ML20003E973
| ML20003E973 | |
| Person / Time | |
|---|---|
| Site: | Comanche Peak  |
| Issue date: | 03/31/1981 |
| From: | Brigham E TEXAS POWER & LIGHT CO. |
| To: | |
| Shared Package | |
| ML19240B984 | List:
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| References | |
| 3780, NUDOCS 8104170600 | |
| Download: ML20003E973 (51) | |
Text
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Doeke+ No. 3'180 1
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DIRECT TESTIMONY OF 10 11 12 EUGENE F. BRIGHAM 13 14 15 FOR 16 l
17 18 TEXAS POWER & LIGHT COMPANY l
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MARCH 1981 22 I
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g TEXAS POWER & LIGIIT COMPANY
PAGE 2 cf 36 DIRECT TESTIMONY OF DR. EUGENE F. BRIGHAM 1
i 2
Q.
PLEASE STATE YOUR NAME, ADDRESS, AND OCCUPATION.
3 A.
Eugene F. Brigham. I live in Gainesville, Florida, where I am Graduate Research 4
Professor of Finance and Director of the Public Utility Research Center at the 5
University of Florida.
6 Q. PLEASE DESCRIBE YOUR EDUCATIONAL BACKGROUND.
7 A.
I received my Bachelor's degree from the University of North Carolina and both 8
my MBA and Ph.D. degrees from the University of California.
9 Q. WHAT UNIVERSITY POSITIONS HAVE YOU HELD?
10 A.
I have taught at UCLA, and at the Universities of California, Wisconsin, il Connecticut, and Florida. In addition, I have taught in executive programs at 12 UCLA, Wisconsin, Stanford. Duke, Penn State, and Virginia.
13 Q. WHAT BUSINESS EXPERIENCE HAVE YOU HAD?
14 A.
Af ter receiving my MBA, I worked for approximately one year with Del Monte 15 Corporation as a financial analyst, studying the feasibility of building new plants.
16 I rtext worked for U. S. Leasing Corporation, a financial institution that supplies 17 capitalin the fcrm of leasing to all types of business firms. I analyzed the credit 18 worthiness of potential lessees and made decisions as to whether or not to lend 19 money to various credit applicants.
20 In addition to this full-time employment, I have served as a consultant to a 21 number of firms and government agencies, including the Federal Reserve Board, i
22 the Federal Home Loan Bank Board, the U. S. Office of Telecommunications 23 Policy, the Utah Public Service Commission, and the Florida Public Service 24 Commission.
l 25 Q.
HAVE YOU PREVIOUSLY TESTIFIED BEFORE PUBLIC SERVICE COMMISSIONS 26 OR OTHER PUBLIC AGENCIES?
27 A.
Yes.
I have testified before a number of state commissions (Utah, Florida, 28 Maryland, Georgia, South Carolina, Kansas, Arkansas, Minnesota, Missouri, Missis-TEXAS POWER & LIGiff COMPANY l
PAGE 2 of 36 sippi, Connecticut, Delaware, Virginia, Montana, Louisiana, Oregon, Pennsylvania, 1
Alabama, Texas, and Illinois) and before the Federal Communications Commis-2 si n, the Federal Energy Regulatory Commission, two U. S. Senate Committees 3
(Banking and Housing), and several times before the Florida Legislature in 4
connection with utility regulatory procedures. With regard to Texas, I testified 5
during 1980 for Southwestern Bell and for Texas Power & Light Company (TP&L) 6 in its last rate case.
7 8
Q.
PLEASE DESCRIBE YOUR ACADEMIC PUBLICATIONS.
9 A.
I have authored or co-authored thirty-one books and thirty-five journal articles.
\\1y finance and economics textbooks are used at Harvard, Columbia, Stanford, 10 Texas, and over one thousand other colleges and universities.
11 English editions of the texts are used in various countries around the world, 12 and the texts have been translated into Spanish, Italian, French, Turkish, 13 14 Japanese, and Portuguese.
I receive many comments and suggestions from Professors who are using the books, and our publisher also retains a number of 15 academicians each year to review the books.
Such feedback helps me keep 16 abreast of new developments in the theory of finance.
17 The books are also widely used in corporate training programs. Included are 18 19 such firms as IBM, Bank of America, Gulf Oil, and General Motors, as well as 20 many smaller companies. I correspond periodically with such users, and their 21 comments help insure that the books are practical and realistic, as well as 22 theoretically up-to-date.
23 Q.
YOU ALSO MENTIONED THAT YOU ARE DIRECTOR OF THE PUBLIC UTILITY 24 RESEARCH CENTER AT THE UNIVERSITY OF FLORIDA.
COULD YOU 25 DESCRIBE THE CENTER'S ACTIVITIES?
26 A.
Yes. Our Public Utility Research Center was established in 1972 to conduct i
27 research on various aspects of public utility operations and regulation.
The 28 Center receives financial support, data, and suggestions for research projects TEXAS POWER & LIGitT COMPANY 5
PAGE 3 of 36 from the Florida State Legislature, the Florida Public Service Commission, the 1
U.S. Department of Energy, and the utility industry. Our recent activities have 2
included studies of accounting issues, rate structures, investment policies, and 3
methods of estimating the cost of capital.
4 5
Q.
WHAT SPECIFIC WORK HAVE YOU DONE ON THE COST OF CAPITAL?
6 A.
I have written several journal articles on the subject. They have appeared in a variety of journals, including the Financial Analysts Journal, Public Utilities 7
Fortnightly, Financial Management, the Accounting Review, and the Journal of 8
9 Finance. Also, my textbooks have several hundred pages devoted specifically to rate of return and cost of capital, and I have done studies of the cost of capital 10 fcr various companies and reported these studies in academic cases. Finally, i 11 have testified on the cost of capital to utilities before the FCC, the FERC, and 12 the state commissions noted earlier.
13 14 Q. WITH WHAT ACADEMIC AND PROFESSIONAL ORGANIZATIONS ARE YOU 15 AFFILIATED?
16 A.
I am a member of the American Finance Association, the American Economics 17 Association, the Financial Management Association, various regional finance associations, and Beta Gamma Sigma, the National Business Administration 18 19 Honorary Society.
I 20 Q.
WHAT OFFICIAL POSITIONS HAVE YOU HELD IN THESE ASSOCIATIONS?
21 A.
I have served the Financial Manapment Association in several capacities, 22 including president.
I have served on the editorial board of the Journal of l
73 Finance, and I have been on the Boards of Directors of the Western, Midwest, 24 Eastern, and Southern Finance Associations. I was also named Beta Gamma Sigma 23 Distinguished Scholar fear 1979.
j 26 Q.
DR. BRIGHAM, WHAT IS THE PURPOSE OF YOUR TESTIMONY IN THIS RATE 27 CASE?
28 A.
I was asked to testify as to the fair rate of return on the common equity capital TEXAS LOWER & LIGIIT COMPANY
PAGE 4 of 36 of Texas Power & Light (TP&L).
1 Q. HOW IS YOUR TESTIMONY ORGANIZED?
2 A.
It is divided into eight sections:
3 (1)
L_egal and Economic Framenork.
This section reviews the reasons for 4
regulation and the legal and economic background of current regulatory 5
Practices.
6 (2)
Relationship with Texas Utilities Company. This section discusses TP&L's 7
affiliation with Texas Utilities Company and the effect of this affiliation on 8
TP&L's cost of capital.
g (3)
TP&L's Changing Investment Risk Status.
This section shows that the 10 utilities in general, including TP&L, have become more risky investments in 11 12 recent years.
(4)
Risk Premium Approach to Measuring the Cost of Equity. One method of 13 estimating the cost of common equity is the risk premium, or stock / bond 14 yield spread method. Under this approach, one adds a risk premium to the 15 rate of return on default-free ("riskless") U. S. Government bonds to 16 17 estimate the cost of equity. Using this procedure, I concluded that TP&L must earn a return in the range of 17.2 to 17.7 percent, plus a market value 18 19 adjustment, if it is to attract equity capital on terms that are fair to its 20 current stockholders.
21 (5)
DCF Approach. I also used another procedure, the DCF, or dividend yield P us growth rate approach, as a basis for my recommended rate of return l
22 23 which the Company must earn. The DCF metled produced a required rate 24 of return on equity in the range of 16.8 to 17.9 percent, plus a market value i
I 25 adjustment.
2G (6)
Market Value Adjustments.
The risk premium and DCF methods both 27 produce estimates of the cost of equity which must be adjusted in order to 28 provide for the issuance of new common stock. A market value adjustment TlX\\S POWER & LIGHT COMPANY
PAGE 5 of 36 factor in the range of 90 to 100 basis points must be added to the DCF or 1
g risk premium cost of equity to produce a fair rate of return for regulatory 2
3 Purposes.
4 (7)
Attrition. A utility n.ast be allowed a reasonable opportunity to actually 5
earn its fe'. _e of return on book equity. Fair and reasonable regulation requires that attrition, which is the tendency for earnings to be eroded by 6
rising costs pushing against fixed service rates, be dealt with appropriately.
7 8
(8)
Capital Niarket Changes. As a part of my analysis, I also reviewed changes 9
in capital market conditions in recent years. This review shows that the cost of capital to firms in general, including TP&L,is higher now than it has 10 11 been in most recent years.
12 O.
HAVE YOU PREPARED SO\\tE EXHIBITS TO BE USED IN CONNECTION WITH 13 YOUR DIRECT TESTIN10NY?
Yes, I have prepared an exhibit which consists of 5 schedules and a total of 14 14 A.
15 pages.
16 LEG AL AND ECONON11C FRAN1EWORK 17 18 Q. WOULD YOU EXPLAIN BRIEFLY THE ECONO \\i!C PURPOSE OF REGULATION, 19 AND TELL US HOW. ECONO \\ TIC CONSIDERATIONS AFFECT YOUR ESTIN1A-20 TION OF A FAIR RATE OF RETURN ON EQUITY?
21 A.
The electric utility industry is a natural monopoly--one firm can generally supply l
22 service to a given set of customers more cheaply than could two or more 23 firms--so economic efficiency calls for single firm operations. Accordingly, utilities are granted franchises and certificates to serve specified territories (in 24 25 Texas, these franchises and certificates are not exclusive).
