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• Target Return (WACC)

• Infrastructure Development

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• Airfield Inquiry

• Final Report Part IV

• Risk-Free Rate
• Debt Premium
• Market Risk Premium
• Asset Beta
• Leverage
• Appropriate WACC

49. Weighted average cost of capital (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. Like the asset base, it is relevant both for the purpose of determining prices and for the purpose of assessing performance. It is the element of the pricing models that allows for a required rate of return to be earned by debt and equity security providers.

50. The Commission has determined what it considers to be an appropriate WACC (target return) for the airfield activities of each airport. In formulating the views expressed on WACC in this Report, the Commission obtained independent advice from Dr Martin Lally on the appropriateness of the WACC estimates most recently adopted by the airports, and on the robustness of the airports' justification for those estimates. A copy of his report to the Commission is included in Appendix 18 to this Report. Full discussion of generic issues regarding WACC are contained in Chapter 6, and for each airport in Chapters 8-10.

51. Key determinants of WACC are the risk-free rate, debt premium, market risk premium, asset beta and leverage.

Risk-Free Rate

52. The risk-free rate is the interest rate that an investor would earn, or an entity would pay to borrow, on a riskless investment. Rates for Government stock are usually used to approximate the risk-free rate.

53. In determining the appropriate risk-free rate, the Commission first considered what term (maturity) of the rate to use. Alternatives are to use the maturity corresponding to the period for which prices are set, or the period of the life of airfield assets. The Commission's view is that the risk-free rate should match the revision frequency of pricing. Prices are set by the airports for upwards of five-year periods due to the requirement to consult with substantial customers every five years on charges. However, CIAL has recently set prices for a period of three years, and AIAL seven years.

54. Having determined the appropriate maturity date to use, the Commission then considered how to set the rate. Options include using the range over the relevant 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. The Commission elected to use an average on Government stock relating to 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).

55. In analysing the efficiency implications of current prices for the airfield activities of AIAL, the Commission used a risk-free rate of 6.33%, being the five-year Government stock rate averaged for the six months April to September 2001. For CIAL, the Commission used a risk-free rate of 7.04%, representing the yields on three-year Government stock averaged over the six month period February to August 2000. For WIAL, the rate used is the average yield on five-year Government stock in the six months preceding 1 July 1997, when the current price formula was settled for the next five years. This figure is 7.62%.

56. For assessing historical performance on an annual basis (and on average over time), the Commission adopted the risk-free rate for the appropriate financial period, based on the last price reset. For example, the risk-free rate for the six months preceding 1 July 1997 (date on which WIAL set prices in the past) is used in assessing returns for the five years from 1 July 1997 to 30 June 2002 (the five-year period for which prices were set).

Debt Premium

57. 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.

58. The Commission's view is that a debt premium of 1% above the risk-free rate is appropriate for all three airports.

Market Risk Premium

59. The Market Risk Premium (MRP) represents the additional premium that investors require in order to hold the market portfolio - a diversified basket of `risky' assets - over and above the returns that can be obtained from investing in risk-free assets.

60. A number of approaches can be used to estimate the MRP. The common approach is to observe the difference between the ex-post risk-free rates and market returns and calculate an arithmetic average over a number of years. Other methods involve examining market volatility changes over time (looking at variances and standard deviations), estimating growth in market dividends, and considering estimates of market risk premium for foreign markets.

61. The Commission's approach was to adopt a tax-adjusted MRP of 8%, within a range of 7-9%.

Asset Beta

62. 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. Beta measures the sensitivity of an asset to the market, its undiversifiable (or systematic) risk.

63. Looking at an entity as an asset in a portfolio, the beta of an entity measures the sensitivity of an entity's cash flows to changes in the economy that impact on asset values and returns (not the specific risk associated with investing in a particular company). It is a relative concept and specifically measures the sensitivity of returns to changes in the returns of the market. The higher the beta, the more volatile and risky the asset.

64. Beta may or may not be capable of being estimated directly. Betas can only be directly estimated for listed companies, and only with any degree of accuracy where there is data for a significant period and for a significant number of entities. 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 entities or assets with similar activities and risks.

65. Characteristics important in assessing the suitability of comparators include the nature of the firm's output, the nature of the customer, the duration of any contracts with customers, the extent of any regulation, degree of monopoly (e.g., as reflected in the price elasticity of demand), the nature of options for expansion, operating leverage, market weight, and capital structure.

66. The regulatory environment could significantly effect the performance of the airports and is, therefore, a key consideration in choosing appropriate comparators. The Commission adopted benchmarks for asset beta based on 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), and firms in the United Kingdom subject to RPI-X price caps. Other airports are not used as comparators because there is not sufficient data to arrive at reasonable estimates.

67. The Commission considers that an appropriate asset beta for the airfield activities at all three airports is 0.5 (the mid-point), within a range of 0.4 to 0.6.

Leverage

68. If a company has no debt - it 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, reflected in its equity beta becoming 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 profits available for distribution to shareholders, and the greater difference between its asset and equity betas. 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 one with less debt.

69. A leverage rate is used to determine the cost of equity, and also to weight the costs of debt and equity to derive WACC. The leverage (or debt) ratio reflects the proportion of total assets that are funded by debt (as opposed to equity).

70. A number of alternatives exist to determine the appropriate debt ratio. However, the Commission considers that the current leverage ratio based on the market values of debt and equity is most appropriate (given the debt premium used).

71. The appropriate market value weights of debt and equity can easily be computed for AIAL. Taking the book value of debt as a proxy for market value of debt, and dividing the number of issued shares multiplied by the current share price results in a debt ratio of 25% for AIAL. For the purposes of its analysis, the Commission also used a 25% debt ratio for WIAL and CIAL.

Appropriate WACC

72. For the purposes of this Report, the Commission chose to use a nominal post-tax WACC in order to be consistent with its approach to asset base, and its analysis of historical returns.

73. Each airport can have its own unique characteristics, which can result in a distinct risk profile and WACC. The Commission considers that the appropriate WACC for the airfield activities of each of the airports are as follows: