I direct and conduct 9
complete financial, managerial, and technical research and analyses of electric 10 utilities, and combination companies. In the course of my duties I meet with and 11 give advice to financial officers of these corporations, and to investors as well. I 12 am also responsible for writing reports about the industry. These reports are
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13 recieved by more than two thousand members of the financial investing com-14 munity.
15 Among other things, my reports form the basis upon which our clients make 16 investment decisions. The institutions which receive my reports and the portfolio 17 managers and analysts with whom I regularly speak are among the major 18 investment decision-makers.
Their minimum return requirements and their 19 interpretation of fundamental financial factors determine whether they are 20 buyers or sellers of the securities of the companies I analyze in the course of my 21 research. The decisions of these institutional investment managers, together with
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22 the prevailing economic and financial forces, determine the current cost of equity i
23 for companies. My value to these managers as a research analyst rests on my i
24 ability to enable them to do a better investment job with their clients' money. In 25 sum, my job is to analyze utility companies, and to give advice to our clients with 26 respect to buying or selling equity and debt holdings in utilities at given prices at 27 given times. My job involves making judgements every day as to the cost of 28 common equity of utilities and those judgments influence directly the movements g 1Exas imtR& tioiir couPaxv 7
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Luftig PAGE 4 of 29 1
of millions of investment dollars.
2 Q.
IN WHAT OTHER PROFESSIONAL ACTIVITIES HAVE YOU BEEN ENGAGED?
3 A.
I am President and a member of the Executive Committee of the Naticeal Society 4
of Rate rf Return Analysts, Inc. and a member of the New York Society of 5
Security Analysts. I am a Registered Principal with the National Association of 6
Securities Dealers and a Registered Representative with the New York Stock 7
Exchange. I am also a member of the Utility Finance Committee of the Public 8
Utility Law Section of the American Bar Association and a member of the Public 9
Utility Law Section of the New York State Bar Association. In addition, I am also 10 on the faculty of the Lincoln Institute of Land Policy, a private foundation which, 11 among other things, gives courses on taxation of utility property and rate of 12 return. I have also lectured at and participated in Public Utility Symposiums 13 before investors, utility executives, regulators and underwriters. My comments 14 on utility financing have been quoted in The Wall Street Journal, The New York 15 Times, many other newspapers, Business Week, Electrical Week, and Public Utility 16 Fortnightly. I have testified before this Commission, the Connecticut Public 17 Utilities Control Authority, the Illinois Commerce Commission, the Massachusetts 18 Department of Public Utilities, the Michigan Public Service Commission, the 19 Missouri Public Service Commission, and the New York Public Service Commis-20 sion and I have filed testimony with the District of Columbia Public Service 21 Commission, the Iowa Commerce Commission, the North Carolina Utilities 22 Commission and the Federal Energy Regulatory Commission.
23 Q. ON WHAT SUBJECT HAVE YOU BEEN ASKED TO TESTIFY IN THIS PRO-24 CEEDING?
25 A.
I have been asked to testif y with respect to the cost of capital to Texas Power &
26 Light (TP&L) and to recommend a fair rate of return on equity for TP&L.
27 Q. WHAT CONCLUSIONS DID YOU REACH?
28 A.
Af ter a thorough examination of the relevant data, and based upon my experience, TEXAS POWER & l.IGilT COMi%NY
Luftig PAGE 5 of 29 1
1 have reached the following conclusions:
2 1.
Utilities are viewed by investors as riskier investments than in the past and 3
thus their costs of capital have increased in recent years.
4 2.
While there has been some recent improvement in the level of TP&L's 5
earnings, costs of capital have also increased, leaving a deficiency between 6
earned return and required return.
7 3.
TP&L continues to face a large construction' program.
Although the 8
construction program appears to have peaked in 1979, the 1980 program is 9
the second largest in the company's history and the 1980-81 program is 10 projected to be as large as the 1977-78 program, both about $583 million.
11 4.
TP&L will be able to attract capital on reasonable terms only if it can earn 12 its full cost of capital and offer investors a prospective return commen-13 surate with that which they can obtain elsewhere from investments of 14 comparable risk.
15 5.
To accomplish this, TP&L needs improved earnings over a sustained period.
16 A number of guides to determining a fair rate of return on common equity 17 which I have examined show that TP&L requires a return on book equity of 18 at least 16.0%. This is the minimum return on book equity necessary to 19 enable TP&L to maintain its financial integrity, and to attract capital by 20 giving investors an opportunity to earn returns comparable to those avail-21 able on investments of corresponding risk.
22 Q. WHAT ARE SOME OF THE SIGNIFICANT CHANGES THAT HAVE OCCURED IN 23 THE CAPITAL MARKETS SINCE DECEMBER,1977, WHEN YOU SUBMITTED 24 TESTIMONY IN DOCKET NO.1517?
25 A.
Costs of capital have increased drastically. Debt costs have reached historical 26 heights. The prime rate which was 7 3/4% in December,1977, doubled to 151/4% -
27 151/2% currently.
The discount rate doubled from 6% to 12% while new 28 long-term triple A bond rates increased by almost 3 percentage points from TEXAS POWER & LIGHT COMPANY
Luftig PAGE 6 of 29 1
81/4% to 10 7/8%. Long-term government bonds, which are viewed as a proxy 2
for a risk-free investment, increased from 7 3/4% to over 10%.
3 Not only has the cost of debt increased, it is also clear that costs of equity 4
have also risen significantly.
5 Finally, in December,1977, the one hundred electric utilities we follow on a 6
regular basis were selling at 102% of book value and Texas Utilities was at 116%
7 of book value. Using a June 30 book value, currently the group is at 83% of book 8
value, while TU is at 96% of book value. In other words, the market prices of the 9
Company's and industry's common shares have deteriorated drastically and in 10 about the same proportions.
11 I wish to state at the outset that, to a large extent, I do not attribute the 12 deterioration in TU's market / book ratio to faults in management, or in the 13 Commission, but rather to inflation.
I firmly believe that the Company's 14 maintenance of financial flexibility and its decision to accelerate into a lignite 15 construction program at a relatively early stage, and backed by the Commission's 16 actions to support the Triple A bond rating, will result in mi!! ions of dollars in net 17 savings to TP&L customers.
18 Q.
PLEASE DE5" RIBE BRIEFLY YOUR GENERAL APPROACH TO THE TASK OF 19 DETERMINING A FAIR RATE OF RETURN ON COMMON EQUITY FOR TP&L.
20 A.
First, I examined the financial and business condition of TP&L to determine the 21 character and extent of the risk which potential investors in the common equity 22 of the Company would be asked to evaluate. Then I made an analysis of general 23 economic and business conditions to determine the climate affecting the cost of 24 equity capital to TP&L. This is important because, in an economy in which the 25 supply of capital is scarce in relation to demand, investor requirements, and thus 26 capital costs, are generally higher than in an economy in which capital is more 27 plentiful in relation to demand. Finally, I made a determination of the minimum 28 fair rate of return on common equity for TP&L.
By the decisions of this TEXAS POWER & LIGilT COMPANY
Luftig PAGE 7 of 29 1
Commission, the minimum fair rate of return is that which enables a utility to 2
earn its cost of capital. The cost of capital to a company, such as TP&L, which 3
has both long-term debt and equity is the weighted average cost of the company's 4
debt and equity capital. Determination of the cost of senior securities (debt and 5
preferred stock) poses relatively few problems, but the cost of common equity is 6
far more difficult to ascertain.
7 To ascertain a fair rate of return on common equity, I first determined the 8
minimum current cost of common equity to TP&L, based on a number of different 9
guides used by sophisticated investors, a discounted cash flow analysis, a multiple 10 regression model, an examination of what industrial companies were earning, and 11 consideration of the spread, or so-called risk premium, between the return 12 currently available on triple A - rated utility bonds and the additional return 13 required to induce investors to invest in equity securities, which are subject to 14 greater risk.
15 Q.
BEFORE DISCUSSING YOUR ESTIMATE OF THE COST OF EQUITY CAFIrAL 16 TO TP&L SPECIFICALLY, WOULD YOU PLEASE COMMENT ON THE GENERAL 17 FINANCIAL CONDITIONS THAT ARE RELEVANT TO THE PROPER DETER-18 MINATION OF THE COST OF EQUITY CAPITAL?
19 A.
In making a judgment as to what investors are requiring as a return on equity 20 capital at a particular point in time, one must be cognizant of certain general 21 economic factors, such as inflation rates, interest rates, levels of demt.nd for 22 capital and supply of investment funds, and general business conditions. These 23 factors indicate whether, in general, investors will be requiring users of capital to 24 pay relatively higher, or relatively lower, costs of capital.
This is a useful 25 starting point because it indicates whether the inherent uncertainty in estimating 26 the cost of common equity should be resolved in a somewhat higher, or a 27 somewhat lower, direction.
28 The state of the economy today is uncertain. Real GNP growth slowed in
'l EXAS LOWER & LIGil'1 COMPANY
Luftig PAGE R nf 79 1
the first quarter of 19M and is currently close to a standstill. Most economists 2
believe that we are either in a recession or are heading towards one. Unemploy-3 ment continues at a relatively high level. Interest rates are up sharply. The 4
discount rate of 12% is at its highest level in history. It was at 6% as late as 5
January, 1978. From May,1977 to November,1979, the prime rate rose from 6
61/4% to 151/4% - 151/2%. As I have shown earlier, long term interest rates 7
have also risen significantly. This increase in interest rates is attributable to a 8
number of factors, including:
9 1.