I 26 Although single firm operations reduce costs, such firms also have the 27 potential for earning returns that are too high. Therefore, it is necessary for regulatory agencies to insure that the price utilities charge the public for service 28 l
TEXAS POWER & l.lGIIT CON!PANY m
PAGE 6 of 36 1
is fair. This question immediately arises: "What constitutes a fair price for 2
service?" The answer is generally formulated in terms of the rate of return that 3
investors carn on their investment, and prices are set so as to cover costs and 4
Produce a target rate of return. However, this immediately raises.a second 5
question: "What constitutes a fair rate of return on invested capital?"
6 The fair rate of return depends upon the cost of capital to the utility, with 7
capital coming in three forms: debt, preferred stock, and common stock. Since 8
debt and preferred stock are contractual obligations with fixed and known 9
charges, one can ascertain their costs direcuy and accurately merely by examin-10 ing the firm's financial statements. The cost of common equity is much more 11 dif ficult to determine, although two landmark United States Supreme Court cases 12 do provide a framework for addressing this issue. First, in Bluefield Water Works 13
& Improvement Co. v. Public Service Commission of West Virginia,262 U. S. 679 14 (1923), the Court made the following statement:
15 16 "A public utility is entitled to such rates as will permit it to earn a return on the value of the property which it employs for 17 the convenience of the public equal to that generally being made at the same time and in the same general part of the 18 country on investments in other business undertakings which are attended by corresponding risks and uncertainties; but it has no 19 constitutional right to profits such as are realized or antici-pated in highly profitable enterprises or speculative ventures.
20 The return should be reasonably sufficient to assure confidence in the financial soundness of the utility, and should be adequate, 21 under efficient and economical management, to maintain and support its credit and enable it to raise the money necessary for 22 the proper discharge of its public duties."
23 This decision was amplified in the Hope case (FPC v. the Hope Natural Gas Co.,
24 320 U.S. 591,603 (1944)) when the Court made this statement:
25
... The return to the equity owner should be commensurate with returns on investments in other enterprises having corres-26 ponding risks. That return, moreover, should be sufficient to assure confidence in the financial integrity of the enterprise, so 27 as to maintain its credit and to attract capital."
28 Between them, the Hope and Bluefield cases established the general economic TEXAS IUWER & l.IGiIT CONII%NY
PAGE 7 of 36 criteria for setting a fair rate of return.
j 2
Q.
ARE THE HOPE AND BLUE _ FIELD CASES CONSISTENT WITH THE TEXAS PUBLIC UTILITY REGULATORY ACT?
3 4
A.
Yes, I have read the Texas Act, and it does appear to be consistent with the Hope and Bluefield decisions.
5 6
Q. ARE THE METHODS THAT YOU USE CONSISTENT WITH THE BLUEFIELD AND HOPE DECISIONS?
7 8
A.
Yes, they are, at least with regard to setting a minimum rate of return a utility 9
should be allowed to earn. Although neither the risk premium nor the DCF method as they are used today had been developed at the time the Bluefield and 10 Hope cases were tried, the proper use of these methods will assure investors' 11 confidence in the financial integrity of a utility enterprise, maintain its credit, 12 and enable it to attract capital.
13 14 TEXAS UTILITIES 15 16 Q. HOW DOES TP&L'S REL ATIONSHIP WITH TEXAS UTILITIES AFFECT YOUR 17 ESTIMATE OF TP&L'S COST OF EQUITY?
18 A.
In determining the market value cost of equity for a wholly-owned subsidiary such 19 as TP&L, an estimate of the holding company's cost of equity can serve as a proxy 20 for the subsidiary's cost of equity. This procedure is necessary for the DCF 21 approach because (1) the subsidiary's common stock has no separate market value 22 and (2) all new common equity for the subsidiary is obtained by the holding 23 company from the general public. A reasonable estimate of the DCF cost of 24 equity for TP&L can be obtained by examining data on Texas Utilities.
25 Q. WOULD TP&L'S COST OF COMMON EQUITY BE THE SAME OR DIFFERENT IF 26 IT OPERATED INDEPENDENTLY RATHER THAN AS A PART OF THE TEXAS 27 UTILITIES SYSTEM?
28 A.
Its cost of common equity would not be changed materially, although it might be TEXAS LOWER & l.lGifT COMPANY
\\
\\
PAGE 8 cf 36 slightly higher if it were not a part of the Texas Utilities System. As a larger, 1
more diversified company, Texas' Utilities as a whole enjoys greater diversifica-2 tion than its individual operating subsidiaries. In effect, risks are pooled, so the 3
risk of the whole is less than the sum of the risks of the parts.
4 5
Q. IS TP&L'S COST OF COMMON EQUITY CAPITAL IDENTICAL TO TEXAS UTILITIES' COST?
6 I
7 A.
To the best of my ability to measure it, I see no difference between the cost of common equity capital to Texas Utilities and to TP&L. As I noted previously, if 8
there is a difference, it is extremely slight. Therefore, in my DCF analysis, I use 9
10 Texas Utilities as a proxy for TP&L.
11 CHANGING INVESTMENT RISK OF TP&L AND OTHER UTILITIES 12 Q. HAS THE RISK OF TP&L, AND OF THE UTILITIES IN GENERAL, CHANGED IN 13 )
14 RECENT YEARS?
15 A.
Yes. Back in the 1950's and early to mid-1960's, TP&L and other utilities were 16 viewed as being less risky than most other companies. More recently, because of I
17 inflation, regulatory lag, environmental concerns, fuel shortages, nuclear prob-18 lems, and the like, the utilities' investment risks have increased to the point 19 where an average electric utility today is perceived to be about as risky as an 20 average large industrial company. This conclusion is supported by the data in 21 Schedule 1, and more specifically by the analysis contained in a paper entitled 22 "The Risk Premium Approach to Estimating the Cost of Common Equity Capital,"
23 which I presented at the Iowa State Regulatory Conference in May,1980, and 24 updated in February,1981. I have done other work which goes into detali as to 25 why utilities' risks have increased, but the cited paper quantifies the extent of 26 both changes over time and changes in the current position of the utility industry l
27 vis-a-vis industrial companies.
(
28 Q. COULD YOU SUMMARIZE BRIEFLY THE FINDINGS OF YOUR STUDY TENAS POWER & LIGHT COMPANY
PAGE 9 of 36 REGARDING WHY THE UTILITIES' INVESTMENT RISKS HAVE INCREASED?
i 2
A.
Yes. The major reasons include the following:
3 (1)
Inflation _. Utilities can only raise prices after lengthy regulatory hearings.
If costs rise, but prices are fixed, then profits will be squeezed as time goes 4
5 by. Therefore, if a utility were originally earning profits that provided a fair rate of return on invested capital, then inflation would tend to erode 6
the earned rate of return and to drive it below the cost of capital.
7 This problem is compounded because most of TP&L's and other 8
utilities' investment is mandatory-when people turn the switch, the lights 9
10 should go on, so TP&L must invest to meet demand anticipated ten or more 11 years into the future. This investment must be made even though current 12 returns are below the cost of capital.
The inflation / regulatory lag problem is also compounded in many 13 jurisdictions by political pressure applied by consumer groups in an effort to 14 15 hold rates down. Of course, it is proper to hold rates to reasonable levels.
However, there is a danger that utility rates will, because they are the focal 16 17 Point of so much consumer pressure, be held to levels that prevent TP&L 18 and other utilities from actually earning their costs of capital.
19 (2)
Increased forecasting dif ficulty. Back when prices were declining, or at 20 least stable,it was easy to forecast future demand for electricity. Further, 21 plants could be built in only a few years, so the forecast period was not long.
l 22 Now there is far greater uncertainty about future demand, and the period of 23 the forecast is much longer, for to take a large coal or nuclear plant from 24 inception to completion requires at least eight to twelve years.
- Thus, 25 utilities have become hostages to a much longer and more uncertain future.
i 26 (3)
Uncertainty about fuel cost and availability. Fears of fuel shortages and 27 uncertainty about fuel prices are also problems. The 1978 coal strike, and 28 the r-tent (and continuing) questions about the availability and costs of TESAs LOWER & l.lGIIT COMI'ANY
PAGE 10 cf 36 1
natural gas, nuclear fuel, and oil, suggest that this uncertainty will continue.
i 2
Fuel adjustment clauses reduce this risk somewhat, but high service rates 3
might cause customers to reduce their demand for power, thus compounding 4
the forecasting problem. This is especially important for a company such as 5
TP&L, which currently uses natural gas for a major part of its generation, 6
but which will, under the Fuel Use Act of 1978, be required to severely 7 ]
restrict its use of gas as a boiler fuel after 1989.
]
(4)
Pollution abatement.
Fears about the ultimate impact of the evolving 8
9 pollution control requirements 'ncrease the utilities' risks and uncertainties.
10 Both the installation and the operation of pollution abatement equipment 11 are expensive. Even worse, a utility may install equipment that r$eets 12 stated standards and then find, a few years later, that the standards have 13 been changed, necessitating expensive retro-fits.
Questions about the 14 disposal of nuclear wastes and negative salvage values are important parts 15 of this issue.
16 (5)
Nuclear safety. The question of nuclear safety has been with us as long as 17 we have had nuclear power, but the recent 'three Mile Island accident has 18 heightened investors' awareness of this issue.
New plants may at be f
19 licensed, and existing plants may be closed either permanently or for 20 prolonged modifications. All of this could adversely affect customer costs, 21 utility earnings, and stock prices.
Currently, few if any utilities are 22 planning new nuclear plants because of these problems, but many utilities, 23 including TP&L, began the design and construction of nuclear units in the 24 past, when such action was encouraged by a national policy which was based 25 on sound economic analyses. For those utilities with large investments in 26 unlicensed plants, the risks are especially great.
27 (6)
Earnings quality.
The quality of utilities' reported earnings has deteri-28 orated.
In essence, quality involves both predictability and liquidity.
TEXAS POWER & LIGIIT COMPANY
PAGE 11 of 36 Predictability encompasses both volatility over time and the chance of a 1
2 Permanent erosion of earning power, while liquidity refers to cash available for current use. Most utility companies' earnings have become more volatile 3
in recent years, and, as the General Public Utility (GPU) situation has 4
5 shown, utilities are also exposed to the risk of long-run earnings declines.
6 Liquidity is reduced by AFUDC paper profits resulting from the failure to 7
allow CWIP in the rate base.
8 Earnings quality reflects a number of different factors. First is the matter of financial leverage--how much debt and preferred stock is in line 9
10 for the Company's income ahead of the common stockholders? If a great 11 deal of debt and preferred is at the head of the line, then even a small 12 decline in operating income can cause low or even negative earnings for the 13 common stockholders.
