ML20003E976
| ML20003E976 | |
| Person / Time | |
|---|---|
| Site: | Comanche Peak  |
| Issue date: | 03/31/1981 |
| From: | Luftig M TEXAS POWER & LIGHT CO. |
| To: | |
| Shared Package | |
| ML19240B984 | List:
|
| References | |
| NUDOCS 8104170618 | |
| Download: ML20003E976 (47) | |
Text
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i Deckel No. 3920 0
1 2
3 4
5 6
7 DIRECT TESTIMONY OF 8
9 10 MARK D. LUFTIG 11 12 13 FOR 14 15 16 17 TEXAS POWER & LIGHT COMPANY 18 19 20 MARCH 1981 21 22 23 24 25 26 27
$150 {9l$
28 g TEXAS POWER & LIGHT COMPANY
r PAGE 1 of 29
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DIRECT TESTIMONY OF MARK D. LUFTIG j
Q.
PLEASE STATE YOUR NAME AND BUSINESS ADDRESS.
2 3
A.
My name is Mark D. Luf tig. My business address is One New York Plaza, New 4
York, New York 10004.
5 Q.
BY WHOM ARE YOU EMPLOYED AND IN WHAT CAPACITY?
6 A.
I am Vice President and Manager of the Utility Group in the Stock Research 7
Department at Salomon Brothers.
8 Q.
WOULD YOU PLEASE DESCRIBE BRIEFLY YOUR EDUCATION AND YOUR 9
BUSINESS EXPERIENCE?
10 A.
I obtained my Bachelor of Arts degree (major in Economics) from Columbia 11 University in 1958.
Upon graduation, I undertook simultaneous programs in 12 business and law.
I obtained my Master's degree in business from Columbia 13 Graduate School of Business in 1961 where I majored in accounting and a 14 doctorate degree in law from Columbia Law School in 1962. From 1962 to 1968,I 15 was engaged in the private practice of law. During that time, among other things, 16 I participated in the formation and management of an investment advisory 17 company and a mutual fund. I became associated with New York Telephone 18 Company in 1968, and, between 1968 and 1975, I served as Attorney, General 19 Attorney-Rates and Regulatory Matters and as a member of the Company's 20 Finance Committee. I also lectured on rate of return and participated in the 21 preparation and trial of several general rate proceedings, as well as in a 22 proceeding involving the investigation of the Bell System's capital structure.
23 These cases, lectures, and my daily work were concerned with the performance of 24 the uti!ity industry as viewed by the financial community. I joined Salomon 25 Brothers in 1975 and became a Vice President in 1977.
26 Q.
WOULD YOU PLEASE DESCRIBE BRIEFLY THE BUSINESS OF SALOMON 27 BROTHERS?
28 A.
Salomon Brothers is an investment banking firm with offices throughout the TEXAS POWER & LIGIIT COMPANY
/
PAGE 2 of 29 1
United States, an office in Hong Kong and a subsidiary in England. We are 2
underwriters and brokers in addition to making markets at our own risk in all 3
security markets. Because of our varied activities, we are in daily touch with 4
thousands of analysts, portfolio managers and traders from banks, corporations, 5
insurance companies, mutual funds, and others. This activity gives us an up-to-6 the-m;;;ute awareness of their thinking. We also give advice to corporations as to 7
financial matters and with respect to the best ways to raise capital.
8 Q.
WHAT IS THE VOLUME OF SECURITIES HANDLED BY SALOMON BROTHERS?
9 A.
During its fiscal year, ended September 30, 1980, Salomon Brothers managed or 10 co-managed 209 public offerings of corporate securities with a total value of 11
$23.0 billion.
Recent figures disclose that Salomon Brothers ranked first or 12 second in total underwritings managed during the first half of 1980. Our firm is 13 the leader in the field of private placements. During fiscal 1980, the firm placed 14 privately, securities aggregating $3.3 billion. We are also among the largest 15 managers of new debt issues in the United States. During our 1980 fiscal year, we 16 managed or co-managed 43 utility debt issues aggregating $3.8 billion. Our net 17 worth at the close of the fiscal year was over $250 million, ranking us third in size 18 among all United States securities firms. During our 1980 fiscal year, we handled 19 over $900 billion in purchases and sales of securities. We also have investment 20 banking relationships with a number of utilities and at any given time maintain 21 positions in the various debt and equity issues of those utilities. This gives us an j
1 22 unusual insight into investors' current attitudes toward utility securities.
23 Q. WOULD YOU PLEASE DESCRIBE THE FUNCTIONS OF AN UNDERWRITER?
24 A.
An underwriter or underwriting syndicate buys a security issue from an issuing 25 company and then resells it to the investing public at an " offering price" fixed by 26 the underwriter. The difference between the purchase price and the offering 27 price must compensate the underwriter for its costs and services in marketing the 28 issue, as well as for the risk it assumes. If the issue cannot be completely resold l
TEXAS POWER & LIGHT COMPANY
PAGE 3 of 29 at the offering price fixed by the underwriter, it is the underwriter, rather than j
the issuing company, who bears the full measure of any loss.
2 Q. WHAT OTHER SERVICES DOES SALOMON BROTHERS PERFORM?
3 4
A.
We provide a broad range of bond market, money market, and equity research, and advisory services for investors in, and issuers of, securities.
One of our 5
6 Specialties in this area is public utility stocks and bonds.
7 Q.
WHAT ARE YOUR DUTIES WITH SALOMON BROTHERS?
8 A.
As Vice President and Manager of the Utility Group, I direct and conduct complete financial, managerial, and technical research and analyses of electric 9
utilities and combination companies. In the course of my duties, I meet with and 10 give advice to financial officers of these corporations, and to investors as well. I 11 am also responsible for writing reports about the industry. These reports are 12 received by more than two thousand members of the financial investing com-13 14 munity. Among other things, my reports form the basis upon which our clients 15 make investment decisions. The institutions which receive my reports and the 16 Portfolio managers and analysts with whom I regularly speak are among the major 17 investment decision-makers.
Their minimum return requirements and their i
18 interpretation of fundamental financial factors determine whether they are 19 buyers or sellers of the securities of the companies I analyze in the course of my research. The decisions of these institutional investment managers, together with 20 21 the prevailing economic and financial forces, determine the current cost of equity i
22 for companies.
I 23 My value to these managers as a research analyst rests on my ability to 1
24 enable them to do a better investment job with their clients' money. In sum, my
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l 25 job is to analyze utility companies, and to give advice to our clients with respect 26 to buying or selling equity and debt holdings in utilities at given prices at given 27 times. My job involves making judgments every day as to the cost of common i
28 equity of utilities and those judgments influence directly the movements of l
l TEXAS POWER & LIGHT COMPANY
PAGE 4 of 29 1
millions of investment dollars.
2 Q. IN WHAT OTHER PROFESSIONAL ACTIVITIES HAVE YOU BEEN ENGAGED?
3 A.
I am Past President and a member of the Executive Committee of the National 4
Society of Rate of Return Analysts,Inc. I am a member of the New York Society 5
of Security Analysts and on its utility Program Committee. I am also a member 6
of the New York Utility Group. I am a Regaered Principal with the National
~
7 Association of Securities Dealers and a Registered Representative with the New 8
York Stock Exchange. I am also a member of the Utility Finance Committee of 9
the Public Utility Law Section of the American Bar Association and a member of 10 the Public Utility Law Section of the New York State Bar Association.
In 11 addition, I am also on the faculty of the Lincoln Institute of Land Policy, a private 12 foundation which, among other things, gives courses on taxation of utility 13 property and rate of return. I have also lectured at and participated in Public 14 Utility Symposiums before investors, utility executives, regulators and under-15 writers. My comments on utility financing have been quoted in The Wall Street 16 Journal, The New York Times, several other newspapers, Business Week, Forbes, 17 Electrical Week, and Public Utility Fortnightly.
I have testified before the 18 Connecticut Public Utilities Control Authority, the District of Columbia Public 19 Service Commission, the Federal Energy Regulatory Commission, the lilinois 20 Commerce Commission, the Massachusetts Department of Public Utilities, the 21 Michigan Public Service Commission, the Missouri Public Service Commission, and 22 the New York Public Service Commission, the North Carolina Utilities 23 Commission and this Commission.
24 Q. ON WHAT SUBJECT HAVE YOU BEEN ASKED TO TESTIFY IN THIS PRO-25 CEEDING?
26 A.
I have been asked to testify with respect to the cost of capital to Texas Power &
27 Light (TP&L) and to recommend a fair rate of return on equity for TP&L.
28 Q. WHAT CONCLUSIONS DID YOU REACH?
1
,e 4
PAGE 5 of 29 A.
After a thorough examination of the relevant data, and based upon my experience, 1
2 1 have reached the following conclusions:
1.
Utilities are viewed by investors as riskier westments than in the past and 3
4 thus their costs of capital have increased in recent years.
2.
While there continues to be improvement in the level of TP&L's earnings, 5
costs of capital have also increased, leaving a deficiency between earned 6
7 return and required return.
8 3.
TP&L continues to face a large construction program.
The 1980 construction program, which was to have been less than 1979 construction, 9
10 exceeded it.
Furthermore, the 1981-83 program is projected to be $1.3 11 billion.
12 4.
TP&L will be able to attract capital on reasonable terms only if it can earn 13 its full cost of capital and offer investors a prospective return commen-surate with that which they can obtain elsewhere from investments of 14 15 comparable risk.
16 5.
To accomplish this, TP&L needs improved earnings over a sustained period.
17 A number of guides to determining a fair rate of return on common equity 18 which I have examined show that TP&L requires a return on book equity of 19 at least 18.0E This is the minimum return on book equity necessary to 20 enable TP&L to maintain its financial integrity, and to attract capital by 21 giving investors an opportunity to earn returns comparable to those avail-22 able on investments of corresponding risk.
23 Q.
WHAT ARE SOME OF THE SIGNIFICANT CHANGES THAT HAVE OCCURRED 24 IN THE CAPITAL MARKETS SINCE DECEMBER,1979, WHEN YOU SUBMITTED 25 TESTIMONY IN DOCKET NO. 3006?
26 A.
The increase in the rate of inflation has been reflected in higher interest rates.
27 While there is not necessarily a one-to-one relationship between the amount of 28 the increased costs of debt and equity, they typically move in the same direction.
TEXAS POWER & LIGitT COMi%NY
PAGE 6 of 29 Debt costs have reached historical heights. The prime rate which was 151/2% in j
December,1979, increased 31/2 - 4 percentage points to 19 - 19 1/2 % currently.
2 New long-term triple A bond rates increased over 4 percentage points from 10 3
7/8% to 151/4%. Long-term government bonds, which are viewed as a proxy for 4
a risk-free investment, increased more than 3 percentage points from 10% to over 5
6 13%.
