Financial Reporting Requirements and Rate of Return Methodology in the Domestic Offshore Trades
Federal RegisterApr 7, 1994
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FEDERAL MARITIME COMMISSION
46 CFR Part 552
[Docket No. 94-07]
Financial Reporting Requirements and Rate of Return Methodology
in the Domestic Offshore Trades
AGENCY: Federal Maritime Commission.
ACTION: Proposed rule.
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SUMMARY: The Federal Maritime Commission proposes to amend its
regulations governing financial reporting requirements and rate of
return methodology applicable to vessel-operating common carriers by
water in the domestic offshore trades to discontinue use of the
comparable earnings test in determining the reasonableness of a
carrier's return on rate base. In its place, the Commission proposes to
use the weighted average cost of capital methodology. In addition, the
Commission proposes to amend its rules pertaining to the treatment of
insurance expenses, accumulated deferred taxes and the Capital
Construction Fund for purposes of calculating a carrier's rate base.
The proposed rule addresses a number of shipper and carrier concerns
regarding the Commission's current rate of return methodology and would
align the Commission's ratemaking methodologies more closely with those
used by numerous other regulatory agencies. The intent is to improve
the Commission's methodology for evaluating the reasonableness of rates
filed by carriers in the domestic offshore trades and for acquiring the
data that are essential to that evaluation.
DATES: Comments due June 6, 1994.
ADDRESSES: Comments (original and fifteen copies) to: Joseph C.
Polking, Secretary, Federal Maritime Commission, 800 North Capitol
Street, NW., Washington DC 20573-0001, 202-523-5725.
FOR FURTHER INFORMATION CONTACT:
Richard J. Kwiatkowski, Bureau of Trade Monitoring and Analysis,
Federal Maritime Commission, 800 North Capitol Street, NW., Washington
DC 20573-0001, 202-523-5790.
C. Douglass Miller, Office of the General Counsel, Federal Maritime
Commission, 800 North Capitol Street, NW., Washington DC 20573-0001,
202-523-5740.
SUPPLEMENTARY INFORMATION: On March 11, 1993, the Federal Maritime
Commission (``FMC'' or ``Commission'') published a final rule in Docket
No. 91-51, Financial Reports of Common Carriers by Water in the
Domestic Offshore Trades, which amended the provisions under which
carriers could obtain waivers of certain financial reporting
requirements. 58 FR 13414. (1993) (``Docket No. 91-51''). The
Commission stated that it intended ``* * * to turn its attention,
separately, to the numerous other substantive changes to 46 CFR part
552 that have been suggested in this proceeding.'' Id. at 13417.\1\ In
this regard, the Commission conducted an extensive review of part 552
to assess the need for changes to its financial reporting requirements
and rate of return methodology in the domestic offshore trades.
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\1\In its Advance Notice of Proposed Rulemaking issued in Docket
No. 91-51, 56 FR 57298, the Commission had solicited comments and
information from the public on issues which could be addressed in a
proposed rule concerning substantive guidelines for determining what
constitutes a just and reasonable rate of return or profit for
common carriers by water in the domestic offshore trades.
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Based on its review, the Commission has determined that several
issues regarding the adequacy and appropriateness of various aspects of
its present regulations should be addressed. The issues on which the
Commission is proposing changes to existing regulations include:
The FMC's methodology for computing an allowable rate of
return on rate base.
The treatment of deferred taxes and the Capital
Construction Fund for rate base purposes.
The definition of working capital.
Each of these issues is discussed in turn below.\2\ Also discussed
are the rules governing the allocation of assets and expenses, but no
changes are proposed.
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\2\Copies of the proposed new schedules for collecting the data
required under the proposed regulations are available from the
Secretary, Federal Maritime Commission.
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Computing an Allowable Rate of Return on Rate Base
I. The Allowable Rate of Return Should Equal the Cost of Capital
The fundamental objective when using a rate of return on rate base
method of regulation is to set a regulated firm's maximum allowable
rate of return on rate base equal to the regulated firm's cost of
capital. The cost of capital, sometimes referred to by economists as
``the opportunity cost of capital'' or ``the required rate of return,''
is the minimum rate of return necessary to attract capital to an
investment. It is the expected rate of return prevailing in capital
markets on alternative investments of equivalent risk.\3\ The bases for
setting the allowable rate of return equal to the cost of capital are
legal and economic.
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\3\A. Lawrence Kolbe, James A. Reed, Jr., and George R. Hall,
The Cost of Capital, 3rd Printing, The MIT Press, Cambridge,
Massachusetts, 1986, p. 13.
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A. Legal Rationale
Two landmark Supreme Court cases defined the legal principles
underlying rate of return regulation and provided the notion of a fair
rate of return. The two cases, Bluefield Water Works & Improvement Co.
v. Public Service Commission of West Virginia, 262 U.S. 679 (1923) and
Federal Power Commission v. Hope Natural Gas Company, 320 U.S. 391
(1944), established that investors in companies subject to rate
regulation must be allowed an opportunity to earn returns sufficient to
attract capital and comparable to those they would expect from
investments in other firms for incurring the same amount of risk, and
that revenues must not only cover operating expenses, but capital costs
as well.
B. Economic Rationale
The economic rationale for setting the allowable rate of return of
a regulated enterprise equal to its cost of capital is that the
regulated firm's customers will thereby pay the lowest cost for service
in the long run.\4\ For example, if a regulator sets the allowable rate
of return above the cost of capital, the firm's stockholders will
realize earnings in excess of those they could earn on alternative
investments of comparable risk. Such excess earnings are paid for by
the firm's customers in the form of prices higher than those that they
would otherwise be required to pay. If, on the other hand, a regulator
sets the allowable rate of return below the cost of capital,
stockholders will realize earnings less than they could on alternative
investments of comparable risk. In the short run, the firm's customers
may benefit because they pay prices lower than those they would
otherwise be required to pay. In the long run, however, the firm's
stockholders will be unwilling to continue to invest their funds, and
the firm will, therefore, lack the requisite financial capital for
maintaining and augmenting the firm's physical plant and equipment.
Customers, in turn, will be supplied with a lesser quantity and/or
quality of service.
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\4\Setting the allowable rate of return equal to the cost of
capital also ensures that society's supply of capital is used most
productively. Because capital markets are considered to be highly
competitive, the cost of new capital is an accurate gauge of that
capital's value in alternative uses. When the allowable rate of
return is greater than the cost of capital, investors will supply
too much capital to a regulated firm, thereby diverting capital from
alternative investments where it could be more productive.
Conversely, when the allowable rate of return is less than the cost
of capital, investors will supply too little capital to a regulated
firm, thereby allocating funds to less productive investments. Such
a misallocation of resources represents a welfare loss for society
as a whole.
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C. Methodologies
The Commission uses a version of the Comparable Earnings Test
(``CET'') to determine the reasonableness of rates of return. The
carrier's projected rate of return ((net income after taxes + interest
expense)/rate base\5\) is compared with the rate of return on total
capital earned by U.S. manufacturing firms over an extended period of
time--the benchmark rate of return. Where appropriate, adjustments are
made to the benchmark for current trends in rates of return, the cost
of money and relative risk.
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\5\Rate base is a carrier's investment in Commission-regulated
activities. It consists of investments in vessels less accumulated
depreciation, other property and equipment less accumulated
depreciation, and working capital.
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However, most regulatory agencies use the Weighted Average Cost of
Capital (``WACC'') methodology to set allowable rates of return,
including, for example the Federal Energy Regulatory Commission, the
Interstate Commerce Commission (``ICC''), the Federal Communications
Commission, and the Maryland Public Service Commission. Indeed, the
most recent yearbook published by the National Association of
Regulatory Commissioners shows that virtually every state regulatory
commission in the U.S. uses some variation of the WACC.6 Further,
current economic literature recognizes the WACC approach as the most
generally accepted method of setting allowable rates of return.
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\6\See ``Table 47--Agency Authority Over Rate Of Return--All
Utilities,'' in Utility Regulatory Policy in the United States and
Canada Compilation 1992-1993, National Association of Utility
Regulatory Commissioners (``NARUC''), Washington D.C., 1993, pp.
110-111.
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The WACC approach recognizes that there are several methods by
which a firm may raise capital and each has its attendant cost.
Typically, the total capital of a firm has come from three different
sources, long-term debt, preferred stock7 and common-stock equity.
Thus, the total capital of a firm may have a debt component, a
preferred stock component and a common-stock equity component. Under
the WACC methodology,8 the cost of each of these components is
calculated separately and weighted by the proportion the component is
to the total capital of the firm.9
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\7\ Preference stock, also known as prior-preferred stock, is
preferred stock that has a higher claim than other issues of
preferred stock on dividends and assets in liquidation.
\8\ Charles E. Phillips, Jr., The Regulation of Public
Utilities, 3rd ed., Public Utilities Reports, Inc., Arlington,
Virginia, 1993, p. 388.
\9\ Short term debt that has become a permanent portion of the
regulated firm's financing is also included in the computation.
Deferred taxes are included at zero cost (unless they have been
deducted from rate base).
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To illustrate the calculation of the WACC, consider a hypothetical
regulated company that has total invested capital of $100 million,
consisting of $25 million of long-term debt, $15 millon of preferred
stock, and $60 million of common-stock equity. Assume that the firm's
cost of long-term debt is 7 percent, cost of preferred stock is 9
percent, and cost of common-stock equity is 12 percent. Further, assume
that the firm operates in a world where corporate taxes do not exist.
The WACC for this firm is calculated as follows:
Calculation of WACC10
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Amount
(millions Proportion Cost WACC
Capital component of dollars) (percent) (percent) (percent)
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Long-term debt...... 25 25 7 1.75
Preferred stock..... 15 15 9 1.35
Common-stock equity. 60 60 12 7.20
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Total......... 100 100 ........... 10.30
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10 The algebraic expression for the overall cost of capital or the WACC,
is as follows (ignoring taxes):
TP07AP94.006
where:
Kd is the regulated firm's cost of long-term debt capital;
Kp is the regulated firm's cost of preferred stock capital;
Ke is the regulated firm's cost of common-stock equity capital;
D is the value of the regulated firm's long-term debt outstanding;
P is the value of the regulated firm's preferred stock outstanding; and
E is the value of the regulated firm's common-stock equity outstanding.
Thus, given the assumptions of this example, the WACC is 10.30
percent. The allowable rate of return for this hypothetical company
should, therefore, be set at 10.30 percent, which would provide the
firm with the opportunity to earn revenues sufficient to service the
company's overall cost of capital.11
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\1\1 In reality, a regulated firm typically does pay taxes, and
the WACC must be adjusted to arrive at a final number for an
allowable rate of return. Such adjustment is made by calculating the
WACC on a before-tax basis (``BTWACC''). The BTWACC is described in
detail later.
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The costs of long-term debt and preferred stock capital may be
calculated with relative precision. For the debt component, this is
done by computing the actual total annual fixed charges on long-term
debt for all issues, including any amortized discount or premium and
issuance expense. The total annual fixed charges are then divided by
the actual total value of long-term debt outstanding for all issues in
order to arrive at the cost of debt stated as a percentage. For
example, if the annual fixed charges on long-term debt are $1,750,000
and the total long-term debt outstanding is $25 million, the cost of
debt would be 7 percent ($1,750,000/$25 million=.07).
The cost of preferred stock is calculated in similar fashion. The
actual total annual dividend requirements on the preferred stock for
all issues is divided by the actual total value of preferred stock
outstanding for all issues in order to arrive at the cost of preferred
stock stated as a percentage. For example, if the actual total annual
dividend requirements amounted to $1,350,000 and the total value of
outstanding preferred stock is $15 million, the cost of preferred stock
would be 9 percent ($1,350,000/$15 million=.09).
The calculation of the cost of common stock equity capital, the
third component of the WACC, is more difficult. Commonly used methods
are the Discounted Cash Flow (``DCF''), the Capital Asset Pricing Model
(``CAPM'') and the Risk Premium (``RP''). Each of these models is based
on market variables (e.g., stock market prices and bond yields) which
reflect the expectations of investors in capital markets. More
specifically, the DCF, CAPM and RP models are constructed under the
generally accepted assumption that a company's stock market price at
any moment in time reflects completely investors' current expectations.
Because these market-based models are designed to reflect the
expectations of investors, and because a company's cost of capital is
defined as the rate of return expected by investors on alternative
investments of equivalent risk, the WACC framework implemented through
the use of such models will, in general, equate the allowable rate of
return with the cost of capital.
II. The Commission's Comparable Earnings Test Compared to the WACC
A. Theoretical Issues
The Commission has used its variation of the CET in a number of
rate investigations. Commission orders adjudicating the reasonableness
of rate increases under the CET have been repeatedly upheld by the
courts. E.g., Matson Navigation Company, Inc. v. FMC, 959 F.2d 1039
(D.C. Cir. 1992); and Puerto Rico Maritime Shipping Authority v. FMC,
678 F.2d 327 (D.C. Cir.), cert. denied, 459 U.S. 906 (1982). However,
the Commission's CET does present a theoretical shortcoming compared to
the WACC method, in that it is unlikely to equate the allowable rate of
return with the cost of capital, because it uses historical accounting
data to calculate an average book value12 rate of return that the
regulated carrier should be allowed.
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\1\2 Book value means the value at which an asset is carried on
a balance sheet.
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The accounting rate of return for a company is not equivalent to
the firm's true economic rate of return because accounting and economic
concepts of income and value are substantially different. Accounting
numbers are derived on the basis of generally accepted accounting
principles while economics specifies the use of opportunity costs. This
difference is particularly acute when the economy is characterized by
high and variable rates of inflation. For example, accountants define
asset values in terms of acquisition or historical costs while
economists define asset values on the basis of market values or
replacement costs. This distinction effects both the income statement
as well as the balance sheet. Consequently, an accounting-based rate of
return methodology such as the Commission's CET does not adequately
measure a regulated carrier's true cost of capital. In Docket No. 91-
51, the State of Hawaii noted the problems associated with using
accounting data and criticized the Commission's CET for being
accounting-based and not market-based.
Several empirical tests have demonstrated that there is a large
discrepancy between accounting rate of return and true economic
return.13 These studies also demonstrate that biases inherent in
book returns are systematic, and that these biases do not cancel out by
averaging across companies. Furthermore, the type and magnitude of bias
for regulated firms are different than those of unregulated firms
contained in the comparable risk group of firms selected in applying
the Commission's CET method.14
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\1\3 See, for example, Franklin M. Fisher and John J. McGowan,
``On the Misuse of Accounting Rates of Return to Infer Monopoly
Profits,'' 73 Am. Econ. Rev. 82-97, March 1983; and Richard Brealy
and Stewart C. Myers, Principles of Corporate Finance, New York:
McGraw-Hill, Chapter 12, 1981.
\1\4 Regulators (including the FMC) commonly set rates on the
basis of a book value rate base. In such instances, the economic
(i.e., market) value of a regulated firm will tend to be closer to
its book value in comparison to the economic values and book values
of the unregulated firms contained in the proxy group. The book
returns of the unregulated firms are, therefore, likely to be
substantially more biased than those of the regulated firm under
consideration.
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B. Practical Issues
The WACC approach also presents some important technical
advantages. First, the WACC uses the actual long-term interest expense
currently provided by a regulated carrier to compute the company's cost
of long-term debt capital, while the Commission's CET uses an estimate
of a carrier's long-term interest expense based on moving averages of
Baa-rated corporate bond yields in computing an allowable rate of
return on rate base. By definition, a firm's actual long-term interest
expense is more accurate than an estimate of that expense. In its
comments in Docket No. 91-51, the State of Hawaii stated that the
Commission's CET introduces imprecision into the calculation by
requiring that parties substitute a proxy for carrier interest expense
as a component of the carrier's rate of return, although this component
is known and subject to verification.
Second, the WACC, when implemented properly, ensures that the
regulated carrier will be allowed a return on rate base that is large
enough to ensure that the carrier will have the opportunity to earn, at
a minimum, revenues that are sufficient to cover its embedded (actual
historical) cost of debt. Assuming that debt capital financing is less
expensive than preferred stock and common-stock equity capital
financing, when the known cost of long-term debt is weighted by the
regulated company's proportion of long-term debt capital outstanding,
and then added to the firm's cost of preferred stock weighted by the
firm's proportion of preferred stock capital outstanding and the firm's
cost of common-stock equity capital weighted by the firm's proportion
of common-stock equity capital outstanding, the resulting sum (i.e.,
the WACC) can be no less than the cost of the firm's embedded cost of
debt. Such a guarantee is not available under the Commission's CET, as
Matson Navigation Company, Inc. (``Matson''), has pointed out. For
example, if the long-term interest expense estimate, derived on the
basis of a moving average of historical Baa corporate bond yields, is
not representative of the actual long-term interest expense of the
regulated carrier, or if the historical financial data reflecting the
financial picture of the benchmark group of firms are not
representative of the regulated carrier's financial position, then the
regulated carrier's calculated allowable rate of return on rate base
could fall short of its embedded cost of debt.
Third, the Commission's CET has proved difficult to apply in the
case of the Puerto Rico Maritime Shipping Authority (``PRMSA''), which
has a capital structure composed entirely of long-term debt and by law
is not required to pay taxes. On the other hand, the WACC can be used
effectively to establish an appropriate allowable rate of return for
such a carrier. The WACC is computed for such a carrier by weighting
the cost of long-term debt near or equal to one, the cost of preferred
stock near or equal to zero, and the cost of common-stock equity near
or equal to zero, and setting the corporate tax rate equal to zero. The
WACC can be used effectively to compute an accurate estimate of the
overall cost of capital and, in turn, to establish an appropriate
allowable rate of return for a regulated carrier that is financed
exclusively or almost completely by long-term debt15 and is tax-
exempt, because it distinguishes between such a carrier and one that is
financed with substantial amounts of common-stock equity and is not
tax-exempt. In its comments in Docket No. 91-51, PRMSA observed that
the Commission's CET makes no such distinction because it uses as a
benchmark for every regulated carrier, regardless of actual capital
structure or tax status, a typical firm financed with a relatively
balanced mixture of long-term debt and common-stock equity capital, and
is not tax-exempt.
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\1\5A profitable firm will generally have at least some amount
of common-stock equity capital in its capital structure because such
a firm will usually have an internal source of such capital in the
form of retained earnings.
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Lastly, the WACC method typically uses a number of different
methods to calculate the regulated firm's cost of common-stock equity
capital. This yields several different estimates of the firm's WACC
providing a regulatory commission with a range of numbers from which a
single number representing an allowable rate of return on rate base can
be chosen. This minimizes the possibility that the allowable rate of
return will be distorted by inappropriate subjective judgements or by
extraordinary economic conditions existing during the time period used
to measure that return. By comparison, the Commission's CET produces a
single measure of an allowable rate of return.
On the basis of its review, the Commission has determined to
propose the use of the WACC methodology to evaluate the reasonableness
of a carrier's rates in the domestic offshore trades. The Commission
believes that the WACC approach set forth in the proposed rule
represents a substantial improvement over the existing methodology and
addresses the criticisms voiced in comments in Docket No. 91-51. We now
turn to the proposed rule.
III. Estimating the Weighted Average Cost of Capital
A. Capital Structure
The first step in calculating the WACC is to determine an
appropriate capital structure (i.e., the proportions of long-term debt,
preferred stock, and common-stock equity capital issued by a firm to
finance its operations) for the regulated firm. There are two important
issues that may have to be resolved. The first is whether to calculate
the WACC using a ``typical'' or ``ideal'' capital structure as some
regulatory commissions do, or the actual capital structure or that
expected in the near future, as others do. The second issue concerns
the situation where the regulated company is a subsidiary of a parent
company. The issue is whether to use the capital structure of the
subsidiary or that of the consolidated system (i.e., the parent company
and all of its subsidiaries) in computing the WACC.
1. Hypothetical Versus Actual Capital Structure. The WACC may be
much lower when the proportion of debt contained in a company's capital
structure is relatively high compared to common-stock equity. This is
because the interest rate on debt is usually much lower than the cost
of common-stock equity.16 In addition, debt costs the firm and the
ratepayer less than equity because equity earnings are subject to
income taxes and debt is not. The revenue that a company is allowed to
earn on its common-stock equity is increased by amounts added to that
revenue for the purpose of paying income taxes. By contrast, since
interest is deductible for income tax purposes, earnings to cover debt
costs are computed before any income tax calculations, and are not
subject to income tax. Consequently, within limits determined by such
factors as the risk of a business, the WACC may be lower and ratepayers
may pay less when the firm employs a relatively large proportion of
debt than when it uses a relatively large proportion of equity. Given
this differential, some regulatory commissions compute the WACC using
what they believe to be the ``typical,'' or ``ideal,'' capital
structure without regard to the actual capitalization of the regulated
company in question. Other regulatory commissions base their WACC
estimates on either the actual capital structure, or that expected in
the near future when rates to be decided will be in effect.
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\1\6There are two reasons for this: (1) debtholders have
priority over equityholders as to the remaining assets of the firm
in the event that the firm is liquidated; and (2) debtholders must
be paid their contractual level of interest (i.e., their coupon
payment) before equityholders receive any compensation (i.e.,
dividend payments). A company may reduce or eliminate dividend
payments to equityholders in the event that it is under financial
strain. However, it is far less likely that coupon payments will be
eliminated because this could result in bankruptcy if the firm does
not take corrective action. Equityholders, therefore, require a
higher return than do debtholders. Consequently, it costs a firm
more to issue common-stock equity than it does to issue debt. The
more expensive common-stock equity financing could be borne by
ratepayers in the form of higher rates.
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There are strong reasons for using a regulated carrier's actual or
expected capital structure rather than the alternative of a
hypothetical or ideal capital structure in calculating the carrier's
WACC. First, a regulated company's current capital structure could be
the product of decisions that were logical and efficient at the time
they were made, although a different capitalization might be consistent
with a lower WACC at the time of a rate investigation and hearing.
Although hindsight is always more accurate than foresight, a company
must make financial decisions based on an evaluation of the present and
projections of future conditions.17 Second, using a hypothetical
or typical capital structure substitutes an estimate of what the WACC
would be under conditions that do not exist for what it actually is or
will soon be under existing conditions.18
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\1\7Charles E. Phillips, supra note 4, at 390.
\1\8James C. Bonbright, Albert L. Danielsen, and David R.
Kamerschen, Principles of Public Utility Rates, 2nd ed., Public
Utilities Reports, Inc., Arlington, Virginia, 1988, p. 309.
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Accordingly, the Commission's proposed rule specifies the use of a
regulated domestic offshore carrier's expected capital structure in
computing the carrier's WACC. The proposed rule stipulates the use of
the expected rather than the actual capital structure because the
Commission uses a future instead of a historic test year.
2. Subsidiary Versus Consolidated Capital Structure. Where a
regulated company is a wholly owned subsidiary which obtains its
common-stock equity capital through a parent company, regulators often
use the capital structure of the consolidated system (i.e., the parent
company and all of its subsidiaries) in computing the WACC. The
consolidated capital structure is an appropriate capitalization to use
in calculating a regulated subsidiary's WACC when: (1) No substantial
minority interest in the subsidiary exists (i.e., the regulated
subsidiary is wholly-owned by a parent company or nearly so), and (2)
the risks are similar between the parent and subsidiary.\19\ In such a
situation, investors' appraisals of the parent company's common stock
are thought to represent the best measure of the current cost of
common-stock equity to the subsidiary.\20\ When the consolidated
capital structure is used, the consolidated system's cost of common-
stock equity capital (issued by the parent company), the consolidated
system's cost of preferred stock, and the consolidated system's cost of
long-term debt, rather than the respective capital component costs of
the regulated subsidiary, are also used because the consolidated
capital structure directly affects the capital component costs of the
consolidated system and not those of the subsidiary.\21\ The use of the
regulated subsidiary's capital component costs is inconsistent with the
use of the consolidated system's capital structure and could,
therefore, distort the WACC estimate obtained for the regulated
subsidiary.
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\19\The use of the consolidated capital structure differs from
the ``double leverage'' concept used by some expert witnesses. The
latter approach uses the parent company's WACC as a measure of the
subsidiary's cost of common-stock equity capital along with the
subsidiary's capital structure, the subsidiary's cost of preferred
stock, and the subsidiary's cost of debt. Those that favor the use
of such a method cite the advantage of using the actual data of the
subsidiary for which an allowable rate of return is being computed.
The merits of the approach are highly debatable, however, since it
could produce an estimate of the cost of common-stock equity capital
for the regulated subsidiary that is lower than the opportunity cost
of such capital when the subsidiary is more risky than the parent,
and an estimate that is higher when the subsidiary is less risky.
The Commission's proposed rule does not, therefore, rely on the
double leverage method of calculating the WACC for a regulated
subsidiary company.
\20\J. Rhoads Foster, ``Fair Return Criteria and Estimation,''
28 Baylor L. Rev. 889 (1976), in Charles E. Phillips, supra note 4,
at 392.
\21\To see how a company's capital structure could affect its
component capital costs, consider, for example, the case of a
heavily-leveraged company (i.e., one that has a relatively large
proportion of debt in its capital structure). Such a company could
be perceived by current and potential debtholders and equityholders
as having a relatively high probability of bankruptcy (in which case
coupon and dividend payments would be discontinued and the
possibility that principal could also be lost would be heightened)
and, therefore, as being a relatively high risk investment.
Debtholders and equityholders would require a return on their
investment funds that is commensurate with the relatively high risk
of such a company in order for them to be willing to purchase and
hold the company's debt and common stock. A heavily leveraged firm
could, therefore, have relatively high costs of debt and common-
stock equity capital.
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The use of the consolidated capital structure is not correct,
however, when a substantial minority interest in the regulated
subsidiary exists, or when the regulated subsidiary's risk differs
substantially from that of the parent company. The appropriate approach
in this situation is to ignore the parent-subsidiary relationship and
to estimate the subsidiary's WACC using the subsidiary's own capital
structure and capital component costs. This method, referred to as the
``stand alone'' or ``subsidiary approach,'' recognizes the subsidiary
as an independent operating company, and its cost of common-stock
equity capital is inferred as the cost of common-stock equity of firms
having risk comparable to that of the subsidiary.\22\ The basis for
this method is that the required return on an investment depends on its
risk (i.e., the subsidiary's risk) rather than on the parent's
financing costs. In short, this method emphasizes the use, rather than
the source, of the subsidiary's capital funds.
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\22\The issue of selecting an appropriate sample of firms having
risk similar to that of the regulated company under consideration is
explored in detail below.
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The Commission's proposed rule specifies that a subsidiary
carrier's capital structure is to be used in computing the WACC unless,
after notice and opportunity for comment, the Commission determines
that: (1) The subsidiary carrier's parent company issues publicly
traded common-stock equity; (2) no substantial minority interest in the
subsidiary carrier exists; and (3) risks are similar between the
subsidiary carrier and the parent company. Under the proposed rule, no
substantial minority interest in a subsidiary carrier exists when a
parent company owns 90 percent or more of the subsidiary's voting
shares of stock. It also must be demonstrated that both the business
and the financial risks facing the parent and subsidiary are
similar.\23\
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\23\Business risk is the variability that a company's internal
(e.g., the skill levels and salaries of employees) and external
(e.g., the number of competitors) operating variables impart to the
earnings available to investors because of the fundamental nature of
the company's business.
Financial risk is the additional variability that debt and
preferred stock financing impart to the earnings available to
common-stock equityholders.
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Such an evaluation may involve a comparison of such financial risk
measures as total capitalization and debt-to-equity ratios, investment
quality ratings on short-and long-term debt instruments, and coverage
ratios such as the times interest earned and fixed charges coverage
ratios.\24\ There must also be an assessment of the degree to which the
regulated subsidiary comprises the parent's holdings. To the extent
that a subsidiary accounts for a substantial majority of the
consolidated system's revenues, expenses, and profits, the business
risks of the parent and subsidiary would, in general, be the same.