14 The second quality factor relates to the source of the earnings, 15 whether from cperations or from the accountant's pen. TP&L and other 16 utilities get income (1) by producing and selling electricity and (2) by 17 multiplying an allowed rate of return (the AFUDC rate) times the 18 Company's construction work in progress (CWIP):
19 Addition to Reported Income,
[
\\.
i(AFUDC)(
)
Il CWIP called Allowance for Funds
=
ate I
20 Used during Construction (AFUDC) 21 AFUDC income is not cash, so it cannot be used to pay interest or dividends.
22 The best way of measuring earnings quality and the exact impact of 23 earnings quality on the cost of capital have been hotly debated, but there is 24 no question about the fact that earnings quality does indeed have a 25 significant impact on the cost of capital.
26 (7)
Governmental regulations. Although governmental regulations were men-27 tioned in connection with several points made earlier in this discussion, their 1
28 impact is of sufficient rnagnitude to warrant further consideration. Utilities
(
TEXAS l'OWER & LIGliT COMIMNY
I PAGE 12 cf 36.
such as TP&L are facing an increasing number of federally mandated I
regulations which heighten uncertainty about the future riskiness of their 2
3 Operations. Some of the areas of particular concern include regulations 4
under the following acts and/or agencies:
5 (1)
Environmental Protection Agency 6
(2)
Nuclear Regulatory Commission 7
(3)
Power Plant and Industrial Fuel Use Act of 1978 8
(4)
Public Utility Regulatory Policies Act of 1978 9
(5)
Federal Strip Mining Act All of the above are intended to protect and benefit the general public.
10 11 However, they also have adverse effects on utilities in terms of both costs 12 and the ability to get the job done.
Specifically, these regulations (1) 13 increase the length of time necessary to complete a facility, (2) often 14 change in mid-stream the engineering design and, consequently, the schedul-15 ing and cost of a construction project, (3) impose untried and unproven 16 technologies or theories in order to meet the required standards, which can 17 result in unequal or disproportionately burdensome impacts on different 18 segments of the industry or nation, and (4) most importantly, generally 19 increase both the construction and the operating costs of a project or 20 function which must ultimately be passed on by the utility to its customers 21 if the utility is to remain viable. Utilities take much of the blame for these 22 problems and cost increases in the eyes of the public, and this increases the 23 utilities' political dif ficulties.
24 25 All of the factors discussed above-inflation, regulatory lag, mandatory 26 investment, forecasting difficulties, uncertainties about fuel costs and avail-27 ability, environmental considerations, the decline in the quality of earnings, and 28 increased governmental regulations--have increased uncertainties about the TEXAS IUWER & LIGliT COMi%NY 1
PAGE 13 of 36 1
utilities' future investment performance, and this translates directly into higher 2
risks and a higher cost of capital.
3 Q.
HOW RISKY IS TEXAS UTILITIES RELATIVE TO THE AVERAGE ELECTRIC 4
UTILITY?
5 A.
Texas Utilities is currently less risky than most other electric utility companies.
6 TU's subsidiaries have the only bonds rated triple A by both Moody's and Standard i
7
& Poor's; TU's management is regarded as being exceptionally good; the Company 8
has developed ample supplies of low cost fuel; its capital structure is sound; its 9
coverages are relatively good; its earnings are of relatively good quality; its 10 service area's economy is enjoying a strong, well-balanced growth; and, perhaps 11 most important of all, the Texas Commission has operated in a more balanced, 12 responsible manner than most other commissions. For all these reasons, the 13 investment community regards Texas Utilities as being one of the strongest utility 14 systems in the nation, which has been to the benefit of its customers.
15 Q. DO YOU BELIEVE THAT IT 15 IN TP&L'S CUSTO\\1ERS' BEST INTERESTS THAT 16 THE CO\\1PANY MAINTAINS ITS STRONG FINANCIAL POSITION?
17 A.
Yes, I certainly do, and for three major reasons:
18 (1)
Lower cost of capital. TP&L has a much lower cost of debt, preferred, and 19 common equity than it would have if its financial strength were diminished.
20 For example, single A utility bonds sold today must carry an interest rate of l
21 about 15.5 percent versus 14.8 percent for triple A rated bonds. Since TP&L l
22 has long been rated triple A, its embedded cost of debt, which must be paid 23 by customers, is much lower than it would be if the Company's financial 24 strength were lower. The same thing holds true for common equity capital, 25 although it is not so easy to quantify the benefits. in any event, the fact 26 that TP&L is a financially sound company means that its cost of capital is 27 lower than it would otherwise be, and this certainly benefits customers.
28 (2)
Lower cost fuel and more economically efficient plants. TP&L's service
'IT.XAS POWER & LIGIIT COMPANY
PAGE 14 cf 36 area is growing rapidly, and it is also in the process of converting from gas 1
to coal and nuclear generation. Thus,it has a large construction program.
2 The Company's financial strength has enabled it to plan for and then build 3
4 the best, most efficient plants possible. The lignite plants are a case in 5
point. Because of its financial strength, the Company was able to secure 6
lignite fuel back in the 1950's, then to build cost-efficient plants to burn 7
this fuel as gas became more costly and scarce.
8 (3)
Service reliability.
An adequate, reliable supply of electrical power is 9
absolutely essential in our economy--without adequate power, our economy 10 simply could not function.
Thus far in the U.S., major shortages of 11 generating capacity have not developed, but in some regions reserves 12 forecasted for the future, given normal load growth, are dangerously low. In 13 this situation, the breakdown of a major plant, a cold winter or a hot 14 summer, or above-normal demand growth could trigger spot outages or even 15 chronic power shortages, which would disrupt economic activity and lead to 16 all kinds of hardships. Almost always, the reason for the low forecasted 17 reserves is financial weakness which caused construction program cutbacks.
18 Q.
IS THERE ANY EVIDENCE WHICH SUGGESTS THAT TEXAS UTILITIES SHOULD 19 NOT BE CLASSIFIED AMONG THE LEAST RISKY UTILITIES?
20 A.
Yes, there is. Texas Utilities' service area is growing far more rapidly than that 21 of most other utilities, which means that its construction program is relatively 22 large.
A more rapidly growing utility faces potential problems that a more 23 normal utility does not face. First, whenever a major plant is being built, there is 24 always the danger that it will not be completed on schedule and at the forecasted 25 cost, or that it will not operate as expected. Second, the addition of new plants is 26 a major reason for earnings attrition, so companies with large and continuous 27 construction programs are exposed to more danger of potential attrition than are 28 less dynamic companies. Third, rapidly growing companies are frequently selling TEXAS LOWER & l.lGliT CO5fl%NY
PAGE 15 of 36 new debt and preferred stock, whose marginal costs exceed their embedded costs, 1
and this too increases the dangers of attrition. Finally, rapidly growing utilities 2
are forced to sell a relatively large amount of 'new common stock, and if the 3
stock's price is below book value, stock sales will result in dilution and sub-4 5
sequently in lower future earnir:gs per share.
So, while Texas Utilities is currently in a relatively strong position, and its 6
risk, as measured by current statistical indicators, is lower than the industry 7
average, the Company could, because of its high growth rate and large construc-8 tion program, deteriorate more rapidly than most other utilities under a different 9
10 but certainly possible set of circumstances.
11 RISK PREMlUN1 METHOD 12 13 Q. PLEASE DESCRIBE THE RISK PREMlUM METHOD, AND EXPLAIN HOW YOU USED IT TO DETERMINE A FAIR RATE OF RETURN ON EQUITY FOR TP&L.
14 15 A.
This method recognizes that common equity capital is more risky than debt from an investor's standpoint, and that investors require higher returns on stocks than 16 17 on bonds to compensate for this additional risk. The risk premium approach is especially useful during periods of high inflation, because it highlights the 18 19 relationship among inflation, risk, and the cost of capital.
The basic idea behind the risk premium approach is indicated in Schedule 2 20 21 of my Exhibit. (The graph is meant to illustrate the concepts involved; it is not 22 meant to be an exact representation of the cost of capital situation in either 1965 23 or 1980.) The horizontal axis reflects risk--the further to the right a particular security lies, the greater its investment risk. Since U.S. Treasury bonds are free 24 25 of def ault risk, they are shown at the origin. The vertical axis gives required and SML are " security 26 rates of return, while the lines labeled SML1965198027 market lines" which show, at two points in time, the relationship between a 28 security's risk and its required rate of return.
TEXAS POWER & LIGIIT COMPANY
PAGE 16 of 36 The term RF designates the rate of interest on default-free securities as j
measured by the rate of interest on U.S. Treasury bonds. It consists of a "real," or 2
inflation-free rate (RR), plus a premium for expected inflation:
3 4
RF = Real rate + Inflation premium.
5 6
In the early 1960's, the default-free rate, RF, was only about 4 percent. In 7
1980, the expected long-term inflation rate was much higher, which resulted in a 8
9 much higher rate on long-term governments. (RF averaged about 11 percent during 1980, and it is currently almost 13 percent.)
10 Corporate bonds are riskier than U. S. Government bonds, so their yields are 11 higher. As the data in Schedule 4 show, high quality corporate bonds are yielding 12 close to 15 percent, and yields (and risk premiums) are still higher for lower-rated 13 14 corporate bonds. Therefore, if corporate bonds were plotted on t5e graph in Schedule 2, their risks would lie above the zero risk of U. S. Treasury bonds, and 15 16 their required returns would be higher.
Common stocks are riskier than corporate bonds; therefore, risk premiums 17 18 and consequently required returns on stocks are also higher than tr.ose on 19 corporate bonds. Our studies show that the risk premium on an average share of common stock (either utility or industrial) over long-term government bonds 20 varies over time, but it was generally well over 6 percent during the latter 1970's.
21 During 1980, rapid changes in both Federal Reserve policy and in expectations for 22 23 inflation combined to cause an unprecedented volatility in interest rates.
24 Fluctuating interest rates, in turn, caused volatility in bond prices. People have, 25 of course, always been aware of the possibility of bond price volatility caused by 1
changing interest rates (" interest rate risk"), but never before in history had such 26 27 sharp interest rate increases, and correspondingly sharp bond price declines, 28 occurred. This situation has narrowed somewhat the perceived risk differential i
l TEXAS POWER & LIGHT CON 1PANY
PAGE 17 of 36 between stocks and bonds, and consequently has lowered the stock-bond risk 1
2 Premium. On February 1,1981, the risk premium for industrials was down to 3
5.33%, while the corresponding figure for the utilities, 5.30%, was almost 4
identical.
