WACC Methodology
6.4 Companies are typically funded by a combination of debt and equity. WACC is the weighted average cost of each new dollar of capital raised at the margin. In the simplest terms, it is the cost of debt and the cost of equity weighted by the proportion of debt and equity. It is expressed by the following formula:
WACC = WdRd(1-tc) + WeRe
| where: |
Wd |
= |
proportion (weight) of debt funding |
| |
Rd |
= |
cost of debt |
| |
tc |
= |
statutory corporate tax rate |
| |
We |
= |
proportion (weight) of equity funding |
| |
Re |
= |
cost of equity |
6.5 Determination of the elements of WACC is subjective and involves considerable uncertainty. Careful and detailed examination is required to ensure that figures used (and assumptions adopted) are reasonable. If WACC is too high, airport operators will be able to achieve excess returns, while if it is too low, it may discourage investment. For this reason, a range for WACC is estimated around a point estimate.
Cost of Debt
6.6 The relevant cost of debt is the interest rate required by investors to earn their desired return. It can, in some instances, be observed directly as the yield on debt issued by a company (e.g., through a bond issue with specified return), but is typically determined by way of a margin over and above the risk free rate, which is assumed to reflect the cost for which a firm of similar credit risk with an efficient capital structure could be expected to obtain financing. Computed in this way, the cost of debt (Rd) is expressed by the following formula:
Rd = Rf + Debt Premium
| where: |
Rf |
= |
risk-free rate |
| |
Debt Premium |
= |
 d(MRP) + Expected Default Losses + Liquidity Premium |
| |
d |
= |
debt beta |
| |
Market Risk Premium (MRP) |
= |
Rm - Rf |
| |
Rm |
= |
expected rate of return on the market portfolio |
6.7 The debt premium determines the premium over and above the risk free rate that is required by investors for holding the debt. It reflects marketability and exposure to the possibility of default. It represents the incremental cost of raising debt.
6.8 In determining the debt premium, the Commission has considered such factors as how the airports finance their assets (debt or equity), the actual premiums that the companies pay above the risk-free rate, their liquidity and cashflow situation, and their credit ratings. However, as noted above, the key consideration in determining the debt margin is the cost for which a firm of similar credit risk with an efficient capital structure could be expected to obtain financing.
6.9 The cost of debt is estimated for the same period as that used to determine the risk-free rate (the period for which prices are set) and not the duration of the airport's assets or its debt.
Cost of Equity
6.10 The cost of equity is the expected rate of return just compensating for risk. While the cost of debt can often be observed directly as the yield on debt issued by the company, the cost of equity cannot, and must be estimated. A number of methods are available to estimate the cost of equity. However, the Capital Asset Pricing Model (CAPM) is the most popular, due to its intuitive appeal and relative ease of application.
6.11 The CAPM develops a relationship between the non-diversifiable risk of an asset (measured by its beta) and the opportunity cost of investing in that asset.189 The essential principle underlying the CAPM is that risk-averse investors will not hold risky assets unless they are adequately compensated for the non-diversifiable risks that they bear and, therefore, the greater an asset's non-diversifiable risk, the greater the expected return. The CAPM links the risk-free rate, the asset's non-diversifiable risk, and the expected return on the market portfolio. Given the non-diversifiable risk of an asset, it provides the premium that investors can expect in terms of expected rate of return (over and above the risk-free rate) - it determines non-diversifiable risk adjusted expected return on equity.190
6.12 The standard CAPM model for return on equity (Re) was developed by Sharpe and Lintner and is expressed by the following formula:191
Re = Rf + e(MRP)
| where: |
e |
= |
equity beta |
Taxes
6.13 In developing the costs for the different capital components, issues regarding taxes arise. The standard CAPM does not take personal taxation incurred by investors explicitly into account and, therefore, does not adjust for the effect of any imputation credits attaching to dividends. Building on the work of Brennan, Lally has developed a version of the CAPM that explicitly takes account of personal tax rates that differ across both investors and sources of income, and which is applicable to the New Zealand tax regime. However, the resulting cost of equity is still an expected rate of return before personal taxes.192 This model has been adopted by the airports.