However, where a parent's holdings are diversified into areas of
business unrelated to the regulated subsidiary, the business risks of
the parent and of the subsidiary are more likely to differ.
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\24\Times interest earned ratios (``TIER'') measure the extent
to which operating income can decline before a firm is unable to
meet its annual interest costs. TIER is computed by dividing a
firm's earnings before interest and taxes by the firms' annual
interest expense.
The fixed charges coverage ratio (``FCCR'') measures the ability
of a firm to satisfy all of its fixed obligations. FCCR is computed
by dividing the total of net income, interest expense, depreciation
and amortization expense, and the provision for income taxes, by
fixed charges. Fixed charges are the total of interest expense,
principal payments, and capital lease obligations.
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Accordingly, the Commission's proposed rule states that the
Commission shall consider some or all of the aforementioned business
and financial risk criteria in determining whether to approve the use
of a consolidated system's capital structure and component costs in
computing the subsidiary's WACC.
Other measures of business and financial risks may also be used in
comparing the risk of a parent with the risk of a subsidiary. These
could include those discussed later for selecting an appropriate proxy
group of firms.
3. Book Value Versus Market Value Capitalization Ratios. Another
capital structure issue is whether to use market or book values in
computing the capitalization ratios (i.e., the weights) in the WACC
formula. Technically, capitalization ratios should be computed on the
basis of market value. A capital structure computed on the basis of
historical (i.e., book values) as opposed to current market values
misrepresents the true capital structure over time, since price levels
fluctuate. The common practice is, nevertheless, to compute
capitalization ratios on the basis of book values. This is defended on
grounds that a regulated firm supposedly raises capital in such a
fashion that a target capitalization ratio expressed on the basis of
book values is maintained by the company. Consequently, regulators must
compute the firm's overall cost of capital on the same basis in order
to ensure that the company's capital costs are adequately covered. In
addition, book value capitalization ratios are stable and the regulator
is, therefore, not required to deal with the uncertainties associated
with volatile market weights. Further, effective regulation is said to
force book and market values toward equality. Accordingly, the
Commission's proposed rule requires the use of book value
capitalization ratios in computing the WACC.
4. Average Versus Year-End Capital Structure. Finally, there is the
issue of whether a year-end or average capital structure should be used
in computing the WACC. The fact that financial variables and ratios are
commonly stated on an average basis argues in favor of using an
expected average capital structure projected over a future test year,
rather than a year-end capital structure. Earnings per share, for
example, are typically expressed on the basis of average number of
shares outstanding. Equity returns are also frequently expressed on the
basis of average common-stock equity. In addition, an average capital
structure computed over a future test year is likely to represent the
company's capital structure during the time interval in which a
proposed general rate increase will be in effect better than a year-end
capital structure, because the company could acquire new capital from,
or return existing capital to, investors during that period of time.
The use of an average capital structure rather than a year-end capital
structure is, therefore, more likely to enable a regulated firm to
actually earn its allowable rate of return. Accordingly, the
Commission's proposed rule specifies the use of test-year
average25 book value capitalization ratios in computing the WACC.
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\2\5Such average ratios are computed using the average amount of
each capital component (expected to be) outstanding during the test
year. The average test year amount outstanding for any class of
capital is computed by adding the amount of a particular type of
capital (expected to be) outstanding at the beginning of the test
year to the amount of that same type of capital (expected to be)
outstanding at the end of the test year, and dividing the sum of the
two amounts outstanding by two.
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B. Annual Cost of the Capital Components
Determining the cost of the regulated firm's senior capital (i.e.,
debt and preferred stock) and common-stock equity is the second step in
estimating the WACC. The costs of each of these components are then
applied to the capital structure (i.e., each is weighted on the basis
of the proportion of the value of the total capital outstanding that
each represents) in order to determine the WACC.
1. Cost of Senior Capital. There are usually few problems
encountered in computing the cost of senior capital with precision.
Regulatory commissions traditionally compute cost of senior capital on
the basis of embedded (actual historical) cost. This is done by first
computing the actual total annual fixed charges on long-term debt,
including any amortized discount or premium and issuance expense, and
the actual total annual dividend requirements on the preferred (and
preference) stock for all issues on a dollar basis. These dollar
figures are then converted to a percentage by dividing the actual total
annual fixed charges on long-term debt by the actual total value of
long-term debt outstanding, and the actual total annual preferred stock
dividend requirements by the actual total value of preferred stock
outstanding for all issues. If a future (rather than a historical) test
year is used (as the FMC does), the cost of senior capital is
calculated on the basis of: (1) The embedded cost for the existing
long-term debt and preferred stock, and (2) the current cost for any
new long-term debt and preferred stock that the regulated firm
anticipates issuing on or before the final day of the projected test
year.
The embedded cost is used to calculate the cost of existing senior
capital in order to determine what the senior capital will cost the
firm today, in view of the fact that the majority of it was issued at
prior points in time, and under bond and stock market conditions that
could have differed substantially compared to those prevailing today.
The objective is not to determine what the existing senior capital
would cost if issued today. Rather, the embedded debt cost measures
precisely what the regulated firm needs to satisfy its contractually
required interest payments to those holding existing long-term debt,
and preferred-dividend payments to those holding existing preferred
stock. The current cost of bonds and preferred stock is, therefore,
estimated only to measure the cost to the regulated firm when such
senior securities are to be issued in the near future.
2. Cost of Common-Stock Equity Capital. The most critical problem
in determining the WACC is that of estimating the cost of common-stock
equity capital. The objective is to determine how much the regulated
firm is required to earn in order to be able to entice investors into
purchasing and holding its common-stock equity. A precise answer to
this question is difficult to arrive at due to the absence of any
expressed or fixed agreement as to the level of dividends that are to
be paid by the regulated firm to its common-stock equityholders.
Dividend payments, on the one hand, depend upon the profits of the
regulated company. The allowable amount of profits, on the other hand,
is the object of a rate investigation and hearing. A regulator, in
allowing a fair rate of return, does not, therefore, have any
predetermined gauge as to the level of profit and common-stock equity
dividends required by investors.
There are five major methods used to estimate the cost of common-
stock equity capital: DCF, RP, CAPM,26 Market-to-Book Ratio
(``MBR''), and Comparable Earnings (``CE'').27 The DCF, CAPM, RP,
and MBR methods are market-based approaches that emphasize the standard
of capital attraction articulated in Hope and Bluefield by examining
investors' expectations of the regulated firm's profits, dividends, and
market prices. The CE method emphasizes the comparable earnings
standard specified by those cases by estimating the return on book
common-stock equity of firms having risk similar to that of the
regulated firm under consideration. The five methods are reviewed in
turn.
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\2\6The CAPM is actually a specific type of RP model.
\2\7The CE method is used by regulatory commissions
traditionally to calculate the regulated firm's cost of common-stock
equity capital. This approach differs significantly from the
comparable earnings test currently used by the FMC, which estimates
the rate of return on total invested capital (i.e., on long-term
debt and common-stock equity) of the regulated carrier under
consideration.
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a. Discounted Cash Flow Method. The DCF method of estimating the
cost of common-stock equity is the technique that is used with the
greatest frequency by state and federal regulatory commissions and
agencies. Its popularity reflects the intuitive appeal of the DCF model
with its basis in valuation theory. That theory holds that the current
market price of a common stock is equal to the present value of its
expected future dividend payments plus the proceeds that an investor
would expect to receive when the common stock is finally sold. Because
the value of an amount of money to be received in the future is less
than the value of the same amount of money received today,28 the
expected value of the future dividends and ultimate proceeds must be
discounted back to the present at the investor's required rate of
return in computing the present value of a common stock. The most basic
mathematical representation of this concept assumes that: (1) Dividends
grow at a constant annual rate, and (2) that an investor will hold the
common stock forever. The latter assumption implies that the value of
the stock depends solely on the dividends that are expected to be paid.
The basic DCF model is expressed algebraically as follows:
\2\8 The value of a dollar received today is greater than that
of a dollar received a year from today, for example, because today's
dollar can be invested and begin to earn a rate of return
immediately.
TP07AP94.007
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where:
Po is the current market price per share of the regulated
company's common stock;
D1 is the dividend to be received at the end of year 1
(mathematically D1=Do(1+g), where D0 is the current
dividend);
Ke is the required or expected return on the regulated firm's
common-stock equity capital (i.e., the cost of common-stock equity
capital); and
g is the constant expected annual rate of growth in dividends per
share.
The equation is solved for Ke in rate of return testimony in
order to determine the cost of the common-stock equity of the regulated
firm under consideration. Solving the equation for Ke yields the
following expression:
TP07AP94.008
Hence, the basic or standard DCF model states that the cost of common-
stock equity is equal to the expected (first-year) dividend yield plus
the rate at which investors expect dividends to grow in the future.
To illustrate the basic DCF model, assume that the current market
price of a hypothetical regulated company's common stock is $30.00 per
share, and that a single common stock share currently pays a $2.00
dividend, which is expected to grow at a rate of 5 percent per year.
The cost of common-stock equity capital for such a company is:
TP07AP94.009
i. Practical Issues
(a) Expected Growth Rate of Dividends. The major practical issue
involves determining ``g,'' the constant expected annual rate of growth
in dividends per share. There are three techniques that are commonly
used to estimate ``g'': (1) Historical growth rates; (2) professional
investment services' projections; and (3) sustainable growth or
retention growth. An average of the growth rates arrived at separately
using each of the three methods is often used to produce a final growth
estimate. This averaging procedure is the one reflected in the proposed
rule.
(i) Historical Growth Rate. The historical growth rate in dividends
over some period, frequently five or ten years, is one method used to
estimate ``g.'' Historical data are used because investors'
expectations of future growth are based in part on growth rates
experienced in the past. The historical growth in earnings per share,
or book value per share, is sometimes used as a proxy for the growth in
dividends, because dividends are often increased at discrete intervals,
so that their estimated growth rate can differ considerably depending
upon the precise beginning and ending points of the selected data
series. The proposed rule, therefore, requires averaging the historical
growth rate of dividends per share, earnings per share, and book value
per share in arriving at an estimate of ``g.''
The period over which ``g'' is to be measured must be sufficiently
long to avoid distortions in the data resulting from short-term
conditions and aberrational years, but sufficiently short to capture
foreseeable influences relevant for investors' evaluation of the
future. The most recent five- and ten-year periods are commonly used to
calculate the growth rate. The proposed rule uses an average of the
five- and ten-year growth rates on the basis that the average
represents a reasonable trade-off between the incongruous requirements
of representativity and statistical adequacy.
(ii) Professional Investment Services' Projections. The expected
growth rate of dividends is also commonly based upon the growth rates
published by professional investment services, since investor
expectations are the desired quantities in the DCF model, and
investors' growth anticipations are based in part upon the projections
of such services. Growth forecasts of dividends per share, earnings per
share, and book value per share are published by several services,
including Value Line Publishing, Inc. (``Value Line''), and the
Institutional Brokers Estimation Service (``IBES''). Such growth rates
are published on a regular basis, usually for five-year periods, and
are readily available to investors. Expert witnesses usually develop a
consensus forecast by averaging the forecasts of the professional
analysts, and use this average in calculating ``g.'' The Commission's
proposed rule similarly specifies that ``g'' will be measured by using
the average of: (1) The five-year dividend, earnings, and book value
forecasts published by Value Line, and of (2) the five-year earnings
forecast published by IBES.29
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\2\9IBES produces a consensus forecast of earnings based on the
individual predictions of virtually every major brokerage house.
---------------------------------------------------------------------------
(iii) The Sustainable Growth Rate. The third technique used to
estimate ``g,'' known alternately as the ``sustainable growth,''
``retention ratio,'' or ``plowback'' method, is to multiply the
proportion of earnings expected to be retained by the company, ``b,''
by the expected return on book equity, ROE. The relationship is
expressed algebraically as g=(b)(ROE). The theoretical underpinning for
the method is that future growth in dividends for existing equity can
only occur if a portion of the overall return to investors is plowed
back into the firm rather than being paid out as dividends.
To illustrate the sustainable growth rate method, assume that a
hypothetical regulated company is expected to retain 75 percent of its
earnings, and is expected to earn a 10 percent return on book equity.
The company's sustainable growth rate estimate of ``g'' is:
g=.75(.10)
=.075 or 7.5 percent.
Both historical and projected values of ``b'' and ROE are used to
estimate ``g.'' Projected values are regarded as superior, however,
since forecasted values incorporate current and predicted changes into
the values. In addition, the use of historical realized book returns on
equity in estimating ROE has been criticized because the realized
returns are the product of the regulatory process itself, and are also
subject to tests of reasonableness. Therefore, the Commission's
proposed rule requires that the forecasted values of ``b'' and ROE
published by Value Line be used in implementing the sustainable growth
method.
(iv) Final Estimate of ``g''. The final estimate of ``g'' for the
DCF model is commonly based on an average of the separate estimates
arrived at using the historical data, the professional investment
services' projections, and the sustainable growth model. Thus, the
Commission's proposed rule reflects such an averaging procedure.
(b) Dividend Yield. Two methods are commonly used to calculate
dividend yields in DCF analyses. The standard DCF model uses the annual
dividend expected to be paid 12 months following the purchase of the
security. This method assumes that dividends are paid annually. The
other method uses the current dividend to compute the yield portion of
the annual return. This method assumes that dividends are paid
continuously. However, the assumption of annual payments results in an
overstatement of the required return (i.e., the regulated firm's cost
of common-stock equity capital), and the assumption of continuous
payments results in an understatement of the required return. Since
most firms pay dividends on a quarterly basis, however, it is proper to
use a method that recognizes such quarterly installments. Such a method
applies an adjustment factor to the current dividend yield to account
for quarterly payment of dividends. The dividend yield, assuming
quarterly payment of dividends, is calculated on the basis of the
following formula:
TP07AP94.010
where:
D0 is the current annualized dividend (defined as four times the
current quarterly installment) per share;
P0 is the current market price per share of the common stock; and
g is the constant expected annual rate of growth in dividends per
share.