The level of federal budget deficits. While the level of the federal deficit 10 for fiscal 1979 was less than $30 billion, it is likely to be closer to $50 11 billion in calendar 1980 and it could approach $100 billion in 1981.
12 2.
Inflation increased in 1978. The Consumer Price Index rose by 8% in 1978 13 and, on an annualized basis by 13% in the first nine months of 1979. We are 14 likely to experience double digit inflation at least through 1980. As recently 15 as the late 1960's,4% was considered to be " runaway".
16 3.
Corporate demand for debt capital still remains very strong. The volume of 17 new money requirements set a record in 1979, which we do not expect to be 18 reduced substantially in 1980.
19 Q.
HOW ARE INVESTORS REACTING TO THESE GENERAL FINANCIAL CONDI-20 TIONS?
21 A.
Investors are cautious. They have lost faith in the ability of government to buffer 22 or cushion sharp economic fluctuations since the shattering experience of the 23 1974-1975 period when we experienced double-digit inflation and near double-24 digit unemployment.
An element of uncertainty exists with respect to the 25 effectiveness of the government's economic policies and practices. Investors are 26 viewing the rise in interest rates as inflationary. This also increases their return 27 requirements on equity investments. The Federal Reserve, in an attempt to 28 restrain growth in the money supply, and hence in the rate of inflation, has pushed TEXAS POWER & LIGIIT COMPAM'
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up interest rates in an attempt to discourage borrowers. President Carter's 4
2 inflation and energy programs will necessarily lead to higher interest rates. The 3
first effects are already being felt by the housing and automobile industries. The 4
only event that has a reasonable chance of breaking the interest rate spiral is a 5
continued slowing in the economy's growth rate and a recession. However, even a 6
recession, if energy induced, might not break the interest rate spiral.
In a 7
classical recession, idle capacity usually results in a slowing of demand, reduced 8
plant expansion, reduced borrowing and reduced prices. If the recession were 9
energy induced, however, idle capacity could appear only in areas where there was 10 no real demand. Growth in other areas could continue. The term " stagflation" 11 has been coined to describe this kind of economy where low growth and inflation 12 persist simultaneously.
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13 This focuses investors' attention on high quality, very liquid investments. In 14 my opinion, this will continue to make financing difficult and expensive for U.S.
15 industry in general, and for public utilities in particular, over at least the next 16 few years.
17 Even when utility stocks were selling in the market closer to their book 18 values and when interest rates were lower than they are today, a number of 19 utilities experienced difficulty raising needed captial, particularly if they were 20 not of the highest investment quality. For example, we still see utilitics being 21 forced to cut their construction programs because of financing difficulties.
22 Moreover, the cost of capital is very high by historic standards and is likely to 23 remain so in the long term.
24 Q.
WHAT WILL BE THE NATURE OF THE COMPETITION FOR CAPITAL THAT 25 WILL BE FACED BY TEXAS POWER & LIGHT?
26 A.
With its large construction program and large external financing requirements, 27 Texas Power & Light will face rapidly and substantially increasing competition for 28 new capital. Exhibit MDL-1 shows the tremendous increase in the demand for es d
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Luftig
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1 credit over the years 1974 through 1979 and as projected through 1980, rising 2
from an annual level of $180.9 billion in 1974 to a projected demand for 1980 of 3
$392.3 bill!on. The demand of the highest quality borrowers available--the U.S.
4 Government and U.S. Government agencies--has risen phenomenally.
It is 5
projected to be $96.5 billion for 1980, compared to $28.4 billion in 1974. The 6
credit demands of other high quality borrowers, state and local governments and 7
corporations, have also risen at tremendous rates. For example, the demand of 8
state and local governments is projected to total $27.0 billion in 1980 or almost as 9
much as in 1974 and 1975 combined.
As shown by Exhibit MDL-2 net new 10 corporate bond issues for 1980 are expected to total about about $30 billion 11 compared with $23 billion in 1974. In summary, competition for capital funds in 12 recent years has of ten been intense. Investors are well aware of this fact, and 13 further they anticipate that this competition may intensify even more in the 14 future.
15 Q.
PLEASE PROVIDE SOME ASSESSMENT OF THE NATURE OF THE COMPETI-16 TION FOR FUNDS IN THE FUTURE.
17 A.
Exhibit MDL-3 shows that the total amount of credit market debt outstanding 18 more than doubled from 1966 through 1976 and that estimates are that it will just 19 about double again by 1986. In addition, to support the corporate debt structure 20 indicated in that table, net new issues of corporate stocks, which averaged only 21
$.93 billion per year during the 1960's and $8.6 billion annually since the start of 22 this decade, are likely to swell to $30 to $35 billion annually by *.he miu-1980's.
23 This continual growth in the demand for capital has increasingly focused investors' 24 attention on the subject of a capital shortage. A number of studies support the 25 conclusion that a capital shortage will manifest itself as soon as the early and 26 mid-1980's.
f 27 For investors, the capital shortage problem is closely linked with the 28 problem of rising interest rates and inflation. They have been made wary by the TEXAS LOWER & LIGIIT COMPANY
Luftig PAGE LLof_29 1
bitter experiences of the past decade, in which rising inflation pushed interest 2
rates to new high levels and stock prices were depressed to the point where total 3
market returns were of ten negative. As inflation accelerates, corporate balance.
4 sheets become more impoverished and corporate internal cash flows become 5
inadequate to finance the rapidly increasing nominal dollar costs of doing 6
business. This is particularly true for capital intensive utilities whose deprecia-7 tion charges are inadequate to provide for replacement of existing plant. For 8
example, if plant purchased 30 years ago for $100 million now costs $700 million 9
to replace the same capacity, depreciation has recovered only one-seventh the 10 needed replacement funds, in essence, high rates of inflation do not allow 11 businesses to generate sufficient capital internally to meet their needs. Thus,to 12 be reasonably assured of raising the capital needed to meet the demand for 13 services in the years ahead, it is extremely important that TP&L maintain its 14 credit position and attain an attractive return on common equity, not only to 15 minimize its cost of capital, but also to maximize the sources of funds to which it 16 may have access.
17 Q. DOES A LOWER BOND RATING LIMIT THE SOURCES OF FUNDS TO WHICH A 18 COMPANY HAS ACCESS?
19 A.
Yes, it certainJy does. Primary emphasis is of ten placed on the limiting nature a 20 lower bond rating has in terms of foreclosing from the market those large 21 institutional investors which are restricted to bonds above a certain rating.
22 However, there is another significant limiting result due to lower quality bond 23 ratings, that is the foreclosure from the new equity markets which results when 24 bond ratings fall.
25 Q.
HOW DOES INFLATION AFFECT BOND RATINGS?
26 A.
In part, lower bond ratings can be traced to inflation, depreciation reserves which 27 do not meet the cost of replacements, and the rise in interest rates combined with 28 sharply increased amounts of debt which has adversely affected both cash flow TEXAS POWER & LIGHT COMPANY
Luftig i
PAGE 12 cf 29 1
and fixed charge coverage. As a result of the deterioration in the quality of 2
corporate securities, investors in recent years have been exhibiting a marked 3
preference for quality.
Maintaining quality ratings has proven particularly 4
difficult for utilities because they cannot adjust their pricing mechanism at will, 5
and because of the severe adverse impact inflation has had on their ability to 6
control expenses. With interest rates surpassing the 1974-1975 levels, there is 7
concern about a repeat of 1974 and 1975 market conditions.
For example, 8
between May 1974 and the end of 1975, only five Triple B-rated utilities were able 9
to sell long-term bond issues, although many more would have liked to do so.
10 Also, as an example of the penalty for a lower rating,in January 1975, two similar 11 sized, intermediate-term issues, one rated Triple A and the other rated Triple B, 12 were sold on the same day with an interest spread of 464 basis points between the 13 two issues.
14 With the latest rise in interest rates, quality spreads have begun to widen.
15 The spread between new long-term triple A and triple B issues was 70 basis points 16 in December 1977. It has tripled to 212 basis points in November 1979. On a spot 17 basis, in October 1979, a $170 million,40-year, triple A bond issue and a smaller, 18
$100 million, 35 year, single A bond issue were sold on the same day at a l
19 difference in cost to the companies of 236 basis points. Yield spreads are likely 20 to continue to widen at least for the next few months.
21 Underscoring this strong preference for quality is Exhibit MDL-4, which j
22 shows the amount of publicly offered straight bonds, by credit rating, for the past i
23 ten years. The table shows that whereas 30% of publicly offered straight bonds 24 were rated 3aa or below in 1967, only 16% of such bonds carried a Baa or below 25 rating in 1978. This occurred because it has become more difficult for lower-26 rated barrowers to float bond issues. and when they could do so, only relatively 27 sm6 issues could be sold.
28 Q.
YOU HAVE TESTIFIED THAT A LOWER BOND RATING HAS A LIMITING TEXAS POWER & LIGilT CONF PANY
Luftig PAGE 13 of 29 1
EFFECT ON THE ABILITY TO SELL BOTH NEW BONDS AND EQUITY. HOW 2
HAS INVESTOR PERFORMANCE IN THE BOND MARKETS BEEN REFLECTED 3
IN THE EQUITY MARKETS?
