1. Economics of Competition and Regulation Lecture 4
The cost of capital and CAPM

2. Overview
The cost of capital
Risk
Risk and return
Cost of equity: CAPM

3. Cost of capital
Terms on which privatised companies can raise funds for regulated businesses
Two main types of capital:
Debt
Equity

4. Debt or bond finance
“Guaranteed” interest payments (before equity holders)
Tax deductible
Normally lower cost than equity
Cost of debt = risk free rate plus risk premium
Risk free rate measured by gov’t stocks
Risk premium depends on rating assessed by rating agencies
The perceived rick of debt will depend on the gearing of the company. i.e. ratio of debt to debt plus equity. This limits use of cheaper debt finance.

5. Equity finance Gives shareholders rights to residual incomes
higher risk than debt
Shareholders can spread risk by holding balanced portfolio of equities
But even a completely balanced equity portfolio has a risk = market risk –cannot be diversified
This market risk has a risk premium
= market risk premium (topic for another day)

6. Calculating the cost of capital
Weighted average cost of capital =
cost of debt  proportion of debt in financing +
cost of equity  proportion of equity in financing
cost of finance =risk free rate +risk premium
Equity risk premium = market risk premium  equity “beta”
Beta measures the relative risk of the company’s equity with that of the market as a whole
Based on Capital Asset Pricing Model
These arithmetic calculations are typically checked against views of City professionals on returns required for regulated companies

7. CAPM
Focus on the equilibrium relationship between the risk and expected return on risky assets
Builds on Markowitz portfolio theory
Each investor is assumed to diversify his or her portfolio according to the Markowitz model
Only compensate investors for bearing non-diversifiable risk

8. A. Market Portfolio From the Markowitz Portfolio Selection model
Separation Theorem
All investors hold the same portfolio of risky assets
CAPM: extension of the Markowitz model
In equilibrium: this risky portfolio consists of all risky securities in the market
Hence, the name - market portfolio

9. Characteristics of the Market Portfolio
All risky assets must be in the market portfolio, so it is completely diversified
Contains only systematic risk
All securities included in proportion to their market value
In theory, should contain all risky assets worldwide

10. B. Capital Market Line
Line from RF to L is the capital market line (CML)
x = risk premium = E(RM) - RF
y = risk = M
Slope = x/y
= [E(RM) - RF]/M
y-intercept = RF L M
E(RM) x RF y M
Risk

11. CML (cont’d)
Relationship between risk and expected return for portfolio P (Equation for CML):
Slope of the CML is the market price of risk for efficient portfolios, or the equilibrium price of risk in the market (Risk premium per unit of risk)

12. C. Security Market Line
The CML applies to markets in equilibrium and to the selection of efficient portfolios
The Security Market Line depicts the trade-off between risk and expected return for individual securities in equilibrium
Under CAPM, all investors hold the market portfolio
How does an individual security contribute to the risk of the market portfolio? Focus: covariance between security and market

13. SML (cont’d)
Equation for the expected return for an individual stock, E(Ri), is similar to the CML equation:
All securities should lie on the SML
The expected return on the security should be only that return needed to compensate for systematic risk (CAPM is a one-factor model)

14. SML (cont’d) Beta = 1.0 implies: as risky as market
Securities A and B are riskier than the market
Beta > 1.0
Security C is less risky relative to the market
Beta < 1.0
SML
E(R) A
E(RM) B C RF
0.5
1.0
1.5
2.0
BetaM

15. SML: Application
to calculate the required rate of return on an asset (ki):
ki = RF +i [ E(RM) - RF ]
Risk-free rate (RF)
Risk premium (i [ E(RM) - RF ])
Market risk premium adjusted for security i
The greater the systematic risk, the greater the required return

16. Finding Beta Plot stock returns against market:
Beta = 1 CoC = risk free rate + equity risk premium
High Beta and equity cost
Return to Equity
Low Beta =>low cost of equity
Return to market

17. Company “Beta”
Ideally should relate to regulated company rather than plc
Based on degree to which company returns vary with those of market.
Estimated from regression equation: company return = alpha + beta  market return
For regulated companies Beta should be <1

18. Using data Returns to stock Regressed on stock market return:
price increase: log(pt)-log(pt-1) plus
dividend: added in at day goes ex-dividend
Regressed on stock market return:
price change plus dividends
Rough measure, data easily found:
just look at price changes - see today's lab

19. Recent examples of the cost of capital
Regulator Case Basis WACC Gearing
Ofgem Electricity distribution (2004) Gross, real 6.9% net of tax 4.8% 57.5%
Ofwat Water (2004) Post tax, real 5.1% 55% (assumed)
CC Mobile phone inquiry (2003) Pre-tax, real 11%a 10% (estimate of actual level)
CC Manchester Airport (2002) Pre-tax, real 7.25%a % (estimate of actual)
CC BAA (2002) Pre-tax, real 7.21%a 25% (estimate of actual level)
Postcomm Consignia (2002) Pre-tax, real % 20% (actual)
Ofgem Independent gas transporters (02) Pre-tax, real % 37.5%
CAA NATS (2001) Pre-tax, real % % (optimal)
Ofgem Transco (2001) Pre-tax, real % 62.5%
Oftel Eff comp review:mobiles(01) Pre-tax, noml % % (optimal)
MMC Mid Kent Water (2000) Pre-tax, real 7.4%b 35%
ORR Railtrack (2000) Pre-tax, real % 50% (assumed)
Ofgem NGC (2000) Pre-tax, real % %
Source: Cepa: Report to the London Underground PPP Arbiter: Cost Of Capital Annex 3 ( July 2003), plus author's update.
Notes: a including 0.5% uncertainty premium b including 1% small size premium and 0.3% embedded debt premium

20. Further reading
A study into certain aspects of the cost of capital for regulated utilities in the UK
February 2003
Paper 08/03 from Ofgem or
oftel/publications/pricing/2003/cofk0203.htm
Authors are academics and core paradigm is non-diversifiable risk, as above.