To illustrate the quarterly dividend formula, assume that the
current market price of a hypothetical regulated company's common stock
is $30.00 per share, and that a single common stock share currently
pays quarterly a 50 cent dividend ($2.00 annually), which is expected
to grow at a rate of 5 percent per year. The dividend yield for such a
company is:
TP07AP94.011
The Commission proposes to use this formula in calculating the
dividend yield in DCF analyses.
In calculating the current price per share found in the denominator
of the expression for the dividend yield, an average price over a
period of time, rather than a price on a particular day, is often used
in order to remove aberrations from the calculation. Such aberrations
could be the result of events internal to the company (e.g., the stock
may go ex-dividend30) or external factors (e.g., political events
that affect the price of a firm's stock). The period over which to
average the price of the common stock should be sufficiently long to
remove the aberration, but sufficiently short so as not to obscure any
real trends in the stock market. The Commission believes that the use
of an average of the monthly high and low prices for a six-month period
in computing the dividend yield meets these criteria, and such an
average is, therefore, reflected in the proposed rule.
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\3\0Ex-dividend is the interval between the announcement and the
payment of the next dividend. An investor who buys shares during
that interval is not entitled to that dividend. Typically, a stock's
price moves up by the dollar amount of the dividend as the ex-
dividend date approaches, then falls by the amount of the dividend
after that date.
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(c) Company-Specific Versus Comparable Group DCF Approach. The DCF
model can be applied directly to a regulated company which issues
publicly-traded common-stock equity (so that the requisite stock market
price data for doing so exist), to a group of companies comparable in
risk to the subject carrier which issue publicly-traded common-stock
equity, or, where possible, both. The company-specific DCF approach
provides the stock market's most direct and meaningful measure of a
company's cost of common-stock equity capital. Accordingly, the
Commission's proposed rule requires that the DCF model be applied
directly to the subject carrier where the carrier issues common-stock
equity which trades publicly.31 Only where a carrier issues no
publicly-traded common-stock equity is the DCF model to be applied to a
comparable group of firms under the proposed rule. Some expert
witnesses do, however, apply the DCF model to a comparable group of
firms, even where direct stock market data are available, either in
place of, or in addition to, the company-specific DCF approach. The
Commission's proposed rule does not prescribe the comparable group DCF
approach where direct stock market price data are available because it
is not certain that this approach would improve upon the accuracy of
the cost of common-stock equity capital estimate obtained using the
carrier-specific DCF approach.
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\3\1Alternatively, under the proposed rule, the DCF model is to
be applied directly to the parent company of a subsidiary carrier
where a consolidated capital structure and consolidated system
capital component costs are to be used to calculate the WACC,
assuming that the parent company issues common-stock equity which
trades publicly.
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b. Capital Asset Pricing Model. The conceptual basis of the CAPM is
that investors hold diversified portfolios consisting of individual
common stocks to minimize risk. Diversification reduces the risk of the
portfolio because individual common stock rates of return32 are
not perfectly correlated. The rate of return on some common stocks
tends to be high while on others it tends to be low so that the average
risk or variability of the return of the portfolio is less than the
average risk of the returns of the common stocks contained in that
portfolio. Diversification does not completely eliminate risk, however,
since individual common stock returns are correlated to a certain
degree due to the influence of pervasive forces not specific to a
particular security that affect the overall market.
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\3\2The annual rate of return on a common stock is the sum of
two components: (1) The annual dividend yield, which is annual
dividend income divided by the price of the common stock at the
beginning of a given year; and (2) the annual capital appreciation
or depreciation, which is the annual increase or decrease in the
price of the common stock, divided by the price at the beginning of
the given year.
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The total risk of a common stock is partitioned into two
components: (1) The ``specific'' or ``unsystematic'' risk unique to a
company that can be diversified away in a well-constructed portfolio,
and (2) the ``market'' or ``systematic'' risk that cannot be
diversified away. The core idea of the CAPM is that because investors
can diversify away company-specific risk, they should not be rewarded
for bearing this superfluous risk. Diversified risk-averse investors
are exposed solely to market risk and are, therefore, rewarded with
higher expected returns for bearing higher market risk.
The CAPM provides a measure of market risk, known as ``beta,''
which gauges the degree to which an individual common stock's return
moves with the overall market's return. Specifically, the common
stock's historical returns are compared with the overall market's
historical returns (commonly measured as the returns on a broad market
index such as the Standard and Poor's 500). A common stock is
considered to be of above average risk if the stock's return is more
volatile than that of the market,33 and of below average risk if
the stock's return is less volatile than that of the market.34
``Beta'' is used in the CAPM model to adjust the market premium
expected by investors in comparison to debt for the riskiness of an
individual common stock.
---------------------------------------------------------------------------
\3\3The ``beta'' for such an above-average risk common stock is
greater than one.
\3\4The ``beta'' for such a below-average risk common stock is
less than one.
---------------------------------------------------------------------------
The CAPM holds that the return on a common stock expected by an
investor is equivalent to that which could be earned on a riskless
investment, plus a premium for assuming risk that is proportional to
the common stock's market risk (i.e., ``beta''), and the market price
of risk (i.e., the difference between the overall expected stock market
return and the expected return on a risk-free investment). The CAPM is
represented algebraically as follows:
Ke=Rf+B(Rm-Rf)
where:
Ke is the expected return on the regulated firm's common stock
(i.e., its cost of common-stock equity capital;
Rf is the expected risk-free return;
B is the relevant expected market risk ``beta'' of the regulated firm's
common stock; and
Rm is the expected overall stock market return.
To illustrate the CAPM, assume that a hypothetical regulated
company's expected ``beta'' is .95, the expected risk-free rate is 7
percent, and the expected overall stock market return is 12 percent.
The company's cost of common-stock equity capital is:
Ke=.07+.95(.12-.07)
=.07+.0475
=.1175 or 11.75 percent.
i. Practical Issues. The practical application of the CAPM requires
estimates of the expected ``beta'' of the regulated firm, the expected
risk-free rate, and the expected return on the stock market. Each of
these inputs is discussed in turn.
(a) Risk-Free Rate. The yield on a 90-day Treasury Bill is
theoretically risk-free. It is devoid of default risk and is subject to
little interest rate risk. Treasury Bill rates vary widely, however,
resulting in volatile and unreliable common-stock equity return
estimates. In addition, 90-day Treasury Bill rates generally do not
match investors' planning horizons, which typically are far in excess
of 90 days. Short-term government obligations may also reflect the
impact of factors (e.g., inflation) differently than long-term
securities such as common stocks, or may reflect different factors than
those influencing the long term securities. Long-term Treasury bonds
(e.g., 30-year bonds) may more closely approximate investors' planning
horizons, and their yields usually match more closely with common stock
returns. The yields on long-term bonds are subject to substantial
interest rate risk, however, and so are not truly risk-free. A
compromise is to use the yields on Treasury securities of intermediate
maturities as proxies for the risk-free rate. Accordingly, the
Commission's proposed rule implements the CAPM using a six-month
average of five-year Treasury Note yields.
(b) ``Beta.'' The value of ``beta'' used in applying the CAPM
should, in principle, be that which is expected in the future. The
``beta'' actually used in the practical application of the model is,
however, more commonly calculated on the basis of historical data.
``Beta'' could be calculated by applying regression analysis, using
historical price and dividend data for the regulated firm under
consideration, in order to measure the variability of the return on the
regulated firm's common stock relative to that of the market. The usual
practice, however, is to use the ``betas'' published by an investment
firm such as Value Line. Value Line ``betas'' are derived from a
regression analysis between weekly percent changes in the price of a
company's common stock and the weekly percent changes in the New York
Stock Exchange Composite Indices over a period of five years.35
Provided that the regulated firm's market risk is not expected to
change appreciably in the future, ``betas'' based on historical data
are appropriate for estimating the cost of common-stock equity.
Therefore, the Commission's proposed rule specifies the use of Value
Line's most current ``betas'' in implementing the CAPM.
---------------------------------------------------------------------------
\3\5Value Line publishes adjusted ``betas.'' The adjustment
recognizes the tendency of ``betas'' to move toward one. (The market
index by definition has a value identically equal to one.) There are
two justifications for making such an adjustment: (1) Empirical
studies demonstrate that ``betas'' tend to move toward one over
time, and (2) the average ``beta'' is known to be one, and adjusting
an estimated ``beta'' toward one is, therefore, an appropriate use
of existing information.
---------------------------------------------------------------------------
(c) Market Return. The third input required by the CAPM is an
estimate of the expected return on the stock market. One broad approach
is to estimate the expected return on the market directly. One such
technique is to apply a DCF analysis to a broad market index such as
the Standard & Poor's 500. A second broad approach is the historically
derived risk premium method, which involves two steps: (1) The
arithmetic average difference between the actual annual returns
realized in the past on the overall stock market and the risk-free rate
is calculated,36 and (2) this historical differential is added to
the currently prevailing yield on the risk-free security. The resulting
sum is a measure of the return on the market. The rationale for this
method is that investors anticipate that common stocks will yield a
higher return than the return on lower risk, fixed income securities,
and the additional return on the common stocks is expected to be
approximately equal to what it was in the past. The Commission's
proposed rule stipulates the use of the historically derived risk
premium method because it is relatively easy to apply, and its data
requirements are relatively light compared to methods designed to
measure the expected market return directly.
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\3\6The arithmetic mean, not the geometric mean, should be used,
since the quantity desired is the rate of return investors expect
over the next year for the random annual rate of return on the
market. The arithmetic mean is the unbiased measure of the expected
value of repeated observations of a random variable.
---------------------------------------------------------------------------
The historical risk differential is commonly based on the
historical return series published annually by Ibbotson Associates in
the Stocks, Bonds, Bills, and Inflation Yearbook (``SBBI Yearbook'').
The SBBI Yearbook provides averages of the historical risk
differentials relative to various government securities for the period
1926 to the present, using Standard and Poor's 500 Index to compute the
overall market rate of return. The Commission's proposed rule specifies
the same source for measuring the arithmetic average risk premium
relative to the required risk-free rate proxy (i.e., the five-year
Treasury Note).
The choice of a time period for measuring the historical
differential sometimes differs, but frequently it matches the entire
period over which Ibbotson Associates provides the data. Returns
calculated over a substantially shorter horizon (e.g., five or ten
years) are sometimes used to calculate the risk premium. This is not
appropriate, however, due to the extreme volatility of the return on
the overall stock market.37 Accordingly, the Commission's proposed
rule stipulates that the entire length of the data series be used as
the time horizon.
---------------------------------------------------------------------------
\3\7In statistical terms, this extreme variability implies an
extremely large standard deviation over any short period of time.
Estimates of the overall market return calculated over such a short
period of time are, therefore, unreliable.
---------------------------------------------------------------------------
In summary, the proposed rule requires that the market return used
in CAPM calculations be computed using a risk premium defined as the
arithmetic average historical risk differential relative to the five-
year Treasury Note using the data published in the most current SBBI
Yearbook for the period 1926 through the most recent date for which the
data are available.
c. Risk Premium Method. The RP method, alternately referred to as
the ``risk positioning method'' or the ``stock-bond yield spread
method,'' is based upon the premise that common-stock equity capital is
riskier than debt from an investors' perspective and that investors,
therefore, require a larger rate of return on investments in common
stocks than on bonds to compensate them for bearing the extra risk.
Common stock equity is riskier than debt because the payment of
interest and principal to debtholders has priority over the payment of
dividends and return of capital to common-stock equityholders. The RP
method, therefore, estimates the cost of capital by adding an explicit
premium for risk to a current interest rate, frequently an interest
rate on a particular government security. The general mathematical
expression for the RP model is as follows:
Ke=Kd+RP
where:
Ke is the regulated firm's cost of common-stock equity capital;
Kd is the incremental (i.e., current) cost of debt; and
RP is the risk premium.
To illustrate the RP model, assume that the incremental cost of
debt is 7 percent, and the risk premium is 5 percent. The regulated
company's cost of common-stock equity capital is:
Ke=07+.05
=.12 or 12 percent.
i. Practical Issues
(a) Risk Premium. There are several procedures for estimating the
risk premium. One common approach is to use the historical arithmetic
average return differential between rates of return actually earned on
investments in common-stock equities and bonds. This approach is
expressed mathematically as follows:
Ke=Kd+Historical bond-equity spread
The historical bond-equity spread, in turn, is often based on the
data series published annually in the SBBI Yearbook. The portfolio of
common stocks used as the benchmark for estimating the risk premium
should be one that is composed of a broad array of firms and is well
diversified, in order to minimize the potential for it to be
contaminated by the peculiarities of a particular group of common
stocks. The SBBI Yearbook database is based upon the Standard & Poor's
500 Index, which meets these criteria. The range of companies in such a
broad group as the Standard & Poor's 500 Index covers the broad
dimensions of investor perceptions of the trade-off between risk and
return, and serves as a benchmark for investor-required returns. The
Commission's proposed rule stipulates the use of the historical bond-
equity spread based on the data published in the SBBI Yearbook.
Risk premiums based on the historical differential can be extremely
volatile and may fluctuate as macroeconomic and microeconomic
conditions change. The time period over which the risk premium is
selected should, therefore, be sufficiently long that short-term
aberrations are smoothed out. Such a time period must encompass at
least several business and interest rate cycles. The Commission's
proposed rule requires the use of the entire data series (1926-present)
published annually in the SBBI Yearbook in estimating the risk premium.
(b) Debt Security. The particular debt security used to implement
the RP model should be one which is, at least in theory, risk-free and
embodies a premium for inflation similar in magnitude to that reflected
in common stocks. Satisfying these criteria would isolate the spread
component of the return and obviate the need to make any type of
adjustment to the debt yield to account for default risk, which can
vary over time, and obscure the long-term relationship between returns
on common stocks and debt. These criteria are the same as those
identified for selecting a debt security to measure the risk-free rate
in implementing the CAPM.