5 Q.
WHAT IS THE BASIS FOR YOUR CONCLUSIONS REGARDING RISK PREMIUMS?
6 A.
I recently presented an extensive risk premium study covering the period 7
January 1,1964, to January 1,1980, at the Iowa State Regulatory Conference. In 8
that study, we developed risk premiums for large industrial and utility companies.
9 Schedule 3 of my Exhibit presents the major results of this study. We used 10 projected data from Value Line for the period 1966-1980, and we analyzed both 11 industrial and electric utility stocks. We subsequently updated the study on a 12 monthly basis during 1980, and down to February 1,1981.
13 Q.
PLEASE DESCRIBE IN GENERAL THE METHODOLOGY EMPLOYED IN YOUR 14 RISK PREMIUM STUDY.
15 A.
We estimated both expected rates of return and risk premiums for individual 16 companies using Value Line's projected data annually from 1/1/66 to 1/1/80, and 17 slso on a monthly basis during 1980 and for the first two months of '981. We then 18 determined the risk premium for the Dow Jones 29 Industrials and 11 Electrics as 19 a market value weighted average of the individual firms' risk premiums. A 20 summary of the 1966-1981 results is given in Schedule 3, Pages 1, 2, and 3. The 21 data show that risk premiums declined sharply during 1980 and 1981, primarily 22 because of the increased volatility of bond prices.
23 Q. WHAT IS YOUR CONCLUSION REGARDING THE AVERAGE RISK PREMIUM 24 FOR USE IN THIS RATE CASE?
l 25 A.
My analysis indicates that the risk premium of an average utility company today 26 is approximately 5.3 percent. Texas Utilities is somewhat less risky than an 27 average utility, and my analysis suggests that a risk premium in the ranse of 4 5 28 to 5.0% is appropriate.
h TEXAS 10WER & LIGIIT COMPANY
~
- m PAGE 18 of 36 1
1 Q.
HOW DID YOU USE THE RISK PREMlUM DATA TO DERIVE AN ESTIMATE OF i
2 TP&L'S COST OF EQUITY CAPITAL?
3 A.
To arrive at TP&L's cost of equity as indicated by the Risk Premium Analysis, I 4
Proceeded as follows:
5 (1)
I took as a starting point the rate of interert on long-term U, S. Treasury 6
bonds, which in early February 1981, as I was preparing this testimony, was 7
about 12.9% Schedule 4 shows data on recent bond yields. Bond rates have 8
been fluctuating, and the current 12.9% rate is somewhat above expecta-9 tions for long-term rates currently being reported by many analysts, and it 10 is also above rates as predicted by futures market interest. ate data.
11 Therefore, I used the average rate of interest currently being predicted by 12 the futures market,12.7%
13 (2)
Next, I considered the relative risk position of TU's stock. As already 14 indicated, TU appears to be regarded by investors as being less risky than 15 most utility companies. With the average utility having a premium of about 16 5.3%, a premium in the range of 4.5 to 3.0% is appropriate for TP&L.
17 (3)
I next added the Treasury bond rate to the risk premium to develop a market 18 value cost of capital estimate for TP&L:
19 Low end of range: 12.7% + 4.5% = 17.2%
Upper end of range: 12.7 + 5.0 = 17.7%
20 Q.
IF INTEREST RATES AND RISK PREMlUMS CHANGE BETWEEN THE TIME 21 YOUR TESTIMONY 15 FILED AND THE TIME ORAL TESTIMONY IS HEARD, 22 WOULD THIS CAUSE YOU TO REVISE YOUR ESTIMATED COST OF EQUITY?
23 A.
Yes. Interest rates and risk premiums do change over time, causing changes in 24 the cost of equity. Any changes that occur between the time the testimony is 25 filed and the time the record is closed should be reflected in the order.
26 27 DISCOUNTED CASH FLOW (DCF) METHOD l
l 28 Q. YOU INDICATED EARLIER THAT YOU ALSO USED THE DCF METHOD TO t
i i
TEXAS POWER & LIGIIT COMPANY l
PAGE 19 of 36 1
ESTIMATE TP&L'S MARKET VALUE COST OF EQUITY. PLEASE CXPLAIN HOW 2
YOU USED THIS METHOD.
3 A.
The discounted cash flow (DCF) method, which is sometimes called the " dividend 4
yield plus growth rate" method, recognizes that when' investors buy stocks, they 5
expect to receive a total return consisting of both dividends and capital gains.
6 While investors may in fact suffer capital losses rather than realize capital gains, 7
no investor would buy the stock of a utility, or of any other company, unless the 8
chances were regarded as good that the stock would increase in value as a result 9
of the reinvestment of earnings.
10 The DCF model actually blends the risk premium approach with an approach 11 based on expectations about dividends and growth in the future.
The DCF 12 required rate of return, which is called "k," is determined by competition in the 13 marketplace. It consists of a riskless rate of return, R, generally taken as the p
14 current yield on long-term U. S. Treasury bonds, plus a risk premium, RP:
15 k=RF + R P.
(1) 16 For common stocks, investors expect to receive their required return in the form 17 of dividends plus capital gains, and, if growth is expected to be constant, 18 k = D /PO + E*
g is the current price of the 19 Here D is the dividend expected during the year; PO g
20 stock; and g is the expected growth rate in earnings and dividends. Equation 2 is 21 the familiar "DCF cost of capital forme!2 that is of ten used in rate cases.
22 The DCF expected raturn (D /PO + g) must be equal to the required return:
g 23 Expected return = Required return 24 D /PO+g=Rp + R P.
g 25 This condition must hold, or else the stock is not in equilibrium. For example, 26 suppose the expected rate of return on a stock exceeded its required return. The 27 stock would be a bargain, so investors would start buying it and in the process 28 would push its price up and its dividend yield (D /P ) down until an equilibrium g O 1
TEXAS POWER & LIGIIT COMPANY
PAGE 20 cf 36 had been reached. It is a well accepted principle that over time stock prices do 1
indeed reflect equilibrium conditions. Thus, if the expected growth rate is a 2
constant, we can estimate k either as Rp + RP (the bond yield plus risk premium 3
4 methed) or as D /PO + g (the DCF approach).
Applied properly, these two 3
5 approaches should produce similar estimates.
6 Q. WHAT IS TU'S DCF DIVIDEND YIELD?
7 A.
TU's stock has recently been selling at a price of about $17.375 per share. Within the week preceding the date of this writing, February 12, 1981, the stock price 8
ranged from $16 5/8 to $17 3/4, and it closed near the midpoint of that range at 9
10
$17.375. Based on these facts, we can conclude that $17.375 is a reasonable estimate of the representative price at which one could actually buy or sell TU 11 12 shares, and a price which also reflects current expectations and market conditions. This price is not just an outlier representing a randomly high or low 13 14 trade.
According to most security analysts, Texas Utilities is expected to pay 15 16 dividends of $1.88 per share over the next twelve months.
Combining the 17 projected dividend, D3 = $1.88, with the current stock price, P0 = $17.375, we 18 obtain the expected dividend yield component:
(
19 Expected Dividend = D /P0 = $1.88/$17.375 = 10.8%
g 20 Yield l
HOW DOES ONE GO ABOUT DETERMINING THE ESTIMATED GROWTH RATE l
21 Q.
22 FOR USE IN THE DCF FORMULA?
l 23 A.
Because of inflation and other changing aspects of our economy, it is not appropriate today to predict a continuation of past growth trends; hence, we I
24 cannot base expected future growth rates on past growth rates. A method used by 25 many analysts to predict the long-term future growth rate involves multiplying 26 l
27 the fraction of the company's earnings that it is expected to retain (which we call i
"b") by the expected rate of return on book equity (ROE). The product is an 28 TEXAS POWER & I.lGHT COMPANY l
l PAGE 21 of 36 estimate of the future growth rate in both earnings and dividends per share (g):
1 g = b(ROE).
2 To apply the growth rate formula, we therefore need two numbers--the company's 3
expected retention rate (b) and its expected rate of return on book equity (ROE).
4 5
Q.
HOW DO YOU ESTIMATE THE TWO COMPONENTS, b AND ROE, IN THE 6
GROTTH EQUATION g = b(ROE)?
7 A.
TU's book value at year-end 1980 was $21.76 per share, and the projected value for 12/31/81 is $23.25. If the Company were to earn 15.5%, the rate of return the 8
Commission authorized TP&L in its last rate case, during the coming year on book 9
value of $22.50, which is the approximate average book value that will prevail 10 11 during WSI, then it would have EPS of about $3.49:
12 Projected EPS = 0.155 ($22.50) = $3.49.
13 If it paid the dividend of $1.88 which we have projected, then its retention rate 14 would be Retention rate = b = ($3.49 - $1.85)/($3.49) 15
= 0.46, or 46%.
16 17 Tith b = 0.46 and ROE = 15.5%, the growth rate would be 7.1%:
18 Growth rate = g = 0.46 (15.5%) = 7.1%.
19 This growth rate, combined with the current dividend yield, would produce total 20 returns of:
21 k : D /PO*E g
22
= $1.88/$17.375 + 7.1%
23
= 10.8% + 7.1%
24
= 17.9%
25 This is the situation that would exist if TU actually earned the return on equity 26 during the next year that the Commission authorized in the latest TU rate cases.
27 in fact, because of weather, and other factors, TU may well earn more or less 28 than 15.5 percent on equity during the coming year, so the carnings growth rate TENAS POWER & L.IGHT COMPANY
PAGE 22 of 36 i
for this one year may be different from 7.1 percent. Still, this is the situation 2
that would exist in a normal year, where normal is defined as a year when the 3
Company earns what the Commission has said it should earn.
Q. SUPPOSE INVESTORS ACTUALLY EXPECT TU TO EARN ONLY 14.5% ON 4
5 EQUITY, NOT THE 15.5% THAT IT IS PRESENTLY AUTHORIZED TO EARN BY THIS COMMISSION. HOW WOULD THIS AFFECT THE COST OF EQUITY?
6 7
A.