4 A.
This selectivity on the part of investors has also been transferred to the equity 5
markets, where a second trend has emerged. Here, persistent inflation has led 6
many equity investors to question the real quality of reported earnings. At the 7
same time, yields in the fixed-income area have begun to approach and even 8
surpass the total returns available from common stock holdings. This phenomenon 9
has caused many asset managers to question whether common equity investments 10 really provide any protection against inflation and whether the prospective higher 11 returns from common equities are worth the additional risk. For example, in 12 seven of the past ten years, at least one major sector of the bond market has 13 outperformed common stocks.
14 This past experience has caused hitherto equity-oriented institutions to 15 effect a sharp cutback in the volume of stocks purchased in favor of fixed-income 16 investments.
Exhibit MDL-5 illustrates this, showing the net acquisition of 17 corporate securities by investment groups.
Every major investment group 18 purchased more bonds than stocks during 1974. Indeed, some even sold stocks in 19 order to buy bonds. Only private pension funds purchased more stocks than bonds 20 in 1975 and 1976. In 1977 no group bought more stocks than bonds and two groups 21 were net sellers of stocks. Similar trends continued into 1978 and 1979. This 22 switch to bonds occurred because the investor, noting the attractive yields and 23 lower risk available from fixed-income investments, judged these returns to be 24 more attractive than the returns available from higher risk equities.
25 The above discussion highlights the extreme importance which adequate 26 rates of return have for utilities in the present capital market environment.
27 Returns must be sufficient to provide both adequate fixed charge coverages (to 28 ensure acceptable bond ratings) and a level of earnings that will allow for TEXAS POWER & LIGHT COMPANY
Luftig PAGE 14 of 29 1
meaningful increases in retained earnings as well as reasonable dividend returns to 2
stockholders.
3 Q. DOES THE QUALITY OF A COMPANY'S DEBT HAVE AN EFFECT ON ITS COST 4
OF CAPITAL?
5 A.
Yes. The rating of a company's bond affects the interest cost to the issuing 6
company. Almost without exception, the higher the rating the lower these costs, 7
and vice versa. Also, other things being equal, higher interest costs require a 8
higher return on equity just to maintain a constant fixed charge coverage.
9 Bond ratings are also taken into account by equity investors. Thus, just as 10 an investor will require a higher interest rate on bonds of a double A rated 11 company than on those of a generally comparable company whose bonds are rated 12 triple A, so will he require a higher equity return from the double A company than 13 from the triple A rated company. Furthermore, investors demand higher returns 14 on a given company's common equity than from its debt capital to compensate for 15 the higher risk of common equity. Thus, since lower bond ratings increase a 16 company's cost of debt, they also increase the cost of its own, more risky equity.
17 Q. WHAT DO INVESTORS SEE WHEN THEY VIEW TU'S AND TP&L'S FINANCIAL 18 CONDITIONS?
19 A.
For stock market data, they must lock to TU. Investors see earnings per share 20 increasing but not by enough to keep the market / book ratio of the stock from 21 eroding continuously. Exhibit MDL-6 is a table showing the financial measure-22 ments to which I referred. Column 2 shows that TU's earnings per share increased 23 from $1.32 in 1967 to $2.18 in 1974, decreased in 1975 to $2.02 and then resumed 24 an upward trend. For the twelve months ended September 1979, they were $2.51.
25 This rise in earnings per share was not enough to prevent a continual erosion 26 in TU's market / book ratio, however. The average price of $27.50 in 1967 equated 27 to 313% of book value. The price declined to only 87% of book by the end of the 28 test year (September 30, 1979). In January 1979, the company sold 5,000,000 TEXAS POWER & LIGHT CONIPANY
Luitig PAGE 15 Cf 29 1
shares of common stock at 97% of book value. It is likely that the next issue will 2
be at a bigger discount from book value. Investors who paid $30 for the stock and 3
lost a third of their investments are wary of investing more funds in TL'. Average 4
annual market prices, book values and market / book data are shown in columns 3, 4 5
and 5 of the exhibit.
Q. WHAT DO INVESTORS SEE IN TP&L'S RETURN ON EQUITY AND INTEREST 6
7 COVERAGE?
8 A.
Other things being equal, given the upward trend in interest rates since 1967, one 9
would expect TP&L to be earning a higher return on equity, and to have 10 maintained its interest coverage to pay investors for the increased risk associated 11 with the higher interest rates, or at least to ameliorate it somewhat. Instead, 12 interest coverage has declined and return on equity has deteriorated in relation to 13 market requirements.
14 While investors' return requirements have increased with increased risk, 15 earned returns on average common equity decreased from 17.6% in 1967 to only 16 11.4% in 1975. Return on average common equity improved to 15.2 percent in 17 1978 but for the tv elve months ended September 30, 1979, return on average 18 common equity was only 14.7%. These data are shown in the second column of 19 Exhibit MDL-7.
20 Q. THE THIRD COLUMN ON EXHIBIT MDL-7 SHOWS PRE-TAX INTEREST 21 COVERAGE. PLEASE DISCUSS ITS IMPORTANCE.
22 A.
Pre-tax interest coverage for TP&L, wLich affords protection to its bondholders 23 and is thus an important indicator of a < ompany's financial strength, decreased 24 from 6.9 times in 1967 to 3.3 times in 1975 and 1976, and then improved to 4.2 25 times in 1978. For the twe've months ended September 30,1979, it was 4.0 times.
26 Q.
IS IT APPROPRIATE TO LOOK AT TP&L'S COVERAGE USING ONLY ITS 27 INCOME STATEMENT?
28 A.
No.
Texas Utilities Generating Company (TUGCO) and Texas Utilities Fuel TEXAS POWER & LIGHT COMPANY
Luftig PAGE 16 of 29 Company (TbFCO) are TU subsidiaries. TUGCO acts as agent for the three 1
g 2
electric utilities in lignite mining and in operation of their jointly-owned 3
generating stations and furnishes related services at cost, while TUFCO owns a 4
natural gas pipeline system, acquires, stores, and delivers fuel gas and oil and 5
provides other fuel services for the electric utility subsidiaries. Both of these 6
companies are highly leveraged. (The net plant of both companies at 7
September 30,1979 was $441.8 million and they had'only $2 million in equity 8
capital.)
9 The debt of these companies is supported by the equity of the electric 10 utility subsidiaries. Rating agencies and sophisticated investors are aware of this 11 and include the pro rata share of the TUGCO and TUFCO debt for each of the 12 electric utility subsidiaries in computing their interest coverages and capital 13 structure ratios. When the Company's pro rata share of the TUFCO and TUGCO 14 senior debt interest obligation is taken into consideration, the pre-tax interest 15 coverage ratios of TP&L for 1977, 1978 and twelve months ended September 30, 16 1979, are reduced to 3.6,3.9 and 3.5 times respectively, as illustrated in the last 17 column of Exhibit MDL-7.
It should be noted that the September 30, 1979, 18 supplemental coverage of 3.5 times will be further reduced. By the time rates set 19 in this proceeding go into effect, TUGCO will have issued an additional 20
$200 million in Senior Notes.
This in turn, will increase the supplemental 21 interest obligation of TP&L.
22 Q. WHAT DO YOU BELIEVE TO BE AN APPROPRIATE BOND RATING FOR TEXAS 23 POWER & LIGHT TO MAINTAIN?
24 A.
TP&L, along with the other two subsidiaries of Texas Utilities Company, are 25 presently the only remaining electric utilities with a triple A bond rating from 26 both major rating agencies, in order for Texas Power & Light to maintain 27 financial flexibility, that is, to retain the ability to issue either debt or equity l
l 28 when required, to be able to do so at dif ficult times and on reasonable terms, and TEXAS POWER & LIGHT COMPANY
Luftig PAGE 17 cf 29 1
to maintain investor confidence, I believe it is advantageous for the Company to 2
strive to maintain its top quality rating. It is possible for Texas Power & Light 3
and the Texas Utilities system to finance with a double A rating. However, even 4
this downgrading would cause problems for the Company. First of all, it is becoming more difficult to externally raise the enormous amounts of money 5
6 required to provide the quantity and the quality of service to customers.
7 Secondly, many of the institutional investors in TP&L's' securities have both legal 8
and self-imposed requirements as to the diversity and quality of the securities in 9
which they invest. Thirdly, the spread in cost between triple A and double A debt 10 is widening. On November 19, 1979, a double A bond was sold at a cost to the 11 issuing company of over 12% or about 75 basis points over the triple A rate.
12 Furthermore, once a downgrading has occurred and credit deterioration has begun,it is difficult to stop, much less reverse. Investors become uncertain as to 13 14 the stability of such issues and become concerned about the future speculative 15 characteristics and the smaller margins of protection of the bonds.
Investor 16 confidence and the probability of investors purchasing these as well as subsequent 17 securities are impaired.
Such investor reactions intensify the probability of 18 additional downgradings. If TP&L were to be downgraded to a double A rating, 19 the chances of being lowered to a single A would not be that slim. Bonds which 20 are rated single A are judged to be of medium quality. However, for TP&L, a lowering of its rating for a second time would create special difficulties with 21 22 respect to the continuous increase in investors' concerns since the Company was 23 originally a highly rated company.
Investors who suffered through the first 24 downgrading would not soon forget this experience, and a downgrading to a i
j single A would tend to confirm investors' suspicions that as soon as there is 25 26 further financial stringency, the bonds will be downgraded again. During the c
27 credit crunch of 1974, single A companies were unable to finance in the manner they wished and, as a result, they were forced to cut construction programs and to 28 TEXAS POWER & LIGHT COMPANY
Luftig PAGE 18 of 29 1
incur high short term debt positions. Similarly today, companies have been forced f
2 to cut construction programs because of financial constraints.
3 A poignant example is Commonwealth Edison.
That Company's first 4
mortgage bonds were downgraded from Aaa to A by Moody's Investor Service in 5
two steps, both in 1979. At the same times, its debentures were downgraded from 6
Aa to Baa. The Company was forced to cut its construction program and entered 7
November 1979, with $485 million in unfilled financing requirements for the year 8
and an inability to sell mortgage bonds.
9 Q. WHAT INTEREST COVERAGES AND OTHER FINANCIAL STANDARDS DOES 10 TP&L REQUIRE TO MAINTAIN A TRIPLE A RATING?
11 A.
The standards are the same as I reported in Docket 1517. The Company needs to 12 maintain a pre-tax interest coverage of 4.0 times or over and a post-tax coverage 13 of 3.0 times or more on an ongoing basis.
The earnings elements of these 14 coverages should not include excessive amounts of AFUDC. The interest element 15 must include the Company's pro rata share of the TUFCO and TUGCO interest.
16 Additional important standards are: a high quality level of earnings, an average 17 of 50% internal cash generation, a common equity ratio of 40% or more, and a 18 realistic regulatory environment.
19 TP&L's pre-tax interest coverage for the test year will have to be higher 20 than 4.0 times in order for it to achieve a 4.0 times coverage in the period that 21 rates will be in effect which will be a period of high interest rates.
22 Q. WHAT HAS HAPPENED TO THE QUALITY OF TP&L'S EARNINGS?
23 A.
Relevant data are shown on Exhibit MDL-8. During the 1967 to 1979 time period, 24 TP&L's capital requirements increased by a factor of seven times, from about $51 25 million in 1967 to $364 million for the twelve months ending September 30,1979.
26 AFUDC as a percent of income available to common increased from 6.3% in 1967 27 to 28.1% in 1976.
28 The effects of AFUDC on cash earnings can be readily seen by comparing TEXAS POWER & LIGHT COMPANY
Luftig PAGE 19 nf 79 I
returns on average common equity including and excluding AFUDC. TP&L's t
return on equity in 1967 was 17.6%. This included a relatively small proportion of 2
3 AFUDC, so that excluding AFUDC return on average common equity was 16.5%.
4 However, in 1976, those returns were 12.4% and only 8.9% respectively.
5 The percentage of AFUDC to income available to common decreased from 6
the 1976 level to 19.3% for the twelve months ended September 30, 1979, partly 7
as a result of this Commission's finding of the need to improve cash flow and 8
quality of earnings, and its allowance of portions of CWIP in rate base without 9
AFUDC offsets. In my opinion, these were principal factors in TP&L's ability to 10 maintain its triple A rating when coverage fell below the minimum levels I have 11 outlined.
12 Q. HOW HAS TP&L PERFORMED WHEN COMPARED WITH THE INDUSTRIALS 13 WITH WHOM IT MUST COMPETE FOR CAPITAL?
14 A.
At one time, it was commonly accepted " doctrine" cr " dogma" that securities of 15 utilities were a less risky investment than securities of industrial companies such 16 as those which form the S&P 400 Industrials. Today, one could argue about the 17 relative risk of a utility such as TP&L versus the S&P 400 Industrials. I believe 18 utilities to be at least as risky as that average, and the consensus of the large 19 institutional investors with whom I communicate on a day-to-day basis is that an 20 investment in most utility common stocks, including TP&L, is as risky or more 21 risky than investing in the S&P 400.
22 It is clear why such a situation exists today. On a relative basis, TP&L has 23 fared much worse than industrials with which it must compete for the investors' 24 dollar.
25 Exhibit MDL-9 shows similar data for the S&P 400 Industrials for the period 26 1967-1978, as is shown for TU and TP&L in Exhibits MDL-6 and MDL-7. l'or the 27 industrials, earnings per share more than doubled from $5.62 to $13.12, an 28 increase of 133% versus a much smaller increase for TU. While the market price TEXAS POWER & LIGHT COMPANY
Luftig PAGE 20 0f 29 1
of TU common shares decreased by 27% during that period, the S&P Index 2
increased by 12%. The market / book value ratio for S&P is considerably above 3
TU's average market / book ratio.
The S&P composite market to book ratio 4
decreased from 2.05 times to 1.25 times still 25% above book value.
TU's 5
market / book ratio has fallen from 3.13 times to 1.00 times in the same time 6
frame and at the end of the test year was 8% below book value. Return on equity 7
for the S&P Index increased from 12.0% to 15.4%; and produced fixed charge 8
coverage of more than 8 times which is adequate. These important financial 9
ratios have been more favorable for the S&P 400 Industrials than for TP&L.
10 Q. DO YOU HAVE ANY OTHER BROAD GROUPS OF COMPANIES WITH WHICH TO 11 COMPARE TP&L'S RETURN ON EQUITY?
12 A.
Yes. In April of each year Citibank in its Monthly Economic Newsletter shows the 13 return on net worth for leading manufacturing companies. As shown in Exhibit 14 MDL-10, Citibank's Leading Manufacturing Companies by Industrial Group earned 15 15.9% on net worth for 1978 and 15.0% sr better in four of the five years.
16 Earnings for the first nine months of 1979 generally have been very strong for this 17 group.
18 Q.
PLEASE SUMMARIZE YOUR VIEWS CONCERNING TP&L'S CURRENT FINAN-19 CIAL CONDITION.
20 A.
TP&L's financial health was good in the late 1960's. It slipped badly in the 21 mid 1970's, but has been improving. The overall erosion that has taken place 22 between 1967 and 1979 is demonstrated in part by te following comparison:
23 24 25 26 27 28 g TEXAS POWER & LIGHT COMPANY
Luftig PAGE 21 ef 29 Test Year 1
Ending Sept. 30 2
1967 1979 3
Average Market Price of Common Stock (TU) $27.50
$19.25 4
Average Market to Book Ratio (TU) 3.13 0.93 5
Return on Average Common Equity 17.6 %
14.7 %
6 Return on Average Common Equity Excl.
AFUDC 16.5%
11.8%
7 AFUDC as % of Income Available 8
to Common 6.3%
19.3 %
9 Pre-tax Interest Coverage 6.9x 4.0x 3.5x 10 Pre-tax supplemental Interest Coverage 11 12 I have previously shown that TP&L's financial condition has also eroded relative to 13 industrials.
14 Q.
WHAT CAUSED THIS EROSION OF TP&L'S FINANCIAL POSITION?
15 A.
Many of the fundamental changes encountered by the entire utility industry were 16 also experienced by TP&L. For example,in the late 1960's, the industry's position
~
17 shif ted from one of decreasing incremental cost to one of rising incremental cost.
18 This made it necessary for utility companies to request frequent, and sometimes i
19 substantial, rate increases which too of ten produced inadequate and delayed rate 20 relief.
21 Regulatory delay and inadequacy alone would have posed a major problem 22 for the industry, but that problem was exacerbated by the onset during the 1970's 23 of very high rates of inflation; required suspension of sales promotion; conserva-24 tion; spiraling fuel costs and the need to convert to alternative fuels; unsettled 25 capital markets accompanied by high interest rates; a high degree of investor 26 selectivity; and environmental concerns. The accident at Three Mile Island and 27 the reduction in General Public Utility's (GPU) dividend that followed made 28 investors realize that utility dividends were not sacrosanct and that, under certain TEXAS POWER & LIGHT COMPANY
Luftig
~
PAGE 22 of 29 1
circumstances, investors could be asked to assume greater risks than they had 2
anticipated and that they were being paid to assume. The combination of these 3
factors, among other things, has, over recent years, led investors to conclude that 4
the utility industry involves increased risk. This realization has increased the cost 5
of both debt and common equity to utilities generally and to TP&L specifically.
6 Q. MR. LUFTIG, I WOULD LIKE NOW TO TURN TO YOUR DETERMINATION OF A 7
FAIR RETURN ON COMMON EQUITY FOR TEXAS POWER & LIGHT. PLEASE 8
DEFINE THE COST OF COMMON EQUITY OR FAIR RATE OF RETURN.
9 A.
The cost of common equity is the investor's required rate of return, or the 10 capitalization rate, on common stock, competitively determined in the capital 11 markets, af ter adjustments for flotation costs and market pressure.
This 12 capitalization rate is the discount rate which equates the sum of all expected 13 dividends in the future combined with the market price investors eventually 14 expect to realize, to the present market price. While this is a simple enough 15 concept, it is difficult to measure precisely since measurement requires an 16 assessment of the expectations and requirements of the investors who determine 17 the market price. Stated another way, the cost of common equity to a company is 18 the return the investor requires to commit his capital to that particular 10 enterprise, as opposed to alternate investment opportunities. A fair return on l
equity must be sufficient to allow the company to compete for capital with 20 21 alternative investment opportunities at reasonable costs and without diluting 22 investors' equity. These guidelines have been established by the Supreme Court of 23 the United States:
24
... it is important that there be enough revenue not only for operation 25 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 26 return to the equity owner should be commensurate with returns on investments in other enterprises having corresponding risks.
