ML20030B587
| ML20030B587 | |
| Person / Time | |
|---|---|
| Site: | Allens Creek File:Houston Lighting and Power Company icon.png |
| Issue date: | 09/30/1980 |
| From: | Hadaway S TEXAS, STATE OF |
| To: | |
| Shared Package | |
| ML20030B571 | List: |
| References | |
| 3320, NUDOCS 8108180325 | |
| Download: ML20030B587 (60) | |
Text
{{#Wiki_filter:____ mU H. DOCKET NO D20 RE: APPLICATION OF HOUSTON i PUBLIC UTILITY COMMISSION LIGHTING AND POWER COMPANY l gi. FOR A RATE INCREASE i OF TEXAS $.Y-fC \\ g e3 t y ?s-I cfc. 3 gil 4>.. f i: DIRECT TESTIMONY OF SAMUEL C. HADAWAY ECONOMIC RESEARCH DIVISIC N PUBLIC UTILITY COMMISSION OF TEXAS )_ September,1980 .v
- e. -
h E a$ v: f-{ e ('* 8108180325 810812 PDRADOCK05000g y
? DOCKET NO. 3320 RE: APPLICATION OF HOUSTON i PUBLIC UTILITY COMMISSION LIGHTING AND POWER COMPANY l FOR A RATE INCREASE OF TEXAS i t i DIRECT TESTIMONY OF l i SAMUEL C. HADAWAY i f ECONOMIC RESEARCH DIVISION l PUBLIC UTILITY COu.,;;;S!ON OF TEXAS i i l 1 l September,1980 4 t l t i p
[ DOCKET NO. 3320 RE: APPLICAIlON OF HOUSTON i PUBLIC UTILITY COMMISSION LIGHTING AND POWER COMPANY l FOR A RATE INCREASE i OF TEXAS DIRECT TESTIMONY OF SAMUEL C. HADAWAY Q. Please state your name and business address. A. Samuel C. Hadaway,7800 Shoal Creek Boulevard, Suite 400N, Austin, Texas. Q. By whom are you employed and in what capacity? A. I am employed by the Public Utility Commission of Texas as Director of Economic Research. Q. What are your principal areas of responsibility? A. I have overall responsibility for the coordination and direction of the Economic Research Division, which includes economic analysis and research activities concerning public utilities under the Commission's jurisdiction. Q. Please state briefly your educational background, professional qualifications, and business experience. A. I hold a BA degree with an economics major from Southern Methodist I University, an MBA with a finance concentration from the University of Texas, and a Ph.D. in finance with areas of concentration in econometrics and statistics from the University of Texas. I have worked as a security analyst, a computer programmer, and as a consultant for various financial institutions and industrial companies. Most recently I was Interim Coordinator and Assistant Professor of Finance at Texas Tech University. I have also been Assistant Professor of Finance at the University of Alabama. I have taught courses in financial management, investment an.itysis and capital market theory, as we!! as supervised thesis research and student projects in firuncial market analysis. I have published artic!cs on
f HADAWAY TESTIMONY, PAGE 2 l security analysis and portfolio management in national financial journals including the Journal of Economics and Business, the Appraisa! Journal, the Journa: or Financial and Quantitative Analysis, the Review of Business and Economic Research, and others. I have aSo presented papers at regional and national conferences on topics ranging from fair rates of return for Public Utility Companies to the evaluation of investor risk-return perceptions. I currently serve as an adhoc referee for several national financial and economics journals. Q. Would you please state the intent of your testimony in Docket No. 3320, Houston Lighting and Power Company, and describe the scope of your review and analysis in this case? A. The purpose of this testimony is basically threefold. Initially, I will discuss the general principles inve!ved in determining the rate of return on equity, and second I will conduct a specific analysis of the cost of equity to Houston Industries, Inc. (HII) to estimate the return required by investors for their commitment of equity capital to the parent company. Using this return as a benchmark, a fair return on the equity invested in Houston Lighting and Power (HL&P) will be determined which, in turn, will lead to my recommendation as to a fair composite rate of return on the original cost of invested capital. In the third portion of my testimony,I will discuss affiliate transactions between HL&P and Utility Fuels, Inc. (UFI). To address these issues, this prepared testimony has been organized into seven sectione i 1. Principles of Rate of Return on Equity II. Cost of Equity to Houston Industries, Ir.;. 111. Market-to-Book Adjustment IV. Retian to Equity of HL&P V. Composite Rate of Returo VI. Affilitate Transactions with UFI Yll. Conclusions and Summary of Recommendations l l
I HADAWAY TESTIMONY, PAGE 3 In addition, 13 exhibits have been prepared to support my analyses and follow the text of this testimony. PRINCIPLES OF RATE OF RETURN ON EQUITY Q. Would you please explain the purposa of this portion of your testimony? A. This section is intended to identify the general principles involved in determining the rate of return on equity or the minimum return required by marginal irvestors to induce them to purchase shares of a company's common stock. Q. Would you please elaborate on the cost of equity concept? A. As indicated, the cost of equity is the minimum price that must be paid to investors for the use of their money. Equity capital is a resource-- just like debt funds, labor, fuel, etc.- which has a cost, or rent, attendant with its usage. By identifying the cost of this resource and allowing a utility the opportunity to earn at approximately this rate, consumers are required to pay only for the actual cost of the money invested in plant and facilities. At the same time, however, because the price of equity capital is determined by its alternative uses, the expected return is the same as might be expected those on other investments of similar risk. If equity capitalis authorized to earn its opportunity cost, a company should experience little difficulty l raising additional funds, in short, by allomng a utility company to earn its l cost of equity. stockholders receive neither windfall gains nor is their investment confiscated; and, the return is sufficient to attract new capital so that service can be maintained and expanded as needed. Q. Is the cost of equity the same as a fair return to equity? A. Not necessarily. While the terms are of ten used synonymously, there can be a difference between the two if there are other objectives - such as encouraging a market-to-book ratio greater than ene - that would cause the i L
HADATAY TESTIMONY, PAGE 4 values to be different. Even when other objectives exist, however, the cost of equity concept provides a rational basis upon which to develop a fair return to common equity. Q. ilow is the cost of capital determined? A. The cost of capital is a function of two things: the time value of money and the risk to which the capital will be exposed. In other words, the cost of all capital can be generally orscribed as: Cost of Capitaf Risk-Free Rate + Risk Premium = Obviously in this model, the more risky the use to which capital is put, the greater the required return; and alternatively, a less risky use of capital will command a lower return. Four risk-return continuums have been illustrated in Exhibit SCH-1, where capital market lines for long-term or permanent capital are depicted for 1978,1979, March 1980 and August 1980. As shown, default-free assets - such as U.S. Treasury Bonds - require only a minimum yield to account for the pure time value of money and long-term inflationary expectations. As risk increases, however, the total required return rises as investors demand additional compensation for their risk-bearing. This is particularly evident in the case of bonds and preferred stocks where the relationship between risk levels, as indicated by ratings, and required yields are fairly well-defined. Moving from fixed income securities to common siock on the risk spectrum, though, is more complicated because risk and required returns for equities are not directly observable. Nevertheless, in an efficiently functioning capital market, the risk-return principle evidenced by bonds and preferreds undoubtedly extends to common stocks as well. Thus, for low risk equities - such as very stable, blue chip companies - a lower expected return is required than from other more risky common stocks. Furthermore, investors should require even higher expected returns from extremely speculative investments. I l l
HADAWAY TESTIMONY, Fr.GE 3 Q. What other observations can be made from the capital market lines in Exhibit SCH-l? A. Two other items of significance should be noted from t'Js discussion of the capital market line. First, inflation is implicitly taken into account by the marketplace. In other words, the current returns required by investors for the use of their money already reflect their expectations for future inflation; they have already adjusted for anticipated loss of purchasing power while their funds are loaned out. Secondly, the capital market line is not a fixed function but may move over time. Not only does the slope of the line change, but paralle! shif ts also occur as investors revise expectations of future inflation, monetary policy changes, etc. This is illustrated in Exhibit SCH-1, where an August 1980 capital market line is compared with one of six months ago, one from last year, and one from two years ago. As evidenced here, the recent current capital market line has shif ted markedly downwards in comparison to the March 1930 line, but it is still at a significantly h. Der level than the 1978 and 1979 lines. This reflects a decline from the extremely high rates of interest and inflation that occurred last Spring. Q. Are the capital market lines in Exhibit SCH-1 fairly accurate, and what are l their implications? A. The graphs in Ltxhibit SCH-1 are, in my opinion, representative of capital market conditions of the last two years, and I believe that the August 1980 line fairly reflects current economic conditions and investor expectations. If a return on equity consistent with the current capital market line is authorized, not only will it include adequate compensation for the expected effects of inflation, but the return will also be commensurate with the returns available from other investment opportunities of similar risk.
i HADAWAY TESTIMONY, PAGE 6 Q. You have pinpolated the returns required for various fixed income securitics in Exhibit SCH-1; why not do the same for common equities? A. As noted previously, unlike bonds and preferred stocks, the dividends and capital gains that (.ommon stockholders expect from their investments are i not known with certainty, since there is no stated or contracttal rate of return on equity securities. Consequently, it is impossible to compute the i precise rate of return that investors expect from a share of common stock, even given the stock's current market price. Further complicating the I effort to deterrnine investors' minimum required return is the problem of precisely specifying the risk level of a particular company. There are a multitude of factors contributing to investors' perceptions of the risk of a i company's common stock. Q. How, then, does one determine the required return or cost of equity for a I given company? Obviously, this is a difficult task due to the uncertainties inherent in equity A. securities. However, by analyzing information about a company and other cc npanies judged to be of comparable risk, a reasonable estimate of a firm's cost of equity can be made. While various quantitative approaches i are used as guides to investors' minimurr' required returns, in the final analysis the cost of equity estimate is fundamently a judgemen: decision based upon all of the information available to the analyst. II. COST OF EQUITY TO HOUSTON INDUSTRIES, INC. Q. Would you please explain the purpose of this portion of your testimony? A. This section is intended to identify the cost of equity capital to Houston Industries, Inc.; or in other words, to estimate the minimum return that l margirul investors require to induce them to purchase shares of the Company's common stock. t i
HADAWAY TESTIMONY, PAGE 7 Q. Why have you initially focused on the cost of equity to Houston Industries rather than the minimum return required from HL&P? A. HL&P is a wholly-owned subsidiary of Houston Industries (along with Primary Fuels, Inc. and Utility Fuels, Inc.), and all equity is financed through the parent. While we are ultimately concerned with a fair return to the equity capital invested in HL&P, the logical starting point for determining this quantity is where the subsidiary effectively meets the investor directly- - in the marketplace, at the parent or consolidated level. Q. How have you gone about estimating the cost of equity to Houston Industries, Inc.? A. I have estimated Hil's cost of equity in a variety of ways. Initially, I have evaluated the fundamental financial and operating characteristics of the Company. These characteristics are then compared to those for the electric utility industry and the unregulated sector to obtain a general estimate of the Company's relative risk position. Concurrently, today's market conditions are contrasted with those of the near past, and recent developments are explored. This effort is intended to provide a better understanding of changes in investor expectations, perceptions, and requirements that have occurred recently. In particular, investors' changing perceptions of the electric utility industry and of HI! as part of that industry are analyzed. Secondly, I have examined the equity returns realized by other firms judged to have risks similar to Hil in an attempt to estimate what investors might expect from alternative investments. t l Thirdly, a conventional discounted cash flow analysis is performed. This l analysis attempts to replicate market expectations and impute investors' l required returns from Hil, given the Company's current market price. In connection with this, a variation of the traditional DCF model, utilizing l investment analysts' earnings forecasts, is also employed as an estimate of l
HADAWAY TESTIMONY, PAGE 3 the Company's cost of equity. I will also discuss a recently conducted survey of investors that inquires directly as to the return they require from electric utility company shares. A final test is to examine the risk premium, or additional return, that investors require for holding common stock instead of long-term bonds. Even though each of these methods is usefulin estimating investors' required
- returns, results vary substantially between methodologies. Because some tests may be stronger than others, I have given careful consideration to the strengths and weaknesses of each model in arriving at a final cost of equity estimate.