In this event, the growth rate would drop to about 6%, and the es"imated cost of 8
equity would fall to 16.8%. However,it should be noted that while TU and many 9
other utilities have frequently not earned their authorized rates of return in 10 recent years,it is well recognized that they must earn them in the future if the 11 industry is to be viable. Therefore, it is not unreasonable for investors to expect 12 TU and other companies to earn what their regulators say they should be able to Of course, the expectations of individual investors range somewhat for TU 13 earn.
14 and other utilities. Some investors expect TU and other utilities to continue to 15 earn inadequate, below-authorized returns.
Others expect the companies to 16 return to toe levels of the mid-1960's, when their earnings were about as high, and 17 of as high a quality, as those of the industrials. Actual market prices are set by 18 investors with expectations somewhere between these extremes, and, in my 19 judgment, the most reasonable expectation is (1) that commissions will authorize 20 utilities to srn fair rates of return and (2) that the companies will actually have 21 earnings which average out to their authorized levels over time. On this basis, 22 the 17.9% calculated above is a reasonable estimate of TU's DCF cost of equity 23 capital, before the market value adjustment.
24 Q. DOES THE DCF METHOD, AND ESPECIALLY THE g = b(ROE) METHOD OF 25 ESTIMATING EXPECTED FUTURE GROTTH, PRODUCE AN ACCURATE 26 REPRESENTATION OF THE GROWTH RATE WHICH INVESTORS EXPECT?
27 A.
The g = b(ROE) procedure matches investors' estimates of future growth only if 28 the following conditions hold:
,e l
e e
N
PAGE 23
.i 1.
Investors expect the company to retain a constant percentage of earnings in 1
the future. Investors never literally expect a constant retention rate, but 2
the assumption is satisfied if the best current estimate of the retention rate 3
during any future year is the same as the expected rate for any other future 4
5 year.
2.
Investors expect the company either to sell no new common stock, or to 6
7 make any sales at approximately the book value.
8 3.
Investors' best current expectations for the rate of return on book equity ir.
9 any future year are the same as their estimates for any other future year.
if these conditions hold true, at least to a reasonable approximation, then a good 10 estimate of the expected future growth rate can be obtained with the equation, if 11 these conditions are not met reasonably well, then the equation will not produce a 12 13 good estimate of investors' growth expectations. For a relatively stable company such as Texas Utilities, the formula provides a reasonable indicator of the 14 15 fong-term expected growth rate over the time horizon for which most investors 16 make their investment decisions.
17 Q.
IN TP&L'S LAST RATE CASE, YOU USED A NONCONSTANT GROWTH \\10 DEL 18 TO ESTIMATE THE DCF COST OF EQUITY.
DID YOU APPLY THE NON-19 CONSTANT MODEL IN THIS CASE?
20 A.
In December 1979, v^en I was preparing my testimony in the last case, TU's ROE 21 was only 12.2%, wc!! below the authorized level. Consequently, investors were 22 projecting a spurt of catch-up growth that could not be sustained indefinitely.
23 Under those conditions, it seemed mandatory to apply the nonconstant growth 24 model. Today, however, TU's ROE, and consequently its earnings, are above tie 25 depressed 1979 levels, and the assumptions of the constant growth model seem to 26 be met reasonably well. Nevertheless, I did apply the nonconstant model. Based 27 on the same methodology I used in the last rate case, I obtained a DCF cost of 28 capital estimate of 16.8%, which in my opinion would be a most conservative TEXAS LOWER & LIGIIT COMPANY
PAGE 24 of 36 1
estimate.
2 Q. WHAT DCF MARKET VALUE COST OF EQUITY SHOULD BE USED IN THIS 3
R ATE CASE?
4 A.
My analysis suggests that the DCF cost of equity lies within the range of 16.8% to 5
17.9%:
6 Lower end of range: 10.8% + 6.0% = 16.8%
7 Upper end of range: 10.8% + 7.1% = 17.9%
8 Q. IS YOUR DCF ESTIMATE CONSISTENT WITH VALUES ACTUALLY USED BY 9
INVESTORS?
10 A.
Yes. My own personal forecasts for TU are not relevant--the relevant forecasts 11 are those of investors in the market. Therefore, in my analysis I have paralleled 12 the process that most analysts go through when they estimate returns which are 13 then reported to investors and used as a basis for investors' decisions.
14 It is clearly impossible to ascertain the actual expectations of all investors 15 in the marketplace. However, analysts do occasionally publish their forecasts for 16 TU and other companies. For example, the Value Line Investment Survey, the 17 largest independent advisory service in the U. S., issued a report on TU dated 18 January 30, 1981. Value Line reported an expected dividend yield of 10.4% (based 19 on an $18 price) and an expected growth yleid of 7.6%, which, when totalled, 20 results in a cost of equity of 18%. This is very close to the upper end of my DCF 21 estimate.
22 The Value Line analysts follow standard estimating techniques, and this 23 service is subscribed to by more individual and.nstitutional investors than any 24 other investment service. Additionally, the Value Line earnings estimates are 25 reasonably consistent with other analysts' forecasts that I have seen. The Value 26 Lir.e analysts, as well as analysts from other organizations, all use similar data 27 bases for making their forecasts, and they generally confer with company officials 28 to learn of new developments and to check on the reasonableness of their TI%\\S POWER & LIGIIT COM1%NY
PAGE 25 of 36 1
forecasts. For these reasons, at any point in time different security analysts 2
typically make relatively consistent earnings and dividend forecasts for a given 3
company, and especially for a utility company.
4 Value Line's forecasts have also been studied in depth by academic 5
researchers.
No forecasters are perfect, but the Value Line forecasts are 6
certainly better than simple projections of past earnings and dividends trends, and 7
they are generally as good as those of most other analysts.
8 For all these reasons, I feel that the Value Line estimate is a reasonably 9
good proxy for the views of investors in general. Therefore, I regard Value Line's 10 18 percent to be a reasonable estimate of TU's cost of equity, and it certainly 11 supports my own estimate.*
12 MARKET V%LUE AD3USTMENT Q.
DOES THE MARKET VALUE COST OF COMMON EQUITY REPRESENT A FAIR RATE OF RETURN ON BOOK EQUITY CAPITAL FOR TP&L?
15 TP&L should be permitted to earn a rate of return on book commor. equity A.
No.
16 that is somewhat higher than its market value cost of common equity. The 17 difference results from the fact that companies incur certain costs when they 18 issue new stock, and rates must be set at a level sufficiently high to cover these 19 costs.
20 9
HOW DOES ONE GO FROM A MARKET VALUE COST OF EQUITY TO A FAIR 21 RATE OF RETURN ON BOOK EQUITY?
22 l
A.
The approach which has traditionally been taken calls for adjusting the market 23 24
- Value Line ant other organizations forecast accounting data such as earnings and dividends, and they also forecast stock prices both in general and for each specific 25 company. Value Line and other analytical organizations are much better at fore-casting earnings and dividends than at forecasting stock prices. My use of Value Line 26 is confined to their earnings aad dividend forecasts. Also, a Public Utility Research i
27 Center Working Paper ("Value Line Forecasts versus Other \\nalysts' Forecasts,"
October,1980) analyzes the Value Line forecasts.
28 TEXAS IUWER & LIGIIT COMI%NY
PAGE 26 of 36 value cost of equity up to a level which would cause the stock price to sell at j
about 10 percent over its book value. Other approaches, which have some basis in 2
finance theory, have been suggested. However, since these other approaches have 3
weaknesses in practical application, I prefer to use the traditional appioach.
4 5
Q.
PLEASE EXPLAIN HOW THE TRADITIONAL APPROACH OPERATES.
6 A.
The logic behind the Traditional Approach is as follows:
7 (1)
TP&L should be able to provide reliable service on demand within a reasonable period of time. This means that it must build the required plant 8
9 well ahead of anticipated demand. The construction program requires a large amount of capital, and the nature of electric power construction 10 dictates that, for maximum efficiency, the program be continuous, not of a 11 12 start /stop nature.
13 (2)
Because of its mandatory construction program, TP&L is required to make recurring trips to the capital markets, including the equity capital markets 14 15 (through Texas Utilities). It is a well-known fact that, if a company sells 16 stock at less than its book value, the book value of the previously 17 outstanding shares will be diluted.
Further, since TP&L (hence Texas Utilities)is allowed a return on the book value of its common equity, if book 18 value per share is diluted, then so will be the target levels for earnings and 19 20 dividends per share, and also the market price per share.
21 (3)
TP&L is required to raise capital in order to serve the public and, if part of this capital must be obtained by selling stock at less than book value, then 22 23 the effect,in economic terms,is a confiscation of stockholders' investment.
[
24 (4)
Therefore, TP&L and the other Texas Utilities subsidiaries should be l
permitted to earn a return that is high enough to keep Texas Utilities' M/B 25 2G ratio sufficiently above 1.0 to permit the sale of stock at prices equal to or i
27 grea:;c than book value.
28 (5)
If there were no flotation costs, if there were no market pressure on a TEXAS IMER & LIGIIT COMI%NY
PAGE 27 of 36 o
company's stock when it brings out a new issue, and if stock prices did not 1
fluctuate over time, then new shares could be sold without diluting the book 2
3 value simply by maintaining the market / book ratio at 1.0. However, there 4
are costs of floating new equity issues; there is pressure on the stock when a-5 new offering is made; and stock markets do fluctuate. Therefore, if the Commission were to set rates designed to produce a target M/B ratio of 1.0, 6
7 then new stock would certainly have to be sold at less than book value, thus 8
diluting the value of the outstanding stock and confiscating part of the value 9
of the equity. Consequently, rates should be designed to produce a target 10 market / book ratio above 1.0.
11 Q.
BY HOW MUCH SHOULD THE TARGET M/B RATIO EXCEED 1.0?
12 A.
I believe that the most reasonable figure, based on the capital attraction standard 13 as set forth in the Hope case, is 1.10. This would allow for flotation costs of 14 about 4 percent, for market pressure of about 2 percent, and for a 4 percent break 15 in the stock market during the underwriting period. Therefore, if Texas Utilities' 16 subsidiaries were earning a return on book that produced a M/B ratio of 1.10, then TU could generally sell new common stock at a price that would about equal the 17 18 book value of the outstanding shares and, thus, avoid dilution of book value and 19 confiscation of the existing stockholders' economic value.
Q. WHAT AD3USTMENT TO MARKET VALUE COST OF EQUITY WOULD BE 20 21 REQUIRED TO CAUSE TEX AS UTILITIES TO SELL AT A M/B RATIO OF 1.10?