Accordingly, the Commission's proposed rule stipulates the use of
the six-month average five-year Treasury Note yield in implementing the
RP model, for the reasons identified for selecting this same yield as
the risk-free rate in implementing the CAPM.
(c) Risk Adjustment. The risk premium estimate derived from a
composite market index is sometimes adjusted if there are differences
in the risk of the firms represented in the common-stock equity index
and that of the regulated firm under consideration. The CAPM (which is
actually the company-specific form of the general RP model), for
example, adjusts for such risk differences by multiplying the risk
premium by ``beta,'' which serves as the measure of relative risk in
the CAPM model. The Commission's proposed rule specifies that the RP
model be used in its general form without making any adjustment for
risk, because the generic form provides a useful benchmark for the
range of companies contained in the Standard & Poor's 500 Stock Index
on which it is based and, therefore, measures the broad dimensions of
investor perceptions of the trade-off between risk and return. The cost
of capital estimate produced using the RP model is not to be used as
the estimate, but instead is to be used as a check on, and in
combination with, the cost of capital company-specific estimates
produced using the DCF and CAPM models.
d. Market-to-Book Ratio Method. The MBR method is based on the
notion that the market value of a regulated firm's common-stock equity
should be equal to its book value (plus some allowance for
underpricing), and will be so if the firm's allowable rate of return on
common-stock equity capital is equal to the firm's cost of common-stock
equity capital. The MBR approach is considered solid conceptually, but
is criticized widely for being impractical or even impossible to
implement. In order to apply the MBR, a regulator must be able to
accurately predict the effect that its rate order will have on the
common stock price of a regulated firm in attempting to maintain the
equality between the market value and book value of the firm's common
stock. Critics argue that regulators are unable to produce such
accurate forecasts even when sophisticated econometric models are used.
In addition, a regulator may influence, but cannot control completely,
the market price of the regulated firm's stock. Even if it could, the
exercise of such control would produce violent swings in rate levels
which would be uneconomical to both the ratepayer and the regulated
firm alike. Finally, diversification by the regulated firm into
unregulated activities could result in a market price that differs from
book value, although the earnings of the regulated segment are
restrained.
The severe practical problems involved with implementing the MBR
method of computing an allowable rate of return on common-stock equity
capital sharply reduces the utility of the approach. Accordingly, the
Commission does not propose the MBR method of computing an allowable
rate of return on common-stock equity capital.
e. Comparable Earnings Method. The CE method is based upon the
fundamental economic concept of opportunity cost. This concept states
that the cost of using any resource (i.e., land, labor, or capital) in
a particular activity is what that resource could have earned in its
next best alternative use. Thus, the opportunity cost of an investment
in a regulated firm's common stock is what the invested funds could
have earned in their next best alternative investment (e.g., in another
company's common stock, in a government or corporate bond, in real
estate, in gold, etc.). In brief, the CE method infers a regulated
company's cost of common-stock equity capital from the average
(sometimes the adjusted average) book value rate of return on common-
stock equity of a group of firms comparable in risk to the regulated
company.
As already discussed above, the CE method is not thought to be well
grounded in economic theory, primarily because the method is
implemented using accounting data rather than market information, and
does not accurately reflect the regulated carrier's cost of common-
stock equity capital. Accordingly, the proposed rule does not specify
the CE method for computing the regulated firm's cost of common-stock
equity capital.
f. Final Cost of Common-Stock Equity Capital Estimate. Rather than
choosing between the DCF, CAPM, and RP methods, the Commission believes
that all three methods should be used to produce separate estimates in
arriving at a final estimate of a regulated carrier's cost of common-
stock equity capital, in order to avoid any inappropriate judgments
that could be embodied in any one of the individual estimates.
Accordingly, the proposed rule states that the Commission shall
consider the cost of common-stock equity capital estimates obtained
using the DCF, CAPM, and RP methods in arriving at a final cost of
common-stock equity capital estimate.
C. Other Cost of Capital Issues
1. Comparable-Risk Companies. a. Comparable-Risk Cost of Common-
Stock Equity Capital Estimates. When a regulated firm finances assets
with common-stock equity that does not trade publicly, it is necessary
to use a surrogate to impute the firm's cost of common-stock equity
capital. The cost must be imputed because the regulated firm's equity
position is not explicitly recognized in the capital market and,
consequently, the necessary data for directly estimating the regulated
firm's cost of common-stock equity do not exist. This occurs when: (1)
The regulated firm is an independent company (i.e., one which has no
corporate parent) which issues no publicly traded common-stock equity,
or (2) the regulated firm is a subsidiary of a parent company, and the
subsidiary issues no publicly traded common stock of its own.
In the case of the independent regulated company which issues no
publicly-traded common stock, the cost of common-stock equity capital
must be imputed from a sample of firms having risk similar to that of
the regulated company. Once an appropriate sample is selected, the cost
of common-stock equity capital is calculated using the methods
described earlier (i.e., DCF, CAPM, and RP) to produce a range of
estimates for the independent regulated company. In the case of the
regulated subsidiary, as discussed above, it may be appropriate to use
the consolidated system's capital structure and component costs to
estimate the subsidiary's WACC. If so, the consolidated system's cost
of common-stock equity is obtained by applying the DCF, CAPM, and RP
methods directly to the parent company, provided that the parent issues
publicly-traded common-stock equity so that the stock market price data
required for such an application exist. Otherwise, the regulated
subsidiary's capital structure and component costs are used, and it is
necessary to impute the subsidiary's cost of common-stock equity from a
sample of firms having risk similar to that of the subsidiary.
b. Selecting a Proxy Group. The proxy group must be composed of
companies whose business and financial risks are substantially
comparable to the risk of the regulated firm. Since no two companies
are identical in risk characteristics, and because a company's risk
profile may not be perfectly stable over time, at least several
companies must be chosen to maximize the reliability of the estimated
cost of common-stock equity capital computed for the regulated company.
The criteria for selecting the proxy companies should evaluate the
comparability of each company's business risk and financial risk with
those of the regulated firm. Comparability with regard to business risk
is most readily and directly accomplished by selecting companies in the
same line of business as the regulated firm. The comparability of
financial risk can be established by analyzing various financial
statistics and investment quality ratings which are commonly used as
measures of risk by investors. The Commission's proposed rule sets
forth a set of risk criteria for selecting proxy companies.
The proposed rule further directs carriers that must rely on proxy
companies to impute their cost of common-stock equity capital to use
the prescribed risk criteria in selecting proxy companies, and to
annually submit their selection of proxy companies along with their
annually filed statement of financial and operating data, as required
in Sec. 552.2. After notice and opportunity for comment, the Commission
shall annually designate the respective proxy group of companies for
each applicable carrier in accordance with its prescribed risk
criteria. The sequence of steps for selecting the proxy companies and
the prescribed risk criteria are discussed in detail below.
i. Risk Criteria
(a) Step 1: U.S. Companies Listed in Value Line. The Commission's
proposed rule stipulates that the proxy companies must be U.S.-based,
and must be those for which The Value Line Investment Survey (``Value
Line'') provides financial data. The proxy companies are to be based in
the U.S. so as to maintain consistent accounting and tax requirements.
Value Line contains financial information on 1,700 companies that
publicly issue common stock for over 95 industries, including the
transportation sector. The use of Value Line as a resource for
selecting proxy companies is particularly suitable since it contains
the requisite historical and projected financial data for estimating
the cost of common-stock equity.
(b) Step 2: Companies that Operate as Common Carriers. Consistent
with the concept of selecting firms of comparable business risk, the
proxy companies should be those which are in the same line of business
as the regulated firm. The proxy companies should operate and derive a
major portion of their gross revenues primarily as common carriers in
the business of freight transportation. The proxy group, for example,
could be comprised of common carriers that transport freight by air,
truck, water, and/or rail. The companies should also own or operate
transportation vehicles or vessels. Excluded from this group are
companies with gross revenues equal to or less than the $25,000,000
waiver level for vessel operating common carriers in the domestic
offshore trades, as described in 46 CFR Sec. 552.2(e).
(c) Step 3: Financial Analysis of Comparable Risk. The proposed
rule further states that the Commission may also consider a company's
financial strength in evaluating the degree of financial risk faced by
each of the selected companies. This may include an examination of
some, but not necessarily all, of the factors listed below.
(i) Total Capitalization Ratios and/or Debt/Equity Ratios. Total
capitalization ratios and debt/equity ratios measure the proportional
mix of financing in a company's capital structure. They are useful
measures of financial risk because they indicate the extent of leverage
or fixed-cost financing in a company (i.e., the degree to which the
company's assets are financed by long-term debt and/or preferred
stock). A low percentage of fixed-cost financing generally denotes a
low level of financial risk.
(ii) Debt Ratings. Investment analysis services, such as Standard &
Poor's and Moody's, provide investment quality ratings of companies'
long-term debt instruments. These include ratings on corporate bonds
and commercial paper. The ratings reflect a company's risk of default
on debt obligations and the possible risk of bankruptcy. The primary
basis of the debt ratings is interest coverage. This represents the
number of times a company's earnings are greater than its fixed
contractual charges or interest costs.
(iii) Stock Safety Rankings. Both Value Line and Standard & Poor's
provide common-stock equity rankings for each company listed in their
respective publications. While the basis of their ranking systems
differ, they both measure the degree of risk associated with each
company's common-stock equity. Value Line bases its ranking system on
the stability of the common stock's price adjusted for trends, as
measured by the standard deviation of weekly percent changes in the
stock's market prices over a five-year period, and partially on the
subjective analysis of its financial experts. Value Line's safety scale
ranges from 1, the highest, to 5.
(iv) Financial Strength Ratings. Value Line rates the financial
strength of each of the 1,700 companies listed in its publication
relative to all the others. The ratings are based on key variables that
determine financial leverage, business risk, and company size. The
ratings range from A++, the highest, to C.
(v) Standard Deviation. The standard deviation is a common
statistical measure which can be used to determine the variability of a
company's common-stock price changes, or returns on common-stock
equity. A high standard deviation indicates a high variability in the
range of price changes or returns relative to the average price change
or return. Thus, a high standard deviation implies a greater degree of
risk associated with a particular company's common stock. Value Line
provides a price stability index which ranks the standard deviation of
the weekly percentage changes in the market price of each company's
common stock over a five-year period.
(vi) The Beta Coefficient. Beta is a regression coefficient that
measures the volatility of a company's common-stock price changes, or
returns on common-stock equity, relative to the stock market as a
whole. Where beta for the stock market equals one, common stocks with
beta values of less than one are said to be less risky than the market,
while stocks with beta values greater than one are said to be riskier
than the market. Value Line and Standard & Poor's provide the beta
values associated with the common stock of each company listed in their
respective publications.
The Commission may also consider other information commonly
accepted by investors as measures of risk in a company. In this regard,
commenters may wish to address whether an accurate measure of
comparable risk should include some consideration of the regulated
firm's status as a subsidiary of a larger organization and, if so,
whether the criteria for inclusion in the proxy group should include
position in a larger corporate structure.
2. The Before-Tax Weighted Average Cost of Capital. The WACC was
defined above as the composite of the cost of the various classes of
capital used by the regulated firm weighted on the basis of the
proportions of the total which each class represents. Corporate taxes
were excluded. In reality, a regulated firm typically does pay taxes,
and the WACC must be adjusted accordingly in arriving at a final
allowable rate of return. The use of the WACC to determine an allowable
rate of return without making such an adjustment would result in an
understatement of the total cost of servicing capital to ratepayers.
Assuming a 40 percent corporate income tax rate, for example, a company
requires only $1.00 of revenue to provide a $1.00 return to bondholders
because interest payments are tax deductible for corporate income tax
purposes. The same company requires $1.67 of revenue, however, to
provide a $1.00 return to preferred stock and common-stock equity
shareholders because the firm must pay corporate income taxes, and
dividend payments to such shareholders are not tax deductible.
The following before-tax expression of the WACC (``BTWACC'')
recognizes explicitly the existence of income taxes and is, therefore,
the appropriate formula to use in computing an allowable rate of
return:
TP07AP94.012
where:
Kd is the regulated firm's cost of long-term debt capital;
Kp is the regulated firm's cost of preferred stock capital;
Ke is the regulated firm's cost of common-stock equity capital;
D is the value of the regulated firm's long-term debt outstanding;
P is the value of the regulated firm's preferred stock outstanding;
E is the value of the regulated firm's common-stock equity outstanding;
and
T is the corporate income tax rate.
To illustrate the calculation of the BTWACC, consider a
hypothetical regulated company that has total invested capital of $100
million, consisting of $25 million of long-term debt, $15 million of
preferred stock, and $60 million of common-stock equity. Assume that
the firm's cost of long-term debt is 7 percent, cost of preferred stock
is 9 percent and cost of common-stock equity is 12 percent, and that
the corporate income tax rate is 40 percent. The BTWACC for this firm
is calculated as follows:
Calculation of BTWACC
----------------------------------------------------------------------------------------------------------------
Amount
(millions Proportion Cost WACC Tax factor
Capital component of dollars) (percent) (percent) (percent) (1/1-T) BTWACC
----------------------------------------------------------------------------------------------------------------
Long-term debt.................... 25 25 7 1.75 1.00 1.75
Preferred stock................... 15 15 9 1.35 1.67 2.25
Common-stock equity............... 60 60 12 7.20 1.67 12.02
-----------------------------------------------------------------------------
Total....................... 100 100 ........... 10.30 ........... 16.02
----------------------------------------------------------------------------------------------------------------
The allowable rate of return for this hypothetical company should,
therefore, be set at 16.02 percent, which would provide the firm with
the opportunity to earn revenues sufficient to service the total cost
of capital and taxes.
The Commission's proposed rule specifies that the allowable rate of
return on rate base for a regulated carrier in the domestic offshore
trades shall be set equal to the carrier's WACC calculated on a before-
tax basis. The proposed rule also stipulates the use of the regulated
carrier's normalized corporate income tax rate (i.e., the statutory
corporate income tax rate, not the actual or effective corporate income
tax rate) in computing the BTWACC. This is consistent with the approach
the Commission uses currently in calculating the rate of return on rate
base. Furthermore, the large majority of regulatory commissions in the
U.S. use the normalized income tax rate for ratemaking and accounting
purposes.38
---------------------------------------------------------------------------
\3\8See NARUC, ``Table 40--Accounting Treatment Of Tax
Reductions--All Utilities,'' supra note 4, at 95-96.
---------------------------------------------------------------------------
3. Flotation Costs. Three factors could theoretically result in a
firm receiving as net proceeds from the issuance of common stock an
amount less than the pre-announcement common stock price: (1) The cost
of floating new issues (e.g., the fee paid to the underwriter) and
other administrative expenses (e.g., printing, legal, and accounting
expenses); (2) the downward market pressure resulting from the
increased supply of the common stock (i.e., the ``market pressure''
effect); and (3) the potential market price decline related to external
market variables (i.e., the ``market break'' effect).
The Commission's proposed rule specifies that an allowance for the
cost of common-stock equity capital financing be made for those
flotation costs that are actually incurred (i.e., those that are
identifiable and directly attributable to underwriting, printing,
legal, and accounting expenses), but only in the event that the
regulated carrier under consideration plans on issuing new common stock
to the general public during the test year in question.
No allowance would be made for any hypothetical costs such as those
associated with market pressure and market break effects. The proposed
rule also specifies that the allowance is to be applied solely to the
new common-stock equity and not to the existing common-stock equity
balance.39 The regulated carrier would be required to supply the
requisite information for computing the allowance.
---------------------------------------------------------------------------
\3\9The appropriate formula for computing such as allowance is
as follows:
k=Fs/(1+s)
where:
k is the required increment to the cost of the regulated firm's
common-stock equity capital that will allow the company to recover
its flotation costs;
F is the flotation costs expressed as a decimal fraction of the
dollar value of new common-stock equity sales; and
s is the new common-stock equity sales expressed as a decimal
fraction of the dollar value of existing common equity.
---------------------------------------------------------------------------
Deferred Taxes and The Capital Construction Fund
Under its current rules, the Commission does not address the issue
of deferred taxes for calculating rate base. The Commission proposes to
amend its rules to provide for the treatment of deferred taxes,
including the Capital Construction Fund (``Fund'').
The Fund is comprised of three components: (1) The capital account,
which results from contributions, (2) capital gains on investment
transactions, and (3) ordinary income, representing the earnings of
Fund assets. Section 607 of the Merchant Marine Act, 1936, 46 U.S.C.
app. Sec. 1177, which governs the Fund, provides for different tax
treatment for withdrawals from the various components of the Fund.
Section 607 requires that the basis of vessels, barges or containers
purchased with monies from the Fund be reduced by the amount of funds
withdrawn from the ordinary income and capital gains components of the
Fund. The proposed rule takes a similar approach, and would require
carriers to reduce the cost of an asset as shown in rate base by the
amount of funds withdrawn from the ordinary income and capital gains
components of the Fund which are used in acquiring the asset.
A certain portion of a carrier's physical capital (rate base) is
financed by deferred taxes. Unlike the debt, preferred stock, and
common-stock equity components of financial capital, deferred taxes
cost the carrier nothing. Deferred taxes are in the nature of an
interest-free loan from the government. Given that these funds are
obtained at zero cost, we believe that the carrier should not be
allowed a return on that portion of rate base which results from
deferred taxes, except on that portion that results from deferred taxes
that may arise from the Fund or the expired Investment Tax Credit, and
that rate base be reduced accordingly.
This treatment comports with the treatment of deferred taxes by
other federal agencies, as well as a majority of state regulatory
agencies.40 When it is necessary to allocate such accumulated
deferred taxes between Commission and non-Commission regulated
activities, such allocation shall be on the ratio of vessels and other
property and equipment included in rate base, less accumulated
depreciation, to total company vessels and other property and
equipment, less accumulated depreciation.
---------------------------------------------------------------------------
\4\0See NARUC, ``Table 39--Treatment Of Accumulated Deferred
Income Taxes In Rate Base--All Utilities,'' supra note 4, at 93-94.
---------------------------------------------------------------------------
Working Capital
The inclusion of working capital in rate base is intended to
recognize the necessity for the carrier to maintain an adequate supply
of cash for the purpose of meeting expenditure requirements during the
period between the payment of expenses and the collection of revenue.
Average voyage expense is used as the measure of working capital for a
self-propelled vessel operator under the Commission's existing rule.
With regard to the treatment of insurance expense in the
computation of average voyage expense, the Commission's current
regulations provide for the inclusion of 90 days' hull and machinery
insurance and protection and indemnity insurance. Hawaii suggests that
insurance expense be treated in the same manner as other operating
expenses, i.e., include that amount applicable to the duration of an
average voyage. The proposed rule adopts that approach.
Allocation of Assets and Expenses
In 1980, the Commission amended its rules governing the allocation
of assets and expenses. As a result of these changes, cargo cube or
space occupied replaced weight or revenue ton as the basis for
allocations. The rationale for this decision was that in a
containership operation, the cost of providing service is the cost of
providing space. The Commission concluded that the carrier's cost per
container remains the same regardless of the amount of cargo in the
container or revenue generated by the container.
Accordingly, part 552 currently prescribes that vessels,
accumulated depreciation and vessel expense shall be allocated on the
cargo-cube-mile relationship as defined in 46 CFR 552.5(n), while those
expenses related to cargo handling are allocated on the basis of cargo
cube loaded and discharged. Other property and equipment, and
administrative and general expenses are required to be allocated on the
voyage expense relationship, as defined in 46 CFR 552.5(p).
Commenters in Docket No. 91-51 suggested several alternative
allocation methods, including a method based on cargo carried on the
outbound portion of the voyage or based on revenue generated by
Commission and non-Commission regulated cargo. These proposals stemmed
from the bifurcation of regulatory authority in the domestic offshore
trades between the Commission and the Interstate Commerce Commission.
However, that split in jurisdiction has no direct connection with the
costs a carrier incurs in providing service. The Commission shall not
attempt to contrive an allocation methodology as a solution to an issue
that can best be remedied by legislative action.
The Federal Maritime Commission certifies pursuant to section
605(b) of the Regulatory Flexibility Act, 5 U.S.C. 605(n), that this
rule will not have a significant economic impact on a substantial
number of small entities, including small businesses, small
organizational units and small government jurisdictions. The Commission
grants a waiver of the detailed reporting requirements to carriers
which earn gross revenues of $25 million or less in a particular trade
in accordance with 46 CFR 552.2(e).
The collection of information requirements contained in this
proposed rule have been submitted to the Office of Management and
Budget for review under the provisions of the Paperwork Reduction Act
of 1980 (Pub. L. 96-511), as amended. The incremental public reporting
burden for this collection of information is estimated to range from an
average of 41 hours to 65 hours per response, including the time for
reviewing instructions, searching existing data sources, gathering and
maintaining the data needed, and completing and reviewing the
collection of information. Send comments regarding this burden
estimate, including suggestions for reducing this burden, to Sandra L.
Kusumoto, Director, Bureau of Administration, Federal Maritime
Commission, Washington, DC 20573 and to the Office of Information and
Regulatory Affairs, Office of Management and Budget, Washington, DC
20503.
List of Subjects in 46 CFR Part 552
Maritime carriers, Reporting and recordkeeping requirements,
Uniform system of accounts.
Therefore, pursuant to 5 U.S.C. 553, sections 18 and 43 of the
Shipping Act, 1916, 46 U.S.C. app. 817 and 841a, and sections 2 and 3
of the Intercoastal Shipping Act, 1933, 46 U.S.C. app. 844 and 845,
Part 552 of Title 46, Code of Federal Regulations, is proposed to be
amended as follows:
PART 552--FINANCIAL REPORTS OF VESSEL OPERATING COMMON CARRIERS BY
WATER IN THE DOMESTIC OFFSHORE TRADES
1. The authority citation for part 552 continues to read as
follows:
Authority: 5 U.S.C. 553; 46 U.S.C. app. 817(a), 820, 841a, 843,
844, 845, 845a and 847.
2. In Sec. 552.1, paragraph (b) is revised to read as follows and
paragraph (d) is removed:
Sec. 552.1 Purpose.
* * * * *
(b) In evaluating the reasonableness of a VOCC's overall level of
rates, the Commission will use return on rate base as its primary
standard. A carrier's allowable rate of return on rate base will be set
equal to its before-tax weighted average cost of capital. However, the
Commission may also employ the other financial methodologies set forth
in Sec. 552.6(f) in order to achieve a fair and reasonable result.
* * * * *
3. In Sec. 552.2, paragraph (a) is amended by revising the filing
address contained therein, paragraph (b) is redesignated as paragraph
(b)(1) and revised, a new paragraph (b)(2) is added, paragraph
(f)(1)(iv) is amended by removing ``and,'' from the end thereof,
paragraph (f)(1)(v) is amended by changing the period at the end
thereof to a semicolon and adding ``and,'' to the end of the paragraph,
and a new paragraph (f)(1)(vi) is added reading as follows:
Sec. 552.2 General requirements.
(a) * * *
Federal Maritime Commission, Bureau of Tariffs, Certification and
Licensing, 800 North Capitol Street, NW., Washington, DC 20573-0001
(b)(1) Annual statements under this part shall consist of Exhibits
A, B, and C, as described in Sec. 552.6, and shall be filed within 150
days after the close of the carrier's fiscal year and be accompanied by
a company-wide balance sheet and income statement having a time period
coinciding with that of the annual statements. A specific format is not
prescribed for the company-wide statements.
(2) Concurrently with the filing of the carrier's annual financial
statements required under this section, a carrier that issues no
publicly traded common-stock equity must submit for Commission approval
annually:
(i) A proxy group of companies to impute the carrier's cost of
common-stock equity capital in accordance with the requirements set
forth in Sec. 552.6(e)(3); or
(ii) An application to use a consolidated capital structure in
accordance with the requirements set forth in Sec. 552.6(e)(4).
* * * * *
(f) * * *
(1) * * *
(vi) Projected schedules for capitalization amounts and ratios
(Schedule F-I); cost of long-term debt capital calculation (Schedules
F-II and F-III); cost of preferred (and preference) stock capital
calculation (Schedules F-IV and F-V); corporate income tax rate
(Schedule F-VI); and flotation costs (Schedule F-VII) for the 12-month
period used to compute projected midyear rate base in paragraph
(f)(1)(ii) of this section.
* * * * *
4. In Sec. 552.5, paragraphs (b) and (c) are revised, and
paragraphs (v), (w), (x), (y), (z), (aa), and (bb) are added to read as
follows:
Sec. 552.5 Definitions.
* * * * *
(b) The service means those voyages and/or terminal facilities in
which cargo subject to the Commission's regulation under 46 CFR
514.1(c)(2) is either carried or handled.
(c) The trade means that part of the Service subject to the
Commission's regulation under 46 CFR 514.1(c)(2), more extensively
defined in this section under Domestic Offshore Trade.
* * * * *
(v) Book value means the value at which an asset is carried on a
balance sheet.
(w) Capital structure means a company's financial framework, which
is composed of long-term debt, preferred (and preference) stock, and
common-stock equity capital (par value plus earned and capital
surplus).
(x) Capitalization ratio means the percentage of a company's
capital structure that is long-term debt, preferred (and preference)
stock, and common stock-equity capital.
(y) Consolidated system means a parent company and all of its
subsidiaries.
(z) Subsidiary company means a company of which more than 50
percent of the voting shares of stock are owned by another corporation,
called the parent company.
(aa) Long-term debt means a liability due in a year or more.
(bb) Times-interest-earned ratio means the measure of the extent to
which operating income can decline before a firm is unable to meet its
annual interest costs. It is computed by dividing a firm's earnings
before interest and taxes by the firm's annual interest expense.
5. In Sec. 552.6, paragraph (a)(1), the first sentence of paragraph
(a)(2), the introductory text of paragraph (b)(1), paragraphs (b)(4)(i)
and (b)(5), and the heading of paragraph (b)(9) are revised; paragraph
(b)(10) is added; paragraphs (c)(5) and (c)(10) are revised; paragraphs
(d)(1) and (d)(2) are revised; paragraphs (e) and (f) are redesignated
(g) and (h); a new paragraph (e) is added and paragraphs (d)(3) and
(d)(4) are redesignated (f)(1) and (f)(2) and the paragraph headings
thereof revised reading as follows:
Sec. 552.6 Forms.
(a) General. (1) The submission required by this part shall be
submitted in the prescribed format and shall include General
Information regarding the carrier, as well as the following schedules
as applicable:
Exhibit A--Rate Base and supporting schedules;
Exhibit B--Income Account and supporting schedules;
Exhibit C--Rate of Return and supporting schedules;
Exhibit D--Application for Waiver;
Exhibit E--Initial Tariff Filing Supporting Data; and
Exhibit F--Allowable Rate of Return schedules.
(2) Statements containing the required exhibits and schedules are
described in paragraphs (b), (c), (d), (e), (g), and (h) of this
section and are available upon request from the Commission. * * *
(b) Rate base (Exhibits A and A(A))-(1) Investment in Vessels
(Schedules A-I and A-I(A)). Each cargo vessel (excluding vessels
chartered under leases which are not capitalized in accordance with
Sec. 552.6(b)(10)) employed in the Service for which a statement is
filed shall be listed by name, showing the original cost to the carrier
or to any related company, reduced to reflect the use of funds from the
Capital Construction Fund's capital gains account or ordinary income
account, plus the cost of improvements, conversions, and alterations,
reduced to reflect the use of funds from the Capital Construction
Fund's capital gains account or ordinary income account, less the cost
of any deductions. All additions and deductions made during the period
shall be shown on a pro rata basis, reflecting the number of days they
were applicable during the period. The result of these computations
shall be called the Adjusted Cost.