This is strong evidence that the cost of equity has increased at least 21/2 7
8 Percentage points, if not more.
Finally, in December,1979, the one hundred electric utilities we follow on a 9
regular basis were selling at 76% of book value and Texas Utilities was at 85% of 10 11 book value. Using a September 30 book value, on January 30,1981, the group was at 73% of book value, while TU was 81% of book value. In other words, both the 12 Company's and industry's common shares have deteriorated about the same 13 14 Proportion.
I wish to state at the outset that, to a large extent, I believe the poor 15 16 performance in TU's market / book ratio is not attributable to faults in manage-17 ment, or in the Commission, but rather to inflation. I firmly believe that the 18 Company's maintenance of financial flexibility and its decision to embark upon a 19 fuel conversion program at a relatively early stage, and backed by the 20 Commission's actions to support the Triple A bond rating, will result in millions of 21 dollars in net savings to TP&L customers.
22 Q.
PLEASE DESCRIBE BRIEFLY YOUR GENERAL APPROACH TO THE TASK OF 23 DETERMINING A FAIR RATE OF RETURN ON COMMON EQUITY FOR TP&L.
First, I examined the financial and business condi.on of TP&L to determine the 24 A.
25 character and extent of the risk which potential investors in the common equity 26 of the Company would be asked to evaluate. Then I made an analysis of general 27 economic and business conditions to determine: the climate affecting the cost of 28 equity capital to TP&L. This is important because, in an economy in which the TEXAS LOWER & LIGitT COMPANY
,,n..
.,y
PAGE 7 of 29 supply of capital is scarce in relation to demand, investor requirements, and thus 1
2 capital costs, are generally higher than in an economy in which capital is more P entiful in relation to demand. Finally, I made a determination of the minimum l
3 fair rate of return on common equity for TP&L.
By the decisions of this 4
5 Commission, the minimum fair rate of return is that which enables a utility to 6
earn its cost of capital. The cost of capital to a company, such as TP&L, which 7
has both long-term debt and equity is the weighted average cost of the company's 8
debt and equity capital. Determination of the cost of senior securities (debt and 9
Preferred stock) poses relatively few problems, but the cost of common equity is 10 far more difficult to ascertain. To ascertain a fair rate of return on common 11 equity, I first determined the minimum current cost of common equity to TP&L, 12 based on a number of different guides used by sophisticated investors, a 13 discounted cash flow analysis, a multiple regression model, an examination of 14 what industrial companies were earning, and consideration of the spread, or 15 so-called risk premium, between the return currently available on triple A - rated 16 utility bonds and the additional return required to induce investors to invest in 17 equity securities, which are subject to greater risk.
18 Q.
BEFORE DISCUSSING YOUR ESTIMATE OF THE COST OF EQUITY CAPITAL 19 TO TP&L SPECIFICALLY, WOULD YOU PLEASE COMMENT ON THE GENERAL 20 FINANCIAL CONDITIONS THAT ARE RELEVANT TO THE PROPER DETER-21 MINATION OF THE COST OF EQUITY CAPITAL?
22 A.
In making a judgment as to what investors are requiring as a return on equity 23 capital at a particular point in time, one must be cognizant of certain general 24 economic factors, such as inflation rates, interest rates, levels of demand for 25 capital and general business conditions.
These factors indicate whether, in 26 general, investors will be requiring users of capital to pay relatively higher, or 27 relatively lower, costs of capital. This is a useful starting point because it 28 indicates whether any inherent uncertainty the Commission may have in TEXAS PCWER & LIGHT COMPANY
PAGE 8 of 29 estimating the cost of common equity should be resolved in a somewhat higher, or j
a somewhat lower, direction.
2 The state of the economy today is uncertain. Economists disagree even on 3
4 the direction in which the economy is headed, although the majority believe that 5
the weak recovery will continue. Another uncertain aspect is to what extent a 6
recovery, together with increased governmental deficits, will drive up interest 7
rates. Most economists agree that stagflation (recession accompanied by high 8
interest rates) is likely to persist for the next several months. Unemployment 9
continues at some of the highest levels in the past forty years. Interest rates are 10 up sharply. Since July 1980, the prime rate increased from 11% to 19.5%. It may 11 move higher before turning down. it is expected to remain at least 14% for some 12 time, however. Long-term interest rates have risen dramatically. Currently, 13 fong-term triple A-rated utility bonds yield 151/4%. They are not likely to 14 decline below the 12% range for the foreseeable future. This increase in interest 15 rates is attributable to a number of factors, including:
16 1.
The level of federal budget deficits. The deficit for fiscal 1979 was less 17 than $30 billion. In fiscal 1980 it was over $50 billion. President Reagan 18 Projected an $80 billion deficit for fiscal 1981.
19 2.
The Consumer Price Index rose by 8% in 1978, by 13% in 1979 and 12.6% in l
20 1980. In 1979-1980, therefore, was the first time this country has had two 21 consecutive years of double digit inflation since World War I. 1981 is likely 22 to be another year of double digit inflation. As recently as the late 1960's, 23 4% was considered to be " runaway" inflation.
24 3.
Government and corporate demand for debt capital still remains very 25 strong. The volume of new money requirements set a record in 1980, which 26 is likely to be matched in 1981.
I 27 Q. HOW ARE INVESTORS REACTING TO THESE GENERAL FINANCIAL CONDI-28 TIONS?
TEXAS LOWER & LIGHT COMPANY
PAGE 9 of 29 1
A.
Investors are cautious. They have lost faith in the abilty of government to buffer or cushion sharp economic fluctuations since the shattering experience of the 2
1974-1975 period when we experienced double-digit inflation and near double-3 4
digit unemployment. The experience cf 1979-80 compounded and accentuated 5
investor's fears. An element of uncertainty exists with respect to the effective-6 ness of the government's economic policies and practices.
The President's 7
Economic Report, the budget message and the long-term implications of the U.S.
8 response to instability in the Persian Gulf area and to the war b; tween Iran and 9
Iraq reinforced investors' opinions that the current high rate of inflation and 10 continuing Federal Government deficits would persist. Investors are viewing the 11 rise in the interest rates as inflationary.
This also increases their return 12 requirements on equity investments. This focuses investors' attention on high 13 quality, very liquid investments.
In my opinion, this will continue to make 14 financing difficult and expensive for U.S. industry in general, and for public 15 utilities in particular, over at least the next few years. Even when utility stocks
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16 were selling in the market closer to their book values and when interest rates 17 were lower than they are today, a number of utilities experienced difficulty 18 raising needed captial, particularly if they were not of the highest investment 19 quality.
For example, we still see utilities being forced to cut their 20 construction programs because of financing difficulties. Moreover, the cost of 21 capital is very high by historic standards and is likely to remain so in the long 22 term.
23 Q. WHAT WILL BE THE NATURE OF THE COMPETITION FOR CAPITAL THAT 24 WILL BE FACED BY TEXAS POWER & LIGHT?
25 A.
The Company will face rapidly and substantially increasing competition for new 26 capital. Exhibit MDL-1 shows the tremendous increase in the demand for credit 27 over the years 1975 through 1980 and as projected through 1981, rising from an 28 annual level of $177.3 billion in 1975 to a projected demand for 1981 of $411.9 TEXAS POWER & LIGHT COMPANY
PAGE 10 of 29 billion, a new record. The demand of the highest quality borrowers available-the 1
U.S. Government and U.S. Government agencies-has risen phenomenally. It is 2
Projected to be $107.9 billion for 1981, compared to $28.4 billion in 1974, and the 3
$70-80 billion range for the 1975-1979 time frame. The credit demands of other 4
high quality borrowers, state and local governments and corporations, have also 5
6 risen at tremendous rates.
For example, the demand of state and local 7
governments.is projected to total $33.0 billion in 1981, or inore than in 1975 and 8
1976 combined.
Exhibit MDL-2 shows net new corporate bond issues for 1980 and 1981 of 9
about $30 billion each year compared with $18-26 billion in the 1976-1979 time 10 11 Period. In summary, competition for capital funds in recent years has of ten been 12 intense. Investors are well aware of this fact, and further they anticipate that 13 this competition may intensify even more in the future.
14 Q. WOULD YOU PLEASE PROVIDE SOME ASSESSMENT OF THE NATURE OF THE 15 COMPETITION FOR FUNDS IN THE FUTURE?
16 A.
Exhibit MDL-3 shows that the total amount of credit market debt outstanding 17 more than doubled from 1966 through 1976 and that estimates are that it will just 18 about double again by 1986. In addition, to support the corporate debt structure 19 indicated in that table, net new issues of corporate stocks, which averaged only 20
$.93 billion per year during the 1960's and $8.6 billion annually since the start of 21 this decade, are likely to swell to $30 to $35 billion annually by the mid-1980's.
22 This continual growth in the demand for capital has increasingly focused investors' 23 attention on the subject of a capital shortage.
24 For investors, the capital shortage problem is closely linked with the 25 problem of rising interest rates and inflation. They have been made wary by the 26 bitter experiences of the past decade, in which rising inflation pushed interest 27 rates to new high levels and stock prices were depressed to the point where total 28 market returns were of ten negative. As inflation accelerates, corporate balance l
l TEXAS IOWER & LIGIIT CO.\\f PANY
PAGE 11 of 29 sheets become more impoverished and corporate internal cash flows become 1
2 inadequate to finance the rapidly increasing nominal dollar costs of doing 3
business. This is particularly true for capital intensive utilities whose deprecia-4 tion charges are inadequate to provide for replacement of existing plant. For example, if plant purchased 30 years ago for $100 million now costs $800 million 5
6 to replace the same capacity, depreciation has recovered only one-eighth the 7
needed replacement funds.
In essence, high rates of inflation do not allow 8
businesses to generate sufficient capital internally to meet their needs. Thus, to 9
be reasonably assured of raising the capital needed to meet the demand for 10 services in the years ahead, it is extremely important that TP&L maintain its 11 credit position and attain an attractive return on common equity, not only to 12 minimize its cost of capital, but also to maximize the sources of funds to which it 13 may have acceu.
14 Q. DOES A LOWER BOND RATING LIMIT THE SOURCES OF FUNDS TO WHICH A 15 COMPANY HAS ACCESS?
16 A.
Yes, it certainly does. All too of ten emphasis is placed on the limiting nature a
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17 lower bond rating has in terms of foreclosing from the market those large 18 institutional investors which are restricted to bonds above a certain rating.
19 However, there is another limiting result due to lower quality bond ratings. That 20 is the foreclosure from the new equity markets which results when bond ratings 21 fall.
22 Q.
HOW DOES INFLATION AFFECT BOND RATINGS?
23 A.
In part, lower bond ratings can be traced to inflation, depreciation reserves which 24 cannot possibly meet the cost of replacements, and the rise in interest rates 25 combined with sharply increased amounts of debt that have adversely affected 26 both cash flow and fixed charge coverage. As a result of the deterioration in the 27 quality of corporate securities, investors in recent years have been exhibiting a 28 marked preference for quality.