That 27 return, moreover, should be sufficient to assure confidence in the financial integrity of the enterprise, so as to maintain its credit and to 28 attract capital." (Emphasis added) FPC v. Hope Natural Gas Co., 320 US 391,603 (19%)
TEXAS POWER & LIGHT COMPANY
Luftig PAGE 23 of 29 Q. WHAT ARE SOME OF THE FACTORS INVESTORS TAKE INTO CONSIDERATIO 1
g 2
IN ASSESSING RETURN REQUIREMENTS?
3 A.
The return on any given security required by investors is a function of *he returns 4
which are available on alternate 'nvestments.
When examining all of the investment alternatives, an investor has a number of factors he must explore: the 5
business and financial risk of the enterprise, the risk inherent in the type of 6
7 security, and the time span over which the investment is to be made.
Q. IN YOUR OPINION, WHAT IS THE RETURN INVESTORS PRESENTLY REQUIRE 8
9 TO COMMIT THEIR FUNDS TO TU COMMON EQUITY?
To put my answer in coi. text you must understand that I am in daily contact with 10 A.
11 institutional investors. These investors set prices by trading in the securities of 12 TU and similar companies. They own approximately 30% of the stock listed on the New York Stock Exchange and account for about 70% of the trading on that 13 exchange. They also own 80% of the corporate bonds outstanding and account for 14 15 virtually all trading in those securities. These institutional investors provide a 16 tremendous discipline to the market by their activities.
For example, the dividend yield and market to book ratio of one utility comoany's common stock 17 will not be allowed to be materially different from those of other utilities whose 18 regulatory climate, earnings potential, etc. are perceived to be similar to it.
19 20 Dividend yield and market to book will be determined by the market price these 21 investors will pay for the stock, it is apparent from their actions that currently, 22 these investors are not willing to invest new funds in the common equities of 23 utilities unless they can anticipate market returns at least in the range of 24 15-16%, and where current market returns are not sufficient to meet these 25 requirements, investors will discount the price of the stock to achieve their 26 required return.
Given the disappointing results which these equities have 27 exhibited in the past, it is neither surprising nor unreasonable for them to require 28 returns of this magnitude to compensate them for the increased risk which they TEXAS POWER & l.IGHT COMPANY
Luftig
~
PAGE 24 of 29 l
1 are being asked to bear.
The lower portion of that range is reserved for 2
companies like TU and TP&L that have exhibited relatively better past earnings 3
performance, that are located in states where regulation has been more respon-4 sive to the need of the utilities to earn higher equity returns, and whose bonds are 5
rated triple A or double A. I will use 15% in my analysis. Again, these returns 6
aie market returns to investors and do not include any adjustment for flotation 7
costs or market pressure.
8 Q. WHY ARE YOUR OPINIONS SO HEAVILY INFLUENCED BY THE MARKET 9
RETURN REQUIRED BY INSTITUTIONAL INVESTORS?
10 A.
I don't know of a more meaningful factor, or place to begin, in an analysis of a 11 fair rate of return. You can go through a lot of abstract mathematical exercises 12 using formulas that are supposed to represent the minds of investors, but the only 13 direct evidence of what investors think is the communication of their views, 14 objectives and requirements as expressed to their financial advisors who guide 15 them regularly on the commitment of billions of dollars of investment funds.
16 Q. DO YOU ACCEPT THE MARKET RETURN REQUIREMENT OF INSTITUTIONAL 17 INVESTORS AT FACE VALUE FOR PURPOSES OF YOUR ANALYSIS?
18 A.
I use a number of-guides or tests to evaluate the reasonableness of that 19 requirement. For example, I have already shown that the S&P 400 and leading 20 manufacturing companies have been achieving returns of 15% or more and that 21 investors believe utilities to be as risky us the S&P Industrials. Another test is 22 the so-called discounted cash flow, or DCF, test. By this test, under certain 23 simplifying assumptions which have been accepted by many regulatory agencies 24 and economists, the capitalization rate to which I referred can be expressed as 25 the sum of dividend yield and expected growth in carnings or dividends per share.
26 TP&L does not have publicly traded stock and it is necessary and appropriate to 27 use, as a proxy, market data with respect to TU stock.
28 Q. WHAT IS TU'S DIVIDEND YIELD?
TEXAS POWER & LIGHT COMPANY
~
Luftig PAGE 75 of 79 1
A.
Dividend yield is the ratio of dividends to market price per share. The DCF 2
method calls for use of the current yield. I reviewed the average yield for 3
September, October, and November,1979, the last three months available to me a
4 which is much more indicative of current yield and investor expectations than is 5
the historic average over a period of one to three years, which no investor would 6
view as the yield currently available to him.
7 The average dividend yield on TU's common stock for these most recent 8
three months was 9.0%.
9 It is at least as appropriate to use 9.6%, which is derived by substituting a 10
$1.76 annual dividend, which many investors anticipate will be declared in 11 February 1980, for the current $1.6ti dividend. At least a portion of the higher 12 dividend la in the price of the stock.
13 For purposes of my analysis,1 have averaged the 9.0% and 9.6% and will use 14 9.3%.
15 Q. WHAT IS A REASONABLE GROWTH RATE TO USE FOR TU IN THIS CASE?
16 A.
Beginning in 1977 and continuing through 1979, TU has increased its dividend at an 17 annual rate of 12 cents a share, or approximately 7 1/2% a year. The 5 year 18 growth rate from 1974 to 1979 is 7.9%. With a 60% payout ratio, investors expect 19 that dividend increases of this magnitude will continue on an annual basis at least 20 for the next several years. As I stated previously, investors are expecting a 7.3%' '
21 increase to $1.76 in February,1980.
Value Line Investment Service in its 22 November 2,1979 report, forecasts a 7.5% average annual dividend increase for 23 TU over the next five years.
24 Through 1978, earnings per share grew at an average annual rate of 7.9%
25 over the last three years, and at 4.8% a year over the past 5 years, a rate which 26 included an earnings decrease in 1975. Value Line projects a 6.5% annual growth 27 in earnings over the next five years and $2.85 earnings per share for 1980. Street 28 estimates of TU's earnings for 1980 are in the 2.85-3.00 range. Most sophisti-TEXAS POWER & LIGHT COMPANY
Luftig PAGE 26 cf 29 l
cated investors believe a projected five year growth rate in earnings of at least 1
2 61/2% to be reasonable.
3 I believe a growth rate of around 6 to 61/2% is a very conservative one for 4
this commission to use in this proceeding. Even if earnings failed to keep pace for 5
a period, investors expect that div;dends will continue to grow.
6 Q. IS THERE ANY RELATIONSHIP BETWEEN A COMPANY'S GROWTH RATE AND 7
ITS RETENTION RATE?
8 A.
Yes. It is expressed commonly as g = br. This says that the growth rate from 9
retained earnings (g)is equal to the retention rate (b) times return on book equity 10 (r). A 40% retention rate, which I believe is reasonable for TU over the next few 11 years, and the 15% market return on equity required by investors,if earned, would 12 produce a growth rate of 6%. The growth rate should be improved in the near 13 term by an increasing return on common equity but would be restricted if sales of
~
14 common stock are made below book value.
15 Q. WHAT ARE INVESTORS' RETURN REQUIREMENTS BASED UPON THE 16 DIVIDEND YlELD AND GROWTH RATE YOU HAVE BEEN DISCUSSING?
17 A.
Based upon an average three month dividend yield of 9.3% and a 6 to 61/2%
18 growth rate,investcrs' return requirements are about 15.3 to 15.8%.
Q. DO YOU HAVE ANY OTHER STATISTICAL AIDS TO HELP EVALUATE THE 19 20 COST OF COMMON EQUITY TO TP&L?
l 21 A.
Yes, almost three years ago I developed a computerized multiple regression model l
22 of 100 electric utility common stocks. The independent variables are: estimated 23 return on equity, dividend / book ratio, regulatory ranking and quality of earnings.
24 The regression equation has been explaining approximately 75% of the difference 25 in the market / book ratio (the dependent variable) of these 100 companies.
26 As of November 30, 1979, the last model run, the industry was at 83% of 27 June 30,1979 book values. If it is assumed that TU fit the industry format, then i
28 all other things being equal, TU would require an expected market return on TEXAS LOWER & LIGilT COMi%NY
Luftig PAGE 77 of 79 f
I equity of 14.6% for its stock to sell at book value.
2 While in my opinion, historical data, equations such as g = br, and the 3
regression model should not be used to compute return on equity initia!!y, these 4
tools are helpful in evaluating and verifying independently obtained market data.
5 Q.
HAVE YOU MADE ANY OTHER CHECKS OF THE COST OF COMMON EQUITY?
6 A.
Yes. As I stated earlier, investors require certain spreads between the returns 7
they can receive from the bonds of a company and the returns they demand on the 8
more risky investment in that company's common stock. Investors require a 9
spread of 450-500 basis points to purchase common stocks rather than the bonds 10 of a utility or a 50% greater return on the stock than on the bond in order to 11 invest in the stock. On this basis, with Triple A rated utility bonds currently 12 yielding about 10 7/8%, the market return requirements for the common stock of 13 that company are in the range of 15.4 % - 15.9 %
14 Q.
15 IT IMPORTANT FOR A COMPANY TO BE ABLE TO SELL NEW STOCK AT OR 15 ABOVE BOOK VALUE?
16 A.
Selling equity below book value has five adverse effects:
17 1.
