The weighted average cost of capital (WACC) methodology is a widely accepted method for calculating the allowed rate of return. Regulators use different models to set the allowed cost of capital. This section explains the models and their practical application.
· Definition of cost of capital
o WACC
o Cost of equity
o Cost of debt
o Capital structure (gearing)
o Treatment of taxes
· Quantification of cost of capital
o CAPM (Capital Assets Pricing Model)
o Price Arbitrage Theory
o Dividend Growth Model
o Comparable Earnings Model
o “Precedent Case” Approach
· Financial Analysis
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Electricity Markets Regulation - Lesson 5 - Cost of Capital
1. Training on Regulation A webinar for the European Copper Institute Webinar 5: Cost of Capital Dr. Konstantin Petrov / Dr. Daniel Grote 14.12.2009
2. Agenda b) Weighted Average Cost of Capital (WACC) a) Concept and Regulatory Objectives 1. Definition of Cost of Capital c) Cost of Debt d) Cost of Equity 2. Quantification of Cost of Capital a) Capital Asset Pricing Model (CAPM) c) Arbitrage Pricing Theory (APT) d) Dividend Growth Model (DGM) e) Comparable Earnings Model (CEM) e) Capital Structure (gearing) f) Treatment of Taxes f) Regulatory Precedents b) Fama-French 3-factor Model
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5. 1. Definition of Cost of capital b) Weighted Average Cost of Capital (WACC) (2) Cost of Equity No default risk No reinvestment risk + Market risk measure * Base Equity Premium Country Risk Premium Risk-free rate + Debt premium Risk-free rate Beta Risk Premium Premium for average risk investment Debt / Equity ratio E = Equity D = Debt Tax rate Cost of Debt Gearing T = Tax D E+D WACC (post-tax) = Cost of equity + Cost of Debt (1-T) E E+D * * *
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11. 2. Quantification of Cost of Capital Overview Quantification Models Capital Asset Pricing Model (CAPM) Arbitrage Pricing Theory (APT) Dividend Growth Model (DGM) Regulatory Precedents Comparable Earnings Model Fama-French 3-factor model
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13. 2. Quantification of Cost of Capital a) Capital Asset Pricing Model (CAPM) – Formula or E(R a ) = R f + β ( E(R m ) – R f ) + ε Expected return on individual capital asset a Risk-free rate of interest sensitivity of asset returns to market returns Expected return of the market Risk-free rate of interest market premium or equity risk premium Error term systematic or non-diversifiable risk specific or diversifiable risk * E(R a ) - R f = β ( E(R m ) – R f ) β (beta) times market premium = individual risk premium *