6.14 The Brennan-Lally model can be expressed as follows:
Re = tdivDiv + Rf(1-tint) + e(TAMRP)
| where: |
tdiv |
= |
excess of personal tax on dividends over capital gains tax |
| |
Div |
= |
dividend yield of the company |
| |
tint |
= |
excess of personal tax on interest over capital gains tax |
| |
Tax-Adjusted Market Risk Premium (TAMRP) |
= |
Rm - Rf(1-tint) - tdivmDivm |
| |
tdivm |
= |
weighted average of tdiv over the individual companies in the market portfolio |
| |
Divm |
= |
dividend yield of market portfolio |
6.15 Assuming fully imputed dividends (and that investors have the ability to fully utilise them), the average investor faces a 33% marginal tax rate on interest, and capital gains are not taxed. It follows that tdiv and tdivm are zero and tint is 33%. These assumptions result in a simplified Brennan-Lally model expressed as follows:
Re = + Rf(1 - 0.33) + e(TAMRP)
| where: |
TAMRP |
= |
Rm - Rf(1 - 0.33) |
6.16 While there has recently been a change in the top marginal personal tax rate, the assumption that the average investor faces a 33% marginal tax rate is still valid.
6.17 The Commission's view is that WACC should be computed using the tax-adjusted Brennan-Lally CAPM.
Risk-Free Rate
6.18 The risk-free rate is the interest rate that an investor would earn on a riskless investment. However, there is no such thing as the risk-free rate in reality. Governments are typically the only entities in the market for funds considered to have such a low level of risk. Therefore, rates for Government stock are usually used to approximate the risk-free rate.
6.19 The risk-free rate is used in calculating both the cost of debt and the cost of equity. The choice of risk-free rate significantly impacts on the resulting WACC and should be determined carefully.
6.20 A question that has to be resolved in determining the appropriate risk-free rate relates to the term (maturity) of the rate used. Alternatives are to use the maturity corresponding to the period for which prices are set, or the life of airfield assets - the former leads to the use of three to five year rates, and the latter 10 year rates or longer. The Commission's view is that the risk-free rate should match the revision frequency of pricing on the basis that landing charges should reflect expected costs and risks over the period prices are set, but not be affected by the expectations of rates beyond that period. Prices are typically set by the airports for upwards of five-year periods due to the requirement to consult with substantial customers every five years on charges. The Commission acknowledges, but does not accept, submissions from WIAL193 in support of using a 10 year rate.
6.21 having determined the appropriate maturity date to use, debate revolves around how the rate is set. Options include using the range over the consultation period, the midpoint, the endpoint, an average of the beginning and ending rates for the period, or the average over the period. The selection of the rate is important, as risk-free rates vary daily.
6.22 The Commission notes that the Australian Competition and Consumer Commission (ACCC) supports the use of short-term averaging of yields in order to smooth out the effects of financial markets volatility. In its recent decision regarding Sydney Airports Corporation Limited (SACL), the ACCC decided to use the 40 day moving average of the five year rate.194
6.23 There is nothing inherently significant about the date on which an airport makes a decision on new prices (or on which the new prices take effect), and the date is largely controlled by the airport. This suggests that the risk-free rate at that particular date should not be used. The Commission's approach is to use an average yield on Government stock over the period in which an airport consults with its substantial customers (ending with the point at which any new prices come into effect) and with a maturity matching the point at which prices will again be reviewed (at maximum five years).
6.24 The Commission agrees with WIAL that the risk-free rate should reflect compounding interest.195
Market Risk Premium
6.25 Market Risk Premium (MRP) represents the additional premium that investors require to hold the market portfolio - a diversified basket of "risky" assets - over and above the return that can be obtained from investing in risk-free assets. It is not affected by firm specific factors. Continuing debate exists about the appropriate size of the MRP.