Q. How does the risk of the electric utility industry compare with that of the unregulated sector? A. Electric utilities have traditionally been considered one of the least risky groups of stocks available. This is in large part due to the essential nature of electric service, the stability of demand for utility services, and the market protection afforded by regulation. Beginning in the early 1970's, however, uncertainties in the form of more volatile and rising interest rates, rapid inflation, regulatory 1,in some jurisdictions, consumer militancy, fuel 4 l problems, and increasing needs for external capital caused electric utilities to lose some of their market favor. Even during this period, though, electrics were still considered relatively safe investments, since even nonregulated companies were facing similar problems with the energy crisis, inflation, and rising capital costs. During 1977 and 1978, regulation generally improved nationwide, boiler fuel prices began to stabilize, and l capital expenditures showed some promise of leveling off. Hence, some i uncertainties were reduced. Althour,h this improving tiend has been interrupted recently by the mandatory shutdowns of several nuclear stations following Three Mile Island, the rhn tinued dependence on and the rising price of foreign oil, i
HADAWAY TESTIMONY, PAGE 9 environmental concerns, and the anti-nuclear movement in general, the electric utility industry is still generally considered to have advanced substantially in coping with these problems. Although growth is expected to continue, most industry analysts expect that during the next decade growth will be moderated by increased conservation efforts by consumers, generally slower economic activity, and continued high rates of interest and inflation. All these factors have caused analysts to forecast industry growth in the 3 to 5 percent range for the 1980's. Thus, tne relative risk of owning common stock in the electric utility industry, reflecting the various uncertainties noted above, has increased substantia!!y from ten to fifteen years ago. The apparent improvement in conditions that marked 1977 znd 1978 has been moderated by the events and circumstances of the last two years, and investors apparently now view the industry with greater caution and concern than was previously typical. Despite these mcertainties, the moderation of the rate of inflation and of capital financing costs that has occurred over the past few months has been i beneficial to electric utilities. This phenomenon, coupled with a slower ( forecasted growth rate in kilowatt hour demand (3 to 5 percent) for the future, affords electric utilities more flexibility in financing and rescheduling major construction projects. On the whole, the industry is still I typically viewed as being, over the long run, more stable and thus less risky than the mregulated sector and the market in general. Q. How cb investors view Houston Industries as compared with other electrics? l A. The bonds of Houston Industries (HL&P) are rated Double A by both major bond rating agencies. This rating reflects a good long-run outlook for the Compr.ny's fixed income securities. The level of quality reflected by this l rating is a function of many factors. The Company's fundamental business {
HADAWAY TESTIMONY, PAGE 10 position is enhanced by its location in the Sunbelt, and, in particular, in Texas and the Houston area. Its Greater Houston service area provides a revenue composition that is well balanced across customer classes (27 percent residential, 20 percent commercial, 46 percent industrial and 7 percent municipal and other). Houston Lighting and Power Company is currently engaged in a large construction program designed to diversify its fuel supplies, convert from gas to alternate fuels, and to meet projected growth in kilowatt hour demand of approximately 4 percent per year for the near-term future. This expected growth in peak demand for HL&P in the 1980's is significantly low < r than the 6 to 7 percent rates that were typical in the 1970's. The rate is, however, in the middle range of forecasted load growth of 3 to 5 percent for the electric utility industry as a whole. On the negative side, even in spite of lower projected growth in demand, HL&P will still be hard pressed to meet the 15% capacity reserve position the Company has set as its corporate goal. Due to construction delays in the completion of the Company's nuclear and lignite units, HL&P has contracted to purchase sizable amounts of additional power. The coal and lignite plants that the Company has built, is building, or is planning to build should provide relatively reliable fuel sources. Lignite is an important new fuel source for l HL&P, and the proposed mine-mouth plant in Limestone County should provide not only reliable fuel supplies but also significant cost savings. Due to possible forced interstate power pooling from the Texas Interconnect 1 System, however, the extent to which these cost advantages will be enjoyed by Texans is uncertain. In light of Three Mile Island and HL&P's experience with the South Texas Nuclear Project (STP), there is considerable investor concern about HL&P's involvement with nuclear power. Persistent construction delays at STP and
HADAWAY TESTIMONY, PAGE 11 the escalation of construction costs over and above the $2.6 hillion planned by the Company caused Duff & Phelps to downgrade HL&P's senior sr urities in May 1980. Also, the economic viability of the Allen's Creek Project hinges on the licensing procedures of the Nuclear Regulatory Commission and the Company's ability to secure adequate financing. These company-specific risks are somewhat counterbalanced by HL&P's size - it is the sixth largest electric utility in the nation with assets of over $3 billion - and its location in Houston and Texas. The Company comes under the jurisdiction of the Public Utility Commission of Texas, which is generally considered by investors to be a responsible and fair regulatory body providing timely decisions. In addition, the capital structure and conservative accounting policies of the Company are viewed favorably by investors. In summary, even though the fundamental characteristics of Houston Lighting and Power Company are perceiveJ by investors to have become relatively more risky, due to the size of its construction budget and attendant financing difficulties and its problems in the development of nuclear power, HL&P is still relatively well positioned in the industry and seems to be somewhat less risky than the average electric utility. Q. What has been the recent experience in the capital markets for both debt and equity? A. During the last year, the capital markets have undergone significant shif ts, with bond yields increasing and decreasing dramatically and stock prices fluctuating without a clearly defined trend. The exact causes behind these events are subject to debate, but they clearly reflect continued uncertainty regarding inflation, interest rates, recession, energy policies, etc. The l volatility of capital markets over the past three years and the impcct of l such volatility on the electric utility industry can best be demonstrated by l l examining mme selected financial indicators. Exhibit SCH-2 lists yields on l
HADAWAY TESTIMONY, PAGE 12 public utility fixed incorne securities in July 1978, July 1979, March 1980, and August 1980. As indicated, investors are requiring generally between 140 and 280 basis points less now than in March 1980, to induce them to purchase fixed income securities of comparable risk; while in March 1980, investors required between 400 and 500 additional basis points over July 1979. The experience 'f electric utilities in the equity markets is shown in Exhibit SCH-3, which illustrates average selected financial measures for the 100 largest electric utilities as of August 1,1978,1979, and 1980. Since this time a year ago, dividend yields have risen another 125 basis points on top of the 111-basis point increase from 1978 to 1979, while the 1980 price-earnings ratios have not increased. Similarly, market prices have dropped from an average of 96 percent to 80 percent of book value from 1978 to 1980. These declines occurred during a period when payout ratios increased, and realized return on equity declined from an average of 11.9 percent in 1978 to 10.9 percent in 1980. In all, these statistics present strong evidence that over the past 24 months there has been a significant increase in the returns required by investors. This general upward shif t in the capital market line is illustrated in Exhibit SCH-1 to demonstrate visually the difference between the market returns demanded over the past two years and those required by investors today. Q. How have the charges in the capital markets affected Houston Lighting and Power Company? A. The general changes in economic and financial market conditions have impacted HIl directly. The operating company's cost of new long-term debt has increased from approximately 11.25 percent in December 1979, to approximately 12.1 percent in June 1980 - - an increase of 85 basis points.
HADAUAY TESTIMONY, PAGE 13 Hil's common stock has consistently sold below book value (approximately 80 percent of June 1980 book value) in the marketplace. This indicates that investors do not view future prospects for Hll as being sufficient to justify a stock price equal to or greater than book value. Q. Does inis mean that the returns on equity authorized in the past were inadequate? A. Not at all; the returns allowed by the Commission in previous cases appeared to be appropriate given the economic and financial conditions at the time. Recent changes in market conditions and the increase in investors' required returns, coupled with the Company's continuing need for external financing, have caused HII stock to sell consistently below book value since 1978. Thus, to encourage a market price equal to or greater than book value, so as to prevent dilution of present stockholders' investment, returns authorized on equity must be revised upward to reflect changes in capital market conditions and increases in the rate of return demanded by investors. Q. What tests have you performed to identify the level of investors' required returns f rom Houston Industries, Inc.? A. As a first step in estimating Hil's cost of equity, the eturns earned on book equity by other firms having approximately corresponding risks have been evaluated. It should be noted that for this methodology to be useful in identifying investors' required returns, it must be assumed that other companies, on average, have actually earned for shareholders their cost of equity on net book value - no more and no less. Furthermore, it must be established that the risks to the stockhotders of other companies selected for comparison are similar to the risks of owning the stock in question. It is not vpropriate, for example, to compare Houston Industries, Inc. with all other stocks, because of risk differences. Neither is it proper to classify the
HADAWAY TESTIMONY, PAGE 14 risks to stockholders by looking only at the risks of holding bonds of various quality ratings. The appropriate risk measure must be related to the investor's level of uncertainty associated with holding the Company's stock. Typically, such uncertainty is closely related to the amount of variability expected in the shareholder's return stream. Shareholders are simply less certain about their return over a given time period when the return varies widely from period to period, as opposed to a return stream that is more stable over time. I have measured th}s risk to the HIl investor in two ways - first by the Company's Beta, and second, by the Company's Value Line Price Stability Index (formerly the Value Line Safety Rank). Q. Please explain these measures of risk. A. For diversified investors, Beta is the appropriate measure of investment safety or risk. Beta measures the sensitivity of a stock's return to fluctuations in the general market. A stock with a high Beta is riskier than one with a low Beta because the higher Beta stock tends to fluctuate more vis a vis the stock market as a whole. Because market movements affect even well diversified portfolios, Beta is an index of risk that cannot be diversified away. An alternative risk measure is Value Line's Price Stability index, which is based on the total variaN!!?y of a stock's price. The Price Stability Index measures variability from all causes, not only that growing out of a stock's sensitivity to fluctuations in the general market. This includes not only the systematic risk, or market risk, but also the risk of price fluctuations unique to that company or its industry. This measure of risk is particularly well-suited to the investor who is not completely diversified, and to measuring risk not captured in Beta. Q. Why are Beta and the Value Line Price Stability Index better measures of risk than other fundamental data on the company?
HADAWAY TESTIMONY, PAGE 15 A. Beta and the _Value Line Price Stability Index are appropriate measures of the risk of owning common stock because they directly measure factors that impact the equity holder's position - - they specifically reflect changes in investment value. Beta and the Value Line Price Stability Index avoid having to speculate as to how investors may perceive changes in a company's operating and financial characteristics. Rather than making conjectures as to what specific factors (such as capital structure, market conditions, supply availability, etc.) investors might view as affecting a company's prospects, the two measures of risk directly reflect investors' evaluation of these fundamental factors as embodied in stock prices. Then, by measuring investors' responses, not only are all of a company's fundamental factors considered, but their relative importance to shareholders in general is incorporated as well. For these reasons, Beta and the Value *.me Price Stability Index are the most objective and comprehensive measures of the risk of owning a company's common stock. Q. How have you used Beta in your comparable earnings? A. The Beta-comparable earnings analysis involves an evaluation of the returns realized on average book equity between 1964 and 1978 by those compai.ies included in Standard and Poor's 500 Composite Index. The returns earned on average equity by each of the 500 firms in the study over the five, ten, and 15-year periods between 1964 and 1978 have been computed and combined according to the companies' _Value Line Beta. Because individual company Betas are subject to measurement error and tend to be somewhat unstable over time, the firms have been grouped using a range of Beta values to to improve reliability. Furthermore, the long-term tendency of Betas to regress toward the mean value of 1.0 has already been compensated for by ,Value Line through an adjustment to each company's measured Beta.
- Thus, Houston Industries' May 1980 reported Beta of.80 reflects an adjustment to
a e b-HADAWAY TESTIMONY, PAGE 16 the Company's measured historical Beta of.66. As shun in Exhibit SCH-4, page-1, firms with adjusted Betas of.80 to.90 earned a:. average of 14.0 percent during the most recent five-year period 1974 to 1978,13.7 percent between 1969 and 1978, and 13.8 percent over the 15-year period 1964 to 1978. Q. What are the results of the Price Stability test? A. Value Line has assigned a Price Stability Index of 95 to Houston Industries - the Index ranges from 100 (least risky) to five (most risky). Using identical computational methods and similar grouping procedures as in the Beta analysis, the results of this study are presented in Exhibit SCH-4, page 2. As illustruted, firms with Price Stability Indices comparable to H!!'s realized a 14.2 percent return on average book equity between 1974 and 1978,14.7 percent between 1969 and 1978, and 13.6 percent during the 1964 to 1978 period. Q. Would you briefly summarize your interpretation of these analyses? A. Several problems exist with comparable earnings analyses of this type. First, the basic assumption upon which they are founded, that on average companies realize their cost of equity m book value, must be seriously questioned. in a similar vein, it is disconcerting to note that there is !ittle relationship between bond yields and the returns realized over the 15-year period 1963 to 1977 (Exhibit SCH-4, page 3). If returns on book equity were truly reflective of the cost of equity, one would expect to find a much higher correlation between the required return from bonds and the realized book returns. Most importantly, relying on returns that have been carried in the past under varied financial and economic conditions fails to recognize the current nature and market orientation of equity investors' required rates et return. For these reasons the validity of this type of comparable earnings test must be questioned. L
HADAWAY TESTIMONY, PAGE 17 Q. In.vhat other ways have you estimated the cost of equity to Houston Industries, Inc.? A. The traditional discounted cash flow (DCF) model has also been used to estimate Houston Industries' cost of equity. The DCF method of gauging j I investors' required returns is derived from the familiar Gordon dividend I growth model. This theory of valuation posits that the price of a share of i common stock is equal to the present value of allits future dividends. These dividends are assumed to grow at a constant rate into infinity, and the I discount rate is the minimum return required by tr:vestors given the risk of the security: D, (1 + g)I D, (1 + gh D,(1+g) P = + +... + (1+k)I (1+k)2 f,+k) This equation can be conveniently reduced to the more manageable form of: D 3 P = o k-g and the company's cost of capital can be isolated by rearranging terms: D i k= +g p o l l Essentially, the DCF model recognizes that the return to the stockholder consists of two parts - dividend yield and growth. Equity investors expect to l receive a portion of their total required return in the form of current dividends and the remainder through price appreciation. The model is based upon two fundamental assumptions. Initially, it presumes that investors i evaluate the risk and expected returns of all securities in the capital markets. Given these expected returns, investors then adjust the price of each stock so that they are adequately compensated for the' risks to which l they are exposed. The use of the DCF model to estirnate the cost of equity
HADAWAY TESTIMONY, PAGE 18 is essentially an attempt to replicate the market pricing mechanism described above. Since we can look to the market to determine what investors believe a share of Hil's common stock is worth, the rate of return required by investors can be imputed by approximating their expectations of future dividend growth. Q. In your DCF analysis, what is the dividend yield of Houston Industries, Inc.? A. When an investor purchases a share of stock, he i buying expected future dividends and price appreciation. Therefore, the dividend yield component of the DCF model should be computed by dividing the dividends expected to be received in the comi'.g year (D ) by the current market price (P,). g Although HII's dividends through the first three quarters of 1980 were $0.67 per quarter ($2.68 annual rate), in light of the Cc,mpany's long-standing policy of increasing dividends annually, I have used $2.89 per share in my calculations. This amount was selected on the basis that investors anticipate Houston Industries to raise dividends in 1981 in a manner similar to 1980 -- a $0.07 quarterly increase beginning in the first quarter of 1981 - - which will result in stockholders receiving a $0.67 dividend per share in the last quarter of 1980 and $0.74 per share in each of the first three quarters of j 1981. In recent weeks HIl common stock has traded in the $27.00 - $28.00 range, with a most recent price of $28.13 (September 5,1980). Therefore, an average price of $27.50 has been used in this analysis. This price has been selected because the cost of equity is a current and forward-looking concept, and a recent market price is a better indication of investors' present requirements than would be a historical point estimate or a long-run average. Based on these values, the market presently expects a dividend yield of approximately 10.5 percent from Houston Industries. Q. Please describe the growth (g) component of the DCF model. l l
HADAWAY TESTIMONY, PAGE 19 A, in using the DCF model to estimate a company's cost of equity, we are not concerned with the rate at which the firm will actually grow (that is primarily a function of the regulatory decision, management prowess, weather, economic conditions, and chance); rather, at issu: is the growth expectations which investors have embodied in the current price of the stock. Furthermore, the DCF model technically raaintains that investors are concerned with the present value of all future dividends; in other words, their emphasis is on average long-term growth rather than short-run growth. Consequently, in estimating the growth component of the DCF model, the analyst is attempting to determine what investors think long-term growth will be. Q. What factors influence investors' expectations of a company's growth? A. In addition to the fundamental operating characteristics of the specific company, investors typically analyze the company as an integral part of its particular industry. The overall characteristics and growth expectatbns for the industry are considered as well as the company's relative position in that industry. Thus, when analyzing an electric utility, we would expect investors to consider growth prospects for the electric utility industry, particularly forecasts of kilowatt hour load growth and kilowatt hour sales in addition to projected growth in industry earnings per share and dividends per share. Q. How have you analyzed the growth expectations of HII's investors? A. I have considered the Company's expected earnings retention ratio and earned returr,s on equity in addition to.'.istorical trends in growth. I have also attempted to relate these findings to investors' growth expectations for the electric utility industry overall. Presumably, investors examine many of these same factors when forming their long-term growth expectations and setting the price of HII's common stock.
HADAWAY TESTIMONY, PAGE 20 Please elaborate on your procedure. In general, a firm's internal growth is produced by the retention and A. reinvestment of earnings. In other words, any increase in a stockholder s i interest in a utility company occurs primarily occause some profits are } retained by the firm and plowed back into assets upon which a return is earned. This being the case, investors can look to a company's retention ratio (1 - dividend payout ratio) and the expected returns to be earned on equity as an indication of what future growth is apt to be. Reviewing Houston Industries' history (Exhibit SCH-5, page 1), the Company has had a payout ratio in the 40 to 55 percent range (or a retention rate of 60 to 45 The most percent), with more recent experience in the 50 percent range. recent thece years between 1977 and 1979, however, probably have a very significant bearing on the formation of investor expectations regarding Hil's prospects. During this time the investment community has closely monitered the Company's performance under statewide regulation and under difficult ecor omic circumstances. During this period, Hil's retention rate has decreased from 57.8 percent to approximately 51.2 percent. Meanwhile, the Company's realized return on average common equity during this period has ranged between 13.12 and 14.85 percent annually. Complicating the situtation further is the f act that Hil's stock is now selling at approximately 80% of book value, and investors recognize that any sales of additional l equity to aid in financing the System's construction program are apt to be dilutive and have a negative impact on future growth. There are, of course, an in0 nite number of growth rates that can be computed depending upon the combinr ion of the retention ratio and return on equity used, and several of these possibilities are illustrated in Exhibit SCH-5, page 1. Q. Hmv else did you go about estirnating investor expectation's of HII's future growth?