Maintaining quality ratings has proven TEXAS LOWER & l.lGIIT COMPANY
PAGE 12 of 29 particularly difficult for utilities because they cannot adjust their pricing
)
mechanism at will, and because of the severe adverse impact inflation has had on 2
their ability to control expenses. With interest rates surpassing the 1974-1975 3
levels, there is concern about a repeat of 1974 and 1975. For example, between 4
May 1974 and the end of 1975, only five triple B-rated utilities were able to sell 5
fong-term bond issues, although many more would have liked to do so. Also, as an 6
example of the penalty for a lower rating, in January 1975, two similar sized, 7
intermediate-term issues, one rated triple A and the other rated triple B, were 8
sold on the same day with an interest spread of 464 basis points between the two 9
10 issues. Spreads have declined since then but there is still a gap of at least 200 basis points between new long-term triple A and triple B-rated bonds. Conditions 11 12 became dif ficult again in 1980. Today, many companies cannot sel! Iong-term 13 bonds at a reasonable cost.
Underscoring this strong preference for quality is Exhibit MDL-4, which 14 shows the amount of publicly offered straight bonds, by credit rating since 1967.
15 The table shows that whereas 39% of publicly offered straight bonds were rated 16 Baa/or below in 1967, only 12% of such bonds carried that rating in 1980. This 17 occurred because it has become more difficult for lower-rated borrowers to float 18 19 bond issues, and when they could do so, only relatively small issues could be sold.
20 O.
HO3 HAS INVESTOR PERFORMANCE IN THE BOND MARKETS BEEN 21 REFLECTED IN THE EQUITY MARKETS?
22 A.
This selectivity on the part of investors has also been transferred to the equity 23 markets, where a second trend has emerged. Here, persistent inflation has led 24 many equity investors to question the real quality of reported earnings. At the 25 same time, yields in the fixed-income area have begun to approach and even 26 surpass ths total returns available from common stock holding,s. This phenomenon 27 has caused many asset managers to question whether common equity investments 1
28 really provide any protection against inflation and whether the prospective higher TEXAS l'OWER & l.IGIIT COMPANY
PAGE 13 of 29 1
returns from common equities are worth the additional risk. For example, in 2
seven of the past ten years, at least one major sector of the bond market has 3
outperformed common stocks.
4 The above discussion highlights the extreme importance which adequate 5
rates of return have for utilities in the present capital market environment.
6 Returns t.nst be sufficient to provide both adequate fixed charge coverages (to 7
ensure acceptable bond ratings) and a level of earnings that will allow for 8
meaningful increases in retained earnings as well as reasonable dividend returns to 9
stockholders.
10 Q.
DOES THE QUALITY OF A COMPANY'S DEBT HAVE AN EFFECT ON ITS COST 11 OF CAPITAL?
12 A.
Yes. The rating of a company's bond affects the interest cost to the issuing 13 company. Almost without exceptio'n, the higher the rating the lower these costs, 14 and vice versa. Also, other things being equal, higher interest costs require a 15 higher return on equity just to maintain a constant fixed charge coverage.
16 Bond ratings are also taken into account by equity investors. Thus, just as 17 an investor will require a higher interest rate on bonds of a double A rated 18 company than on those of a generally comparable company whose bonds are rated 19 triple A, so will he require a higher equity return from the double A company than 20 from the triple A rated company. Furthermore, investors demand higher returns 21 on a given company's common equity than from its debt capital to compensate for 22 the higher risk of common equity. Thus, since lower bond ratings increase a 23 company's cost of debt, they also increase the cost of its own, more risky equity.
24 Q. WHAT DO INVESTORS SEE WHEN THEY VIEW TU'S AND TP&L'S FINANCIAL 25 CONDITIONS?
26 A.
For stock market data, they must look to TU. Investors see earnings per share 27 increasing but not by enough to keep the market / book ratio of the stock from 28 eroding continuously. Exhibit MDL-5 is a table showing the financial measure-TENAS POWER & LIGliT CO. fPANY
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PAGE 14 of 29 ments to which I referred. Column 2 shows that TU's earnings per share increased 9
t from $1.32 in 1967 to $2.18 in 1974, decreased in 1975 to $2.02 and then resumed 2
an upward trend. For 1980, they were $3.18.
3 This rise in earnings per share was not enough to prevent a continual erosion 4
in TU's market / book ratio, however. The average price of $27.50 in 1967 equated 5
to 313% of book value. The price declined to only 80% of book value in the test 6
year,1980. In March 1980, the company sold 5,000,000 shares of common stock at 7
71% of book value. Investors who, in the past, paid $30 for the stock and lost 8
almost half of their investments are wary of investing more funds in TU. Average 9
annual market prices, book values and market / book data are shown in columns 3,4 10 11 and 5 of the exhibit.
Q. WHAT DO INVESTORS SEE IN TP&L'S RETURN ON EQUITY AND INTEREST 12 13 COVERAGE?
14 A.
Other things being equal, given the upward trend in interest rates since 1967, one would expect TP&L to be earning a higher return on equity, and to have 15 maintained its interest coverage to pay investors for the increased risk associated 16 17 with the higher interest rates, or at least to ameliorate it somewhat. Instead, interest coverage has declined and return on equity has deteriorated in relation to 18 19 market requirements.
While inv istors' return requirements have increased with increased risk, 20 earned returns on average common equity decreased from 17.6% in 1967 to only 21 22 11.4% in 1975. Return on average common equity improved to 16.2 percent in 23 1980.
The return for 1980 included substantial earnings from electric sales 24 attributable to the effects of unusually severe weather. If the weather had been 25 normal, return on average equity would have been only 15.0%. These data are 26 shown in the second column of Exhibit MDL-6.
27 Q.
THE THIRD COLUMN ON EXHIBIT MDL-6 SHOWS PRE-TAX INTEREST 28 COVERAGE. PLEASE DISCUSS ITS IMPORTANCE.
TEXAS LOWER & I.IGIIT COMPANY
PAGE 15 of 29 1
A.
Pre-tax interest coverage for TP&L, which affords protection to its bondholders 2
and is thus an important indicator of a company's financial strength, decreased i
3 from 6.9 times in 1967 to 3.3 times in 1975 and 1976, and then improved to 4.1 4
times in 1978. For 1980,it was 3.9 times.
5 Q. IS IT APPROPRIATE TO LOOK AT TP&L'S COVERAGE USING ONLY g5 l
6 INCOME STATEMENT?
7 A.
No.
Texas Utilities Generating Company (TUGCO) and Texas Utilities Fuel i
8 Company (TUFCO) are TU subsidiaries. TUGCO acts as agent for the three 9
electric utilities in lignite mining and in operation of their jointly-owned 10 generating stations and furnishes related services at cost, while TUFCO owns a 11 natural gas pipeline system, acquires, stores, and delivers fuel gas and oil and 12 provides other fuel services for the electric utility subsidiaries. Both of these 13 companies are highly leveraged. (The net plant of both companies at i
14 December 31,1980 was $542 million and they had only $2 million in equity 15 capital.)
16 The debt of these companies is supported by the equity of the electric 17 utility subsidiaries. Rating agencies and sophisticated investors are aware of this 18 and include the pro rata share of the TUGCO and -TUFCO debt for each of the 19 electric utility subsidiaries in computing their interest coverages and capital 20 structure ratios. When the Company's pro rata share of the TUFCO and TUGCO 21 senior debt interest obligation is taken into consideration, the pre-tax interest 22 coverage ratios of TP&L for 1980, is reduced to 3.4 times, as illustrated in the 23 last column of Exhibit MDL-6. It should be noted that the 1980 supplemental 24 coverage of 3.4 times will be further reduced. By the time rates set in this l
l 25 proceeding go into effect, TUFCO will have issued an additional $50 million in l
26 Senior Notes. This in turn, will increase the supplemental interest obligation of 27 TP&L.
28 Q. WHAT DO YOU BELIEVE TO BE AN APPROPRIATE BOND RATING FOR TEXAS f
I TEXAS POWER & LIGIIT COMPANY t
PAGE 16 of 29 1
POWER & LIGHT TO MAINTAIN?
2 A.
TP&L, along with the other two subsidiaries of Texas Utilities Company, are 3
Presently the only remaining electric utilities with a triple A bond rating from 4
both major rating agencies.
In order for Texas Power & Light to maintain 5
financial flexibility, that is, to retain the ability to issue either debt or equity 6
when required, to be able to do so at difficult times and on reasonable terms, and 7
to maintain investor confidence, I believe it is advantageous to the customer, as 8
well as the stockholder, for the Company to strive to maintain its top quality 9
rating. It is possible for Texas Power & Light and the Texas Utilities system to 10 finance with a double A rating. However, even this downgrading would cause 11 Problems for the Company.
First of all, it is becoming more difficult to 12 externally raise the enormous amounts of money required to provide the quantity 13 and the quality of service to customers. Secondly, many of the institutional 14 investors in TP&L's securities have both legal and self-imposed requirements as to 15 the diversity and quality of the securities in which they invest.
16 Furthermore, once a downgrading has occurred and credit deterioration has 17 begun, it is difficult to stop, much less reverse. Investors confidence and the 18 probabilty of investors puchasing these as well as subsequent securities are 19 impaired. Such investor reactions intensify the probability of additional down-
'20 gradings. If TP&L were to be downgraded to a double A rating, the chances of 21 being lowered to a single A would not be that slim. Bonds which are rated single 22 A are judged to be of medium quality. However, for TP&L, a lowering of its l
23 rating for a second time would create special difficulties v:th respect to the l
l 24 continuous increase in investors' concerns since the Company was originally a 25 highly rated company. Investors who suffered through the first downgrading 26 would not soon forget this experience, and a downgrading to a single A would tend j
27 to confirm investors' suspicions that as soon as there is further financial 28 stringency, the bonds will be downgraded again. During the credit crunch of 1980, i
TEXAS POWER & l.IGIIT COMi%NY
PAGE 17 of 29 single A companies were unable to finance in the manner they wished and, as a 1
2 result, they were forced to cut construction programs and to incur high short term 3
debt positions.
4 A poignant example is Commonwealth Edison.
That Company's first 5
mortgage bonds were downgraded from Aaa to A by Moody's Investor Service in 6
two steps, both in 1979. At the same times,its debentures were downgraded from 7
Aa to Baa. The Company was forced to cut its construction program and entered 8
November 1979, with $485 million in unfilled financing requirements for the year 9
and an inability to sell mortgage bonds.
10 Q. WHAT INTEREST COVERAGES AND OTHER FINANCIAL STANDARDS DOES 11 TP&L REQUIRE TO MAINTAIN A TRIPLE A RATING?
12 A.
The standards are the same as I reported in Docket Nos.1517 and 3006. The 13 Company needs to maintain a pre-tax interest coverage, on a supplemental basis, 14 of 4.0 times or more and a post-tax coverage of 3.0 times or more on an ongoing 15 basis. The earnings elements of these coverages should not include excessive 16 amounts of AFUDC. The interest element must include the Company's pro rata 17 share of the TUFCO and TUGCO interest. Additional important standards are: a 18 high quality level of earnings, an average of 50% internal cash generation, a 19 common equity ratio of 40% or more, and a realistic regulatory environment.