6.26 A number of approaches can be used to estimate MRP. The common approach is to observe ex-post risk-free rates and market returns, and calculate an arithmetic average over a number of years. Other methods involve: estimating the relationship between MRP and market volatility changes over time; estimating the MRP consistent with the current value of shares and expected growth in market dividends; and considering estimates of the MRP for foreign markets. Whatever approach is used, it is important to ensure that current estimates of investors' expectations are incorporated.
6.27 In estimating the MRP from averaging historical returns, a time period for the analysis has to be chosen. The choice involves a trade-off between using more data (which potentially improves the statistical precision of the MRP estimate), and using potentially less relevant data (by using data that is too historic). Whatever period is used, there will always be some statistical uncertainty surrounding the estimate.
6.28 The Treasury's handbook on cost of capital recommends the use of a 9% tax-adjusted market risk premium in the tax-adjusted version of the CAPM (denoted TAMRP), equating to 6.4% in the standard version of the CAPM.196 In its recent SACL decision, the ACCC adopted a similar pre-tax MRP of 6%. In reaching its decision, the ACCC commented that empirical evidence suggests a declining MRP.197
6.29 Consistent with the version of the CAPM used, the airports have adopted a 9% TAMRP based on the Treasury handbook. However, the airlines consider that, while a TAMRP of 9% was appropriate in the 1980s, more recent studies have indicated lower figures should be used. The airlines' position of a 8% premium is based on work by PricewaterhouseCoopers.
6.30 The recent work by PricewaterhouseCoopers referred to by the airlines arrives at an estimate of 8% to 9% for TAMRP (6% to 7% MRP in the standard CAPM), but suggests that there is evidence to support the use of an estimate of 8%.198 The 8% figure is arrived at using data from 1925, while the 9% is based on data from 1956. The choice between 8% or 9% comes down to a trade-off between determining the TAMRP based on more data (and improving the statistical significance of the results) and including potentially less relevant data in the calculation. Other approaches to estimating the MRP are discussed by Dr Lally in Appendix 18, and they generate estimates in the 7% to 9% region.
6.31 None of the various approaches to estimating MRP is considered by the Commission to be necessarily better than any other. having considered the various submissions received, the Commission's view is to adopt a TAMRP of 8%, within a range of 7% to 9%, in recognition of the uncertainty surrounding the estimate.
Beta
6.32 Risk relates to the possibility that expected returns may not actually materialise. The total risk of an asset or business is made up of both diversifiable risk and undiversifiable risk.
- Diversifiable (or unsystematic) risk is unique to the asset or firm and can be eliminated by diversification. The risk of obsolescence of its technology, the risk of reduced revenues caused by increasing competition, and the risks associated with patent approval, antitrust legislation, labour contracts, management styles, geographic location are all examples of unique risks.
- Undiversifiable (or systematic) risk is market risk, which is not unique to the firm. Such risk cannot be eliminated by diversification. It is related to, and dependent on, the state of the economy as a whole. The more systematic risk that is inherent in the operations of a company, the higher will be the cost of any debt and equity used to fund its operations.
6.33 A common misconception is that all variability and uncertainty in the returns accruing to an asset are included in the computation of WACC. Only the undiversifiable risk is relevant in determining the cost of equity. Investors are not compensated through CAPM for diversifiable risk. The CAPM implies that investors hold a diversified portfolio and, accordingly, diversify away this risk.
6.34 Beta measures the sensitivity of an asset's return to market returns - its systematic risk.199 It is probably the most contentious of the WACC components. It also significantly affects the resulting WACC.
Asset Beta
6.35 The asset beta (a) measures the sensitivity of a company's return to market returns when the company has no debt.
6.36 Airport revenues are affected by changes in passenger and aircraft movements. To the extent that these changes are correlated with Gross Domestic Product (GDP), they are likely to give rise to airport revenue that is highly correlated with GDP variation, and hence, systematic risk. The greater the extent of this systematic risk, the greater the asset beta.
Equity Beta
6.37 Equity betas reflect both operating and financial risk, while asset betas reflect only operating risk.200
- Operating (or business) risk is solely related to the risks associated with the firm's operations and the industry or sector in which it operates.
- Financial risk is the incremental risk (difference between the equity and asset betas) that arises when a firm takes on debt. Leveraged firms are more risky than firms without debt, as interest is a fixed cost that must be paid before shareholders receive anything.
The equity beta is determined by the following formula:
e = a(1 +(Wd/We))
6.39 If a company has no debt - is entirely financed by equity - its asset and equity beta are identical. By adding debt to a company's capital structure, the shareholding becomes more risky, such that its equity beta is greater than its asset beta. The level of systematic risk associated with equity (the equity beta) is magnified according to the proportion of debt in the funding mix. The greater the proportion of debt, the greater the systematic risk associated with the residual cashflows available for distribution to shareholders, and the greater difference between its asset and equity beta. For otherwise identical investments, a company with more debt in its capital structure will have a higher equity beta and a higher required rate of return on equity than a company with less debt.
Pure Play Comparisons
6.40 Beta may or may not be able to be estimated directly. Betas can only be directly estimated for listed companies. Where a beta cannot be estimated directly, a proxy or surrogate beta can be estimated by making adjustments for differences in gearing to the betas of similar entities or assets that are "pure play" - comparable companies with similar activities and risks. While such an approach is useful, it is often difficult to find a "pure play" comparison.201 It is acknowledged that estimation of betas invariably involves an element of judgement of what is most appropriate. Even if a beta can be estimated directly, one should still seek comparators because the statistical reliability of beta estimates for single companies are poor, due to uncertainty.
Factors
6.41 Differences in betas across companies rise from differences in the sensitivity of returns to unexpected changes in the economy. In his report to the Commission, Dr Lally (Appendix 18) stated that the sensitivity of equity returns to such changes are potentially dependent on a number of factors. First, we outline the factors, and then - as part of the consideration of potential comparators - consider the appropriate weight given to each.
- Industry, i.e., the nature of the product or service. Firms producing products with low income elasticity of demand (necessities) should have lower sensitivity to unexpected changes in the economy than firms producing products with high income elasticity of demand (luxuries), because demand for their product is less sensitive. In respect of airfields, much of the demand is recreational travel, for which betas are particularly high.
- Nature of the customer. There are a number of aspects to this.
- The split between private and public sector demand. Firms producing a product whose demand arises exclusively from the public sector should have lower sensitivity to unexpected changes in the economy than firms producing a similar product demanded exclusively by the private sector, because demand should be less sensitive. This has no apparent implications for airfields or any suggested comparators.
- The residency mix. Demand for air travel by New Zealanders should be sensitive to unexpected changes in the New Zealand economy, while demand from foreigners should be sensitive to unexpected changes in the world economy. The changes in the New Zealand economy should be more closely related to the performance of the New Zealand market portfolio. Consequently, airfields with a larger proportion of New Zealand customers should have higher betas.
- The personal/business mix, with the former being more sensitive to unexpected changes in the economy.
- Pricing Structure. Firms with revenues comprising both fixed and variable elements should have lower sensitivity to unexpected changes in the economy than firms whose revenues are entirely variable.
- Duration of contract prices with suppliers and customers. The longer prices are fixed (by contract, for example), the more exposed a firm is to unexpected changes in economic conditions, and the higher is beta.
- Presence of price or rate-of-return regulation. Firms subject to rate-of-return regulation should have lower sensitivity to unexpected changes in the economy, because the regulatory process is geared towards achieving a fair rate of return. Price regulation will have a similar effect, providing prices are frequently reset. However, as the reset interval increases, such a firm tends to resemble one with an output price contractually fixed for a long period. This is likely to increase the beta of an airfield.
