Evidence of Dr. Basil Kalymon
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NEWFOUNDLAND BOARD OF COMMISSIONERS OF PUBLIC UTILITES TESTIMONY ON THE COST OF CAPITAL AND CAPITAL STRUCTURE IN REGARD TO THE 2002 NEWFOUNDLAND POWER APPLICATION TESTIMONY OF DR. BASIL A. KALYMON ON BEHALF OF THE CONSUMER ADVOCATE DECEMBER 17, 2002 1 1 TESTIMONY OF DR. BASIL A. KALYMON 2 Q. Please state your name, address and affiliation. 3 A. I am Dr. Basil A. Kalymon, Professor of Finance at the Richard Ivey School of Business, 4 University of Western Ontario. My office is located at 1151 Richmond Street North, 5 London, Ontario. 6 7 Q. Please describe your qualifications and previous experience. 8 A. I have spent over thirty years as a professor of finance and management sciences at the 9 University of California, Los Angeles, Harvard University, University of Toronto and 10 the University of Western Ontario. During that time, I have also conducted my own 11 consulting practice under Kalymon Consulting Ltd. I hold a B.Sc. degree in Statistics 12 from the University of Toronto and a PhD. degree in Administrative Sciences from Yale 13 University. 14 15 My consulting experience in regulatory matters includes the preparation of cost of capital 16 evidence for electric utility, gas distribution, pipeline, telephone, transportation and 17 insurance hearings. I have also prepared tariff design testimony for oil and gas pipelines, 18 studies of regulated price structure in the energy sector and acquisition analysis in the 19 utility sector. In the past twenty years, I have presented evidence on the cost of capital 20 and capital structure at twenty-nine regulatory hearings in Canada. In addition to my 21 previous appearances at this Board, I have testified on cost of capital and regulatory 22 economics before the National Energy Board, the Ontario Energy Board, the Public 23 Utilities Commission of Prince Edward Island, the Nova Scotia Board of Commissioners 2 1 of Public Utilities, the Alberta Public Utilities Board, the New Brunswick Board of 2 Commissioners of Public Utilities , the Ontario Automobile Insurance Board, the Ontario 3 Telephone Services Commission and the U.S. Federal Energy Regulatory Commission. A 4 resume is included as Appendix A. 5 6 Q. Please indicate the matters to be dealt with in your testimony. 7 A. I will be addressing the issues of 8 - financial structure, 9 - cost of debt and preferred shares , 10 - rate of return on common equity, 11 - and adjustment formula for the return on equity. 12 Financial theory, applied in the context of current capital market conditions and 13 comparable practices for Canadian privately owned utilities, will be used to arrive at 14 a recommended target capital structure and cost of capital to be included in the 15 cost of service charged by Newfoundland Power. (NP) in the 16 regulated utility operation. 17 18 In dealing with these issues, my testimony will be organized as follows: 19 I. Discussion of general economic conditions. 20 II. Discussion of the business risk and appropriate capital structure. 21 III. Discussion of the current cost of debt and preferred shares. 22 IV. Determination of the appropriate return on common equity 23 including the following tests: 3 1 Risk Premium 2 Adjusted Comparable Earnings 3 DCF 4 V. Summary of the rate of return and capital structure 5 recommendations. 6 7 I. GENERAL ECONOMIC CONDITIONS 8 9 Q. Why are general economic conditions relevant to the determination of the cost of capital? 10 A. The cost of capital in financial markets is determined primarily by three factors: 11 (1) The level of inflation in the economy. 12 (2) The level of returns available to risk-free investment. 13 (3) The level of risk to which the investor is exposed. 14 Each of these factors is generally acknowledged to influence the terms and conditions on 15 which capital is provided. Thus, if the returns available to investors are to be determined, 16 they must be placed within the context of the general economic conditions which 17 influence all of the above three factors. 18 19 Q. What is your assessment of the current economic conditions? 20 A. After strong growth for a number of years, the economy of Canada slowed down 21 substantially during 2001 and then showed some renewed growth in the first half of 2002. 22 While equity markets have shown dramatic volatility in recent years, the key factors 23 affecting the cost of capital have stabilized at levels well below those of past decades. 4 1 Investor expectations have been substantially dampened by the volatility of the capital 2 markets with substantial flight of capital to less risky investment. 