20 TP&L's pre-tax interest coverage for the test year will have to be higher 21 than 4.0 times in order for it to achieve a 4.0 times coverage in the period that 22 rates will be in effect which will be a period of high interest rates.
23 Q. WHAT HAS HAPPENED TO THE QUALITY OF TP&L'S EARNINGS?
24 A.
Relevant data are shown on Exhibit MDL-7. During the 1967 to 1980 time period, 25 TP&L's capital requirements increased by a factor of seven times, from.about $51 26 million in 1967 to over $420 million in 1980. AFUDC as a percent of income 27 available to common increased from 6.3% in 1967 to 28.1% in 1976. In 1980, it 28 was 27%.
TEXAS POWER & LIGIIT COMPANY
PAGE 18 of 29 1
The effects of AFUDC on cash earnings can readily be seen by compa-ing 2
returns on average common equity including and excluding AFUDC.
TP&L's 3
return on equity in 1%7 was 17.6% This included a relatively small proportion of 4
AFUDC, so that excluding AFUDC return on average common equity was 16.5%
5 However, in 1976, those returns were 12.4% and only 8.9% respectively. For 6
1980, return on equity excluding AFUDC was only 11.8% Excluding the effects 7
of the severe weather conditions,it was only 10.6%
8 The percentage of AFUDC to income available to common decreased from 9
the 1976 level to about 20% in 1978 and 1979, partly as a result of the effects of 10 Prior orders of this Commission regarding cash flow and quality of earnings, and 11 allowance of portions of CTIP in rate base without AFUDC offsets.
In my OP nion, these were important factors in TP&L's ability to maintain its triple A )
i 12 13 rating when coverage fell below the minimum levels I have outlined. However, 14 AFUDC increased again in 1980 to about 27% of income available to common. It 15 is imperative that this be reduced.
I 16 While TP&L's and TU's construction are large in absolute terms, Exhibit 17 MDL-8 shows. that, for its size, this construction program is about average for the 18 industry. Internal cash generation is below the industry average, however.
19 Q. HOW HAS TP&L PERFOR\\tED WHEN CO\\tPARED TITH THE INDUSTRIALS 20 ;
TITH WHONt IT \\tUST CO\\tPETE FOR CAPITAL?
21 A.
At one time, it was commonly accepted " doctrine" or " dogma" that securities of 22 utilities were a less risky investment than securities of industrial companies such 23 as those which form the S&P 400 Industrials. I believe that today utilities are at 24 least as risky as that average, and the consensus of the large institutional 25 investors with whom I communicate on a day-to-day basis is that an investment in 26 utility common stocks, including Texas Utilities, is as risky or more risky than 27 investing in the S&P 400.
28 It is clear why such a situation exists today. On a relative basis, TP&L has l
TEXAS POWER A-LIGHT COMPANY
PAGE 19 of 29 fared much v>orse than industrials with wh!ch it must compete for the investors' 1
dollar.
2 Exhibit MDL-9 shows similar data for the S&P 400 Industrials for the period 3
1967-1980, as is shown for TU and TP&L in Exhibits MDL-5 and MDL-6. For the 4
industrials, earnings per share almost tripled from $5.62 to $16.00, an increase of 5
184% versus a much smaller increase for TP&L. While the market price of TU 6
7 common shares decreased by 37% during that period, the S&P Index increased by 8
41%. The market / book value ratio for S&P is considerably above TU's market /
9 book ratio. The S&P composite market to book ratio decreased from 2.05 times to 1.28 times, still 28% above book value. TU's market /bcok ratio has fallen from 10 11 3.13 times to.80 times, or 20% below book value.
12 Q.
DO YOU HAVE ANY OTHER BROAD GROUPS OF COMPANIES WITH WHICH TO
~
13 COMPARE TP&L'S RETURN ON EQUITY?
14 A.
Yes. In April of each year, Citibank, in its Monthly Economic Newsletter, shows 15 the return on net worth for leading manufacturing companies.
As shown in 16 Exhibit MDL-10, Citibank's Leading \\tanufacturing Companies earned 18.4% on 17 net worth for 1979, and 15% or better in each of the past four years. Business 18 Week reported that, for 1979, the return on common equity for 1,200 large 19 companies wa316.6%. For the twelve months ended June 30,1980, it was 15.9%.
20 The electric utility industr y's earnings are depressed and, therefore, they should 21 not be used as a measure of e Sir rate of return for TP&L. Electric Utilities are 22 not earning what they have been allowed, let alone what they require.
23 Q.
WOULD YOU PLEASE SUMMARIZE YOUR VIEWS CONCERNING TP&L'S 24 CURRENT FINANCIAL CONDITION.
25 A.
TP&L was in financial health in the late 1960's and it needs very much to return 26 to that condition. The erosion that has taken place is demonstrated in part by the 27 following comparison:
28 TEXAS POWER & LIGHT COMPANY
PAGE 20 of 29 1967 1980 1
2 Market Price of Common Stock (TU)
$27.50
$17.38 3
Market to Book Ratio 3.13 0.80 4
Return on Common Equity 17.6 %
16.2 %
15.0%*
5 Return on Equity Excl.
AFUDC 16.5%
11.8 %
- 10. 6%*
6 AFUDC as % of income Available 7
to Common 6.3%
27.0 %
8 Pre-tax Interest Coverage 6.9x 3.9x 9
Pre-tax Supplemental Coverage 3.4x 10
- 1980, Weather Adjusted 11 I have also shown that TP&L's financial condition has eroded relative to 12 industrials.
13 Q.
WHAT CAUSED THIS EROSION OF TP&L'S FINANCIAL POSITION?
14 A.
Many of the fundamental changes encountered by the entire utility industry were 15 also experienced by TP&L. For example, in the late 1960's, the industry's position 16 shif ted from one of decreasing incremental cost to one of rising incremental cost.
17 This made it necessary for utility companies to request frequent, and sometimes 18 substantial, rate increases which too of ten produced inadequate and delayed rate 19 relief.
20 Regulatory delay and inadequacy alone would have posed a major problem 21 for the industry, but that problem was exacerbated by the onset during the 1970's 22 of nistorically high rates of inflation; required suspension of sales promotion; 23 conservation; the most abrupt business decline in more than 40 years; spiraling 24 fuel costs and the need to convert to alternative fuels; unsettled capital markets 25 characterized by historically high interest rates; a high degree of investor 26 selectivity; and environmental concerns. The accident at Three Mile Island and 27 the reduction in General Public Utility's dividend that followed made investors 28 realize that utility dividends were not sacrosanct and that, under certain TEXAS LOWER & LIGilT COMPANY t
PAGE 21 of 29 1
circumstances, investors could be asked to assume greater risks than they had 2
anticipated and that they were being paid to assume. The combination of these 3
factors, among other things, has, over recent years, led investors to conclude that 4
the utility industry involves increased risk. This realization has increased the cost 5
of both debt and common equity to utilities generally and to TP&L specifically.
6 Q.
MR. LUFTIG, I WOULD LIKE NOW TO TURN TO YOUR DETERMINATION OF A 7
FAIR RETURN ON COMMON EQUITY FOR TEXAS POWER & LIGHT. WOULD 8
YOU PLEASE DEFINE THE COST OF COMMON EQUITY OR FAIR RATE OF g
RETURN?
10 A.
The cost of common equity is the investor's required rate of return, or the 11 capitalization rate, on common stock, competitively determined in the capital 12 markets, ef ter adjustments for flotation costs and market pressure.
This 13 capitalization rate before the adjustment for flotation costs and market pressure, 14 is the discount rate which equates the sum of all expected dividends in the future, 15 combined with the market price investors eventually expect to realize, to the 16 Present market price. While this is a simple enough concept, it is difficult to 17 measure precisely since measurement requires an assessment of the expectations 18 and requirements of the investors who determine the market price.
Stated j
19 another way, the cost of common equity to a company is the return the investor l
20 requires to commit his capital to that particular enterprise, as opposed to 21 alternate investment opportunities. A fair return on equity must be sufficient to 22 allow the company to compete for capital with alternative investment 23 opportunities at reasonable costs and without diluting investors' equity. These 24 guidelines have been established by the Supreme Court of the United States 2nd 25 are:
26
... it is important that there be enough revenue not only for operation expenses, but also for the capital costs of the business. These include 27 service on the debt and dividends on the stock.... By that standard, l
the return to the equity owner should be commensurate with returns on 28 investments in other enterprises having corresponding risks.
That I
TEXAS IOWER & l.lGliT COMPANY
PAGE 22 of 29 o
return, moreover, should be sufficient to assure confidence in the 1
financial integrity of the enterprise, so as to maintain its credit and to attract capital." (Emphasis added) FPC v. Hope Natural Gas Co.,320 2
U.S. 591, 603 (1944) 3 Q. WHAT ARE SOME OF THE FACTORS INVESTORS TAKE INTO CONSIDERATION 4
IN ASSESSING RETURN REQUIREMENTS?
5 The return on any given security required by im Mors is a function of the returns 6
which are available on alternate investments.
When examining all of the 7
investment alternatives, an investor has a number of factors he must explore: the 8
business and financial risk of the enterprise, the risk inherent in the type of 9
10 security, and the time span over which the investment is to be made.
11 Q.
IN YOUR OPINION, WHAT IS THE RETURN INVESTORS PRESENTLY REQUIRE TO COMMIT THEIR FUNDS TO TU COMMON EQUITY?
12 13 A.
To put my answer in context, you must understand that I am in daily contact with 14 institutional investors. These investors set prices by trading in the securities of 15 similar companies. They own approximately 30% of the stock listed on the New 16 York Stock Exchange and account for about 70% of the trading on that exchange.
17 They also own 80% of the corporate bonds outstanding and account for virtually 18 all trading in those securities. These institutional investors provide a tremendous 19 discipline to the market by their activities. For example, the dividend yield and 20 market to book ratio of one utility company's common stock will not be C..swed to 21 be materially different from those of other utilities whose regulatory climate, 22 earnings potential, etc. are perceived to be similar to it.
Dividend yield and 23 market to book will be determined by the market price these investors will pay 24 for the stock. It is apparent from their actions that, currently, these investors 25 are not willing to invest new funds in the common equities of utilities unless they 26 can anticipate market returns at least in the range of 17% - 18% Given the 27 disappointing results which these equities have exhibited in the past, it is neither 28 surprising nor unreasonable for them to require returns of this magnitude to TEXAS POWER & LIGHT CO. f PANY
\\
PAGE 23 cf 29 Compensate them for the increased risk which they are being asked to bear. The 1
2 lower portion of that range is reserved for companies like TU that have exhibited relatively better past earnings performance, that have higher quality earnings, 3
l 4
that are located in states where regulation has been more responsive to the need 5
of the utilities to earn higher equity returns, and whose bonds are rated triple A 6
or double A. I will use 17%, the bottom of the range,in my analysis. Again, these 7
returns are market returns to investors and do not include any adjustment for 8
flotation costs or market pressure.