22 A.
The return on book equity must be approximately 1.0 percentage points above the 23 market value cost of capital in order to produce a M/B ratio of 1.10. The 1.0 24 percentage point adjustment is developed as follows:
It can be shown that the M/B ratio is determined in the following 25 a.
26 way:
(1 - b) (ROE) 27 M/B k - b (ROE) 28 TEXAS POWER & LIGIIT COMPANY
PAGE 28 of 36 1
Here b is the fraction of earnings retained, ROE is the return on book
(
2 equity, and k is the market value cost of equity.
3 4
b.
If we let M/B = 1.10 and b = 0.4, then 5
0.60 (ROE) 1.10 k - 0.4 (ROti) 6 1.10k - 0.44 (ROE) = 0.6 (ROE) 7 1.04 (ROE) = 1.10k 8
ROE = (1.10/1.04)k 9
= 1.058k.
10 c.
If k = 16.8%, then ROE = (1.058)(16.8%) = 17.7%, while if k = 18%,
y ROE = 19%. Therefore, for k in the range of 16.8 to 18 percent, the adj stment necessary to attain a \\1/B ratio of 1.10 is 0.9 to 1.0 12 percentage points.
13 ATTRITION 14 Q.
WHAT WOULD BE THE RESULT IF RATES WERE NOT ACTUALLY SET HIGH 15 ENOUGH TO PERMIT THE COMPANY TO EARN ITS AUTHORIZED RETURN ON 16 COMMON EQUITY?
37 A.
If a commission correctly estimates a company's true cost of capital, but sets 18 service rates that will not give the company a reasonable opportunity to earn this 19 cost of capital, then the company's stock will sell at a price below its book value.
20 In effect, the regulator would not be giving the Company a reasonable opportunity 21 of earning the very return which the regulator finds is reasonable and necessary.
22 Because of inflation, there is a tendency for a utility's earnings to be eroded over 23 time-costs rise because of inflationary pressures, but service rates are held 24 constant between rate cases. The result is a recurrent erosion in the actual ROE.
25 26 This phenomenon is called attrition, 27 Q.
WHAT CAUSES ATTRITION?
28 A.
The fundamental cause of attrition is inflation, but attrition itself may be divided TEXAS LOWER & I.lGilT COMPANY
PAGE 29 of 36 into three separate components which arise from (1) increasing operating costs,
(
1 2
(2) increasing plant cost per customer served, and (3) an increasing embedded cost 3
of debt and preferred stock. Each of these components is discussed below.
4 1.
Increasing Operation Costs. Inflation causes the costs of labor and other 5
items used by utilities to increase over time. The utilities do have fuel 6
adjustment clauses which permit higher fuel costs to be reflected in service 7
rates, but there is no automatic adjustment for the other components of 8
total cost. Bakeries raise bread prices to reflect higher production costs, as 9
do manuf acturers, grocers, apparel manufacturers, and so on; therefore, 10 inflation does not necessarily squeeze profit margins and returns on invested 11 capital for these unregulated firms.
Utility companies, however, are 12 squeezed between fixed rates and rising costs.
13 2.
Plant Additions. Under inflationary conditions, the investment required to 14 serve an average new customer is greater than the average investment per 15 customer currently being served.
Productivity improvements serve to 16 reduce this factor somewhat, but in recent years productivity gains have not 17 been sufficient to offset inflation in construction costs. Therefore, as new 18 plant is added, revenue requirements increase. For example, if the average 19 investment required to serve a customer amounts to $2,000, but new plant 20 costs $4,000 per customer, then the capital charge component of revenue 21 requirements will rise whenever new plant is added to plant in service.
22 Rates that were adequate to compensate investors will, af ter new plant goes 23 into servict be inadequate, and the rate of return will decline in the 24 absence of timely rate increases.
25 3.
Capital Cost Attrition.
Interest rates on debt (and yields on preferred 26 stock) reflect expectations about inflation. Therefore, an increase in the 27 rate of inflation means that new debt and new preferred will cost more than 28 the embedded cost. As a company expands and sells high-cost new debt and TEXAS POWER & LIGIIT CON!PANY
PAGE 30 of 36 1
Preferred to help finance this expansion, or refunds maturing debt issued in i
2 the past at low interest rates, then its embedded costs will rise. Service rates that were sufficient to cover the old cost of debt and preferred will be 3
4 inadequate to cover the new and higher cost. Thus, an inflation-induced 5
rising embedded cost of debt and preferred contributes to attrition.
6 7
Schedule 5 illustrates the attrition problem. Initially, the actual rate of 8
return is equal to the authorized rate, and the company is earning its cost of 9
capital. However, rising costs combined with fixed service rates, cause the actual 10 earned ROE to decline over time. When a rate case is decided and new service 11 rates go into ef fect, the actual ROE begins to rise. Af ter twelve months, the 12 actual ROE should hit the target allowed ROE, but, with continuous inflation, this 13 target is typically not attained.
14 Over time, the actual ROE will average less than the true cost of equity and 15 the authorized rate of return, if investors expect this situation to continue on 16 into the future, then the stock will sell below book value. Stockholders' equity is 17 being confiscated, because the company's service rates are not permitting it to l
18 earn the cost of capital, and any sales of new common stock will be especially 19 damaging because they will dilute the exist!ng book value.
20 Q.
HOW SHOULD THE COMMISSION DEAL WITH THE ATTRITION PROBLEM?
21 A.
Since attrition is primarily caused by inflation-induced cost increases, the most 22 direct approach is to buiH inflationary expectations into the cost of service 23 projected for the period when the rates will be in effect. Other methods, such as l
24 an attrition allowance added to the authorized rate of return. could be used, but l
l 25 in my judgment the most sogical approach is a cost of service adjustment.
l 26 If a commission does not make any sort of attrition adjustment, then it is 27 implicitly stating either one of two things: (1) it does not believe attrition will 28 continue in the future, which amounts to assuming that the inflation rate will fall l
l g TEXASlOWER&l.lGIITCOMPANY
PAGE 31 of 36 to a very low level (really, to a negative level)*, or (2) it is willing by its actions 1
g to force the company to earn less than its cost of capital. Since no one seriously 2
believes that the U. S. inflation rate is going down close to zero in the foreseeable 3
4 future, the first position is obviously invalid. The second position is arbitrary, confiscatory, and somewhat hypocritical. In effect, a comm!ssion that takes the 5
6 second position is telling the utility that it should be earning k percent, but then the commission is setting rates that give the company no reasonable opportunity 7
8 to earn k percent.
9 The major argument against attrition adjustments seems to be the fact that 10 such adjustments ne.:essarily involve estimates, not precise data. However, the 11 entire ratemaking process involves estimates, so there is nothing inherently wrong 12 with estimating an attrition adjustment. Indeed,it is conceptually better to make 13 an attrition adjustment which is approximately correct than to make no adjust-14 ment at all and thereby be precisely wrong.
15 In summary, in an inflationary economic environment, the combination of 16 fixed service rates and rising costs will lead to rate of return attrition. If this 17 attrition is not dealt with in some manner, then the utility will not be given a 18 reasonable opportunity to earn the rate of return the commission says it should be 19 earning. Therefore, to avoid de facto economic confiscation of stockholders' 20 value, as well as for internal consistency in their own decisions, commissions 21 simply must address the attrition issue.
22 23
- Even if the rate of inflation were to drop to zero - which is a most unrealistic 24 assumption - attrition would still continue. The average cost of capacity built in the 25 past is much lower than capacity added today. Therefore, even if inflation went to 26 zero, new plant additions would cost more than existing plant, and, hence, would lead to 27 attrition.
73 TEXAS l'OWER & 1.lGilT COMi%NY
PAGE 32 of 36 CAPITAL MARKET CHANGES 1
Q. WHAT TRENDS HAVE OCCURRED IN THE CAPITAL MARKETS IN RECENT YEARS, AND WHAT DO THESE TRENDS SUGGEST ABOUT TP&L'S ALLOWED 3
RATE OF RETURN?
4 A.
Interest rates have risen dramatically in recent years. This is clearly revealed by the following data:*
Annual Average February 6
1977 1978 1979 1981 7
Long-term Treasury bonds 7.67 %
8.49 %
9.29%
12.98 %
8 Aaa Utility bonds (New Issue) 8.19 %
8.96 %
10.03 %
14.84 %
9 Since the costs of debt and equity move in the same direction, these figures show 10 very clearly that the cost of capital to TP&L and other utilities has increased 11 substantially since 1977.
12 Q.
HOW HAS TU'S STOCK PERFORMED IN COMPARISON TO OTHER STOCK 13 GROUPS IN RECENT YEARS?
14 A.
As the following data show, both TU's and the average utility's stocks have 15 performed worse than have industrial stocks.
16 STOCK PRICES **
17 1977 1978 1979 February % Change Average Average Average 1981 from 1977 18 Industrial 57.84 58.30 61.82 85.58
+47.96 19 Utility 40.91 39.23 36.46 37.75
-7.72 20 TU 21.13 20.13 18.10 17.375
-17.77 21 22 23
- Sources: For 1977,1978, and 1979 data: Federal Reserve Bulletin, January,1980.
24 For 1981 data: the Wall Street Journal, February 12,1981.
I 25 The Aaa utility bond is the Southwestern Bell 141/4s of 2020.
26 l
27 l
- High-low average 28 TEXAS IUWER & LIGliT CONIPANY
PAGE 33 of 36 I
1 Again, the stock market data reinforce the conclusion that the cost of equity has 2
risen and that the return on equity should be increased.
3 Q.
ARE THERE ANY OTHER DATA WHICH SHOW THAT TP&L AND OTHER 4
UTILITIES ARE NOT EARNING THEIR COSTS OF CAPITAL AND NEED RATE -
5 INCREASES?
6 A.
Yes. If a utility's stock is selling at less than its book value, this indicates that 7
the Company is earning less than its cost of capital. If the cost of capital rises 8
because of inflation and other factors, but service rates are not raised suficiently 9
to cover these higher costs, then market prices and, consequently, market / book 10 ratios will decline.