HADAWAY TESTIMONY, PAGE 21 A. Besides looking directly to those internal factors affecting growth, investors inay also form expectations about future growth by analyzing historical trends. Three factors which would seem rmst indicative of Hil's future dividend potential are growth in net book value, growth in earnings per share, and growth in dividends per share. On page 2 of Exhibit SCH-5 the historical values for Houston Industries' net book value (NBV), earnings per shtre (EPS), and dividends per share (DPS) are shown since 1964. For each of these variables, annual compound growth rates for the three periods, 19751979,1970-1979, and 1965-1979, have been computed and are listed on page 5 of the same exhibit. In addition, because comoound growth rates are sensitive to beginning and ending values, the NBV, EPS, and DPS values have been " smoothed" through linear regression models (page 3, Exhibit SCH-5). The annual compound growth rates, using these normalized values for the same 5,10, and 15 year periods, are also shown in Exhibit SCH-5, page 5. Q. What does your analysis of all these fccters suggest about growth for HL&P? A. Houston Lighting and Power Company historically has experienced above-average growth in relation to other electric utilities. HL&P's relatively high rates of historical growth car be attributed in part to the Company's location in the Sunbelt, and p' rticularly in the Houston area, and in prt to relatively high earnings retention ratios. However, the conditions which fostered HL&P's high growth in the past are somewhat altered today. l Growth in the Houston area is slowing (the Company forecasts a 2.8% annual compound growth rate in the Houston area's population during the 1980's and a 4 percent growth rate in kilowatt hour demed), and the Company's retention ratio is down slightly. Therefore, it appears that investors are expecting HL&P's growth rate to be substantially P ver in the future than l was characteristic of the past. In particular, I believe that while investors expecting Houston Industries' future growth to be at least equal to ar
e - HADAWAY TESTIMONY, PAGE 22 growth rates forecasted for the electric utility industry as a whole, the overallindustry growth rate is expected to be lower in the 1980's than it was ir the previous two decades, with corresponding effects on Hil. Most investment analysts and industry sources are forecasting near-term growth for the electric utility industry in the 3 to 5 percent range. Theref ore, I believe that Houston Industries wi!! grow at a rate of approximately 4.0 percent. Q. Pleaw summarize your analysis of Houston Industries' cost of equity using the DCF approach. A. The DCF model is a market oriented, forward-looking metnod of estimating a corapany's cost of equity. It is widely accepted and is based upon a reasonably sound theory of stock valuation. It is particularly applicable to a utility such as HL&P, where investors expect a large portion of their total return to be in te form of dividend yield. The advantages of the DCF model are that it focuses solely on the firm in question, and the company's relative risk is not of explicit concern, since this is implicitly accounted for by investors vehen they set the stock price in the market. For Houston Industries, Inc., the DCF an?Jysis indicates that investors anticipate a dividend yield from the Company of approximately 10.5 percent and expect the Utility's future long-term growth to be in the 4.0 to 4.5 percent vicinity. Summing these two components of return, HII's cost of equity appears to be in the i4.5 to 15.0 percent range. Q. Have you used any other methodologies to estimate the cost of equity to Houston Industries? A. Another approach to estimating Hil's cost of equity is to incorporate investment analysts' forecasts of the Company's earnings into the DCF model. Taking the discounted cash flow formula presented earlier: i l
HADAWAY TESTIMONY, PAGE 23 D I k=p +g 0 the dividend (D ) and expected growt5 (g) components can be rewritten as: g I k= + (br + vs) PO in this reformulation, b represents the Company's expected earnings retention ratio; r is the expected return en book equity; and the vs term describes the dilution or accretion attributable to sales of new common stock at below or above book value (Exhibit SCH-6, page 1). What this equation says is that D will be equal to expected earnings per share in the 3 coming period (E ) times the Company's payout ratio (1 - retention ratio), g and growth will be equal to the retention rate times the return earned on equity, adjusted for the effects of issuing new equity at a market price different from book. Like the DCF method discussed previously, this approach is an expectational model. In other words, proper implementation requires that the model's parameters (except price) be estimated as investors would forecast them. Q. Where have you obtained values for implementating this approach? A. The sources of data for this model are Houston Industries' August 1980 Prospectus; HL&P's Rate-Filing Package; Salomon Brothers Electric Utility Regulation, Quality, and Earnings; Value Line and Standard and Poor's Earnings Forecaster. The Earnings Forecaster is a compilation of earnings projections made by various investment services, and while it does not include estimates from all anslysts, the 51 firms contributing to the public,stion represent a broad cross-section of the investment community (Exhibit SCH-6, page 2). The investment advisory service forecasts con tained in this service have been used as surrogates for investor expectaticos of Houston Industries' future earnings. As shown on page 2 of
HADAWAY TESTIMONY, PAGE 24 Exhibit SCH-6, those services projecting Hil's earnings are forecasting 1980 EPS of between $4.95 and $5.30, with an average estimate of $5.17. From Exhibit SCH-5, page 1, I have also obtained the following data for the last three years: 1977 1978 _1979 E b -Earnings Retention Ratio 57.8% 49.6 % 51.2 % 50.0 % (1-b) -Payout Ratio 42.2 % 50.4 % 48.8 % 50.0 % r -Realized Return on Equity 14.85 % 13.12 % 14.31 % 14.25 % From this recent financial information, it seems reasonable to as;ume that investors would project a 1980 earnings retention rate of approximately 50 percent and a return on equity in the neighborhood of 14.25 percent. Finally, investor expectations of the effects of additional common equity sales on future growth can be approximated from data contained in HL&P 's Rate Filing Package and latest prospectus. As mentioned, the "vs" term in the equation reflects the increase (decrease)in expected growth attributable to selling new common stock at above (below) book value. To estimate the magnituas of this factor, some basic data are required. Houston Industries sold between 2 and 3 million shares of new common each year during 1975 and 1978 (in 1979 it sold approximately 4.5 million shares), recently incurring flotation costs of $0.90 per share. As of June 30,1980, the Company's book value was $34.37 per share for the 39 million plus shares outstanding. Now, if we assume that Houston Industries plans to issue a total of approximately five million shares of new stock in 1980 or early 1981, at the recent average market price of $27.50 per share, the Company would r.et about $26.60 per share. Since this is less than book value, the "s" term (which is the ratio of net proceeds to book value)in the equation would De 7/.39 percent. Furthermore, existing stockholders would forfeit some of
HADAWAY TESTIMONY, PAGE 25 their ownership and earnings participation in the Company to the new shareholders. The "v" term in this case becomes -2.87 percent, and the product of these two values implies that existing owners' expected growth would be 2.22 percent less than it otherwise would have been. Put another way, the book value of the Company's stock would drop from $34.37 before the sale to $33.61 af ter, a decline in value of 2.22 percent. Thus, if investors anticipated five million new shares of common stock to be sold at recent market prices to finance the Company's construction program, they would also expect a reduction in the expected growth rate on the order of 2.22 percent. Of course, if more shares were likely to be sold, the negative impact on growth would be even greater. Q. What, then, does this test suggest about the cost of equity for Houston Industries? in Exhibit SCH-6, page 1, the various computations discussed above are detailed. As shown there, combining investment analysts' forecasts of the Company's future earnings, reasonable estimates of an expected retention ratio and earned return on equity, and conservative external financing figures, this approach indicates that the cost of equity to Houston Industries l is approximately 14.31 percent. Q. How else have you gone about estimating Houston Industries' cost of equity? l A. The previous methods measure a company's cost of equity indirectly; i.e., given various pieces of information about the company and current prices, investors' required returns are imputed. An alternative approach is to query investors directly as to the rate of return they require from a company or l l industry. Recently (April-May 1980), the financial consulting firm of Mitch-11, Hutchins, Inc. surveyed 138 institutional investors (with 115 respoi..cs) about their attitudes toward the electric etility industry. One of the questions included in tie survey inquired as to the total return expected
HADATAY TESTIMONY, PAGE 26 from m investment in the common stock of electric utility companies. A summary of the responses to this question have been reproduced in Exhibit SCH-7. As illustrated the majority of the respondents (75 percent) indicated that a return between 15 and 18 percent or an average of 423 basis points over the bond alternative would be attractive from an average company in this group. Q. Are there any caveats regarding the interpretation of this survey? A. There are several points that merit discussion with respect to this direct measure of investors' required returns. First, it should be noted that ttd survey was conducted during the Spring of 1980, and is therefore fairly current. On the other hand, the survey was conducted af ter a traumatic period in the capital markets. As illustrated by the shift in the capital i market lines depicted in Exhibit SCH-1 and by the changes in yields of public utility fixed income securities shown in Exhibit SCH-2, there has been a settling effect in the capital markets during the last few months. Considering that from August 1979 to March 1980, the yield on 30-year Treasury Bonds had risen from 9.0% to a peak of 12.75%, but has now dropped to about 11.0%, the range of required returns indicated in the survey should be adjusted downward. Investors' perception of HL&P as somewhat less risky than the average electric utility should also be considered. Finally, the results of this poll are subject to the typical limitations of any survey with respect to the reliability of responses, proper interpretation of the questions, sample size and representativeness, etc. Q. Taking these factors into account, what does the survey imply for Houston Industries' cost of equity? l A. Adjusting the survey results for recent capital market conditions and consi& ring HII's relative risk position, this test indicates a current cost of equit3 in the 15.0 to 16.0 percent range. 1 L
HADAWAY TESTIMONY, PAGE 27 Q. What other methodologies have you used to estimate Houston Industries' cost of equity? A. A firal approach for estimating the Company's cost of equity is to examine the additional return that investors have demanded for holding Hil'.= common stock instead of its senior securities. This bond yield / risk premium analysis is intended to reflect the effect of interest rate changes on investors' required returns, and is an offshoot of the idea discussed earlier, that expected returns are ;omprised of the basic time value of money plus a risk premium. Q. Please explain this method. A. This test involves adding a risk premium to the current yield on Moody's Aa bor:ds to obtain the return required by equity investors. I believe that the -isk of Houston Industries and Houston Lighting and Power is such that a 200 to 300 basis-point premium above the Aa bond rate is reasonable compensation for holding the Company's common equity. Therefore, adding 200 to 300 basis-points to the current yield on Moody's Aa public utility bonds of 12.70% gives a cost of equity for Hilin the range of 14.7 percent to 15.7 percent. Q. What has been the major thrust of this portion of your testimony? A. In this section, I have tried to identify the cost of a resource-equity capital to Houston Industries, Inc.- as the basis for making a recommendation as to a fair return on the equity invested in Houston Lighting and Power Company. Probably the most important conclusion to come out of my study is that the electric utility industry has entered a new era, and that industry growth in the 1980's is expected to be somewhat lower than was characteristic of the 1960's ard 1970's. In light of this, I believe that investors' expectations of growth for HL&P have been revised accordingly, and that they are not eyxtind the high gLwth rates of the past to continue into the future. This
HADATAY TESTIMONY, PAGE 28 ccotention is borne out by the fact that expectations of high growth rates are not impounded in the current market price of the Company's common T stock, which is currently selling at approximately 80% of book value. H!!'s stock, like that of many other electric utilities, has recently come under pressure in the market: as of March 31, 1980, the average market-to-book a ratio for the industry was 80 percent, with the median industry market-to-book ratio at 79 percent.- Therefore, I believe that i-astors, taking into account the increasing impact of conservation, the sluggishness in the national economy, inflation, and the high level of capital financing costs, are expecting industry growth I to be in the 3 to 5 percent range. I believe that HL&P, which is somewhat less risky than the average electric utility, is perceived to have sound growth prospects, relative to the rest of the industry, of about 4 percent per year. Another conclusion to come out of my study is that the cost of both debt and equity capital to Houston Industries, has increased. Interest rates, which peaked in March 1980, have now tapered off somewhat but are still l l significantly higher than they were tralve months ago (see ExhibMs SCH-1 l and SCH-2). Therefore, current economic conditions and industry and company-specific factors dictate that the cost of equity for HIl be revised upward. t Q. From your analysis, what do you believe the cost of equity to be for Houston Industries? A. I believe that the electric utility industry is generally less risky than the nonregulated sector as a whole and that HL&P is less risky than the average electric utility company. I have conducted varicus tests to locate the minimum return required by the Hil's investors, and while each of thesc
HADAWAY TESTIMONY, PAGE 29 methodologies is useful, the resulting cost of equity estimates vary in magnitude and credibility. Consequently, my final conclusion is heavily tempered by judgement and by my evaluation of current market conditions. Giving consideration to the relative strengths and weaknesses of the different methodologies, I estimate that the cost of equity to Houston Industries is currently in the range of 14.5 to 15.0 percent. Ill. MARKET-TO-BOOK AD3USTMENT Q. What is the purpose of this portion of your testimony? A. As discussed earlier, the cost of equity provides a basis for determining a fair return to equity. Other considerations, however, might warrant an adjustment to this minimum rent for the use of capital in an effort to achieve other objectives deemed to be in the public interest. Q. Please provide an example of such an adjustment. A. It is generally preferable for the market price of a utility's stock to sell at or above its book value, so that the existing stockholders' equity in the company is not diluted in the event that additional common stock is so!d. The importance of this factor is that a firm can not continually sell new stock at below book value without seriously diluting future growth prospects and possibly causing existing stockholders to take action to block further dilution. Therefore, especia'ly during periods of heavy construction expenditures and external equity financing, it is desirable to moderate the dilutive effect as the utility continues to meet its service obligations to its customers. Q. Brietly explain the relationship between market price and book value. A. The cost of equity is a market-oriented concept. Thus, if a market determined cost of equity is applied to an investment base valued at original cost, the market price of the utility's common stock will be driven towards {
HADAWAY TESTIMONY, PAGE 30 book value (up if the existing market-to-book ratio is less than one and down if it is greater than unity). The reason for this is that if a company is authorized a level of earnings on book value tiat investors had expected on market value, they will adjust the equilibrium price so that the expected rate of return on market investment remains the same. Since regulatory au.norities are constrained to allowing a return on book values r ther than market values, if a market-to-book relationship equal to or greater than one is to be encouraged, the cost of equity needs to be adjusted. Q. What can cause the market price-to-book value ratio to fall below unity? A. A variety of factors can result in a market price below book value. Other things being equal, allowing a return less than that required by investors will cause a market-to-book ratio of less than one. Similarly, if investors' required returns increase af ter rates have been set at the cost of equity, the market-to-book relationship will become less than unity. Also, issuance and flotation costs incurred in connection with a new issue of common stock may have a depressing effect on price. Finally, market pressure associated with the sale of additional equity could cause the market price to fall below book value. Q. Please discuss the effects of flotation costs. A. When a company sells new equity, flotation costs are incurred as a result of fees paid to investment bankers to handle the underwriting and distribution functions and other related issuance expenses. These costs reduce the net proceeds realized by the company from the additional securities. Typically, flotation and issuance costs amount to between 3 and 5 percent of the new issue, but the " dilutive effect" is infinitely smaller than these percentages would indicete, because the flotation costs are borne by all of the issuing company's stockholders. Toerefore, the dilution of existing equity is equal to the flotation costs divided by all shares outstanding.