9 Q,
WHY ARE YOUR OPINIONS SO HEAVILY INFLUENCED BY THE MARKET 10 RETURN REQUIRED BY INSTITUTIONAL INVESTORS 7 11 A.
I don't know o'f a more meaningful factor, or place to begin, in an analysis of a 12 fair rate of return. You can go through a !ct of abstract mathematical exercises 13 using formulas that are supposed to represent the minds of investors, but the only 14 direct evidence of what investors think is the communication of their views, 15 objectives and requirements as expressed to their financial advisors who guide 16 them regularly on the commitment of billions of dollars of investment funds.
17 Q.
DO YOU ACCEPT THE MARKET RETURN REQUIREMENT OF INSTITUTIONAL 18 INVESTORS AT FACE VALUE FOR PURPOSES OF YOUR ANALYSIS?
19 A.
I use a number of guides or tests to evaluate independently the reasonableness of 20 that requirement. For example, I have already shown that, when costs of capital 21 were lower, industrials and leading manufacturing companies have been achieving 22 returns of 16% and that investors believe utilities to be as risky as these 23 companies. Another test is the so-called discounted cash flow, or DCF, test. By 24 this test, under certain simplifying assumptions, which have been accepted by 25 many regulatory agencies and economists, the capitalization rate to which I 26 referred can be expressed as the sum of dividend yield and expected growth in 27 earnings or dividends per share. TP&L does not have publicly traded stock and it 28 is necessary and appropriate to use, as a proxy, market data with respect to TU TENAS POWER & LIGIfl' COMPANY
PAGE 24 of 29 1
stock.
2 Q.
WHAT IS TU'S DIVIDEND YlELD?
3 A.
Dividend yield is the ratio of dividends to market price per share. The DCF method calls for use of the current yield (dividend to be paid over the next year 4
5 divided by current price). I used the current dividend rate of $1.88 and the 6
average price for November, December, and January, the last three months 7
available to me, which is much more indicative of current yield than is the historic 8
average over a period of a year or longer, which no investor would view as the 9
yield currently available to him.
The dividend increase that took place in 10 February was generally expected. The average dividend yield on TU's common 11 stock for these most recent three months is 10.6%. The yield at the end of the 12 Period was 10.7%.
13 Q. WHAT IS A REASONABLE GROWTH RATE TO USE FOR TU IN THIS CASE?
14 A.
The discounted cash flow formula calls for expected long-term growth in 15 dividends. Beginning in 1977 and continuing through 1981, TU has increased its dividend at an annual rate of 12 cents a share, or approximately 71/2% a year.
16 17 The 5 year growth rate from 1976 to 1981 is 7.3%. With a 60% payout ratio, 18 investors expect that dividend increases of this general magnitude will continue 19 on an annual basis at least for the next several years. Value Line Investment 20 Service, in its January 30, 1981 report, forecasts a 7.5% average annual dividend 21 increase for TU over the next five years.
22 Through 1980, earnings per share grew at an average annual rate of 9.8%
23 over the Ian three years, and at 9.5% a year over the past 5 years, which included 24 an earnings decrease in 1975 and 1979. Value Line also projects a 7.5% annual 25 growth in earnings over the next five years. \\1ost sophisticated investors believe 26 a projected five year growth rate in earnings of 61/2% - 71/2% to be reasonable.
27 I believe a growth rate of 61/2% is a very conservative one for this 28 Commission to use in this proceeding. Even if earnings failed to keep pace for a TEXAS lY. ER & LIGilT CO.\\f PANY
PAGE 25 cf 29 period, investors expect that dividends will continue to grow.
3 2
Q. 15 THERE ANY RELATIONSHIP BETWEEN A COMPANY'S GROWTH RATE AND ITS RETENTION RATE?
3 4
A.
Yes. It is expressed commonly as g = br. This says that the growth rate from retained earnings (g)is equal to the retention rate (b) times return on book equity 5
(r). A 40% -etention rate, which I believe is reasonable for TU over the next few 6
years, and the 17% market return on equity required by investors, if earned, would 7
8 Produce a growth rate of 6.8%. The growth rate should be improved in the near term by an increasing return on common equity but would be restricted if sales of 9
10 common stock are made below book value.
11 Q. WHAT ARE INVESTORS' RETURN REQUIREMENTS BASED UPON THE DIVIDEND YlELD AND GROWTH RATE YOU HAVE BEEN DISCUSSINC?
12 13 A.
Based upon an average three month' dividend yield of 10.6% and a 6.5 growth rate, 14 investors' return requirements are about 17.1%.
15 Q.
DO YOU HAVE ANY OTHER STATISTICAL AIDS TO HELP EVALUATE THE 16 COST OF COMMON EQUITY TO TP&L?
17 A.
Yes. Four years ago, I developed a computerized multiple regression model of 100 18 electric utility common stocks. The independent variables are: estimated return 19 on equity, dividend / book ratio, regulatory ranking and quality of earnings. The 20 regression equation has been explaining over 80% of the difference in the 21 market / book ratio (the dependent variable) of these 100 companies.
I 22 As of January 30, 1981, the last modal run, the industry was at 73% of 23 September 30,1980 book values. If it is assumed that TU fit the industry format, 24 then all other things being equal, TU would require an expected market return on 25 equity of 17.7% for its stock to sell at book value.
26 While in my opinion, historical data, equations such as g = br, and the 27 regression model should not be used to compute return on equity initially, these 28 tools are helpful in evaluating and verif ying independently obtained market data.
TEXAS LOWER & LIGIIT CO. f PANY
\\
PAGE 26 of 29 1
Q.
HAVE YOU MADE ANY OTHER ANALYSIS OF A REASONABLE MARKET 2
RETURN ON COMMON EQUITY FOR TP&L?
3 A.
Yes. As I stated earlier, investors require certain spreads between the returns 4
they can receive from the bonds of a company and the returns they demand on the 5
more risky investment in that company's common stock.
For a long time, 6
investors required a spread of 450-500 basis points to purchase common stocks 7
rather than the bonds of utility or a 50% greater return on the stock than on the 8
bond in order to invest in the stock. This was confirmed in a study by Ibbotoson 9
and Sinquefeld. In the past several weeks, the spread has declined to a narrow 250 10 basis points.
11 On this basis, with a triple A-rated utility bond currently yielding about 12 151/4%, the market return requirements for the common stock of that company 13 are about 17.7%. This is additional confirmation that investors' market return 14 requirements for TU's common stock are at least 17%.
15 Q.
IS IT IMPORTANT FOR A COMPANY TO BE ABLE TO SELL NEW STOCK AT OR 16 ABOVE BOOK VALUE?
17 A.
Selling equity below book i ue has five adverse effects:
18 1.
It makes existing shareholders surrender a portion of their investment to the 19 new shareholders; 20 2.
It dilutes earnings per share and growth in earnings per share; 21 3.
It makes it more dif ficult for a company to meet the same dividend l
22 requirement on an increased number of outstanding shares; 23 4.
It creates investor resistance toward further equity offerings; and 24 5.
It fails to meet one requirement of the Hope case, attracting capital on 25 reasonable terms.
26 Exhibit MDL-11 shows the effect on a company's earnings per share of selling 27 stock at, below, and above book value.
For purposes of illustration, I have 28 assumed a company earning 16% on equity, with stockholder equity of $1 million, TEXAS LOWER & l.IGIIT COMi%NY
PAGE 27 of 29 and with 50,000 shares outstanding at a book value of $20 per share. Earnings per 1
share then are $3.20, and the company pays a $2.24 annual dividend. As shown in 2
3 column 3, if the company sells an additional 50,000 shares at the book value of 4
$20, then the book value and earnings per share will remain constant, and the 5
$2.24 dividend continues to be 70% of earnings. I have next shown the situation 6
where the company is forced to sell these shares below book value; in this case, 7
$15 per share. The average book value per share then declines to $17.50, earnings 8
per share decline from $3.20 to $2.80, and the $2.24 dividend rises to 80% of 9
carnings. The next time the company needs to raise equity there will be a smaller 10 earnings base per share, and shareholders will likely be more hesitant to subscribe 11 for the new shares. If the company is forced to sell equity below book value a 12 third time, the thinning dividend coverage and lack of future earnings and 13 dividend growth prospects will discourage buyers. In the last column of the table, 14 I have demonstrated the effects of selling an additional 30,000 shares at a 15 premium over book value; in this case, at $25 per share. As expected, book value 16 per share increases to $22.50 and, because of the higher earnings base per share, 17 earnings improve to $3.60. Now both the earnings per share and the dividend 18 growth potential have been enhanced.
19 Q.
WHAT FACTORS SHOULD BE TAKEN INTO CONSIDERATION IN RECOM-20 MENDING AN APPROPRIATE MARKET TO BOOK RATIO?
21 A.
Two principal factors, both related to the issuance of new stock, must be taken 22 into account in determining a minimum reasonable market to book ratio. The 23 announcement that a firm intends to issue new stock tends to drive down the price 24 of outstanding stock as a result of investors reacting negatively to potential 25 dilution, supply / demand adjustments, investors deferring stock purchases while 26 awaiting the offering, etc. This phenomenon is referred to as market pressure. In 27 addition, the company incurs certain costs in connection with the sale such as 28 legal and printing expenses, underwriter's fees, registrar's fees, etc.
My TEXAS POWER & l.IGIIT COMPANY
PAGE 28 of 29 1
experience has been that costs and expenses of issue and market pressure aggregate about 10% of the proceeds to the company at this time. In making this 2
recommendation, I have taken into account the fact that the industry is selling 3
well below book value. This 10% allowance is the minimum I would envision under 4
5 any c.ircumstances. It could be significantly greater.
It is not impossible to construct a definitive market pressure study. In 6
theory, such a study holds all other things equal while measuring the effect on the 7
8 marxet price of a company's stock from a new issue. Obviously all other things 9
cannot be held equal.
With these considerations in mind, however, I have 10 presented Exhibit MDL-12, which contains data with respect to TU's last common 11 stock issue.
The analysis assumes that, but for the issue, the stock would have performed 12 13 the same as the S&P electric utility index. The Exhibit shows that, measuring 14 from January 17,1980 (one week from the announcement date) to March 4,1980 15 (the offering date), TU stock declined 12.0%, while the index declined by only 16 6.2% One could assume that the difference of 5.8% resulted from the issue.
17 in addition to market pressure, the underwriting spread, the difference 18 between the proceeds to the Company and the offering price, was 4.2% Finally, 19 the Company must pay out-of-pocket registration, printing and legal fees, all of 20 which further reduce the net proceeds.