* * * * *
(4) Investment in other property and equipment; accumulated
depreciation other property and equipment (Schedule A-IV and A-IV(A)).
(i) Actual investment, representing original cost to the carrier or to
any related company, reduced to reflect the use of funds from the
Capital Construction Fund's capital gains account or ordinary income
account, in other fixed assets employed in the Service, shall be
reported as of the beginning of the year. Accumulated depreciation for
these assets shall be reported both as of the beginning and as of the
end of the year. The arithmetic average of the two amounts shall also
be shown and shall be the amount deducted from original cost in
determining rate base. The cost of additions and deductions during the
period, adjusted to reflect the use of the Capital Construction Fund,
shall also be reported. The carrier shall report as though all such
changes took place at midyear, except those involving substantial sums,
which shall be prorated on a daily basis. Allocation to the Trade shall
be based upon the actual use of the specific asset or group of assets
within the Trade. For those assets employed in a general capacity, such
as office furniture and fixtures, the voyage expense relationship shall
be employed for allocation purposes. The basis of allocation to the
Trade shall be set forth and fully explained.
(ii) * * *
(5) Working Capital (Schedule A-V). Working capital for vessel
operators shall be determined as average voyage expense. Average voyage
expense shall be calculated on the basis of the actual expenses of
operating and maintaining the vessel(s) employed in the Service
(excluding lay-up expenses) during the average length of time of all
voyages (excluding lay-up periods) during the period in which any cargo
was carried in the Trade. Expenses for operating and maintaining
vessels employed in the Trade shall include: Vessel Operating Expense,
Vessel Port Call Expense, Cargo Handling Expense, Administrative and
General Expense and Interest Expense allocated to the Trade as provided
in paragraphs (c) (2), (4) and (5) of this section.
* * * * *
(9) Capitalization of leases (Schedules A-VII and A-VII(A)). * * *
(10) Accumulated Deferred Taxes (Schedules A-VIII and A-VIII(A)).
Accumulated deferred taxes, excluding deferred taxes that may arise
from the Capital Construction Fund or the expired Investment Tax
Credit, shall be reported both as of the beginning and the end of the
year and the arithmetic average of the two amounts shall be shown.
Allocation to the Trade shall be based upon the ratio of Trade
Investment in Vessels (Schedules A-I and A-I(A)) less Accumulated
Depreciation (Schedules A-II and A-II(A)) plus Other Property and
Equipment less Accumulated Depreciation (Schedules A-IV and A-IV(A)) to
total company investment in vessels and other property and equipment
less accumulated depreciation.
(c) * * *
* * * * *
(5) Interest expense and debt payments (Schedules B-IV and B-
IV(A)). This schedule shall set forth the total interest and debt
payments, apportioned between principal and interest, short and long-
term, on debt and lease obligations. Payments on long-term debt are to
be calculated consistent with the method set forth in Sec. 552.6(e)(7)
for computing the cost of long-term debt capital. Principal and
interest shall be allocated to the Trade in the ratio that Trade rate
base less working capital bears to company-wide assets less current
assets. Where related company assets are employed by the filing
company, the balance sheet figures on the related company's books for
such assets shall be added to the company-wide total in computing the
ratio. In those instances where interest expenses are capitalized in
accordance with paragraph (b)(9) of this section, a deduction shall be
made for the amount so capitalized.
* * * * *
(10) Provision for income tax. Federal, State, and other income
taxes shall be listed separately. If the company is organized outside
the United States, it shall indicate the entity to which it pays income
taxes and the rate of tax applicable to its taxable income for the
subject year. Federal, State and other income taxes shall be calculated
at the statutory rate. Such tax rates are to be identical to those set
forth in Schedules F-VI or F-VI(A) used in determining the carrier's
allowable rate of return unless the carrier is a subsidiary of a parent
company and a consolidated capital structure is to be used in that
determination.
* * * * *
(d) Rate of Return (Exhibits C and C(A))--(1) General. All carriers
are required to calculate rate of return on rate base. However, the
Commission or individual carriers, at the Commission's discretion, may
also employ fixed charges coverage and/or operating ratios as provided
for in paragraph (f) of this section.
(2) Return on rate base. The return on rate base will be computed
by dividing Trade net income plus interest expense by Trade rate base.
(e) Maximum allowable rate of return on rate base (Exhibits F and
F(A))--(1) General. A carrier's maximum allowable rate of return on
rate base shall be set equal to the carrier's weighted average cost of
capital calculated on a before-tax basis (``BTWACC''). The BTWACC is
defined mathematically by the following expression:
TP07AP94.013
where:
Kd is the carrier's cost of long-term debt capital;
Kp is the carrier's cost of preferred (and preference) stock
capital;
Ke is the carrier's cost of common-stock equity capital;
D is the average book value of the carrier's long-term debt capital
outstanding;
P is the average book value of the carrier's preferred (and preference)
stock capital outstanding;
E is the average book value of the carrier's common-stock equity
capital (par value plus earned and capital surplus) outstanding; and
T is the carrier's composite statutory corporate income tax rate.
A carrier's BTWACC shall be calculated in precise accordance with
the rules set forth in this section.
(2) Subsidiary carrier's capital structure. Where a carrier is a
subsidiary that obtains its common-stock equity capital through a
parent company, the capital structure of the subsidiary shall be used
in computing the BTWACC. The subsidiary carrier's cost of common-stock
equity capital, the subsidiary carrier's cost of long-term debt
capital, the subsidiary carrier's cost of preferred stock capital, and
the subsidiary carrier's composite statutory corporate income tax rate
shall also be used in computing the BTWACC. The subsidiary carrier's
cost of common-stock equity capital shall be inferred as the cost of
common-stock equity capital estimated for a sample of firms having
business and financial risk comparable to the subsidiary carrier when
the subsidiary carrier's capital structure is used in calculating the
BTWACC.
(3) Comparable risk companies. (i) Concurrently with the filing of
the annual financial statements required under Sec. 552.2, a carrier
must submit for Commission approval a proxy group of companies to
impute the carrier's cost of common-stock equity capital where:
(A) The carrier is an independent company (i.e., it has no
corporate parent) which issues no publicly-traded common-stock equity,
or
(B) The carrier is a subsidiary that obtains its common-stock
equity capital through a parent company.
(ii) After notice and opportunity for comment, the Commission will
approve a proxy group of companies based on the following criteria:
(A) The proxy companies shall be based in the United States and
shall be listed in The Value Line Investment Survey.
(B) The proxy companies shall operate and derive a major portion of
their gross revenues primarily as common carriers in the business of
freight transportation, and shall own or operate transportation
vehicles or vessels. Companies with gross annual revenues equal to or
less than the $25,000,000 shall be excluded from the proxy group.
(C) In addition, comparable risk companies shall be selected by
examining some, but not necessarily all, of the following risk
indicators:
(1) A company's total capitalization ratio and/or debt-to-equity
ratio;
(2) The investment quality ratings of a company's long-term debt
instruments;
(3) The investment safety ranking of a company's common-stock
equity;
(4) The rating of a company's financial strength, as provided by
Value Line;
(5) The variability of a company's common-stock price changes or
returns on common-stock equity (i.e., the standard deviation);
(6) The volatility of a company's common-stock price changes or
returns on common-stock equity relative to the stock market as a whole
(i.e., the beta coefficient); or
(7) Other such valid indicators deemed appropriate by the
Commission.
(iii) Any proxy group of companies that has received Commission
approval will not be subject to challenge in a subsequent rate
investigation brought under section (3) of the Intercoastal Act, 1933.
(4) Consolidated capital structure. (i) Upon application, after
notice and opportunity for comment, the Commission may authorize use of
the capital structure of the consolidated system (i.e., the parent
company and all of its subsidiaries) in computing the BTWACC. The
application must show that:
(A) The subsidiary carrier's parent company issues publicly traded
common-stock equity;
(B) The subsidiary carrier's parent company owns 90 percent or more
of the subsidiary's voting shares of stock; and
(C) The business and the financial risks of the subsidiary carrier
and the parent company are similar.
(ii) The similarity of the parent company's and subsidiary
carrier's business risk shall be evaluated by examining the degree to
which the consolidated system's profits, revenues, and expenses are
composed of those of the subsidiary carrier, and the extent to which
the parent's holdings are diversified into lines of business unrelated
to those of the subsidiary carrier, and/or other indicators of business
risk deemed appropriate by the Commission. The similarity of the parent
company's and subsidiary carrier's financial risk shall be evaluated by
examining the consolidated system's and the subsidiary's total
capitalization ratios, debt-to-equity ratios, investment quality
rankings on short- and long-term debt instruments, times-interest-
earned ratios, fixed charges coverage ratios (calculated to include
both FMC and non-FMC regulated operations), and/or other measures of
financial risk deemed appropriate by the Commission.
(iii) When the consolidated capital structure is used, the
consolidated system's cost of common-stock equity capital (issued by
the parent company), the consolidated system's cost of long-term debt
capital, the consolidated system's cost of preferred (and preference)
stock capital, and the consolidated system's composite statutory
corporate income tax rate shall also be used in estimating the
subsidiary's BTWACC.
(iv) Where the Commission has approved the use of a consolidated
capital structure, such use will not be subject to challenge in a
subsequent rate investigation brought under section (3) of the
Intercoastal Act, 1933.
(5) Book-value, average capitalization ratios. Capitalization
ratios representing the capital structure used in deriving a carrier's
BTWACC shall be computed on the basis of average projected book value
outstanding over the 12-month period used to calculate projected
midyear rate base in Sec. 552.2 (f)(1)(ii). The average amount of any
class of capital outstanding used in determining the capitalization
ratios is computed by adding the amount of a particular type of capital
expected to be outstanding as of the beginning of the 12-month period
to the amount of that same type of capital expected to be outstanding
as of the end of the 12-month period, and dividing the sum of the two
amounts outstanding by two.
(6) Capitalization amounts and ratios (Schedules F-I and F-I(A)). A
carrier shall show its long-term debt, preferred stock, and common-
stock equity capitalization amounts outstanding, stated in book value
terms, as of the beginning and as of the end of the 12-month period
used to calculate projected midyear rate base, and the average amounts
and average ratios for that 12-month period. Where a carrier is a
subsidiary of a parent company, the carrier shall show its own
capitalization amounts and ratios unless the carrier applies for and
receives permission from the Commission to use a consolidated capital
structure in computing the BTWACC. Where such permission is granted,
the carrier shall show instead the consolidated system's capitalization
amounts and ratios.
(7) Cost of long-term debt capital (Schedules F-II, F-II(A), F-III,
and F-III(A)). (i) The cost of long-term debt capital1 shall be
calculated by the carrier for the 12-month period used to compute
projected mid-year rate base on the basis of:
---------------------------------------------------------------------------
\1\The cost of sinking fund preferred stock shall be computed in
accordance with the regulations in this section for calculating the
cost of long-term debt.
---------------------------------------------------------------------------
(A) Embedded cost for existing long-term debt; and
(B) Current cost for any new long-term debt expected to be issued
on or before the final day of the 12-month period.
(ii) The arithmetic average annual percentage rate cost of long-
term debt capital calculated on the basis of all issues of long-term
debt expected to be outstanding as of the beginning and as of the end
of the 12-month period used to compute projected mid-year rate base
shall be the cost of long-term debt capital used in computing the
BTWACC.
(iii) The annual percentage rate cost of long-term debt capital for
all issues of long-term debt expected to be outstanding as of the
beginning and as of the end of the 12-month period used to compute
projected mid-year rate base shall be calculated separately for the two
dates by:
(A) Multiplying the cost of money for each issue under paragraph
(e)(7)(v)(A)(10) of this section by the principal amount outstanding
for each issue, which yields the annual dollar cost for each issue; and
(B) Adding the annual dollar cost of each issue to obtain the total
dollar cost for all issues, which is divided by the total principal
amount outstanding for all issues to obtain the annual percentage rate
cost of long-term debt capital for all issues.
(iv) The arithmetic average annual percentage rate cost of long-
term debt capital for all issues to be used as the cost of long-term
debt capital in computing the BTWACC shall be calculated by:
(A) Adding the total annual dollar cost for all issues of long-term
debt capital expected to be outstanding as of the beginning of the 12-
month period used to compute projected mid-year rate base to the total
annual dollar cost for all issues of long-term debt capital expected to
be outstanding as of the end of the 12-month period, and dividing the
resulting sum by two, which yields the average total annual dollar cost
of long-term debt for all issues for the 12-month period;
(B) Adding the total principal amount outstanding for all long-term
debt issues expected to be outstanding as of the beginning of the 12-
month period used to compute projected mid-year rate base to the total
principal amount outstanding for all long-term debt issues expected to
be outstanding as of the end of the 12-month period, and dividing the
resulting sum by two, which yields the average total principal amount
expected to be outstanding for all issues for the 12-month period; and
(C) Dividing the average total annual dollar cost of long term debt
for all issues for the 12-month period by the average total principal
amount expected to be outstanding for all issues for the 12-month
period, which yields the average annual percentage rate cost of long-
term debt capital for all issues to be used in computing the BTWACC.
(v)(A) Cost of long-term debt capital calculation (Schedules F-II,
F-II(A), F-III and F-III(A)). The carrier shall calculate the annual
percentage rate cost of long-term debt capital for all issues of long-
term debt expected to be outstanding as of the beginning and as of the
end of the 12-month period used to compute projected mid-year rate base
separately for the two dates, and shall also calculate the average
annual percentage rate cost of long-term debt for all issues for the
12-month period. The carrier shall support these calculations by
showing in tabular form the following for each class and series of
long-term debt expected to be outstanding as of the beginning and as of
the end of the 12-month period separately for the two dates:
(1) Title;
(2) Date of issuance;
(3) Date of maturity;
(4) Coupon rate (%);
(5) Principal amount issued ($);
(6) Discount or premium ($);
(7) Issuance expense ($);
(8) Net proceeds to the carrier ($);
(9) Net proceeds ratio (%), which is the net proceeds to the
carrier divided by the principal amount issued;
(10) Cost of money (%), which, for existing long-term debt issues,
shall be the yield-to-maturity at issuance based on the coupon rate,
term of issue, and net proceeds ratio determined by reference to any
generally accepted table of bond yields; and, for long-term debt issues
to be newly issued on or before the final day of the 12-month period,
shall be based on the average current yield (published in such a
publication as Moody's Bond Survey) on long-term debt instruments
similar in maturity and investment quality as the long-term debt
security that is to be issued;
(11) Principal amount outstanding (%);
(12) Annual cost ($); and
(13) Name and relationship of issuer to carrier.