HADAWAY TESTIMONY, PAGE 31 Q. Please explain the market pressure argument. A. Market pressure is the drop in price, due to an excess supply of stock, that sometimes occurs when new issues are placed m the market. If this market pressure exists, the effect is to push down the market price, causing the sale of additional shares to have a dilutive impact similar to that described previously. The market pressure argument has been widely debated, and in most caws its effect is thought to be small. Q. If flotation costs and market pressure appear to be minor factors in diluting existing common equity, what reason is there for adjusting the cost of equity? A. As noted above, a market-to-book ratio less than one can be brought about by an increase in the cost of equity over time; or alternatively, by stock price fluctuations attributable to other factors. In order to reduce the likelihoad (in light of Hil's recent experience, obviously not eliminate the possibility) of the Company's having to issue new stock at below book value, a cushion to partially absorb mark-+ fluctuations seems appropriate. i Q. What is an appropriate market-to-oook adjustment? i A. Although selecting any target market-to-book ratio is arbitrary, a ten percent cushion for a company such as Houston Industries seems adequate. This means that the Company's market price could drop approximately ten percent without increasing the dilutive effect. Q. How do you compute the amount of the adjustment necessary to achieve a target market-to-book ratio? A. As explained earlier, if a market determined cost of equity is applied to book accounting numbers, then price will be forced to book value. Assuming that the DCF model of valuation explained in the previous section is a fair description of the pricing mechanism for Hil's stock, then allowing the Company mly its cost of equity, k, will result in market price (P) equalling bwA valua (B): l ~.
HADAWAY TESTIMONY, PAGE 32 D 3 P=B=k-g U marxet price i> to be equal to some target multiple of book value (M/B), then the price of the stock can be expressed as: D I P = B (M/B) = (M/B) ,k-g Solving for k+, the return necessary to encourage a target market-to-book ratio, results in the following (details of this computation are shown in Exhibit SCH-8: D k' = (M/B) + g Therefore, the adjustment to the cost of equity required to encourage a target market-to-book ratio is equal to the company's dividend yield times the desired cushion. Q. What adjustment, then, would be required to achieve a market-to-book ratio of 1.l? A. Since the Company's dividend yield is currently expected to be about 10.5 percent, if it were deemed appropriate for Houston Industries' market price to sell above book value, increasing the cost of equity by 105 basis points should be sufficient to encourage a market-to-book ratio of approximately 110 percent. Q. What, then, is your recommended return on equity for Houston Industries? l l A. Combining my previously determined cost of equity for Houston Industries of 14.5 to 15.0 percent with a market-to-book adjustment of 105 basis-points results in a return on equity of 15.55 to 16.05 percent. As for a point l j estimate, in my judgement, a return of 15.8 percent on the common equity of Houston Industries is fair and reasonable at this poi: an time. I l
HADAWAY TESTIMONY, PAGE 33 IV. _RF. TURN TO EQUITY OF HL&P Q. You have indicated that the cost of equity to Houston Industries is in the 14.5 to 15.0 percent range. How does this relate to Houston Lighting and Power Company's cost of equity? A. So far, my analysis has focused only on identifying the cost of equity capital to Houston Industries, given the consolidated company's composite risk. It is important to recognize, howeser, that the total risk of Hi! is comprised of the individual risks of the various parts of the Company. In other words, when investors evaluate the risk of investing in Hil's stock, they look at the vari >us components and activities included in the total holding company. Afte evaluating the level of risk attributable to each part of the Company and weighting the risk by its proportional contribution, an assessment of H!!'s ove.rall risk can be made. Q. Would you please elaborate on this? A. Houston ind astries is essentially made up of three parts: the operating company, Houston Lighting and Power Company; the fuel service company, Utilities Fuels, Inc. (UFI); and the oil-gas exploration company, Primary Fuels, Inc. (PFI). None of the functions of these entities are similar; each has different operating and financial characteristics and consequently varying levis of risk. For example, PFI, which contributed $.34 per share to Hil's net income in 1979, obviously contributes some element of risk to Hi!. UFI, on the other hand, adds little if any risk to HII because its business is guaranteed by HL&P: HL&P must buy all of UFI's coal. Therefore, the total risk of Houston Industries, which has been examined previously in the determination of an overall cost of equity,is a combination of the individual risks of these three components. Q. Hw does this affect the cost of equity assigned to each component?
HADAWAY TESTIMONY, PAGE 34 A. To the extent that the various parts of Hil have varying levels of risk, the cost of equity captial assigned to each component should be adjusted upward or downward from the System average according to the risk that it contributes to the holding company in total. This is consistent with the principle of identifying the costs of a resource, in this case equity funds, used in providing service and allocating these correctly. Ratepayers should be responsible for the costs incurred in serving them and should not subsidize or be subsidized by customers in other service areas or other parts of the System. Considering the amount of capitalinvested to serve each customer, this is a neatrivial matter. Q. How luve you gone about assigning a return to Houston Lighting and Power Company? A. I believe that PFI, which contributes tome element of risk to Hil, will increase Hil's cost of equity by a small amount. At the rame time UFI, given its contractual agreements with HL&P, may actually reduce HII's cost i of equity. Given the relative sizes of the subsidiaries and the varying degrees of risk contributed to HI! by UFI and PFI, I believe that the cost of l equity to HL&P is approximately the same as that for HII. Therefore, I have estimated a return on equity to HL&P equal to that of Hil, namely 15:8 percent. I V. AFFILIATE TRANSACTIONS WITH UFl Q. Please explain the purpose of this section of your testimony. A. In this section, I will address the Staff's recommended limit on the price per ton of coal that HL&P should be allowed to pass through (via the fuel clause) to its ratepayers, in particular, Ms. Blumentha! has asked me to compute the appropriate return on capital invested in UFI to be used in calculating the fixed charge on the coal sold by UFI to HL&P.
a } HADAWAY TEST! MONY, PAGE 35 Q. la light of the fact that UFl is not a regulated utility, why did the Staff think it was necessary to determine the appropriate return on UFI's invested capital? y A. The Staff is interested in seeing that the price of the coal that HL&P passes through to its ratepayers is not unreasonable or excessive. Under the terms of the contract between UFI and HL&P, UFI is assured that it will recover its actual costs of doing business, and, more importantly,it is guaranteed to earn a predetermined return on its average investment in plant and i equipment, regardless of the number of tons of coal HL&P buys from UFI during the year. Since this return is passed on to HL&P's ratepayers through the fuel clause, I have attempted to determine the appropriate level of return on UFI's invested capital to be passed on to HL&P's ratepayers. Q. How did you approach the calculation of a return on the capital invested in i UFl? A. As discussed earlier, UFI has little, if any, risk, because of the nature of its 4 relationship with HL&P (HL&P is required to buy all of the coal sold by UFI). Therefore, the cost of equity invested in UFI should be the marginal cost of i debt (double A bond rate) plus a small premium, because UFI debt i is subordinated to that of the parent, Hil. Therefore, I have costed the equity invested in UFI at the current Aa bond yield of 12.7 percent plus a fif ty-basis point premium, or 13.2E As shown in Exhibit SCH-9, the rate of return on the capital invested in UFI computes to 10.97 percent (adjusted for tax ef fects). VI. _ COMPOSITE R ATE OF RETURN Q. Please describe the purpose of this portion of your testimony. A. This section will compute an overall percentage rate of return which will be 1 i l applied to HL&P's invested capital, as determined by Ms. Blumenthal, to i arnve at the dollar return to include in the Company's cost of service.
HADAWAY TESTIMONY, PAGE 36 Q. From what sources does Houston Lighting and Power Company obtain capital? A. In addition to the common equity supplied through the market via HII, liL&P's permanent assets are financed through funds provided by preferred stock, long-term debt, miscellaneous notes payable, investment tax credits, and deferred federal income taxes. Q. In what combination are most utilities' various sources of capital employed? A. The ev:nnosition of a firm's long-term capitalization will vary over time, since funds are generally obtained in lumps as additional blocks of securities are scid. Of ten, interim financing is obtained through short-term borrowing until permanent financing can be arranged. Consequently, a firm's capital structure at any point in time may vary from in target level, and it may not be representative of the company's ongoing average capital structure. Q. Can this cause problems in determining an overall rate of return for regulated companies? A. The meven financing sequence experienced by most firms can create significant problems, due to the regulatory practice of applying a weighted average cost of capital to an investment base. Because capital component weights are continuously changing as additional financing is obtained, it can be dangerous to focus on a particular point in time or even a short period to determine a company's capitalization ratios. Following such a narrow i measurement procedure could have several undesirable results. First, if a utility happens to be unusually heavily debt-financed at the time of a rate hearing, the authorized rate of return would likely be insufficient to cover capital costs as the capital structure is subsequently brought back in line with the sale of additional equity. Alternatively, if a company were equity rich at the measurement point, a return greater than necessary would be autheciz.wl as less expensive debt funds were introduced into the capital
HADAWAY TESTIMONY, PAGE 37 struc ture. Secondly, focusing on a very short time interval could cause utihties to sequence their financing around rate cases rather than securing additional capital in a manner most consistent with prudent financial management. Q. What is the capital structure of Houston Lighting and Power Company? A. As of March 31, 1980, HL&P had a capital structure comprised of 49.17 percent long-term debt, 8.07 percent preferred stock, and 42.76 percent common stock. Q. Is this the capital structure that should be used in computing HL&P's overa!! rate of retu n? A. No. The capital structure should be adjusted to reflect the Company's sale of new securities since March 31,1980. Q. Why do you think it appropriate to make this pro-forma adjustment in HL&P's capital structure? A. The capital structure as of March 31, 1980 is not as representative of the Company's past capital structures, nor is it as representative of the electric utility industry as a whole. As of March 31, 1980, the median capital structure for the industry was 50 percent long-term debt, 13 percent preferred stock, 37 percent common equity and 4 percent short-term debt (Salomon Brothers Stock Research Exhibit SCH-l l). If the pro-forma adjustment is made, HL&P's capital structure is closer to the industry median: Hil's percentages become 48 percent long-term debt, 7 percent preferred stock, 39 percent common, equity, and 6 percent deferred investment tax credits. In addition, for the past five years, 1975-1979,the Company has maintained long-term debt ratios in the range of 50.2 percent to 53.5 percent, preferred stock ratios in the range of 6.2 percent to 9.7 percent and common equity ratios from 33.9 percent to 40.3 percent (Exhibit SC H-10). Therefore, adjusting the capital structure to reflect new security
HADAWA. TESTIMONY, PAGE 38 13 sues causes the capitalization ratios for use in the composite cost of capital calculation to be more in line with HL&P's capital structures of the past and those of other electric utility companies. This adjusted capital structure also seems consistent with investor expectations and the cost of equity determined earlier. Q. What capital structure is used to calculate the composite cost of capital for Houston Lighting and Power Company? A. The Company's capital structure of investor-supplied funds is comprised of 38.83 percent common equity, 7.33 percent preferred stock, and 47.62 percent long-term debt. These weights have been arrived at by taking the March 31,1980, capitalization and making pro forma adjustments to reflect the sale in June 1980 of $100,000,000 principal amount of mortgage bonds; the sale of three million shares of new common stock in April 1980; and the application of the estimated aggregate proceeds to the Company, before expenses of sale to the payment of short-term debt. This information was obtained from the Company's June 1980 prospectus and from the rate filing package. Q. What costs, then, have been assigned to the Company's various fixed obligations? l A. The Company's embedded cost of long-term debt as of the end of the test year has been adjusted to reflect the additional issue made in 1980. As shown in Exhibit SCH-12, the adjusted cost of debt is 8.14 percent. The cost l for preferred stock is 8.23 pt :ent. Q. What return has been allowed on HL&P's accumulated deferred investment j ta x credits? A. In accordance with the past practice of this Commission and the recent Internal Revenue Service ruling in March 1979, the composite rate of return hu bemn assigned to these funds.