21 Q.
WOULD YOU PLEASE SUMMARIZE THE VARIOUS MARKET DETERMINED 22 ESTIMATES OF THE COST OF COMMON EQUITY YOU HAVE DETERMINED 23 FOR TP&L.
24 A.
It is easiest to see a summary of my determinations from the table below:
25 Direct investor contact 17.0 %
26 DCF analysis 17.1 %
27 Utility model 17.7 %
28 Bond premium 17.7 %
TEXAS LOWER & LIGIIT COMi%NY
PAGE 29 of 29 1
Q. HOW DOES A MARKET RETURN OF 17.0% AND A MARKET TO BOOK RATIO OF 1.1 RELATE TO A FAIR RETURN ON BOOK EQUITY 7 2
3 A.
As shown on page 1 of Exhibit MDL-13, market return and book return are identical when the market to book ratio is 1.0. On page 2 and 3 of the Exhibit, I 4
cemonstrate this algebraically. From the weight of my analysis as summarized 5
above, I conclude that a market return of 17.0% is required. A market to book 6
value ratio of 1.1 and a market return of 17.0% equates to a fair return on book 7
8 equity of 18.0%. I recommend 18.0% as the minimum fair return which TP&L must be given a reasonable opportunity to actually earn on book common equity.
9 10 Q. MR. LUFTIG, DOES THIS CONCLUDE YOUR TESTIMONY?
11 A.
Yes, it does.
12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 TEXAS LOWER & l.lGitT COMi%NY
S8kNDOE1 BrothefS Exhibit MDL-1 Page 1 of 1 Stock Research Summary of Suppl 3 and Demand for Credit -5 5esi Annuai Ne' an:< eases.n Arnounts Outs anc.rg 4-L-
1975 1976 197-1978 1979 1980+
1961*
?f e:50-NetDemand Pavately Held Mce gages 400 70 0 1096 118 1 10')7 691 100 5 7 ?f31 Corperata & Fere gn Bonds 402 41 4 37 2 32 7 27 1 41 5 39 0 f 24 2 Suetota! Long. Term Prn ate 80 2 111 4 146 8 1506 1368 11C 6 139 5 f.6!~ 3 Short. Term Business Borrowing
-14 8 10 6 45 8 71 7 89 9 53 3 84 5 6::3 Soort. Term Otme Borrowing 15 0 40 7 50 6 66 6 51 5 54 47 0 4 ?! 3 Subtota; Snort-Term Private 02 51.3 96 6 13E3 141 4 SE 7 131 5 70966 Privately He!:: Fecerat Debt 82 6 71.7 74 6 78 4 72 2 111.3 107 9 902 4 Tax-Exempt Notes and Bon::s
$4 3 15 0 31 3 32 9 275 300 33 0 3596 Suttetat Gove<nment Det 96 9 66 7 105 9 111 3 99 7 14L3 140 9
- 2f 2 2 Total Net Demand for Credit 177.3 249.4 349.3 400.4 377.9 310.6 411.9 4,045.9 Net Supply ~
T nn*: Instaubons 53 5 70 7 E2 2 76 7 56 2 400 62 3
- ~5 *
- rsu ance Pensions Encowments 39 6 49 3 67 2 71 7 67 9 691 71 9 72' 2 investment Companies 37 49 6E 63 24 6 29 9 42 0 ff f Otne* Noncan Finance
-30 6C 15 6 16 6 28 6 79 26 2 2:2~
Suetciat Noa. cans Finance 936 132 9 174E 171.3 1775 145 9 2030
- 734 '
Commercial Banns-301 60 6 64 ' 1059 1039 57 6 106 C
- -JF2 Bus ness Corporatio.s 11 6 82 34 44 10 6 67 75
~ ~6 2 State & Local G0vernment
-17 42 15f 151 10 9 05 55 f5f Fore <gn-61 196 47 0 55 5 74 3 *.1 23 0 26i 4 Subt0ta:
139 9 225 7 324 5 355 2 310 5 242 E 345 0 3 Ji4 :
Resicual tmostly nousene:c c ect 374 23 7 24 5 45 2 67 4 67 6 66 9 6i! 9 Total Net Supply of Credit 177.3 249.4 349.3 400.4 377.9 310.6 411.9 4,045.9 Percentage Growth in Outstandings Tcta' Crec't a1 106 13 4 13 5 11 3 E3 iC 2 Governme nt 156 12. '
132 12 2 98 12 6 11 2 Househot:
7' 11 E 15 3 155 13 2 67 104 C orec ate 39
'7 11 4 12 9 12.6 92 11 0 Lorg Term 82 101 12.9 11 6 94
?4 E4 Snor' Term E1 11 1 13 9 15 5 132 93 12 0 Held by Nontan* Finance 1C 5 13 4 15 5 13.2 12 1 29 11 3 Commerciat Banks 43 83 10.5 12.0 10 5 53 92 Fcreign 62 16 7 37 8 34 1 32 131 66 Housencle Direct 97 56 55 96 13 0 11 6 10 3
- I uludes funds for cetics. cash and twccuencous demands not tapulated atsose
- Dornesticelh chartered b ink, and their dernestic affiliates
' includes b t> ranches of foreign backs e - estimate p - projected
h Brothers Exhibit MDL-2 Page 1 of 1 Stock Research Sources and Uses of Corporate Funds' (S Baens>
Anm.4i Ne' tarreases e ammrs OJs sace; A e C.'
1975 1976 1977 197!
1979 198
19818 3 f Dn!:*
Analysis in Brief
. Prof.is t'etore Tases anc IVA 1007 1296 143 3 1659 1900 1800 1935' eP.s inventory Va'uaten AQ
-12 4
-14 6
-152
-252
-41 6 403
-42 0 i
- Aepatnatec Fore 1;a pretts 31 42 52 52 80 90 90 e: ess Fece'at Tan Payments 42 6 452 59 8 652 73 1 72 0 69 0' eD meencs 28 3 32 9 37 0 41 6 46 8 51 ;
$4 5
- Plus Deprec:ation 64 1 91 4 1031 113 1236 132:
152 5' erte'nai Casn. GeaeraSon 1046 132 5 1396 1521 1601 15E 0 166 5 omys:ca:investmen:
115 e 154 0 166 7 212 -
239e 2490 282 5 e
Pts Net Trace & Coescer Crect 10 68 12 0 13 2 11 0 25 70 e ess inte nal Casn Generat.cn 104 E 132 5 139 6 152' 16;,1 1560 1EE 5 0--a Aewe nents 122 303 59 1 73 5 90~
935 103 0 Ecuars Operat:
r Pys Aces for Francia' Assets 27 7 272 24 6 164 12 4 126 22 5 Ec;a,s Esteraa Aec#rements 399 57 5 E3 7 92 2 1031 1C6 3 125 5 Uses of Funds erar1& Ec a ne-t' 1Cf 9 121 2 143 3 17C:
1952 207; 236 8 ewan 100 11 1 t19 13:
14 5 16:
1EC ev'e a' A<;5ts 13 40.
25 2:
47 60 70 eDeect Fo'e gn in.estmen' 60 39 50 36 40 35 35
- Ees:cen a* Cens".,ction 20 30 45 42 43 2C 32 entc* es Acastec to va4at.om
-104 109 192
- F 171 145 14 0 e?cta. P% sca' in.es ent 115 6 1540 I SE '
22~
239 6 24V 2E2 5
- 4 et ? race & Coasre C'ect 10 66 12 0 i3
- 11 0 25 70 74Ff De anc Deposes & Cv'ency C2 15 0&
53 63 1i eC 69:
5 e Deposes'
-3 C
-2 C 4E
-2 C 3:
35 32 2
-21 4-30 4*
5 Governr e~s 95 23
-55 4ece'a' Agenc es
-06 00
-04 0'
-C 5 1:
10 2'
Cre-Yaset Fare ~
22 41 76 E0 10 2C Sf 2 Sta e & Loca' Se:.'oes
-02
-11 CC CI CO
-C 3
-15 3*
Cec /cnase A; ce-en's
-C E 23 12 55 26 15 2C
- ?f c'* ;a De:csis 05 17 13 2:
10
-C 5 05 c
C' e Assets ne 135 124 15 1 12
-09 16 5:
TcT uses 144 5 1900 2233 244 3 263 2 2642 3'20 Sources of Funds taae' a: Cas-Geae at.cn 1046 132 5 1396 152' 1631 159 :
1 ES S Von; ape Dect 95 12 9 18 9 232 24 2 15 21 5 24f ?
Sam Te"a tcaas
-2 E
-21 22
'1-19 6 120 205
!!5 2 Eaa. Sac Te" soaas
-E 4 59 191 199 24 3 159 14 5 1 '4
- Finance Ocmpaa Leans 22 52 103 53 70 09 EC (20 U S Gose rme,t toans 02 C2 0C 12 1E 15 e'
Net Sa'es ot Coea va'=et Pape"
-2 ?
27 23 39 99 12 4 100 4'!
Net Nea TanEnem
- Ecne issses 26 25 35 22 36 3-35 2'3 Net Nea lana $e Sonc issues) 30 2 259 234 203 180 33 5 300 3955 Net New S!cc issues:
69 43 40
-01
-47 106 16 0 f C5f ?-
Tota' Enterna! Sc.rces 399 57.5 837 922 1031 1CE 3 1255 Tctat Sosces 144 5 1930 2233 2443 263 2 264 3 3120
' Nonfarm, nonfinancial corg. orations
- S t A data. compares **th Suncy data of
!!! k 100 5 IP
- 151 &
I *'. I 192.5 216 6 Percentap thanp Sune3
-04
+6 9
+ 12 6
-1.11
- I! )
9*
- 12.5
\\l4
-54
- l34
- lk 2
- lb *
+ 14 >
- e 6
- 14 4
- Our o n ess. mates All che freri Federal Resene Board r4 Gosencer Flem of-F us4s.
- At market
- T dese f:gures renect an eweried $8 5 b.11.on acceleration a nem legislai.onlin depieciano% chedvic lor Federal mcome tate. producirt se !
bill.on less before-tat prc4sts. Sa bdhon less tan pas ments. and 54 b thon more internas resn generai.on in addition a reducteen in ene corporate las rate mill add another $2 $ bellion to inte-mal cash generation e - estimate p - projected
Exhibit MDL-3 Page 1 of 1 THE GROWTH OF CREDIT MARKET DEBT OVER TWO DECADES (Billions of Dollars)
Avg. Annual Increase Outstandings During 5 Years Ended:
Type of Debt 1966 1976 1986E 1979 1966 1976 1986E Mortgages 294 663 1400 1102 23 65 135 Corporate Bonds 134 353 700 476 8
26 60 0
77 4
U.S. Govt. & Fed Ags.