It makes existing shareholders surrender a portion of their investment to the 18 new shareholders; 19 2.
It dilutes earnings per share and growth in earnings per share; 20 3.
It makes it more difficult for a company to meet the same dividend 21 requirement on an increased number of outstanding shares; 22 4.
It creates investor resistance toward further equity offerings; and 23 5.
It fails to meet one requirement of the Hope case, the ability to attract 24 capital on reasonable terms.
25 Exhibit MDL-ll shows the effect on a company's earnings per share u selling 26 stock at, below, and above book value.
For purposes of illustration, I have 27 assumed a company earning 16% on equity, with stockholder equity of $1 million, 28 and with 50,000 shares outstanding at a book value of $20 per share. Earnings per TEXAS POWER & l.IGirl COMPANY
i Luftig i
PAGE 28 ef 29 1
share then are $3.20, and the company pays a $2.24 annual dividend. As shown in 4
2 column 3, if the company sells an additional 50,000 shares at the book value of 3
$20, then the book value and earnings per share will remain constant, and the 4
$2.24 dividend continues to be 70% of earnings. I have next shown the situation 5
where the company is forced to sell these shares below book value; in this case, 6
$15 per share. The average book value per share then declines to $17.50, earnings 7
per share decline from $3.20 to $2.80, and the $2.24 dividend rises to 80% of 8
earnings. The next time the company needs to raise equity there will be a smaller 9
earnings base per share, and investors will be more hesitant to subscribe for the 10 new shares. If the company is forced to sell equity below book value a third time, 11 the thinning dividend coverage and lack of future earnings and dividend growth 12 prospects will discourage buyers.
In the last column of the table, I have 13 demonstrated the effects of selling an additional 50,000 shares at a premium over 14 book value; in this case, at $25 per share. As expected, book value per share 15 increases to $22.50 and because of the higher earnings base per share, earnings 16 improve to $3.60. Now both the earnings per share and the dividend growth 17 potential have been enhanced.
18 Q. WHAT FACTORS SHOULD BE TAKEN INTO CONSIDERATION IN RECOM-19 MENDING AN APPROPRIATE MARKET TO BOOK RATIO?
20 A.
Two principal factors, both related to the issuance of new stock, must be taken 21 into account in determining a minimum reasonable market to book ratio. The
(
22 announcement that a firm intends to issue new stock tends to drive down the price 23 of outstanding stock as a result of investors reacting negatively to potential 24 dilution, supply / demand adjustments, investors deferring stock purchases while 25 awaiting the offering, etc. This phenomenon is referred to as market pressure. A 26 second principal factor is that the company incurs certain costs in connection 27 with the sale such as legal and printing expenses, underwriter's fees, registrar's 28 fees, etc. My experience is that these factors aggregate about 10% of the market TEL\\S l'OWER & LIGIIT COMPANY
Exhibit MDL-1
- $800 mon Snythers P::go 1 of 1 Stock Research Summary of Supply and Demand for Credit (s Bin.ons)
Annual Net increases in Arnounts Outstanding Amt Out 1974 1975 1976 1977 1978 1979*
1980* 3f Dec79' Net Demand Pnvately Held Mortgages 42 2 42.0 70 4 109 0 116.5 118 5 100 7 f,102.9 Corporate & Foreign Bonds 29 1 39 1 39 1 37 4 33.5 32 8 42.7 475 6 Subtotal Long-Term Pnvate 71.3 81.1 109 5 146 4 150 0 151.3 143 4 f.578 5 Short-Term Business Borrowing 50 4 -16 0 98 47.0 78 5 112.9 81.5 577 3 Short-Term Other Borrowing 16 3 14 4 40 7 49 6 66 0 62 3 43.9 486 6 Subtotal Short Term Pnvate 66.7
-16 50 5
%6 144 5 175 2 125 4 f.063 9 Pnvately Held Federal Debt 28.4 82 6 71 8 73 3 83 8 66 9 96 5 760 0 Tax Exempt Notes ar'd Bonds 14 5 16 3 17.1 31.1 32.9 22 0 27 0 328 0 Subtotal Government Debt 42 9 98 9 88 9 104 4 116 7 88 9 123 5 f.088 0 Total Net Demand for Credit 180.9 178.4 248.9 347.4 411.2 415.4 392.3 3,730.4 Net Supply' Thnft Institutions 25 8 53 7 70 0 81 8 80 2 66 7 58 8 738.1 Insurance. Pensions. Endowments 29 0 40.9 53 1 67.3 70 2 75.1 81 4 690 6 Insestment Companies 1.7 3.7 46 6.7 83 23 2 20 7 57.4 Other Nonbank Finance 39
-43 8.7 17 6 15 9 25 6 19 5 785 6 Subtotal Nonbank Finance 60 4 94 0 136 4 173 4 174 6 190 6 180 4 f.67 f. 7 Commercial Banks' 52 6 29 9 59 6 83 5 1070 124 3 1000 f.09 7.9 Business Corporations 88 11 6 77 49 45 10 3 12 2 127.4 State & Local Government 1.1 2.4 49 11.3 14 7 52 30 72 5 Foreign 2 18 5 7.1 19 6 44.1 57.4 21 7 34 6 2490 Subtotal 141 4 145 0 228 2 317.2 358 2 352.1 330.2 3.206 5 Residual (mostly household direct) 39 5 33 4 20 7 30 2 53 0 63 3 62.1 523 9 Total Net Supply of Credit 180.9 178.4 248.9 347.4 411.2 415.4 392.3 3,730.4 Percentage Growth in Outstandings Totat Cred:t 93 84 10 8 13 6 14 2 12 5 10 5 Government 78 16 8 12.9 13 4 13 2 89 11 4 Household 70 6.3 11 6 14 9 14 9 12.8 91 Corporate 14 2 36 74 11.9 14.1 16 1 11 8 Long. Term 82 86 10 7 12.9 11 7 10 6 91 Short-Term 12 5
-03 85 14 9 19 4 19 7 11 8 Held by Nonbank Finance 7.2 10 4 13.7 15 3 13 4 12.9 10 8 Commercial Banks 83 43 83 10 7 12 4 12 8 92 Foreign 23 0 72 18 5 35 1 33 8 95 13 9 Household Direct 13 9 10 3 58 80 13 0 13 7 11.9 Economic Correlations Growth in Real GNP
- 1.4
- 1.3 59 53 44 2.7
-15 Nominal GNP 81 82 11.3 11.6 12 0 11 8 95
'F.sdudes funJs for equities, ca4 and rnncellaneous demands nce tabulated above.
alncludes loans transferred to bwks of nonoperaung holding anJ other bank-related cornpaniet
'Indudes US branches of foreign banks e - estimate p - projected Source:
Salomon Brothers
Exhibit MDL-2 S800mOf1 BrothefS Pcga 1 of 1 Stock Research Sources and Uses of Corporate Funds' ($ BJIions)
Annual Net increases in Amourts Outstanding Amt Out 1974 1975 1976 1977 1978 1979*
19808 3fDec79' Analysis in Brief
. Profits before Tazes and IVA 102 7 100 7 129 6 143 3 165 9 185 0 165 0 e Plus inventory Va'uation Adj
-404
~ 12 4
- 14 6
-152
- 25 2
-40 0
-270 e Repariated Foreign Profits 48 31 42 52 52 70 75 eless Federal ia Payments 41.3 42 6 452 59 8 65 2 77 0 80 0
- Dividends 25 9 28 3 32 9 37 0 41 6 475 50 5
- Pius Depreciation 77 0 84 1 91 4 103 1 113 0 122.0 1320
- Internat Cash Generation 76 9 104 6 132 5 139 6 152.1 149 5 1470
- Phys cal investment 146 0 115 8 154 0 186 7 212 7 242 3 233 5 Plus Net Trade & Consumer Credit 52 12 85 12 0 13 3 15 3 55
- Less Internal Cash Generation 76 9 104 6 132 5 139 6 152 1 149 5 1470 Equais Operationat Requirements 74 3 12 4 30 0 59 1 73 9 108 1 92 0 Plus Regs for Financial Assets 11 0 28 0 30 7 27 6 24 4 15 4 20 0 Equals External Requirements 85 3 40 4 60 7 86 7 98 3 123 5 112 0 Uses of Funds 2
113 0 106 9 121 2 143 3 170 0 192 0 209 5 e Plant & Equipment
+ Land 5 10 2 10 0 11.1 11 9 13 0 14 5 13 0
- Mineral Rights 65 13 40 25 20 30 40
- Direct Foreign Investment 12 60 39 50 38 45 50
. Residential Construction 22 20 30 48 42 28 20 inventor,es. Adjusted for Vafuation 12 9
-10 4 10 8 19 2 19 7 25 5 00
. Total Physical Investment 146 0 115 8 154 0 186 7 212.7 242 3 233 5 Net Trade & Consumer Credit' 52 12 85 12 0 13 3 15 3 55 f 63 6 Demand Deposits & Currency 12 62 15 08 53 40 50 66 0 Time Deposits
- 38
-30
-20 48 55
-20 20 29 2 U S Governments 09 95 23
-58
- 7.1
-05 45 f03 Federat Agencies 14
-08 00
-04 07
-03 20 32 Ope-Market Paper 3 42 22 41 76 75 80 45 55 2 State & Local Sacunties 06
-02
- 1.1 00 02 03 02 40 RepurNse Agreements
-58
-08 23 12 55 25 15 f63 Foreign DepoSts
-02 08 17 13 20 09 10 13 0 Other Assets (net) 49 14 1 21 9 18 1 48 25
-07 Totaf Uses 162 2 145 0 193 2 226 3 250 4 273 0 2590 Sources of Funds Internal Cash Generation 76 9 104 6 132 5 139 6 152.1 149 5 1470 Mortgage Debt 13 7 95 12 9 18 9 23 3 25 5 23 5 233 3 Bank Term Loans 2 12 7
-25
-30 23 11 7 20 5 12 0 702 5 Bank Short-Term Loans 17.1
-83 58 19 3 19 7 28 6 19 5 f 706 Finance Company Loans 58 22 52 10 3 83 10 0 70 64 7 U S Go,e nment Loans 15 02 02 00 17 12 10 69 r
Net Sales of Open V.vhet Paper 3 56
-23 35 28 49 11 0 80 36 7 Net New Tax-Enempt Bond issues 16 26 25 35 32 30 35 fB 9 Net New Taxable Bond issues 8 23 2 29 1 24 1 23 7 22 0 21 4 29 5 353 58 ht New Stock lsstes' 41 99 95 59 35 23 80 Bf00 Total Eaternal Sources 85 3 40 4 60 7 86 7 98.3 123 5 1120 Totat Sources 162 2 145 0 193 2 226 3 250 4 273 0 2590
' honfarm, nonfinancial corporations.