HADAWAY TESTIMONY, PAGE 39 Q. What, then, is your recommended overall rate of return to Houston Lighting and Power Company? A. As computed in Exhibit SCH-13, I recommend that an everall rate of return of 11.32 percent be applied to the original cost of HL&P's invested capital. CONCLUSIONS AND
SUMMARY
OF RECOMMENDATIONS Q. Would you briefly summarize the major points discussed in your testimony? A. The major issues in my testimony have centered around determining a fair rate of retu.n on Houston Lighting and Power's invested equity capital and computing a composite rate of return. The conclusions that I have reached on the various issues are summarized below: -The capital markets have undergone significant shifts over the last 12 months with investors requiring higher yields to induce them to make investments. The net effect of this on Houston Industries Inc. has been that the market price of the Company's common, stock is now consistently below book value. In light of this, it seems apparent that the returns authorized Hilin the past are no longer adequate, and that they must be revised to reflect current economic conditions (Exhibit SCH-1). -Houston Industries continues to be less risky than the average electric utility in the country, and investors have lowered their expectations of the Company's growth in light of revised expectations of growth for the electric utility industry overall. Based tpon my analysis, I believe Houston Industries' cost of equity currently to be in a range of 14.5 and 15.0 percent. -If a market-to-book ratio greater than one :s to be sought, the l return should be adjusted. Thus, to encourags Houston Industries' common stock to sell at approximately 110 percent of book value, l a 105 basis point upward adjustment to the cost of equity is appropriate (Exhibit SCH-8). -The risks of the two subsidiaries, Primary Fuels, Inc. and Utility Fuels, Inc. counterbalance each other so that the cost of equity for Hil can be assigned to HL&P without adjustment. In this case, that amounts to a cost of equity for HL&P of 14.5 to 15.0 percent. Combining the 105 basis-point market-to-book adjustment with the estimated cost of equity to the Company results in a fair rate of return to the equity invested in HL&P of approximately 15.8 percent. I l t i a
4 HADAWAY TESTIMONY, PAGE 40 -Based tpon a return to equity of 15.8 percent and adjusted capitalization ratios to reflect modifications of the Company's capital structure, I believe that a composite rate of return of 11.32 percent should be applied to HL&P's invested capital (Exhibit SCH-13). -Based tpon my analysis of the risk of Utility Fuels, Inc., I recommend that a pre-tax return on the capital invested in UFl of 10.97 percent be used in the Staff's calculation of the cost of coal that is to be passed on to HL&P's ratepayers. Q. Does this conclude your direct testimony in this case? A. Yes, it does.
Public titility Cori-ission of Tenas Exhibit SCH-1 Page 1 of 2 Houj on lichtint anL Ppwee Crreay Praet Lires for Pemament CapitBI us-C March 19ED e e i-a O Assast 1982 e o .3_ m 0 o .C st - e o a ? 6 0 5 .E 8 July 1979 g so-A July 1978 0 e D 9-O e i l 8-f. Etsk
Public Utility Cwission of fewes Dhlblt $CN.] p _ Houston _Lijhting and_ Power Crepa_ny Market tines fer Pemanent Capital U.S. Treasury Aaa lados. Aa Indus. A Indus. Aa Pubile A Pub 1fc sa Pubile boa Public Util. Line Date Bonds Ponds Bonds Bonds Util. Bonds Util. Bonds Util. Pref. Stock Pref. Stoc6 A July 1978 8.65 8.76 8.85 9.14 9.27 9.52 8.88 9.87 8 July 1979 8.88 9.04 9.30 9.50 9.70 10.94 8.99 10.30 l C March 1980 12.48 12.70 13.10 13.59 14.44 14.89 13.09 15.22 I D August 1980 10.82 11.12 11.42 11.89 12.70 12.91 11.12 12.64 Source: Moody's Investors' Services ~ ~ li.
Public Utility Corristion of Temas Exhibit SCH-2 Houston lichtiec and Power Cr:amv Page 1 of 1 Crearisum of fields on Pob11e utiltty Fined lae r e Secu-Sties July July Ma rch Au9ust 1978 1979 1960 1990 Asa genes 9.04: 9.35 13.41: 12.04: Aa 8 cess 9.25 9.69 14.44 12.70 A Bonas 9.57 10.01 14.89 12.91 Baa Bom s 9.71 10.46 15.49 13.35 as Preferred Stock 8.83 8.99 13.09 11.12 a Preferred Ste:k 9.31 9.60 14.74 11.94 baa Preferrec 5tock 9.81 10.47 15.22 12.64 Differen:e Differen:e Differen:e 1979-1979 1979 warem 1990 March-4ucust 19!0 Asa B:mes .31: 4.05 -1.37 Aa Scecs .44 4.75 -1.74 A S nds 44 4.85 -1.95 Baa ace:S .75 5.03 +2.14 aa Preferred Sto:k .16 4.10 -1.97 a Preferrec Ste:k .29 5.14 bas Preferred Stock .66 -2.8 4.75 -2.59 Avera;e 44: 4.67: -2.08* I Source: Moody's Investors' Services. 8 0 I I i e e
Public Utility Corrission of Texas Enhibit SCH.3 N_ousten Lichtino and Po=*r teeny Page 1 of 1 Averate Finaaeial Indicatees fer the 100 Laroest Electrie Utilities _1978 1979 1983 Dividend Yield 8 72 9.831 11.08t Price tarnings Ratio b.$I 7.6X 7.61 Market-to. Sock Patto 96.C1 88.0; 80.01 Paycut Ratio
- 74. 0 *.
75.01 84.0* Return on Average Equity 11.91 12.11 10.9% Difference Difference 1978-1979 1979-1960 Dividenc Yield 1.11 1.25: Price-Earnin95 Ratio -0.91 Market to Book Ratio -8.0* -8.0% Payout Ratto 1.0% Return on Average 9.05 [taity 0.2% 1.2% j Source: Salo6cn Brothers' 5toch Research f l I i l [ 1 i I l 1 l i
4 i i j Public Utility Commission of Temas Enh; tit SCH-4 Nousten Linktino and Power Coreany Page 1 of 3 Co parable Earnings Aealysts Earnes Eetures By Rist Class Beta Covariaate with w r6et (value line Adiusted Beta) a Adjusted l Beta Average Return on Boek Ecaity 1974.1975 3959 1978 1964 197E i 1 0.40 - 0.60 16.C% 14.4% 14.8% 0.65 - 0.75 15.3: 12.71 12.8% i 0.80 - 0.93 14.01 13.7% 13.6% D.95 - 1.05 15.11 14.9% 14.41 1.10 - 1.20 4 14.51 15.2% 14.9% j 1.25 - 1.35 15.2% 15.5 16 4: 1.43 - 1.50 10.51 13.5% 15.1: 1.55 - 1.75 12.C: 13.92 13.C: t TOTAL /A'/ ERA;E 14.51 14.2% 14.4 j l l hwte: Value line has assigned Houston Industries. Inc. a Beta of 0.B3. l l l [
1 I b l l; Public Utility t w ission of Texas Exhibit SCW-4 b usten Lichtine and Power Creaay Co*; arable Eareinos Analvsis } Eareet Retures By Rist Class Price Sta_bility _ Total VariaM11tv (Value time Price Stability inded Price Stability
Average Return on Book Equity------
Ir f" 1974 1978 1959-1978 _1954-1976 I ICO
- 93 14.2%
14.7% 4 85 - 75 13.6% 15.9% 15.5% 15.21 1 70 - 63 15.4% 15.8: 15.5% $5 - 45 15.4% ?!.2 14.7s 40 - 33 i i 12.1% 12.f: 13.6% 25 - 15 11,7: 11.2% 12.7% i 10 - 5 4.4s <g, 7 g,3: TOTAL /AVERGE 12.7% 13.1% 13.5: { Isote: Value tiae has assigned Houston Industries, Inc. a Price stability Index cf 95 I 1 ( { l
h i i i t I Public Utility Commission of Tenas Exhibit SCH-4 Page 3 of 3 Houston Lichtino and Power Coaceay Co-paratie Earninos Amelysis Earned s turns Relative To Bonc vields e Moedy's Average Return Composite Boed Year on Book Ecuity Yield dwere + 1977 13.3% 8.4% 1976 14.61 9.0% 1975 13.6% 9.6% 1974 15.8% 9.0 1973 15.5% 7.8% 1972 13.B: 7.6% 1971 13.1% 7.9% 1970 13.2% 8.5% 1969 14.8% 7.4% 1963 15.3% 6.5 1957 15.5% 5.8% 1966 16.1% 5.3% 1955 15.3% 4.6% 1964 14.41 4.6% 1963 13.1 4.5% I
Exhibit SCH-5 PAGE 1 0F 5 PUPLIC UTILITY COMMISSION OF TEXAS HOUSTON INDUSTRIES INC. IMFLIED GROUTH RATEStA) 98/21/80 1979 1978 1977 1976 1975 1974 1973 1973 1771 1970 1969 1968 1967 1966 1965 1964 RETENTION RATE (I) 51.24 49.64 57.02 59.85 46.58 48.63 54.19 56.13 54.58 53.13 59.66 47.99 59.99 59.25 53.77 34.12 RETUkN ON EQUITY (I) 14.31 13.12 14.85 14.66 11.22 11.73 13.54 15.52 15.49 15.16 14.52 14.13 14.71 15.fi 17.22 16.19 TMPLIED GRDU1H i RATES (t)(B) 7.33 6.51 8.58 8.78 5.23 5.79 7.33 8.71 8.45 8.95 7.36 6.65 7.35 8.92 9.26 8.71 REALIZED RATE OF RETURN (I) A 12.0 12.5 13.0 13.5 14.0 14.5 EARNikCS RETENTION RATIO (%) A 38.9 4.6 4.6 4.9 5.1 5.3 5.5 A 49.9 4.8 5.0 5.2 5.4 5.6 5.8 A 42.0 5.9 5.3 5.5 5.7 5.9 6.1 A 44.0 5.3 5.5 5.7 5.9 6.2 6.4 A 46.0 5.5 5.8 6.0 6.2 6.4 6.7 4 48.9 5.8 6.9 6.2 6.5 6.7 7.9 I A 50.9 6.5 6.3 6.5 6.9 7.5 '.3 A 52.9 6.2 6.5 6.8 7.0 7.3 7.5 EA] VALUES 1.EN FROM COMPANY ANNt'Al REPORTS EARNINGS RETENTION RATIO COMPUTED AS Iff! LESS " DIVIDENDS DEELARED ON COMMON SiOCK, FERCENT OF NET INCOME" AND REALIZED RETURN ON EQUITY PASED ON EARNINGS ON AVERAGE BOOK VALUE. EB) FPODUCT OF EARNINGS RETENTION RATIO AND RE ALIZED RETURN DN EDUITY.