224 455 900 760 3
State & Local 106 246 450 328 6
17 33 Money Market 16 73 150 158 2
7 33 Loans
- 216 531 1050 905 19 39 90 Miscellaneous 71 130 200 Total 1060 2452 4850 3730
- Loans include all types of bank loans, consumer credit at depository institutions, and other loans.
E - Estimate Source:
Salomon Brothers I
PUllLICLY OFTl RED STRAIGili 110t105 IlY CRlDIT RATitJG
'TifiT1' ions or cot 1Jii)---
Rating 196/
196fl 1969 1970 1971 1972 19/3 1914 19/5 1976 1977 1978 1979 1980 Aaa 5 3.0
$ 2.5 5 2.1
$ 6.2 5 5.9
$ 5.3
$ 3.7 5 7.9 5 8.2 5 5.9
$ 8.8 5 5.2 58.'3 S 8.6 Aa 3.2 2.7 3.0 5.3 5.4 4.2 3.8 8.1 8.4 7.3 5.2 5.0 5.5 9.3 A
2.8 1.9 2.6 8.8 6.8 4.5 3.6 7.1 11.0 7.6 4.8 4.4 6.0 12.2 Daa 4.4 2.5 1.8 2.5 2.4 1.2 0.6 1.5 2.5 3.1 2.0 1.6 1.8 2.5 Below Daa &
Not Rated 1.4 1.3 0.0 0.3 0.8 0.7 0.6 0.2 0.8 0.6 1.1 1.6 1.4 1.4 Total
$14.8
$10.9
$ 9.5
$23.1
$21.3
$15.9
$12.3
$24.8
$30.9
$24.5
$22.0
$17.8
$23.0
$34.0
% of Total Aaa 20%
23%
22%
27%
28%
33%
307.
32%
26%
24%
40%
29%
36%
25%
Aa 22 25 32 23 25 27 31 32 27 30 24 28 24 27 A
19 17 27 3 11 32 28 29 29 36 31 22 25 26 36 Baa 30 23 19 11 11 8
5 6
8 13 9
9 8
a Below Daa &
N;t Rated 9
12 0
1 4
4 5
1 3
2 5
9 6
4 s' E
- G M
E lh
[
Source: Salanon Brothers 1.
Exhibit MDL-5 Page 1of1 TEXAS UTILITIES COMPANY Market Data 1 % 7 - 1980 Average Book Value Average Earnings Per Market Price Per Share Market /
Year Share (a)
Per Share (b)
(Year End)
Book Ratio (1)
(2)
T3)
(4)
(5) 1967
$1.32
$27.50
$8.80 313 %
1968 1.35 27.50 9.34 294 1969 1.51 27.125 10.42 260 1970 1.66 27.50 11.18 246 1971 1.74 29.625 12.45 238 1972 1.95 30.00 13.40 224 1973 2.01 28.875 15.09 191 1974 2.18 19.75 16.30 121 1975 2.02 20.625 17.07 121 1976 2.29 19.75 18.09 109 1977 2.40 20.875 19.10 109 1978 2.54 20.25 20.14 101 1979 2.45 19.00 20.80 91 1980 3.18 17.375 21.76 80 (a) On average shares outstanding.
(b) Average of monthly high/ low figures rounded to the nearest one-eighth.
Source: Texas Power & Light y - -
m--
w
,.v-y r---
e---
Exhibit MDL-6 P ga 1of1 TEXAS POWER & LIGHT COMPANY Return on Common Equity and laterest Coverage Return Pre-Tax Interest on Average Pre-Tax Coverage including Year Common Equity (a)
Interest Coverage Supplemental Interest (b)
(1)
(2)
(3)
(4) 1967 17.6 %
- 6. ')x 1968 15.8 6.4x 1969 16.6 6.5x 1970 16.8 5.8x 1971 16.3 4.9x 1972 16.7 5.0x 1973 15.3 4.6x 1974 14.4 4.1x 1975 11.4 3.3x 1976 12.4 3.3x 3.3x 1977 14.0 3.8x 3.6x 1978 15.2 4.1x 3.9x 1979 14.3 3.8x 3.3x 1980 16.2 3.9x 3.4x 1980(c) 15.0 3.7x 3.2 x (a) Includes return granted on unamortized investment credits.
(b) Includes pro rata portion of TUFCO and TUGCO interest on Senior Notes.
(c) Adjusted for normal weather.
Source: Texas Power & Light
TEXAS POWER & LIGHT COMPANY Total Construction Costs, AFUDC, and Return on Common Equity 1967-1980
($000 Omitted)
Total Construction Total Construction AFUDC As Return On Return on Average Costs Costs
% of Incoine Avail.
Average Common Equity Year (Incl. AFUDC)
(Excl. AFUDC)
For Common (a)
~ Common Equity (a)
(Excl. AFUDCXa)
(1)
(2)
(3)
(4)
(5)
(6) 1967
$ 51,169
$ 49,372 6.3%
17.6 %
16.5%
1968 64,257 62,746 5.5 15.8 15.0 1969 75,823 72,715 9.7 16.6 15.0 1970 87,922 83,937 10.8 16.8 15.0 1971 100,604 94,693 14.2 16.3 14.0 1972 107,764 102,796 10.4 16.7 15.0 1973 152,542 147,142 10.7 15.3 13.7 1974 203,771 192,165 20.2 14.4 11.5 i
1975 264,776 250,272 26.8 11.4 8.3 1976 261,171 242,063 28.1 12.4 8.9 1977 278,075 257,408 23.3 14.0 10.7 1978 305,095 286,975 17.1 15.2 12.6
?
y{
1979 363,050 339,225 21.8 14.3 11.2 oo ~
1980 420,829 383,084 27.0 16.2 11.8
- g
- ~ 0 ST
~"
(a) includes return granted on unamortized investment tax credits.
Source: Texas Power & Light
Exhibit MDL-B Pcga 1 of 2 Rioctric Utilley OveNey MeasuremeMe (Sorted Alphabeticany) 1981 1983 E Electree Generossen 1981 E Oroes enesmal mensung Piene Caen touc. Coat ou See Mg
- 1. Allegheny Power C+
20%
75%
92% 7%
1%
- 2. American Elec Pwr.
C+
27 40 12 % 87 1
3 Argona Pub Sve.
C-37 22 90 7
3%
4 Attente C4y Eiec B-53 45 29 43 23 5
5 Bam.more G & E B-41 64 54 24 ff 4
3 6 Boston Edison R
R R
R R
R R
R
- 7. Carohna P & L D+
63 27 37 60 1
2
- 8 Cen Hudson G&E C
44 35 81 15 4
- 9 Cen in LigM B
41 46 100 10 Con til Pub Svc B-38 69 99 1
- 11. Cen Maine Pwr.
C+
53 28 37 43 20
- 12. Cen South West C+
61 40 33 1
66
- 13 Cen Vermont P S C
68 38 49 9
12 33 14 CancinnatiG & E R
R R
R R
R R
R
- 15 Cleveland El lu C-41 24 13 86 1
- 16 Commonwea'th Ed D+
59 50 44 44 to 2
- 17. Commundy P S B+
29 66 Principa!!y Purchased Power
- 18 Consolidated Ed B-20 87 15 69 16
- 19 Consumers Power C-45 30 17 71 11 1
- 20 Dagon P & L C-26 65 97 2
- 21 Delmarva P & L C
31 74 25 46 27 22 Detrod Ed' son C-61 22 90 9
1
- 23 Duke Power C-61 70 32 64 4
- 24 Dvouesne Lght C
32 48 17 83
- 25 Eastern Ut* ties D+
46 20 22 78
- 26 El Paso Electric C.
150 11 12 3
85
- 27 Empire D.st Elec.
C 19 65 95 1
1 3
28 Florida Power Corp A-72 46 18 25 53 4
- 29. Florca P & L B-37 45 25 58 17
- 30 General Pub UtJ D+
17 75 9
77 12 2
- 31 Gutt States Utd C-83 26 13 87
- 32 Ha*aetan Electric 8
33 47 100 33 Houston industries B-80 28 16 1
83
- 34 laaho Po*er C
46 50 35 65
- 35 lilinoes Power C+
64 27 96 3
1
- 36 Indianapot's P & L B
35 47 99 1
- 37. Interstate Power B
39 35 94 6
- 381cea Elec L & P R
R R
R R
R R
R
'39 lomain G & E C+
49 63 46 52 2
- 40 lona Resources B-39 54 2
2
- 41. lona Pub Svc C+
26 90 99 2
- 42. loma Sournern ut C+
17 100 99 1
- 43 Kansas Cdy P & L C-28 71 94 4
2
- 44 Kansas G & E C-60 15 51 3
46
- 45 Kansas P & L C+
55 40 86 1
13
- 46 Kentucky Utilittes A
42 53 99 1
- 47. Long is!and Ltng C-66 7
99 1
- 48 Louiselle G & E A
65 40 94 1
5
- 49 Mad < son G & E A
23 94 27 66 7
- 50 M.dcie South Utd D
58 14 18 14 17 51
Exhibit MDL-8 Prg2 2 cf 2 Electric Utility Quanty iWomeurements (Conrd )
1981 1983 E Electric Generstaen 1981 E ouemy ceneer.
EP8
/ Gross Intemel Itent6ag Plant Ceeh Nuc. Cool OW One Hyd.
- 51. Minnesota P & L C
13%
167%
89% 3%
8%
- 52. Missour: Pub Svc D
29 70 95 1
4%
53 Montana Dakota Ut C+
28 89 98 1
1 54 Montana Power C+
72 31 48 1
51
- 55. Nevada Power C+
99 28 80 16 4
56 New England Elec.
B-44 44 15% 16 61 8
- 57. New Eng G&E Assoc.
B 42 36 27 73
- 58 New York State E&G C
95 22 98 2
- 59 Niat, ara Mohawk Pwr.
C 27 47 15 32 41 12 60 Northeast Util.
C.
42 45 52 45 3
61 Northernind PS C
54 29 98 1
1
- 62. Northern States B
34 78 42 54 1
3 63 Northwestern P.S C
14 158 98 2
64 Ohio E6 son D
48 15 9
90 1
65 Oktanoma G & E C
26 30 43 57 66 Grange & Rock Ut C+
37 46 56 37 7
- 67. Oner Taif Power C+
55 81 99 1
68 Pacific G & E C
47 60 8
32 27 22A 69 Pacific P & L C
53 33 1
63 36 70 Pennsylvania P & L D+
68 41 1
79 18 2
71 Philadelphia Elec C-32 19 27 24 19 4
- 72. Portland Gen. El D.
54 31 49 15 6
30 73 Potomac Elec Pwr.
