Appendix 1 - Weighted Average Cost of Capital
In order to establish the likely ranking and price effects of new power station options we have estimated the long run unit cost of electricity for each option. To do this we have estimated the weighted average cost of capital (WACC) for firms likely to invest in the electricity sector using the Brennan-Lally31 simplified version of the Capital Asset Pricing Model (CAPM). The range of plausible input assumptions that we have derived, and the calculation of WACC are outlined in Table A- 1.
Table A- 1: WACC Calculation| CAPM Calculation | | Low | Med | High |
| Risk Free Rate | Rf | 5.5% | 6.0% | 6.5% |
| Debt Margin | p | 1.0% | 1.5% | 2.0% |
| Tax Rate | Tc | 33.0% | 33.0% | 33.0% |
| Leverage | L | 40.0% | 45.0% | 50.0% |
| Asset Beta | Ba | 0.50% | 0.60% | 0.70% |
| Market Risk Premium | MRP | 7.0% | 7.5% | 8.0% |
| Equity Beta | Be | 0.83% | 1.09% | 1.40% |
| Cost of Debt | Kd | 6.5% | 7.5% | 8.5% |
| Cost of Equity | Ke | 9.5% | 12.2% | 15.6% |
| Nominal WACC | WACCn | 7.5% | 9.0% | 10.6% |
| Inflation | | 1.5% | 1.5% | 1.5% |
| Real post-tax WACC | WACCr | 5.9% | 7.4% | 9.0% |
This suggests a relatively wide plausible range of between 5.9% and 9.0% per annum for firms operating in the electricity sector. For our analysis of long run unit costs we have chosen to use 9.0% per annum reflecting an expectation that firms would look for returns on investment that are slightly higher than their WACC.
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