Exhibit SCH-5 i PAGE 2 0F 5 PUfLIC UTILITY COMMISSTON OF TEXAS [ HOUSTON INDUSTRIES INC. HisTORIEAL GROUTH TRENDS FOR NET B00K VALUE. EARNINGS PER SHARE, DIVIDENDS PER SHARE [A] 08/21/95 1979 1978 1977 1976 1975 1974 l'73 1972 1971 1979 1969 1968 ..'6 7 1966 1965 1964 NPVit) 34.62 33.f4 31.14 28.27 26.42 25.61 24.19 20.85 19.11 17.57 16.21 15.06 14.19 13.19 12.99 11.02 AWNUAL GROUTH II) 4.78 6.19 ff.15 7.00 3.16 5.87 16.92 9.11 8.76 8.39 7.64 6.81 7.63 P.35 9.71 ?-11 (PS(s) 4.84 4.21 4.41 4.91 2.92 2.92 3.05 3.10 2.84 2.56 2.27 2.66 2.99 2.01 1.99 1.76 ANNUAL GROUTH(!) 14.96 -4.54 9.98 37.33 .99 -4.26 -1.61 9.15 19,94 12.78 ff.19 3.96 .59 1.01 17.f4 10.39 3PS(l) 2.36 2.12 1.86 f.61 1.56 1.58 1.4f f.34 1.7? 1.29 1.12 1.09 1.00 1.99 .92 .78 ANNUAL GROUTHl!) 11.32 13.98 15.53 3.21 4.00 7.14 2.94 5.43 7.50 7.14 2.75 9.99 .ff 8.78 17.9* 13.f4 J (A) E0* - ' ANNUAL REPORTS
Exhibit SCH-5 PAGE 3 0F 5 PUfLIC UTILITY CONNISSION OF TEYAS HOUSTON INDUSTRIES INC. LINEAR REGRESSION VALUESEA'J 98/21/89 EDUATION EQUATION INTERCEPT SLOPE 1979 1978 1977 1976 1975 1974 1973 1972 1971 NFV 5 YEARS 24.35 2.12 34.93 32.82 30.7e 28.58 26.46 24.35 .99 .Of .50 If YEARS 15.57 1.91 34.69 32.77 39.86 28.?5 27.04 25.13 23.21 21.39 19.39 15 YEARS 7.36 1.67 32.39 38.72 29.95 27.39 25.72 24.95 22.38 29.71 19.94 EFS 5 YEARS 2.87 40 4.89 4.48 4.98 3.67 3.27 2.87 .99 .99 .50 le TEARS 2.17 .24 4.56 4.32 4.99 3.85 3.61 3.37 3.13 2.89 2.65 15 YEARS 1.52 .28 4.51 4.31 4.11 3.91 3.71 3.51 3.31 3.11 2.71 DFS 5 YEARS 1.27 .21 2.32 2.11 1.99 1.69 1.48 1.27 .99 .59 .86 If YEARS .98 .12 2.16 2.94 1.92 1.88 1.68 1.57 1.45 1.33 1.21 15 YEARS .71 .99 2.06 1.97 1.88 1.79 1.75 1.61 1.52 1.43 1.34 [A] PASED ON VALUES AS REPORTED IN CONPANY ANNUAL REFORTO.
Exhibit
- -5 PAGE 4 0F 5 PUBLIC UTILITY COMMISSION OF TEXAS HOUSTON INiiU?TRIES INC.
LINEAR REGRESSION V* LUES [A] 08/21/89 1970 1969 1968 1967 1966 1965 1964 NP" 5 YEARS .f8 .98 .ff off .93 .99 .99 19 YEARS 17.48 15.57 off .99 .99 .99 .99 15 YEARS 17.37 15.71 14.94 12.37 19.79 9.93 7.36 EPS 5 YEARS .pg ,pg ,gg 19 YEARS 2.41 2,37 off .59 .pp
- gp
- g 15 TEARS 2.71 2.51 2.31 2.11 1.92 g,72 g,52 DPS 5 YEARS
.99 .99 .99 off .99 .99 .99 19 YEARS 1.19 .98 .98 .99 .f9 .99 .99 15 TEARS 1.25 1.16 1.97 .98 .89 .B9 .71
Exhibit SCH-5 PUBLIC UTILITY COMMISSION OF TEXAS PAGE 5 DF S 4 HOUSTON INDUSTRIES INC. FUMMART OF COMPOUND GROUTH RATESCA) 98/21/B0 1979-75 1979-76 1979-65 NET BOOK VALUE ACTUAL (I) 6.21 REGRESSION (t) 7.88 i I 7.49 7.93 B.34 19.39 EARNINGS PER SHARE ACTUAL (1) 19.63 REGRESSION (%) 7.87 11.26 7.23 7.73 7.54 DIVIDENDS PER SHARE ACTUAL (I) 9.49 PEGRESSION(I) 7.74 12.86 7.66 8.23 7.39 IA) COMPOUND GROUTH RATES CALCULATED FROM SCH-5 PAGES 2.3.4.
Public Utility Comission of Texas Exhibit SCH-6 Page 1 of 2 houston Lic% tine and PowerCm m Earninos Projectices Ej (1 - b) k= + p (br + vs) where, k = cost of equity E = expected earnings in next period j b = expected earnings retention ratio P = market price of escon stock r = expectM realized return on comen equity v = percent of funds from sale of new stoct accruing to existing stockholders s = ratio of proceeds from new stock to existing book value Houston Industries. Inc. k=Ej (1-b) + (br + vs) P k = $5.17 f.50) + (0.50 x 0.1425) +(-0.0287 x 0.7739) 527.50 k = 0.0940 + 0.0491 K = 0.1431 or 14.31t E $5.17 Average of analys*.s' forecasts. Exhibit SCH-6, page 2 = j l b 0.50 Extrapolation from Exhibit SCH-5, page 1 of 5. = P $27.50 Text of testimony. = 0.1425 Extrapolation from Exhibit SCH-5. page 1 of S. r = .0787 Net Proceeds ($26.60) less Book Value ($34.37) times New Shares v a (5.000.000) equals Total Oilution ($38.850.000)divteed by peduct of Existing Shares (39.373.572) and Book Value ($34.37) ee.uth Percent Ollution of Existing Shares (-2.87".). s* 0.7739 Proceeds New Stock ($26.60) divided by Book value ($34.37). D
.____m_. i i i k Publie Utility Con ission of Texas Exhibit SCH-6 1 Houston 11chtinc aad Power Comenny Page 2 of 2 4 Earnincs Proiertions Forecest Bv Investnent Analysts 1 19B3 Estimate i Shearson Hayden Stone Inc. $4.95 Standard and Poor's Corporation $5.25 United Business Services $5.10 Value Line $5.25 Salomon Bros. 4 $5.30 l Av!RA0! $5.17 1 i Sowrces: Standard and Poor's farnings Forecaster Salomon Brother's Electric Utility Aeculation. Quality and farninos,Yalue Line.
_Public Utility Coefssion of Texas investor SurveyHouston lichtino and Powe Complesi~ Exhibit SCH-7 Page 1 of 1 - - Reen red Rate of_Be n nes vant that a costle A. utilaty c.sunon stock for the s w rorgany would be attractave toloste o utlpty bond curre tie bons if its espected total return was et least: the you relatave to T_tal asturn o Indieeted R.ist Pr e=1 w-tbasas poants) ever 224 21*22 ever 900 20*21 900 19-20 800 10-19 700 17 18 600 16-17 500 15 16 400 14+15 100 under 14 200 under 200 M... 3as cue.c. u. lit lien.es A t.~r.t.. Iw-1utal th nurn u, aza sta... I'..no ui rr 1 hc ahead Alts rnntwe.. T a I I;.iiera ihas !* ten *=+ I l' ret ent e f fir >P n.h r.e. we 6htrd A re g. sn.n ; r,,,,,,,,, uu e J.. O ee 'AU i1 = 9le p..... ~ 2n '*2 'JRE. Y-ln w
- 3121
- prt, s ! 3; 21
..W ti;lte 7tM8 T-14 .;mm ~ \\ ,. n 42 n s v. uns I v. r n '. _ enamemmmum '_,_w tr. I? .. s. '>,d,E I.'* p /g - 2*.
- las.
dia) . s.. l'. lf. Sri
- (,.