A-23 72 83 17 74 Pub Svc Colorado C
30 53 4
75 1
17 3
75 Pub Svc E & G C+
41 57 37 34 14 15 76 Pub Svc in@ana R
R R
R R
R R
R 77 Pub Svc New Hamp R
R R
R R
R R
R 78 Pub Svc New Men R
R R
R R
R R
R 79 Puget Sound P & L C-68 43 3
17 8
8 64 80 Rochester G & E C
46 35 50 34 12 4
- 81. San D ego G & E C
39 42 6
76 18 82 Savannan E & P C+
34
,79 80 15 5
83 Sierra Pac Pwr Co C+
63 36 12 85 3
84 So Carolina E & G C
27 119 8
79 6
7 85 So Caht Ed R
R R
R R
R R
R 86 Southern Company C-46 55 15 77 1
1 6
87 So Ind G & E B+
48 40 98 1
1 88 Southwestern P S C+
36 45 43 1
56 89 Tampa Electric A-48 34 80 20 90 Tenas Utilities B-50 39 50 1
49
- 91. Toledo E6 son C-45 37 27 72 1
92 Tucson Elec Pwr C
69 34 72 4
24 93 Union Electric D
36 19 95 1
4 94 United Illuminatrng D
70 11 8
92
- 95 Utah Power & Lignt B-48 28 94 1
2 3
96 Virginia E & P C-58 41 39 45 15 1
- 97. Washington Wtr Pwr.
C 66 17 20 2
3 75 98 Wisconsin El Pwt B
34 64 35 59 1
3 2
l 99 Wisconsin P & L A
46 66 21 75 1
3
- 100 Wiscons-n P S A-27 76 21 73 1
5 i
Average 48%
48%
- Sawnon Brothers has managed or co-managed a regvered pubbe under*reen ottering of securde *4 min the past three years i
l E Esteate R Data seleted becasse the common stock of the company es ei registraton A Fues rm incluoes 11% geothermas l
Source Salomon Broiners i
Exhibit MDL-9 Page 1 of 1 S&P 400 INDUSTRIALS STOCK MARKET DATA 1967-1980 Market Market /
Return Fixed Earnings Price Book on Charge Year Per Share Per Share Ratio Equity Coverace 1967 5 5.62
$ 95.73 205%
12.0%
11.0x 1968 6.16 106.54 217 12.6 10.6 1969 6.13 107.00 210 12.0 8.9 1970 5.41 89.23 171 10.4 7.3 1971 5.97 107.60 199 11.1 7.6 1972 6.83 122.57 216 12.0 8.1 1973 8.89 118.96 196 14.7 8.5 1974 9.61 90.59 139 14.7 8.0 1975 8.58 92.56 134 12.4 7.1 1976 10.64 111.17 152 14.5 7.4 1977 11.57 109.40 138 14.6 7.9 1978 13.17 107.12 125 15.4 8.0 1979 16.21 117.66 127 16.3 8.0 1980E 16.00 135.23 128 16.0 7.7 E - Estimat2
~
Sources:
Standard & Poor's; Salomon Brothers l
l l
l l
l
Exhibit MDL-10 Page 1 of 1 PERCENT RETURN ON NET WORTH
- OF LEADING MANUFACTURING COMPANIES (1975-1979)
Jndustrial Group 1975 1976 1977 1973 1979 1.
Baking 17.0 16.1 18.5 19.7 17.9 2.
Dairy Products 14.3 14.7 14.8 15.6 15.7 3.
Meat Packing 12.7 12.9 10.4 12.3 18.9 4
Sugar 23.2 11.4 9.1 11.6 15.3 5.
Other Food Products 14.1 16.1 15.3 17.6 17.4 6.
Soft Drinks 20.6 22.4 22.7 22.3 22.4 7.
Brewing 10.3 11.5 10.3 10.0 15.3 8.
Distilling 11.5 16.3 11.9 14.2 14.9 9.
Tobacco Products 17.9 17.2 19.3 19.7 22.1 10.
Textile Products 3.4 9.6 9.0 9.1 10.0 11.
Clothing & Apparel 9.3 12.3 11.2 16.0 16.5 12.
Shoes, Leather, etc.
10.7 15.0 13.6 16.1 14.4 13.
Rubber & Allied Products 7.8 7.5 10.4 6.2 7.1 14.
Lumber & Wood Products 10.0 15.5 16.1 17.7 20.1 15.
Furniture & Fixtures 7.0 9.8 8.8 11.6 9.7 16.
Paper and Allied Products 12.7 14.8 14.2 14.0 17.1 17.
Printing & Publishing 12.9 13.9 17.4 21.2 19.2 18.
Chemical Products 15.8 16.1 14.5 14.9 17.3 19.
Paint & Allied Products
. 9.0 10.9 12.5 8.8 11.4 20.
Drugs & Medicines 20.4 20.0 18.8 22.0 22.5 21.
Soap, Cosmetics 18.0 18.3 19.4 20.9 19.5 22.
Petroleum Products & Refining 13.9 14.8 14.2 14.5 22.9 23.
Cement 7.1 9.8 13.0 19.1 19.0 24.
Glass Products 9.8 17.3 13.6 11.1 14.4 25.
Other Stone & Clay Products 8.2 10.6 11.6 17.2 15.7 26.
Iron & Steel 10.0 8.7 6.5 9.4 11.5 i
27.
Nonferrous Metals 7.4 S.5 7.8 9.4 16.5 28.
Hardware & Tools 13.6 16.3 15.9 18.7 18.3 29.
Building, Heating & Plumbing Equip.
12.3 21.0 22.4 21.8 22.6 30.
Other Metal Products 13.0 15.0 15.4 13.6 16.6 31.
Farm, Construction, Material Hand. Eqpt.
18.7 17.9 17.5 18.1 17.0 32.
Office Equipment & Computers 15.9 17.4 18.3 23.3 20,7 33.
Other Machinery 11.6 13.6 15.4 16.5 18.2 34.
Electrical Equipment & Electronics 12.7 16.2 17.2 17.5 16.8 35.
Household Appliances 6.2 17.4 19.0 16.8 16.5 36.
Autos & Trucks 5.7 18.3 20.3 17.4 10.5 37.
Automotive Parts 9.6 15.3 16.4 17.4 18.2 38.
Aerospace 11.7 13.6 16.3 17.0 21.8 39.
Instruments, Photographic Goods, etc.
14.3 15.7 16.2 19.2 19.6 40.
Miscellaneous Manufacturing 8.4 15.2 12.3 14.4 19.4 41.
Total 12.6 15.0 15.0 15.9 18.4 Source:
Citibank Monthly Econcmic Newsletter -
April Issues.
- Net worth includes common and preferred shareholders' equity.
EXAMPLE OF EFFECTS OF SE1. LING ADDITIONAL EQUITY AT B'OOK VALUE, BELOW BOOK VALUE AND ABOVE BOOK VAI.UE j
Sale at Book value Sale Delow Book Sale Above Book f
Present (S20) value ($15)
Value ($25)
(1)
(2)
(3)
(4)
(5) g Stockholder Equity
$1,000,000
$2,000,000
$1,750,000
$2,250,000 Shares outstanding 50,000 100,000 100,000 100,000 Book Value Per Share
$20
$20
$17.50
$22.50 Rsturn on Equity 16%
161 16%
161 Earnings Per Share
$3.20
$3.20
$2.80
$3.60 Dividend Per Share
$2.24
$2.24 S2.24
$2.24 70%
70%
80%
62%
Payout Source:
Salomon Brothers l
l MM bh I
- 9
~#
Rg J
~Y C
a a
- Exhibit MDL-12 Page 1of1 TEXAS POWER & LIGHT COMPANY MARKET PRESSURE ANALYSIS TU S&P Utilities Price
% Chg.*
Index
% Chg.*
Base Period 01-17-80 17 3/4 30.37 Announcement 01-24-80 16 7/8 50.07 Offering 03-04-80 15 5/8 (12.0)%
47.27 (6.2)%
' Percent change relative to base period.
Exhibit MDL-13 Page 1 of 3 REQUIRED RETURNS ON BOOK EQUITY TO YEILD A GIVEN MARKET RETURN Market / Book Return Ratio On Equity 1.00 17.0 %
1.05 17.5 1.10 18.0 1.15 18.6
- Based on the relationship ROE = P/B (k-g) + g when:
ROE = required return on book equity k
= required return on market equity g
= growth rate P/B = market book ratio The derivation of this formula is shown on pages 2 and 3.
The table assumes a 6.5% growth rate associated with a 17.0% required market return.
Source: Salomon Brothers l
l l
l 1
l l
Exhibit MDL-13
. * * =
Pcg2 2 cf 3 M
Stock Reseeech Derivation of Formula Used to Convert Market Return to Book Return I.
Definition of Symbols P = market price of a share of stock B = book value per share D = dividends per share THUS P/D = market to book ratio k = annual required rate of return on equity capital = market return ROE = return on book equity g = growth rate of earnings per share.
This is the same as the growth rates of dividends and retained earnings, since the payout ratio is assumed constant.
II.
Derivation l
If for simplicity, we assume continuous growth in dividends A.
l at annual rate 9, then k=D (1) p
+g B.
By definition, ROE = earnings = D + retained earnings B
B (2)
Neglecting changes in ROE, and assuming all growth comes from retained earnings (thus neglecting the effect of the sale of new shares above or below book),
retained earnings
=g (3)
B From (2) and (3),
ROE = S + 9 (4)
B I
Exhibit MDL-13 Page 3 of 3 Stock Reseetch C.
Rearranging (1),
D = P (k-g)
(5)
Substituting this form of D in (2),
(}
ROE = P_, '(K-g) + g III.
Demonstration that if allowed return on equity (ROE) is equal to investors' return requirement (K); the market price (P) will equal book value (B).
Rearranging (1)
D (7) p=
K-g Rearranging (4)
RO -g (8)
Dividing (7) by (8)
P=
ROE-g B
K-g (9) 1 Therefore if K = ROE, P must egaal B.
If an issuing company is to issue new stock and receive net proceeds at least equal to book value P must be greater than B to allow to market l
pressure and selling costs and therefore ROE should be higher than K.
d o
1
eeeo STATE OF NEW YORK :
COUNTY OF NEW YORK:
BEFORE the undersigned authority on this day personally appeared MARK D. LUFTIG, who, having been placed under oath by me, did swear follows:
"My name is MARK D. LUFTIG. I am of legal age and a resident of the State of New York. Tha foregoing testimony, and exhibits offered on behalf of Texas Power & Light Company, are true and correct and the opinions stated therein are to the best of my knowledge and belief accurate, true, and correct."
r"
'?/
f i
']
I
/
MARK D. LUF IG j
SUBSCRIBED AND SWORN TO BEFORE ME by the said Mark D. Luftig 20th j
day of February, A.D. 1981.
i 1
TARY PU C in and for t ' State of New York I-My Commissions expires f
JACQUTLINE S M No. 21-45:0',211. 'h,
Nota y Palc $arte d Uw'3?
e,7 e,
6,
-t--
Cusi.e.eJ ia Kir.;s Cost gA
~ j.'.
. om**on f">'85 Mh *
. ),g C
g, 9,,, ;., :
j
-