(B) Where a carrier is a subsidiary of a parent company, the
carrier shall show the cost of long-term debt calculations and
information required in this paragraph (e)(7)(v) for its own cost of
long-term debt unless the carrier applies for and receives permission
from the Commission to use a consolidated capital structure in
computing the BTWACC. Where such permission is granted, the subsidiary
carrier shall show the required cost of long-term debt calculations and
information for the consolidated system's long-term debt.
(vi) In the event that new long-term debt is to be issued on or
before the final day of the 12-month period used to compute projected
mid-year rate base, the carrier shall submit a statement explaining the
methods used to estimate information required under paragraphs
(e)(7)(v)(A) (1) through (13).
(8) Cost of preferred (and preference) stock capital Schedules F-
IV, F-IV(A), F-V, and F-V(A)). (i) The cost of preferred (and
preference) stock capital shall be calculated by the carrier for the
12-month period used to compute projected mid-year rate base on the
basis of:
(A) Embedded cost for existing preferred (and preference stock);
and
(B) Current cost for any new preferred (and preference) stock to be
issued on or before the final day of the 12-month period.
(ii) The arithmetic average annual percentage rate cost of
preferred (and preference) stock capital calculated on the basis of all
issues of preferred (and preference) stock expected to be outstanding
as of the beginning and as of the end of the 12-month period used to
calculate projected mid-year rate base shall be the cost of preferred
(and preference) stock capital used in computing the BTWACC.
(iii) The annual percentage rate cost of preferred (and preference)
stock capital for all issues of preferred (and preference) stock
expected to be outstanding as of the beginning and as of the end of the
12-month period used to compute projected mid-year rate base shall be
calculated separately for the two dates by:
(A) Multiplying the cost of money for each issue under paragraph
(e)(8)(v)(A)(9) of this section by the par or stated amount outstanding
for each issue, which yields the annual dollar cost for each issue; and
(B) Adding the annual dollar cost of each issue to obtain the total
for all issues, which is divided by the total par or stated amount
outstanding for all issues to obtain the annual percentage rate cost of
preferred (and preference) stock capital for all issues.
(iv) The arithmetic average annual percentage rate cost of
preferred (and preference) stock capital for all issues to be used as
the cost of preferred (and preference) stock capital in computing the
BTWACC shall be calculated by:
(A) Adding the total annual dollar cost for all issues of preferred
(and preference) stock capital expected to be outstanding as of the
beginning of the 12-month period used to compute projected mid-year
rate base to the total annual dollar cost for all issues of preferred
(and preference) stock capital expected to be outstanding as of the end
of the 12-month period, and dividing the resulting sum by two, which
yields the average total annual dollar cost of preferred (and
preference) stock for all issues for the 12-month period;
(B) Adding the total par or stated amount outstanding for all
preferred (and preference) stock issues expected to be outstanding as
of the beginning of the 12-month period used to compute projected mid-
year rate base to the total par or stated amount outstanding for all
issues expected to be outstanding as of the end of the 12-month period,
and dividing the resulting sum by two, which yields the average total
par or stated amount expected to be outstanding for all issues for the
12-month period;
(C) Dividing the average total annual dollar cost of preferred (and
preference) stock for all issues for the 12-month period by the average
total par or stated amount expected to be outstanding for all issues
for the 12-month period, which yields the average annual percentage
rate cost of preferred (and preference) stock capital for all issues to
be used in computing the BTWACC.
(v)(A) Cost of preferred (and preference) stock capital calculation
(Schedules F-IV, F-IV(A), F-V, and F-V(A)). The carrier shall calculate
the annual percentage rate cost of preferred (and preference) stock
capital for all issues of preferred (and preference) stock expected to
be outstanding as of the beginning and as of the end of the 12-month
period used to compute projected mid-year rate base separately for the
two dates, and shall also calculate the average annual percentage rate
cost of preferred (and preference) stock for all issues for the 12-
month period. The carrier shall support these calculations by showing
in tabular form the following for each issue of preferred (and
preference) stock as of the beginning and as of the end of the 12-month
period separately for the two dates:
(1) Title;
(2) Date of issuance;
(3) Dividend rate (%);
(4) Par or stated amount of issue ($);
(5) Discount or premium ($);
(6) Issuance expense ($);
(7) Net proceeds to the carrier ($);
(8) Net proceeds ratio (%), which is the net proceeds to the
carrier divided by the par or stated amount issued;
(9) Cost of money (%), which, for existing preferred (and
preference) stock issues, shall be the dividend rate divided by the net
proceeds ratio; and, for preferred (and preference) stock issues to be
newly issued on or before the final day of the 12-month period, shall
be the estimated dividend rate divided by the estimated net proceeds
ratio;
(10) Par or stated amount outstanding ($);
(11) Annual cost ($); and
(12) If issue is owned by an affiliate, name and relationship of
owner.
(B) Where a carrier is a subsidiary of a parent company, the
carrier shall show the cost of preferred (and preference) stock
calculations and information required in this paragraph (e)(8)(v) for
its own preferred (and preference) stock unless the carrier applies for
and receives permission from the Commission to use a consolidated
capital structure in computing the BTWACC. Where such permission is
granted, the subsidiary carrier shall show the required cost of
preferred (and preference) stock calculations and information for the
consolidated system's preferred (and preference) stock.
(vi) In the event that new preferred (and preference) stock is to
be issued on or before the final day of the 12-month period used to
compute projected mid-year rate base, the carrier shall submit a
statement explaining the methods used to estimate information required
under paragraph (e)(8)(v)(A) (1) through (12).
(9) Cost of common-stock equity capital. A carrier's cost of
common-stock equity capital shall be calculated using the Discounted
Cash Flow (``DCF''), Capital Asset Pricing Model (``CAPM''), and Risk
Premium (``RP'') methods. A final estimate of that cost shall be
derived from the separate estimates obtained using each of the three
methods.
(10) DCF method. (i) The DCF model that shall be used in
calculating a carrier's cost of common-stock equity is defined
algebraically as follows:
TP07AP94.014
where:
Ke is the carrier's cost of common-stock equity capital;
D0 is the carrier's current annualized dividend (defined as four
times the current quarterly installment) per share;
P0 is the current market price per share of the carrier's common
stock; and
g is the constant expected annual rate of growth in the carrier's
dividends per share.
(ii) Current market price per share of common stock. The current
market price per share of the carrier's common stock used in the DCF
model shall be an average of the monthly high and low market prices
during a six-month period commencing not more than nine months prior to
the date on which the proposed rates are filed.
(iii) Estimated growth rate of dividends. The estimate of g used in
the DCF model shall be an average of three separate estimates obtained
using historical growth rate data, professional investment services'
projections, and the sustainable growth rate model.
(iv) Historical growth rate estimate of g. The historical growth
rate estimate of g shall be an average of the carrier's most recent
five- and ten-year historical growth rate averages of dividends per
share, earnings per share, and book value per share.
(v) Professional investment services' projections estimate of g.
The professional investment services' projections estimate of g shall
be an average of Value Line's five-year forecasted growth rate of
dividends per share, earnings per share, book value per share, and the
Institutional Brokers Estimation Service's five-year forecasted growth
rate in earnings per share for the carrier.
(vi) Sustainable growth rate estimate of g. The sustainable growth
rate estimate of g shall be obtained by multiplying the proportion of
earnings expected to be retained by the carrier by the expected return
on book equity. Value Line's forecasted values for expected retained
earnings and expected return on book equity shall be used in arriving
at the sustainable growth rate estimate of g.
(11) CAPM. (i) The CAPM that shall be used in calculating a
carrier's cost of common-stock equity is represented algebraically as
follows:
Ke = Rf + B(Rm - Rf)
where:
Ke is the carrier's cost of common-stock equity capital;
Rf is the expected risk-free rate of return;
B is the relevant market risk beta of the carrier's common stock; and
Rm is the expected overall stock market return.
(ii) Expected risk-free rate of return. A six-month average of
five-year Treasury Note yields computed over a period not more than
nine months prior to the date on which the proposed rates are filed
shall be used as the estimate of the expected risk-free rate of return
in the CAPM.
(iii) Expected beta. Value Line's most current market risk beta of
the carrier's common-stock shall be used as the estimate of the
expected beta in the CAPM.
(iv) Expected overall market return. The expected overall return on
the stock market shall be estimated by adding the six-month average of
five-year Treasury Note yields used as the estimate of the expected
risk-free rate to the arithmetic average difference between the actual
annual returns realized historically by the Standard & Poor's 500 Stock
Index and the five-year Treasury Note. The arithmetic average
differential shall be based on the complete historical series published
annually by Ibbotson Associates in the most recent Stocks, Bonds, Bills
and Inflation Yearbook, for the period 1926 through the most recent
date for which the specified data are available.
(12) RP method. (i) The RP model that shall be used in calculating
a carrier's cost of common-stock equity is defined mathematically as
follows:
Ke = Kd + RP
where:
Ke is the regulated carrier's cost of common-stock equity capital;
Kd is the incremental cost of debt; and RP is the risk premium.
(ii) Risk premium. The risk premium used in the RP model shall be
the historical arithmetic average return differential between rates of
return actually earned on investments in the Standard & Poor's 500
Stock Index and the five-year Treasury Note. This risk premium shall be
based on the complete historical data series published annually in the
Stocks, Bonds, Bills and Inflation Yearbook, for the period 1926
through the most recent date for which the specified data are
available.
(iii) Incremental cost of debt. A six-month average of five-year
Treasury Note yields computed over a period not more than nine months
prior to the date on which the proposed rates are filed shall be the
estimate of the incremental cost of debt in the RP model.
(iv) Risk adjustment. The RP model shall be used in its generic
form and the risk premium specified herein shall not be adjusted for
any possible differences in the risk of the firms represented in the
Standard & Poor's 500 Stock Index and that of the carrier under
consideration. The generic RP model shall be used as a benchmark for
the range of companies contained in the Standard & Poor's 500 Stock
Index on which it is based, and, therefore, shall be used to measure
the broad dimensions of investor perceptions of the trade-off between
risk and return.
(13) Corporate income tax rate (Schedules F-VI and F-VI(A)). The
corporate income tax rate used in computing the BTWACC shall be the
carrier's composite statutory corporate income tax rate for the 12-
month period used to compute projected midyear rate base. Such rate
shall be a composite of the carrier's Federal and State income tax
rates, and of any other income tax rate to be applied to the carrier's
income by any other entity to which the carrier is to pay income taxes.
The carrier shall calculate and show its composite statutory corporate
income tax rate as well as its Federal, State, and any other applicable
statutory income tax rates separately for the 12-month period used to
compute projected midyear rate base. The carrier shall also state the
name of any entity other than the Federal and State governments to
which it is to pay taxes. Where a carrier is a subsidiary of a parent
company, the carrier shall show its own statutory corporate income tax
rates unless the carrier applies for and receives permission from the
Commission to use a consolidated capital structure in computing the
BTWACC. Where such permission is granted, the carrier shall show
instead the consolidated system's statutory corporate income tax rates.
(14) Flotation costs (Schedules F-VII and F-VII(A)). (i) A
carrier's cost of common-stock equity capital shall be adjusted to
reflect those costs of floating new issues that are actually incurred,
but only in the event that new common stock is to be issued to the
general public during the 12-month period used to compute projected
midyear rate base. Those flotation costs for which an allowance shall
be made must be identifiable, and must be directly attributable to
underwriting fees, and printing, legal, accounting, and/or other
administrative expenses. No allowance shall be made for any
hypothetical costs such as those associated with market pressure and
market break effects. The allowance shall be applied solely to the new
common-stock equity and shall not be applied to the existing common-
stock equity balance. The formula that shall be used to compute such an
allowance is as follows:
k = Fs/(1+s)
where:
k is the required increment to the cost of the carrier's common stock
equity capital that will allow the company to recover its flotation
costs;
F is the flotation costs expressed as a decimal fraction of the dollar
value of new common-stock equity sales; and
s is the new common-stock equity sales expressed as a decimal fraction
of the dollar value of existing common-stock equity capital.
(ii) Flotation costs data (Schedules F-VII and F-VII(A)). (A) In
the event that new common-stock equity is to be issued during the 12-
month period used to compute projected midyear rate base, the carrier
shall show separately by category the estimated costs of floating the
new issues to the extent that such costs are identifiable and are
directly attributable to actual underwriting fees, and to printing,
legal, accounting, and/or other administrative expenses that must be
paid by the carrier. The carrier shall submit a statement explaining
the method used in estimating the flotation costs. The carrier shall
also show estimates of the date of issuance; number of shares to be
issued; gross proceeds at issuance price; and net proceeds to the
carrier.
(B) Where a carrier is a subsidiary that obtains its common-stock
equity capital through a parent company, and the parent company intends
to issue new common-stock equity during the 12-month period, the
carrier shall show separately by category the estimated costs to the
parent company of floating the new issues, and estimates of the above
items relative to the parent company's issuance of new common-stock
equity, provided that such carrier applies for and receives permission
from the Commission to use a consolidated capital structure in
computing the BTWACC.
(f) Financial ratio methods--(1) Fixed charges coverage ratio. * *
*
(2) Operating ratio. * * *
By the Commission.
Joseph C. Polking,
Secretary.
[FR Doc. 94-8226 Filed 4-6-94; 8:45 am]
BILLING CODE 6730-01-W
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