~j,, f*., [*. 2s At 14 l'. pa. it i 14 ummmusmemmen . he iI ende,es .t i a .mm. l 42 ili.ia.. p ne. $0urCe: Pafne Webber (ff tchell thtchins. Inc., June 18, 1980 .1
m.. _. 4 t i } l Public Utility Comnission of Texas Exhibit SCH-8 Houston lichtino and Power Comoany Page 1 of 1 Derivation of Market to Beck AJ us tmen t ' + P = sarket crice of common share 8 boek value of common share = M/B target market price to book value ratio = k = cost of equity k' a expected dividend per Share in next period. cost of equity adju D = g 9 = expected long term growth f i D P=8= 1 k-g P = 8(M/S) = _ D1 (M/B) i k*-g P=_ D1 (gfg) { k*-g P Dj (M/B) a -g Pk* - Pg = 0; (M/B) Pk* = Dj (M/8) + P L D go. y (M/s) + P, P k*= 0 F- (M/8)
- g 1
( l ]
Public Utility Corrission of Temes Exhibit SCH-9 Page 1 of 1 Houston Li tti_ng and Power Corcany utility Fuels. Inc. Pre-Tar Weichted Averace Cost of invested Cacital (5000's) Percent Component Percentage Comconent Pre-Tax Cor-;en ee t A ca*.t of Total Cest Weichte: Averace Cest Long-term DettI8) $55.190 86.71 8.911 7.73: Corren EasttyI8} 8,457 13.29 24.4:(b) 3,74 i Total- $63,647 100.00t 10.97t (a) Response to Request for Infomation No.120 of Dow Chemical Co. (b) Coma Equity costed at current Double A bond yield (12.701) plus 50-basis point ore-iu-for eefault risk (13.2%) divided by 0.54 to account for tax effects ((0.127 +.005), 0.54= l 0.244]or24.41. I
i i l Public Utility _Comission_of Tena_s, Exhibit SCW 10 Houston Lighting and Power Comnany Page I of I CaphalIrai O naly] [ ^~ 12/31/75 12/31/76 Amount Percent Amount Percent Amnunt Percent Amnunt Percent Arount Percent 12/31/77 12/31/78 12/31/79 Long Term Debt 1865,805 53.5% $988,000 51.9% $1,113,000 50.2% $1.354,926 52.5% $1,482,200 50.5% Preferred Stock 124.482 7.7 163.847 8.6 214,000 9.7 213,945 8.3 243,518 a.3 C m n Couity 627.439 31 8 753,644 39.5 8_88,613 40.1 _1,009.971 39.2 L208.310 _41.2 TOTAL $1.617.726 100.00% $h905,491 _100.001 12 215,6_13, 190.001 $2.578.842 100.005 $2.934.028 100.005 2 O L_
Public titility Comission of Texas Exhibit SCH-ll Page 1 of 2 Houston Lighting and Power ComDany Electric utility Quality Measuremerts Bond Rating, Capital Structure, AFIDC (March 31,1980) ..a4 a.m.. P,e4.. e..si. n.ii.. Arec sei.ci.. nac lewe esi Pci T.: n.i. Covera;e L7 $4 No peoev s SA " D4P a/e Dett Pfc Com Ocer
- f. n a
e 1 Anegnen, Power 25/23 53% 11 % 36 % 2% 22% 35% 40% 2 Arnencan Elec Par 22/19 55 10 35 6 33 24 31 3 Anzona PuDuc S,: A A-7 24/17 48 13 39 1 70 10 23 4 Atientic C4 Ete: Aa A+ 4 34/31 51 12 37 0 24 34 33 5 Ba nmo'e G & E Aa AA-3 30/28 53 12 38 2 22 34 39 6 Besten Eo sn Gaa BBS ? 24/20 54 13 33 8 70 43 63 7 Carchna p*' & U A A 5 29/20 50 13 37 2 87 36 66 8 Ce.rreI Nueson G & E A A-6 22/18 49 14 37 12 52 17 26 9 Cenirai tti Lont A A+ 4 36/35 49 16 35 3 13 48 50 10 Cc.. tri Pun S : AA AA 4 30/26 50 13 37 2 43 40 49 18 Centra Ma ne P*r A BBB* 7 25/23' 49 12 39 12 32 33 40 12 Centrai Sostn west 33/25 53 8 42 6 57 35 52 13 Cen vt Pot 5,0 Baa BBB 29/24 48 12 40 4 4A 27 37 la Cincinnat G & E Aa AA-4 25/19 49 15 35 ? 63 17 29 15 Cle.cianc Es in m Aa AA-5 25/19 48 15 37 7 62 16 30 s 16 Cemmonaca'in Ec A A 5 20/14 55 13 32 3 100 16 di 17 Ccemu g Put Svc A A 2*/21 56 9 35 5 2 37 36 n 18 Co ss: ate: Ee A A 5 36/36 44 11 45 0 2 31 3i 19 Coasamers PO*; A BBS 9 20/14 52 14 34 4 65 6 15 ?O Dayte Nae' & Lt A A 7 25/17 52 14 34 2 8* 16 32 21 Dei na.c k ' & Lt A A 7 27/23 51 12 37 3 44 ja 37 22 Derro1 Ec ss Baa BSB 9 21/17 53 13 34 3 Es 21 34 23 Ouke Pc c' A A. 4 26/t 9 50 14 35 0 76 23 41 24 Ducscsnc Lr A AA-6 26/24 52 16 32 0 44 36 46 25 Eas:e'n utw s 15/12 51 9 40 27 66 13 36 2! Eivasc Eicerne A AA-6 30/21 42 17 41 0 87 34 63 27 Em;'c D.s Eir: A A 5 27/22 53 12 35 0 50 26 38 26 horr:a Po*c' C0rp A A+ 3 31/31 48 15 37 5 4 47 45 29 honesr** 8Li A A. 3 31/26 52 11 37 1 38 43 52 JO Genera' Pvt Utas 18/t 5 53 12 35 6 57 21 3; 3t Gun 5:ates Uus A A 8 24/t 8 54 13 33 4 83 31 57 32 Ha*3..s-E ic:foc A A 4 29/27 51 12 37 5 20 40 44 33 Ness!:n fas 5"<cs Aa AA 3 34/30 51 8 41 3 31 38 45 34 scane PC*c' A A 6 18/14 58 6 36 6 70 17 34 35 alim: s Pe*o AA AA 3 31/25 49 13 39 0 53 36 50 36 tra a ago t P & L An AA 3 41/39 48 12 40 4 15 45 49 37 'nfe'staic Pe*er A A 7 30/28 53 15 32 1 17 4.1 47 3s ieaa lle: Lt S Par A A 6 23/21 50 15 35 2 41 33 36 39 'caa til Gas & Ele: Aa AA 3 39/35 47 16 37 0 33 42 49 40 loaa Acs:s'res Aa A 5 32/30 50 to 40 7 22 38 43 41 L'* Puc% S c Aa AA-4 2 B/2 4 51 13 36 0 44 37 46 42 60*a Safnern ut ' Aa AA 28'22 51 9 43 s 49 27 t's 43 Ma%ds C4 P & L Aa A 6 20/11 52 12 36 1 150 21 i r,4 44 mansas Gas & Erc Baa BBB 6 19/t 2 51 15 34 4 119 10 47 45 Mensas Po.e 1 Lt Aa AA 4 32/25 45 14 41 1 52 31 Jb 45 ken %cky ubM es Aa AA 3 25/25 51 13 36 11 0 45 4L 4? Long tstand L6rg A A. 7 22/16 45 16 39 1 65 0 1 4el L. m..tu G S L Asa AA t 33/33 48 17 35 7 t' 4/ 47 45 Vatte Gas & Em Aa AA 42/42 43 14 43 0 0 52 $2 '< eca e Seum v' 4 16/09 59 to Lt 8 129 INe;) put;. r Source: Sakr:n 3rothers Stock Research, June 16, 1980
Public Utility Cor.nission of Texas Exhibit SCH-ll Page 2 of 2 Houston Lighting and Power Company Electric Utility Quality Measurements Bond Rafing, Capital Structure, AFUDC (March 31,1980) ea .= c.. a ..,i., o ee. ss, u.c o e-
- o.,
- u. a a
Si. s... A tt A A 2.,t. us i2% 33 s n 3w S,, $2 W soow. *J: 5.c he Raled8 ISI s lit ? SS tl 30 9 $1 (Neg a th:g) e 53 Moasema Comma vi A A 31128 Sc to 40 2 30 34 45 Sd womiana r.e-A A 8 22/20 SO 9 de I 18 23 26 o SS he.asa r -ee Saa 888 ? 24/28 40 te 38 8 3 29 29 o $# he face'8E*c 32/29 St 12 37 2 31 et de Sr me.Eag C & I asso 3 3r32 47 13 40 to 12 as a3 54 he two $4 - e & G A A. 4 28/23 Sc 13 37 3 3' 16 22 59 haqaa:Woaawe P A A. 3 2S/20 48 to 38 8 So il 23 60 hae'was. vi s Ilis 5 SS 12 33 7 $2 is 27 Si honae a ma P S As AA. S 24'23 k 13 37 2 SS 42 SS 62 hoecm S'a es *=* Aa Aa 2 a s /3 9 el 12 e3 0 to 47 50 43 he'tawes e a 8 5 Bas 888 24/20 SS 13 32 1 53 27 39 Sa O'*o losse A 888* 8 2 Sit 7 89 16 3S 4 9e 25 54 65 Omaaome G & E As AA. 3 22158 St 12 37 57 to 40 46 0 s ge s m t. um A A. 8 32'29 47 to 39 2 20 37 41 e 4? One f a:P o.o. a A S 3S/30 St 16 33 4 41 43 Sc se pa:4c Gas & f e As Aa-4 27/20 de 14 40 11 $4 IS 23 49 *a:d'c Po.e' & tt Saa 885 F 2 0/t 6 54 10 32 e as 13 19 70 Peaaseva*4 8 4 L As A. 2 25/37 85 21 34 4 92 17 37 FI P=sses te: A 908 t 2 tit a 12 to 3e 2 82 15 32 72 Poe4as Cea f ee Baa BS B - 8 19111 S3 9 38 S 154 25 193 ?) Po'O*4: tet Power A Ao 31730 St 11 38 a 11 49 43 f a P.t> S.c Co o aso A A 5 2 412 i St 13 34 3 S0 33 45 PS 8 e S.c fet & Gas Aa AA e 31/28 et 12 a3 2 JS 3' 43 76 PwD 5,g end a*a As Aa 2 41134 '. 7 IS 30 5 43 dl $2 7 7 8..e S.c he. 6'a+c Sea 888 9.: e$ to 41 to 127 26 104 f a P e S.e he. aaen.co As AA 4 3S/20 49 IS 36 to 50 30 42 o 79 9,ge So,re P & L Sea Get 8 2 3/t 3 at 13 38 8 St 12 18 0: mocaes<e C a t A A 6 22'17 48 13 39 3 53 a to e' Saa begs C & f Saa 088 8 flit 7 at 14 39 to 52 m 10 82 Sa.a** sa f e: &P-Ses 999 18199 83 9 29 3 5 46 44 83 Seas Paedce-A A 6 24/23 Si 10 39 ft 31 29 36 sa teea Co oi.6a f 4 G A A 5 24st 9 SS 19 34 4 43 32 49 45 Soeme* Cod EC As AA 4 24'23 47 13 80 5 el 16 22 to So me a Comoew 27tt e 59 tt 30 f. 75 43 63 87 SaJae a md G & f Aa AA 2 e.se t 44 12 42 3 af 48 l se Soe**ctie a P S As As a f ai2 0 56 ta 35 8 37 12 87 89 faasafers.c As AA 2 35/3e 50 e at a S 42 a3 De feass ueddes 29'26 St 11 38 4 30 17 as 99 foeso f etna Sas A-F 23/i? So.* 3S 9 82 .0 40 92 7eciaa tec Po < a A. 4 30/24 SI 10 3e 2 42 16 23 93 ue+a f ecirc A A e 2 Set t St 15 34 I 76 32 33 9a vanes smena'.ac Baa BBS 23186 4A 15 37 14 76 54 24 DS Ula* Pome' 4 Legav A AA. 4 2 6 tt s $0 13 37 t PS Ja 39 96 t-g a a t e; & Pe. A A 7 22/17 S2 to 3a S 69 .S 48 97 wasNagsa tW #e. A A. ? 1 ott 9 S3 9 34 27 7 'I at n icors a t ee P as Aa 2 3ri33 a' 18 a2 9 24 43 asi 99
- s*oes a 8** 4 Lt as Aa 2 a
'a 1 af 13 43 0 1 Si ti 500
- scoas* *we S.c As AA e S 32 42 13 a5 2
6 Y
- )
seta $ 3'S 2 03% 2is 8A 16 s IS4% tc. i '. v. Reage Lew 15'09 42 8 28 0 0 P i ee #3 thq. Ideoen 24 22 la 13 37 4 d6 D de
- a. Co*s eav a
f ano a'C: ruee
- yo's. ev e e
f ee af DC e.cssses mee we resas ans a C:w.'ec 0.,aa>= m one e,we a r a..a. --. ~ e - ..e~e...... l [ suce: Sah, men Brothers Stock Research, June 16, 1980
9 Public Utility Comission of Texas Exhibit SCH-12 Page 1 of 1 Houston Lightino and Power Crpany 133ustmants to Lono-Te m Debt Meaa.t Annual interest Recuire ects ts g-Ter9 Debt 3/31/83 (a) $1.483.004.246 $116.625.780 a Add: First Mortgage Bonds (b) 98,192.000 12,100,003 Issued June 3, 1953 Adjasted A-ounts $1,581,196,245 $123,725,783 Weigrtted Average Cost of Cebt M. (a) Schedsle M 6 of Rate filing Package (b) HL&P Prospectus. June 3. 1980 t 1
_g .g_ m umr s ' Public Utility Cer.nission of Texas _ Exhibit SCH-13 Houston Lichtino and powee Comoeay Ei v ted Averate Cest of Investe: Caoital (500's) Con :r. eat Cor enent Weighted Percent Percentage Avera e Cc rene-t Ane;-t of Tetal Cest Cest Long-tem Debt (a) $1.581.196 47.62 8.14t 3.85 Preferred Stock ID) 243.518 7.33 8.23 0.60 Accumulated Deferre Invest.ent Tax Credits IC) 206,529 6.22 11.32 0.7C Comen Equity ID) 1,259,531 38.83 15.80 6.14 TOTAL $3,320.774 100.005 _11.32% (a) Exhibit SCH-12 (b) Schedule H of Rate-filing Package (c) Schedste J of Rate-filing Package .}}