The following data show that this situation has indeed 11 occurred in recent years:
12 13 Market / Book Ratios Feb
% Change 14 1977 1978 1979 1981 from 1977 15 Industrial 1.30 1.23 1.26 N/A N/A 16 Utility 0.95 0.83 0.78 0.71
-25.3 17 TU l.15 0.94 0.85 0.80
-30.4 18 19 Data on the industrials' 1981 M/B ratios are not available, but since industrial 20 stock prices have risen 38.4 percent since 1979, while their book values have 21 increased by only about 10 percent, it is obvious that industrial M/B ratios have 22 actually risen. In any event, these data show very clearly (1) that TU and the 23 other utilities have not been earning their costs of capital, (2) that utility 24 stockholders have been forced to subsidize ratepayers, which amounts to 25 economic confiscation, and (3) that this economic confiscation will be accelerated 26 when companies sell new common stock at below book value to finance their 27 ccostruction programs. Also, in view of the utilities' very poor performance 28 vis-a-vis unregulated companies, it is clear that the utility industry, including TU, TEXAS IUWER & LIGitT CO.\\f PANY
PAGE 34 of 36 will be unable to do its job of supplying power in the long run unless rates are --
I t
raised sufficiently to cover all costs, including the cost of capital.
2 3
SUMMARY
4 5
Q.
WOULD YOU PLEASE SUMMARIZE YOUR TESTIMONY?
6 A.
Yes. My assignment was to estimate TP&L's cost of equity capital. In carrying 7
out this task, I began by examining the way in which the Company's risk as an 8
investment has changed over time. For a variety of reasons, TP&L and other 9
utilities have become more risky in recent years than they were in the 1950's, 10 1960's, and early 1970's.
I combined the information on TP&L's riskiness with (1) a risk premium in 11 12 the range of 4.5 to 5.0% that we have developed at the University of Florida and J
13 (2) a market forecasted 12.7% rate of interest on default-free U. S. Treasury 14 bonds, to develop an estimate of the Company's market value cost of capital.
15 Based on the risk premium method, I estimate that TP&L's market value cost of 16 common equity is app'roximately 17.2 to 17.7%.
17 The market value cost of capital is not a fair rate of return on book equity 18 for any company which must raise new equity by selling common stock. If TP&L 19 and the other TU subsidiaries were earning their market value cost of common 20 equity, then TU's stock would sell at book value. However, when new stock is l
21 sold, flotation expenses and market pressure would reduce the net proceeds of the 22 issue below book value, thus diluting the existing stockholders' equity and l
23 confiscating part of their investment.
Accordingly, the Company should be i
24 allowed to earn a return on its book common equity that is about 90 to 100 basis l
l 25 points above the " bare bones" market value cost of equity.
l 26 I also estimated the cost of equity by the discounted cash flow (DCF) l 27 method. My DCF cost of capital estimate is in the range of 16.8 to 17.9%.
J 28 Again, an adjustment, estimated to be in the range of 90 to 100 basis points, is TEXAS POWER & LIGHT COMPANY l
\\
PAGE 35 of 36 necessary to go from a DCF rate of return to a fair rate of return on book value.
j in summary form, my estimates of TP&L's fair rate of return en equity are s
2
'5 f0lIO*S:
3 4
RISK _PREMlUM METHOD 5
Treasury Risk Market Value 6
Bond Yield Premium Adjustment k
7 Lower end 18.2 %
1.0%
=
4.5%
8 of range:
12.7 %
+
+
9 Upper end 18.7 %
1.0%
5.0%
=
of range:
12.7 %
+
+
10 DCF METHOD _
11
" Bare Bones" Market Value 12 Return Adjustment k
13 Lower end 17.7 %
0.9%
or range:
16.8 %
=
+
Upper end 18.9 %
j 1.0%
15 of range:
17.9 %
=
+
16 17 Based on these figures, TP&L should be allowed to earn a return on common 18 equity in the range of percent 17.7 to 18.9 percent.
19 Q. HAVE YOU CONSIDERED THE INCLUSION OF CWIP IN THE RATC BASE AS 20 REQUESTED BY THE COMPANY IN YOUR TESTIMONY?
21 A.
Yes, I have.
It is my understanding that the Company's request includes 1
22 approximately $637 saillion of CWIP in the rate base. Should the Company's
)
1 23 rer;uested CWIP treatment not be granted, then the allowed return on common i
24 should be set toward the upper end of the range.
Q. DO YOU BELIEVE THAT ATTRITION WILL IMPACT TP&L IN 1981 AND 1982?
25 1
26 A.
Attrition is a fact of life for all utilities. Since utilities have fixed service rates, 1
or prices, and since costs tend to rise over time due to inflation, it is obvious that 27 28 there will be a tendency for profits to be squeezed and for the earned rate of i
TEXAS POWER & LIGliT COMPANY
PAGE 36 of 36 1
return to be eroded during the period between rate cases. Therefore, if the 1
Company is to have a realistic chance of actually earning its authorized rate of 2
return, and thus be able to sell its common stock at a p-ice which wili not result 3
in dilution of the book value of outstanding shares and confiscation of existing 4
stockholders' economic value,then attrition must be dealt with in some manner.
5 6
Q. DOES THIS CONCLUDE YOUR TESTIMONY?
7 A.
Yes, it does.
8 9
10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 I EXAS POWER & LIGHT COMi%NY
Exhibit EFB-1 Schedule 1 Page 1 of 8 AFUDC/ Net income Ratios, 1960-1979 S&P 399 Compustat Texas Year Industrials Electric Utilities Utilities 1960 Not Applicable 6.56 %
3.62 %
1961 Not Applicable 5.25 1.25 1962 Not Applicable 5.01 1.97 1963 Not Applicable 4.06 1.15 1964 Not Applicable 4.05 1.44 1965 Not Applicable 4.09 3.86 1966 Not Applicable 5.16 2.93 1967 Not Applicable 7.17 3.47 1963 Not Applicable 10.23 5.35 1969 Not Applicable 14.17 7.96 1970 Not Applicable 19.73 10.31 1971 Not Applicable 25.13 15.83 1972 Not Applicab!e 29.39 11.98 1973 Not Applicable 32.06 14.66 1974 Not Applicable 39.31 18.80 19H Not Applicable 34.98 27.13 1976 Not Applicable 33.60 33.67 1977 Not Applicable 36.86 33.30 1978 Not Applicable 40.93 26.88 1979 Not Applicable 50.04 28.24 Source: Compustat Industrial and Utility Tapes.
Note: This is not applicable to the S&P 399 Industrials. The sum of AFUDC over all companies in a group is divided by the sum of net income over all companies.
E (AFUDC);
AFUDC/ Net Income = v (Net income)1 4
~
'-+
_s___.
Exhibit EFB-1 Schedule 1 Page 2 of 8 Dividend Payout Ratios, 1960-1979 S&P 399 Compustat Texas Year Industrials Electric Utilities Utilities 1%0 31.77 %
67.55 %
60.00 %
1961 54.15 67.33 63.22 19(2 49.96 65.71 58.33 1963 47.08 66.59 54.55 1964 43.04 65.43 56.64 1965 42.19 65.28 57.14 1966 41.03 64.46 57.83 1967 44.47 64.99 56.93 1968-44.68 67.43 59.26 1969 46.18 66.17 55.81 1970 51.11 67.55 34.05 1971 47.77 67.24 56.25 1972 41.18 63.04 51.81 1973 33.43 65.63 53.61 1974 30.93 69.80 54.63 1975 34.35 64.80 63.92 1976 31.88 64.76 57.64 1977 35.24 67.50 58.33 1978 34.34 68.25 59.84 1979 30.83 70.09 66.94 Source: Compustat Industrial and Utility Tapes; Company Reports.
Note: The average ratio is obtained by dividing the sum of the dividends per share paid by all companies within the group, by the sum of the earnings per share of all companies within the group.
1 (DPS).
Average Payout Ratio =
E (EPS);
._..g-.
.-4
--e-
,,-m.,_---
_y,,
~p_..
y
.,y,
Exhibit EFB 1 Schedule 1 Page 3 of 8 Cash Flow Coverage of Dividends, 1960-1979 S&P 399 Compustat Texa Year Industrials Electric Utilities Utilit.es 1960 2.92x 2.72x 2.54x 1961 2.79 2.61 2.47 1962 2.98 2.74 2.64 1963 3.02 2.71 2.79 1964 3.10 2.68 2.61 1965 3.13 2.64 2.60 1966 3.32 2.60 2.60 1967 3.23 2.57 2.67 1968 3.39 2.50 2.56 1969 3.71 2.53 2.61 1970 3.56 2.41 2.67 1971 3.89 2.41 2.69 1972 4.13 2.50 3.12 1973 4.66 2.49 3.11 1974 4.81 2.45 3.09 1975 4.72 2.68 2.95 1976 4.80 2.84 3.08 1977 4.39 2.76 3.27 1978 4.60 2.55 3.37 1979 5.03 Not Available 2.81 Source: Compustat Industrial and Utility Tapes.
Note: The numerator of this ratio is the summation over all the companies of the sum of net income to common stockholders, depreciation allowances, and deferred taxes less AFUDC, and the denominator is the sum of the total dividends declared by all companies in the group.
1 (Netincometocommonstockholders+ Depreciation Cash Flow Coverage
+ Deferred taxes - AFUDC);
of Dividends E (Dividends Declared);
F
,v--
r
,a a
Exhibit EFB-1 Schedula1 Page 4 of 8 Equity Ratios, 1960-1979 S&P 399 Compustat Texas Year Industrials Electric Utilities Utilities 1960 36.99 %
38.38 %
1961 37.14 37.95 1962 80.13 %
37.65 38.77 1963 78.63 38.17 38.74 1964 78.75 38.75 40.26 1965 77.21 38.79 39.97 1966 74.43 37.72 39.44 1967 71.58 36.64 38.86 1968 70.14 35.49 37 98 1969 68.52 34.66 39.11 1970 66.45
-34.02 37.33 1971 66.95 33.84 38.24 1972 67.76 33.70 36.82 1973 68.48 33.74 39.63 1974 66.75 32.13 38.68 1975 67.55 33.38 34.87 1976 69.02 34.71 36.77 1977 69.03 35.49 35.83 1978 68.29 35.73 36.83 1979 68.09 35.66 38.65 Source: Compustat Indus rial and Utility Tapes.
Note: The numerator of this ratio is the sum of the year-end comn.cn equity for the n companies, while the denominator is the sum of the year-end common equity, the preferred stock, and the long and short term debt of all firms in the group.