3 4 As shown in Schedule 1A (Column 2), the real GDP grew in the range of 4.1% to 5.4% 5 annually from 1997 to 2000 and experienced a slow-down in growth in 2001 to the level 6 of 1.5%. In the first two quarters of 2002 levels of 6.2%% and 4.3%% respectively were 7 achieved. General expectations are for the continuation of the renewed levels of growth 8 for the near term. 9 10 Corporate profits have showed exceptionally strong growth in the recent past. During 11 1999 and 2000, corporate profits increased at a rate of 25.8% and 20.8% (Schedule 1A, 12 Column 8). However, 2001 saw a drop in corporate profits of 9.4% as economic growth 13 slowed. Some recovery in corporate profit growth can be observed again in the first half 14 of 2002. All reported corporate profits are being viewed with greater skepticism by the 15 capital markets in the wake of several major reporting scandals and bankruptcies which 16 have hit North American companies. Profits of risky companies are being discounted by 17 investors who now favour less risky investment. 18 19 Unemployment rates had declined to decade lows in 2000 from the 11.4% level of 1993 20 to 6.8% in 2000 (Schedule 1A, Column 9). Subsequently, in 2001 the unemployment rate 21 increased to 7.2% and is currently at 7.5%. These changes in unemployment levels have 22 resulted in some minor pressure on wage s which increased at rates of 1.4% in 1997 , 23 rising to a rate of 3.2% by 2001. Such increases have produced some corresponding 24 minor increases in inflationary pressure on the economy. 5 1 2 Despite the high levels of economic growth and relatively low levels of unemployment, 3 the rate of inflation in Canada has remained at moderate levels now for the past decade. 4 The annual inflation rates as measured by the Consumer Price Index have been in the 5 range of 0.2% to 2.7% during the 1992 to 2001 period (Schedule 1A, Column 6). While 6 showing a slight upward trend in recent years, the levels of inflation remain low by the 7 standards of the previous decades. As inflation has a direct impact on the return 8 expectations of investor, the stability of inflation at such lower levels has brought 9 lowered expected rates of return. The stated commitment of the Bank of Canada to 10 maintain annual inflation rates below 3% has been realized and this has increased the 11 Bank’s credibility with the capital markets. 12 13 The elimination of budgetary deficits at both the Federal and Provincial levels provided 14 for a significantly more benign environment for the operation of monetary policy by the 15 Bank of Canada in recent years. Projections are for budgetary surpluses into the coming 16 years permitting the continuation of the stricter monetary policies of the central bank. 17 This implies the likelihood of a persistence of lower inflation in the economy. 18 19 Q. What is your assessment of the current overall conditions in capital markets? 20 A. As noted above, the capital markets have shown severe volatility in the past two years 21 with major declines in the equity markets in both 2001 and 2002. This severe volatility 22 has changed the perspective of equity investors who suffered major declines in equity 23 values after a decade of major gains. Overall, concern over volatility increases has lead to 6 1 a shift of investment funds to bonds and less risky equity investment and a moderation of 2 expectations as realized returns declined. 3 4 The capital markets saw a major reduction in financing requirements during the past two 5 years chiefly driven by reduced borrowing requirements of the Government of Canada. 6 This can be seen in Schedule 2 (Column 9) which indicates that the total levels of 7 security issues dropped to a level of $58.8 billion in 2000 and $69.7 billion in 2001 from 8 levels ranging from $88 billion to $100 billion in the previous three years. Federal 9 government repayments reached $20 billion in 2000 and continued at a reduced level in 10 2001. Provincial government borrowings showed the first reductions in over a decade in 11 the first two quarters of 2002. Thus , the budgetary surpluses of governments provided 12 major relief to borrowing pressure in the capital markets and has resulted in lowered yield 13 expectations by investors. 14 15 In fact, the trend in interest rates was toward maintaining the substantially reduced levels 16 of long-term interest rates which have evolved in the past five years. As can be seen in 17 Schedule 3A, Column 4, the Canada 10 yr bond rate has been in the range of 4.86% to 18 6.65% over every month from May 1997 to September 2002. While some fluctuation is 19 evident, nevertheless the current 10yr Canada bond rate of 5.04% (Dec 17) is near the 20 lower end for the 1997-2002 period and substantially lower than rates prior to 1996.