- Degree of monopoly, i.e., price elasticity of demand. So long as firms act to maximise their cash flows, theory offers ambiguous results. By contrast, if monopolists do not optimise their cash flow, in the sense of reacting to unexpected changes in demand by varying the cushion provided by suboptimal pricing and cost control more than do non-monopolists, then their returns should exhibit less sensitivity to demand, and hence to unexpected changes in the economy. In respect of airfields, their monopoly power may be diluted by the extent of countervailing power of airlines.
- Nature of the firm's real options. The existence of options permitting expansions of the firm (adopting a new product, expanding existing operations etc) should increase the firm's sensitivity to unexpected changes in the economy, as the values of these growth options should be more sensitive to such changes than equity value exclusive of them, and these two value components should be positively correlated. By contrast, the existence of options permitting contractions of the firm should reduce the firm's sensitivity to unexpected changes in the economy, because the option value should be negatively correlated with equity value exclusive of it.
- Operating leverage. If firms have linear production functions and demand for their output is the only random variable, then firms with greater operating leverage (higher fixed to total operating costs) should have greater sensitivity to unexpected changes in the economy because their cash flows will be more sensitive to demand. This implies that the high operating leverage of airfields should magnify their betas.
- Market weight. Increasing an industry's weight in the market proxy against which its beta is defined will draw its beta towards 1, although not necessarily in a monotonic fashion. Even for a market weight as low as 5%, the effect can be substantial. Airfields and possible comparators have limited weights in market indexes and, consequently, this point is not relevant in this case.
- Capital structure. Firms with greater financial leverage will have greater sensitivity of equity returns to unexpected changes in the economy, because cash flows to shareholders will be more sensitive to demand. In addition, firm leverage only matters in relation to market leverage. Thus, for a given level of firm leverage, firms in different markets that have different market leverages will have different betas.
6.42 Comparators ideally should be similar in the above respects. However, so long as differences can be corrected for, this is not strictly necessary (and will therefore expand the set of comparators, with resulting improvement in the statistical reliability of the beta estimate).
Potential Comparators
6.43 Both the airports and airlines support their views on beta by reference to estimated betas of what they consider are comparable companies. There is considerable latitude when using comparable firm data to assess the appropriate asset beta for airports. The question as to which firms are most comparable and which factors should receive the most weight in the assessment is open to debate.
6.44 Airports generally consider other utilities to be less preferable as "pure play" comparators, as they exhibit less risk than airports:202
- Airports are likely to be more susceptible to downturns in economic circumstances than other utilities (such as electricity networks), particularly in respect of leisure travel.
- Airport earnings are becoming increasingly volatile as airlines increase flexibility through alliance arrangements, fleet evolutions and the relaxation of international air services agreements.
6.45 However, there are limited estimates of airport betas available. As a result, the airports have provided the Commission with possible alternative comparators. CIAL submitted that port companies were comparable to airports, given that they were in the transport industry, were regional monopolies, and had a mix of contestable and non-contestable business activities.203 Dr Lawriwsky (an expert for CIAL) also presented arguments for using airlines and electric utilities as comparators.204 Dr Marsden (an expert for AIAL) suggested that selected United States gas and electricity companies might be useful comparators.205
6.46 The airlines disagree with using other airports as comparators. They consider that there are considerable differences between Australian and New Zealand airports such that the ACCC's betas are not necessarily applicable in New Zealand, and that, all other things being equal, lower asset betas are appropriate in New Zealand. They argue that New Zealand airports have lower systematic risks than Australian airports due to the following differences (the same reasoning applies to other overseas regulated airports):206
- The regulatory arrangements. New Zealand airports have an explicit legal right to set prices (in contrast to Australian airports) and can establish pricing arrangements that - to a significant extent - insulate them from systematic risk, either mechanistically, or by deciding to amend their prices at some future date.207
- Revenue stability and variation. The current pricing arrangements for AIAL and CIAL fix prices for a shorter period than the Australian airports.