a NIA data. compares with Survey data of 112 4 112 8 120 5 135 7 153 6 173 6 187.3 Percentage change Survey
+ 12.7
+04
+68
+ 12.6
+ 13 2
+ 13 0
+ 7.9 NIA
+ 10 6
-54
+ 13 4
+ 18 2
+ 18 6
+ 12.9
+98 8 Our own ruimates All etw from Federal Rewese Board of Gosernors, flower. Funds
- Al market e - estimate p - projected Source:
Salomon Brothers
Exhibit MDL-3 Page 1 of 1
$8h3mott BrothetS Stock Research THE CROWTH OF CREDIT MARKET DEBT OVER TWO DECADES-(Billions of Dollars)
Avg. Annual Increase Outstandings _ _ _ _
During 5 Years Ended:
Type of Debt 1966 1976 1986E 1966 1976 1986E Mortgages 294 663 1400 23 65 135 Corporate Bonds 134 353 700 8
26 60 U.S. Govt. & Fed. Ags.
224 455 900 3
40 77 State & Local 106 246 450 6
17 33 Money Market 16 75 150 2
7 33 Loans 216 531 1050 19 39 90 Miscellaneous 71 130 200 To tal 1060 2452 4850
- Loans include all types of bank loans, consumer credit at depository institutions, and other loans.
E - Estimate Source: Salomon Brothers l
l 1
w I
PUBLICLY OFFERED STRAICllT BONDS a
BY CREDIT RATING
~
(Billions of Dollars)
Rating 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 Aaa
$ 3.0
$ 2.5
$2.1
$ 6.2
$ 5.9
$ 5.3
$ 3.7
$ 7.9
$ 8.2
$ 5.9
$ 8.8 $ 5.2 Aa 3.2 2.7 3.0 5.3 5.4 4.2 3.8 8.1 8.4 7.3 5.2 5.0 A
2.8 1.9 2.6 8.8 6.8 4.5 3.6 7.1 11.0 7.6 4.8 4.4 Baa & Below 4.4 2.5 1.8 2.5 2.4 1.2 0.6 1.5 2.5 3.1 2.7 2.9 f
Not Rated 1.4 1.3 0.0 0.3 0.0 0.7 0.6 0.2 0.8 0.6 0.4
.3
)
l Total
$14.8
$10.9
$9.5
$23.1
$21.3
$15.9
$12.3
$24.8
$30.9
$24.5
$22.0 $17.8
% of Total Aaa 20%
23%
22%
27%
28%
33%
30'Z 32%
26%
24%
40%
29%
l Aa 22 25 32 23 25 27 31 32 27 30 24 28
'o to A
19 17 27 38 32 28 29 29 36 31 22 25
$5 m*
Baa & Below 30 23 19 11 11 8
5 6
8 13 12 16 i. tT r
g i
O Not luted 9
12 0
1 4
4 5
1 3
2 2
2 mg l
"(
%.. v,.
% i,..., a rn e s.
r.
Exhibit MDL-5 Page 1 of 1 Salomori Brothers Stock Reeeeech NET ACQUISITIONS OF CORPORATE SECURITIES BY INVESTOR GROUPS (Billions of Dollars) 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 Life Insurance Companies Bonds 2.5 2.2 6.1 6.9 ' 5.7 4.9 9.2 14.8 17.2 17.5 Stocks 0.5 1.7 5.2 6.2
-0.9
-4.0 6.1 6.2
-0.5
.5 Private Pension Funds Bonds 0.6 2.1
-0.7
-0.8 1.6 4.7 2.8 1.3 6.5 9.2 S tocks 5.4 4.6 8.9 7.3 5.3 2.3 5.8 7.3 4.5 5.3 State & Local Retirement Funds Bonds 3.4 4.0 4.1 4.4 3.6 7.0 4.1 3.3 4.0 5.4 S tocks 1.8 2.1 3.2 3.5 3.4 2.6 2.4 3.1 3.7 2.7 Other Institutions and Foreigners Bonds 1.7 5.7 5.4 3.0
-2.0 4.9 10.1 7.2 4.5 4.2 S tocks 4.4 3.4 4.3 4.4 3.1
-1.1 3.0 1.3 3.3 5.2 Individual & Misc.
Investors Bonds 7.3 10.4 11.3 6.3 5.1 7.7 13.7 11.5 5.4
-1.8 Stocks
-9.0
-5.3
-6.6
-5.9
-6.7
-2.5
-2.9
-3.3
-6.6
-3.5 Including closed-end corporate bond funds, personal and cocson bank-administered trust funds, and foundations and endow =ents.
Foreign Bonds includes corporates, govern =ents, and international agencies.
Sources: Salomon Brothers; Life Insurance Fact Book
r Exhibit MDL-6 Page 1 of 1
(
TEXAS UTILITIES COMPANY Market Data 1967 - 1979 Average Book Value Average Earnings Per Market Price Per Share Market /
Year
. Share (a)
Per Share (b)
(Year End)
Book Ratio (1)
(2)
(3)
(4)
(5) 1967
$1.32
$27.50
$8.80 313 %
1 1968 1.35 27.50 9.34 294 1969 1.51 27.125 10.42 260 1970 1.66 27.50 11.18 246 1971 1.74 29.625 12.45 238 1972 1.95 30.00 13.40 224 1973 2.01 28.875 15.09 191 1974 2.18 19.675 16.30 121 1975 2.02 20.50 17.07 120 1976 2.29 19,75 18.09 109 1977 2.40 21.00 19.10 110 1978 2.54 20.125 20.14 100 1979*
2.51 19.25 20.81 93
- 12 Months ended September 30,1979.
(a) On average shares outstanding.
(b) Average of monthly high/ low figures rounded to the nearest one-eighth.
Source: Texas Power & Light
s' Exhibit MDL-7 Page 1 of 1 TEXAS POWER & LIGHT COMPANY Return on Common Equity and Interest Coverage Return Pre-Tax Interest on Average Pre-Tax Coverage Including Year Common Equity (a)
Interest Coverage Supplemental Interest (b)
Tlf (2)
(3)
(4) 1%7 17.6 %
6.9x 1968 15.8 6.4x 1969 16.6 6.5x 1970 16.8 5.8x 1971 16.3 4.9x 1972 16.7 5.0x 1973 15.3 4.6x 1974 14.4 4.1x 1975 11.4 3.3x 1976 12.4 3.3x 3.3x 1977 13.9 3.8x 3.6x 1978 15.2 4.2x 3.9x 1979*
14.7 4.0x 3.5x
- 12 months ended September 30,1979 (a) Includes return granted on unamortized investment credits.
(b) includes pro rata portion of TUFCO and TUGCO interest on Senior Notes.
Source: Texas Power & Light
TEXAS POWER & LIGHT COMPANY Total Construction Costs, AFUDC, and Return on Common Equity 1967-1979
($000 Omitted)
Total Construction Total Construction AFUDC As Return Cn Return on Average Costs Costs
% of Income Avail.
Average Common Equity Year (Incl. AFUDC)
(Excl. AFUDC)
For Common (a)
Common Equity (a)
(Excl. AFUDCXa)
(1)
(2)
(3)
(4)
(5)
(6) 4 1967
$ 51,169
$ 49,372 6.3%
17.6 %
16.5 %
1968 64,257 62,746 5.5 15.8 15.0 1969 75,823 72,715 9.7 16.6 15.0 1
1970 87,922 83,937 10.8 16.8 15.0 1971 100,604 94,693 14.2 16.3 14.0 1972 107,764 102,796 10.4 16.7 15.0 1973 152,542 147,142 10.7 15.3 13.7 1974 203,771 192,165 20.2 14.4 11.5 1975 264,776 250,272 26.8 11.4 8.3 1976 261,171 242,063 28.I 12.4 8.9 1977 278,075 257,408 23.3 13.9 10.7 1978 305,095 286,975 17.1 15.2 12.6 1979*
364,284 342,802 19.3 14.7 11.8 m
?
- 12 months ended September 30,1979.
gW K
(a) Includes return granted on unamortized investment tax credits.
k
%nrr e.
Tevas pnwar h i icht
Exhibit fiDL-9 SalOmOf1 Bf0thers Pcgo 1 of 1 stoch nesearch S&P 400 INDUSTRIALS STOCK MARKET DATA 1967-1978 Market Market /
Return pixed Earnings Price Book on Charge Year Per Share Per Share Ratio Equity Coverage 1967
$ 5.62 S 95.73 205%
12.0%
11.0X 1968 6.16 106.54 217 12.6 10.6 1969 6.13 107.00 210 12.0 8.9 1970 5.41 89.23 171 10.4 7.3 1971 5.97 107.60 199 11.1 7.6 1972 6.83 122.57 216 12.0 8.1 1973 8.89 118.96 196 14.7 8.5 1974 9.61 90.59 139 14.7 8.0 1975 8.58 92.56 134 12.4 7.1 1976 10.64 111.17 152 J4.5 7.4 1977 11.57 109.40 138 14.6 7.9 1978 13.12 107.12 125 15.4
8.0 Sources
Standard & Poor's; Salomon Brothers l
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Exhibit MDL-10 Pega 1 of 1 M
Stock Research PERCENT RETURN ON NET WORTH
- OF LEADING MANUFACTURING COMPANIES (1974-1978) 1974 1975 1976 1977 1978 Industrial Grouc 12.0 17.o 16.1 18.5 20.1 1.
Baking 13.2 14.3 14.7 14.8 15.6 2.
Dairy Products 6.7 12.7 12.9 10.4 10.5 3.
Meat Packing 21.3 23.2 11.4 9.1 12.0 4.
Sugar 5.
Other Food Products 14.4 14.1 16.1 15.3 16.5 6.
Soft Drinks 19.0 20.6 22.4 22.7 22.8 7.
Brewing 12.3 10.3 11.5 10.3 11.4 14.1 11.5 16.3 11.9 14.2 8.
Distilling 9.
Tobacco Products 16.4 17.9 17.2 19.3 19.8
- 10. Textile Products 9.1 3.4 9.6 9.o 9.6
- 11. Clothing & Apparel
@.8 9.3 12.3 11.2 14.7
- 12. Shoes, Leather, etc.
11.5 10.7 15.0 13.6 16.3
- 13. Rubber & Allied Products ty. 7 7.8 7.5 10.4 6.2 14.
Lumber & Wood Products 15.9 10.0 15.5 16.1 19.7 15.
Furniture & Fixtures 8.2 7.0 9.8 8.8 9.6
- 16. Paper and Alliec Products 18.3 12.7 14.8 14.2 14.0
- 17. Printing & Publishing 14.5 12.9 13.9 17.4 18.4
- 18. Chemical Products 18.8 15.8 16.1 14.5 15.0
- 19. Paint & Allied Products 11.7 9.0 10.9 12.5 8.1
- 20. Drugs & Medicines 21.0 20.4 20.0 18.8 21.5 21.
Soap, Cosmetics 17.9 18.0 18.3 19.4 20.8
- 22. Petroleum Products & Refining 19.6 13.9 14.8 14.2 14.3
- 23. Cement 8.8 7.1 9.8 13.0 19.7 24.
Glass Products 10.6 9.8 J7.3 13.6 13.6 25.
Other Stone & Clay Products 9.1 8.2 10.6 11.6 17.5 26.
Iron & Steel 17.1 10.0 8.7 6.5 9.6
- 27. Nonferrous Metals 15.1 7.4 8.5 7.8 10.2
- 28. Hardware & Taols 17.7 13.6 16.3 15.9 18.4
- 29. Building Heating & Plumbing Equip.
14.2 12.3 21.0 22.4 21.8
- 30. Other Metal Products 14.0 13.0 15.0 15.4 13.6 31.
Fam, Construction, Material Hand. Eqpt.
14.8 18.7 17.9 17.5 18.3
- 32. Office Equipment & Computers 16.3 15.9 17.4 18.3 22.5
- 33. Other Machinery 12.2 11.6 13.6 15.4 17.0 34.
Electrical Equipment & Electronics 13.1 12.7 16.2 17.2 18.0
- 35. Household Appliances 5.3 6.2 17.4 19.0 15.7
- 36. Autos & Trucks 6.1 5.7 18.3 20.3 17.2
- 37. Automotive Parts 10.4 9.6 15.3 16.4 17.8
- 38. Aerospace 13.8 11.7 13.0 16.3 19.7 39.
Instruments, 7hotographic Goods, etc.
16.1 14.3 15.7 16.2 19.1
- 40. Miscellaneous Manufacturin9 9.5 8.4 15.2 12.3 16.4 41.
Total 15.2 12.6 15.0 15.0 15.9 Source:
Citibank Monthly Economic Newsletter - April Issues.
- Net worth includes common and preferred shareholders' equity.
t R.
EXAMPLE OF EFFECTS OF SELLING ADDITIONAL EQUITY AT BOOK VALUE, BELOW BOOK VALUE E
AND ABOVE BOOK VAI.UE j
Sale at Book value Sale Below Book Sale Above Book Present
($20) value ($15)
Value ($25)
Stockholder Equity
$1,000,000
$2,000,00_0
$1,750,000
$2,250,000 Sheres Outstanding 50,000 100,000 100,000 100,000 1
Book Value Per Share S20
$20
$17.50
$22.50 Return on Equity 16%
16%
16%
16%
Earnings Per Share
$3.20
$3.20
$2.80
$3.60 J
Dividend Per Share S2.24 S2.24
$2.24
$2.24 Payout 70%
70%
80%
62%
l l
Source:
Salomon Brothers 1
I r
TN$h
- G
-r 1
o
~T
s S8lOmOf1 Brothers Exhibit MDL-12 Sicxk Research i
REQUIRED RETURNS ON BOOK EQUITY TO YIELD A GIVEN MARKET RETURN Market / Book Return Ratio On Eauity 1.00 15.0%
15.5%
16.0%
1.05 15.5 16.0 16.5 1.10 16.0 16.5 17.0 1.15 16.4 16.9 17.4 1.20 16.9 17.4 17.9
- Based on the relationship ROE = P/B (k-g) + g when:
ROE - required return on book equity k = required return on market equity g = growth rate P/B = market book ratio The derivation of this formula is shown on pages 2 and 3.
The table assumes growth rates of 5.5%, 6.0% and 6.5%
associated with 15.0%, 15.5%, and 16.0% required market l
returns.
l Source:
Salomon Brothers l
l l
e Exhibit MDL-12 Page 2 of 3 g
Stock Research a
Derivation of Formula Used to Convert Market Return to Book Return I.
Definition of Symbols P = market price of a share of stock B = book value per share D = dividends per share THUS P/h = market to book ratio k = annual required rate of return on equity capital = market return ROE = return on book equity g = growth rate of earnings per share.
This is the same as the growth rates of dividends and retained earnings, since the payout ratio is assumed constant.
II.
Derivation A.
If for simplicity, we assume continuous growth in dividends at annual rate 9, then D
k=p
+g
( 1. )
B.
By definition, earnings = D + retained earnings ROE B
B (2)
Neglecting changes in ROE, and assuming all growth comes from retained earnings (the-reglecting the effect of the sale of new shares above or below b4ok),
retained earnings
=9 (3)
B From (2) and (3),
ROE = S + 9 (4)
B
Exhibit MDL-12 a
88 %
Pag 2 3 of 3 Stock Research I
C.
Rearranging (1),
D = P (k-g)
(5)
Substituting this form of D in (2),
ROE =
.'(K-g) + g (0)
III.
Demonstration that if allowed return on equity (ROE) is equal to investors' return requirement (K); the market pricc (P) will equal book value (B).
Rearranging (1)
D (7) p=
K-g Rearranging (4)
D ROE-g (8)
Dividing (7) by (8)
P-ROE-g B
K-g (9)
Therefore if K = ROE, P must equal B.
If an issuing company is.to issue new stock and receive net proceeds at least equal to book value P must be greater than B to allow to market pressure and selling costs and therefore ROE should be higher than K.
..e o
STATE OF NEW YORK :
COUNTY OF NEW YORK:
BEFORE the undersigned authority on this day personally appeared MARK D. LUFTIG, who, having been placed under oath by me, did swear follows:
"My name is MARK D. LUFTIG.
I am of legal age and a resident of the State of New York.
The foregoing testimony, and exhibits of fered on behalf of Texas Power & Light Company, are true and correct and the opinions stated therein are to the best of my knowledge and belief accurate, true, and correct."
"^ax o res g
.d
. SUBSCRIBED AND SWORN TO BEFORE ME by the said t
.b Mark D. Luftig 7th day of December, A.D.
1979.
1
. e,$M ?. ^.. % '
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- 7,07q53 e
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p rMW NOTARY PUBLIC in a $ for the I
State of New York l
My Commissions expires 30 l
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