E Year-End Common Equity; Equity Ratio =
1 (Common Equity + Preferred + Long-Term Debt +
l
[
Short-Term Debt);
l l
l l
l l
i l
l l
Exhibit EFB-1 Schedule 1 Page 5 of 8 Times Interest Earned, 1960-1979 S&P 399 Compustat Texas Year Industrials Electric Utilities Utilities 1960 21.54x 1961 20.93 5.24x 7.46x 1962 19.84 5.27 8.24 1963 20.44 5.29 8.59 1964 20.82 5.39 7.86 1965 19.94 5.34 7.64 1966 15.75 5.11 6.95 1967 12.24 4.70 6.58 1968 11.93 4.28 6.20 1969 8.83 3.76 6.48 1970 6.98 3.13 5.88 1971 7.99 2.96 4.85 1972 8.93 2.96 4.71 1973 9.49 2.82 4.54 1974 8.86 2.46 4.30 1975 7.70 2.67 3.48 1976 8.78 2.86
-3.39 1977 8.66 2.95 3.28 1978 8.11 2.88 3.40 1979 8.31 Not Available 2.92 Source: Compustat Industrial and Utility Tapes.
Note: The average ratio is computed by dividing the aggregate interest charges by the aggregate of the sum of net income af ter taxes, interest charges, deferred income taxes, and income taxes paid.
1 (Net Income + Interest + Deferred Taxes + Income Taxes);
Average Times interest Earned, TIE E Unterest);
l
- ~-
Exhibit EFB-1 Schedule 1 Page 6 of 8 Return on Equity, 1960-1979 S&P 399 Compustat Texas Year Industrials Electric Utilities Utilities 1960 11.35 %
10.77 %
14.66 %
1961 10.81 10.90 14.44 1962 11.82 11.38 16.17 1963 12.46 11.46 17.41 1964 13.42 11.84 16.47 l
1965 14.34 12.33 15.90 1966 14.30 12.70 15.62 1967 12.99 12.77 15.65 1968 13.75 12.23 14.87 1969 13.18 12.20 15.07 1970 11.33 11.79 15.43 1971 12.09 11.57 14.35 1972 12.90 11.80 14.93 1973 15.70 11.43 13.67 1974 15.88 10.44 12.65 1975 13.27 11.21 11.61 1976 15.37 11.47 12.92 1977 15.07 11.54 13.04 1978 15.56 11.23 13.13 1979 17.83 11.15 12.24 Source: Compustat Industrial and Utility Tapes.
Note: The aggregate of the net income to shareholders is divided by the aggregate of the average equity (defined as Beginning Tangible Equity plus Year-end Tangible Equity divided by 2.0):
1 (Net income to common shareholders);
1 Return on Common Equity, ROE Beginning Year-end Tangible Tangible
+
1 Equity Equity 2.0
.t i
l l
l Exhibit EFB-1 Schedule 1 Page 7 of 8 Price Earnings Ratios, 1960-1979 S&P 399 Compustat Texas Year Industrials Electric Utilities Utilities 1960 17.92 %
19.49 %
25.72 %
1961 22.44 23.52 30.50 1962 16.99 20.93 26.76 1963 18.49 21.35 25.81 1964 18.61 22.15 27.02 1965 18.32 20.13 25.86 1966 14.91 17.24 22.86 1967 19.93 15.21 21.80 1968 19.15 15.92 20.48 1969 17.43 12.64 18.71 1970 19.08 13.47 18.30 1971 19.52 12.69 18.42 1972 20.38 11.78 17.62 1973 12.72 8.72 11.79 1974 7.90 6.28 11.03 1975 11.72 8.20 10.75 1976 11.11 9.03 8.82 1977 9.05 8.76 9.38 1978 8.25 7.79 7.58 1979 7.49 7.33 7.24 Source: Compustat Industrial and Utility Tapes.
Note: The average price / earnings ratio is obtained by dividing the aggregate market value by the sum, over the companies in the group, of the net income available to common shareholders:
Price / Earnings Ratio (P/E) =
I (Market Value);
X (Net income to Common Shareholders);
l
Exhibit EFB-1 Schedule 1 Page 8 of 8 Price / Book Ratios, 1960-1979 S&P 399 Compustat Texas Year Industrials Electric Utilities Utilities 1960 1.99x 2.05x 3.66x 1961 2.37 2.50 4.35 1962 1.96 2.31 4.21 1963 2.24 2.38 4.34 1964 2.41
- 2. 54 4.21 1965 2.53 2.42 3.99 1966 2.05 2.13 3.46 1967 2.49 1.89 3.30 1968 2.53 1.89 2.96 1969 2.22 1.49 2.65 1970 2.11 1.52 2.73 1971 2.28 1.39 2.47 1972 2.54 1.32 2.54 1973 1.90 0.94 1.48 1974 1.19 0.63 1.31 1975
- 1. 50 0.87 1.22 1976 1.62 0.98 1.03 1977 1.30 0.95 1.15 1978 1.23 0.83 0.94 1979 1.26 0.78 0.85 Source: Compustat Industrial and Utility Tapes.
Note: The average price / book ratio is obtained by dividing the aggregate ma'rket value by the sum, over all companies in the group, of the year-end common equity:
E (Market Value).
Price / Book Ratio (P/B) 1 (Year-end Common Equity);
=
Exhibit EFB-1 Schedule 2 Page1of1 Relationships Between Inflation, Risk and Required Rates of Return Rate of Return (%)
SML80 k80 = 16.3 i
1 l
l l
l l
l l
l I
I I
SML65 I
RF80= 10.2 k
- 9.5 g
I I
I increase in anticipated
>e inflation premium i
i i
l i
I i
l l
RF65 = 4.0 I
l I
RF = Reat rate of return I
I
> ~ Original inflation premium
+
I l
l l
1 0
/
\\
=
U.S. Treasury Average Risk Bond Stock i
i
- Exhibit EFB-1 Schedule 3 Page 1 of 3 ESTIMATED RISK PREMlUMS, 1966-1981 Beginning Dow Jones 29 Dow Jones 11 Industrials Electrics of Value Value Weighted Risk Weighted Risk Year k
Premium k
Premium 1966 9.56 %
5.06 %
8.11 %
3.61 %
1967 11.57 6.81 9.00 4.24 1968 10.56 4.97 9.68 4.09 1969 10.96 5.08 9.34 3.46 1970 12.22 5.31 11.04 4.13 1971 11.23 4.95 10.80 4.52 1972 11.09 5.09 10.53 4.53 1973 11.47 5.51 11.37 5.41 1974 12.38 5.09 13.85 6.56 1
1975 14.83 6.92 16.63 8.72 1976 13.'32 5.09 13.97 5.74 1977 13.63 6.33 12.96 5.66 1978 14.75 6.88 13.42 5.55 1979 15.50 6.59 14.92 6.01 1980 16.53 6.35 16.39 6.21 1981*
17.33 5.33 17.30 5.30
- February 1,1981 l
l
Exhibit EFB-1 Schedule 3 Percent Page 2 of 3 (g)
A 0F REMRN ON DOW JONES INWS M ALS 18.0 AND ELECTRICS VERSUS TREASURY BOND YIELDS, 1966-1981 Dow Jones
,\\
/
Industrials f \\
g f
16.0..
/
\\
/
I
\\
/
Dow Jones I
/
Electrics
/
\\
/
/
\\
/
1
/
14.0 -
\\
/
,/
/
N/
/
/
r 12.0
/
s' P ~ ~,,, ~ ~ /
/
/
10.0~
/
[ '-J
/
/
20 Year
/
Government Bonds
- 8. 0 -
- 6. 0 -
4.0 "
2.0 --
1966 1968 1970 1972 1974 1976 1978 1980 1981 Year
Exhibit EFB-1 Schedule 3 Page 3 of 3 ESTIMATED RISK PREMIUMS FOR DOW JONES INDUSTRIALS AND ELECTRICS 1966-1981 Percent
(%)
10.0 --
f\\
8.0
/ \\
/
\\
Industrials
/
\\
/
/
\\
\\
/
/~~
- 6. 0 -.
/
Electrics p
s
,- /
4.0- '#
/
N
/
N/
i l
- 2. 0 -
l l
l l
l l
l l
1966 1968 1970 1972 1974 1976 1978 1980 1981 I
Year l
l I
Exhitit EFB-1 Schedule 4 Page 1ofI
- Tile WAI.I. STREET Jol; RNAI.
ThurWy. February 12. 1931
,~
Treasury Issues
..~,
Bonds, Notes U Bills v'
/
1
- h o-e.a.,er.r n Dini i %.-
1 ece.
w
< =...n.
,u,.,
'%,.. S.,. e,.,,, %,,,,,,.,
PatC UDUNES
"~
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I Treasury Bonde and Notes l
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pr.,
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A vent -
_ tus% __ ta se%
,)
96es See stalst>es* -
- 1415% __ 16 75% _16 CCN 1425%
New As andustnala* _ _ _ _
1383 % - 13 63%
13 00%
11 M%
l s
1181 % - 12 30 %
116?.
11 MN
'N W.' e orsug* 'N'ad ainas W Y U S. Goos'ntri. ate it 5% asu. of iM4-M) _
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Exhibit EFB-1 Schedule 5 Page 1 of 1 i-4 GRAPHICAL VIEW OF ATTRITION I
i d
(
True Cost of Equity
"= Authorized ROE j
g
/_
g
~
s
+ - -}-
/
l/
pe _ '
i
-+
Average ROE N
,k Over Time ss l
l Actual ROE Earned i
l l(12 months trailing) l I
i I
j Rate Case Decision Time i
i i
i 1
-ve-,--r
-~v---.
v,
,,v-en,,,,.,w r-,
e---
wrm...
v----,-weem- ~ - - -
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+--m m
..m.gve,._
THE STATE OF FLORIDA COUNTY OF ALACHUA BEFORE the undersigned authority on this day personally appeared Eugene F. Brigham, who, having been placed under oath by me, did depose as follows:
"My name is Eugene F. Brigham.
I am of legal age and a resident of the State of Florida.
7he foregoing testimony and exhibits, offered by me 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."
I w?
Eugen1!i F. Brigham O SUBSCRIBED AND SWORN TO BEFORE ME by the said Eugene F. Brigham this
/3 day of February, 1981.
f I let 'I?
k'4
, gh.""?..Fh N6tary Publicffn and for
'y
- 1 the State of// Florida
.' N i
V Nh l"cylly ')2 My commission expires
/
Notary Public. State of Flonda at Large
--a
-kh[3Lg,r,-
$. 4,'f My Commission E-pires July 13.1994 3.5IlD3\\ "
~ _
-