6.47 During recent consultations conducted by AIAL and CIAL, Air New Zealand argued that Airways Corporation was the best comparison. Air New Zealand considered airports to be "low revenue risk" for the following reasons:208
- The regulatory environment is light-handed and allows airports to match prices with anticipated volume changes and to adjust quickly for unexpected changes.
- Given this, airports have the power to set prices and insulate themselves from systematic (i.e., non-diversifiable) risk.
- The geographic position of an airport leaves it subject to minimal competition from other New Zealand airports.
- Once consultation is completed to the satisfaction of minimal legal requirements, prices can be immediately changed.
6.48 In its submission on the Draft Report, BARNZ argued for United States rate-of-return regulated electric utilities as a comparator. BARNZ submitted that such entities would be better comparators for airfield activities than United Kingdom price-capped firms, because the New Zealand regulatory environment allows airport companies to set prices as they see fit, and therefore replicate the almost guaranteed returns available to United States rate-of-return regulated firms.209
6.49 The Commission considers that the comparators offered by the airports and the airlines have a number of limitations. It disagrees with arguments made by the airlines that the airports have the ability to amend prices in response to adverse unexpected changes in the economy (in the absence of pricing agreements providing mechanisms for this). Averages of airport betas are also statistically unreliable due to the small number of entities averaged. Furthermore, the comparators' betas suggested have not been adjusted (or have been incorrectly adjusted) for non-aeronautical activities, market leverage differences, or differences in regulation. Some of the other industries suggested as comparators are also markedly different in respect of their monopoly power and regulatory regimes.
6.50 In the case at hand, the Commission considers that the regulatory environment is fundamental to the performance of the airports and is, therefore, the dominant factor considered in choosing comparators. Useful benchmarks for an asset beta for airfield activities are, therefore, as follows:
- United States firms engaged in electricity generation and/or distribution that are subject to rate-of-return regulation (which almost guarantees them a certain rate of return).
- Electricity firms in the United Kingdom subject to CPI-X price caps.
Weights
6.51 A number of options exist with respect to selection of the weights used to determine WACC. They include:210
- Proportions present in the company's financial structure.
- Target or long-run proportions of the company.
- Proportions present in the financial structure of comparator private sector companies (used to estimate e).
6.52 All these ratios involve market values rather than book values.
6.53 It is inappropriate to use the actual weights from the statement of financial position of the company (book value weights). Current ratios are useful only if they reflect the manner in which the company will finance its investments in the long-term. An alternative is target weights, which are suggested to avoid the bias which may occur from one accounting period to the next as actual debt and equity levels change over time.211 However, it is difficult to determine an optimal (target) gearing level. As a result, the Commission considers that actual leverage ratio - based on the market values of debt and equity at the time prices are set - is most appropriate (and is consistent with the debt premium used). The risks associated with any changes in financial structure between price re-sets are, therefore, borne by airport operators.
Nominal v Real WACC
6.54 WACC can be expressed in real or nominal terms. The relationship between the real and nominal WACC - between any real and nominal rate - is defined by the Fisher equation:
(1 + Rnom) = (1 + Rreal)(1 + i)
| where: |
Rnom |
= |
nominal rate |
| |
Rreal |
= |
real rate |
| |
i |
= |
rate of inflation |
6.55 A decision must be made over whether WACC should be computed in nominal or real terms. The choice of real or nominal does not matter provided there is consistency in the application - in particular in the parameter estimates and cashflow estimates. Consistency is particularly important where WACC is used in pricing, valuing assets and comparing actual rates of return. Three options are available:212
- Apply a nominal rate to the depreciated historic cost of assets.
- Apply a nominal rate to revalued assets and include any revaluation amounts as income.
- Apply a real rate to revalued assets, but do not include any revaluation amounts as income.
6.56 For the purposes of this Report, the Commission has chosen to use a nominal WACC in order to be consistent with its approach to asset base and analysis of historical returns. Any asset revaluations in the past and any expected revaluation gains in the future are, therefore, included in income.
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