COMMONWEALTH OF KENTUCKY ISSION IN THE MATTER OF: ) ADJUSTMENT OF THE RATES OF ) CASE NO. 2005-000341 KENTUCKY POWER COMPANY ) DIRIZCT TESTIMONY OF DR. J. RANDALL WOOLRIDGE JANUARY 2006 KENTUCKY POWER COMPANY Case No. 2005-008341 TABLE OF CONTENTS I. Subject of Testimony and Summary of Recommendations 2 11. Comparison Group Selection 8 111. The Cost of Common Equity Capital. 9 A.Overview ~ .. 10 B. Discounted Cash Flow Analysis . 1s C. CAPM . 26 D. Equity Cost Rate Summary . I 47 Iv. Critique of KPC's Rate of Return Testimony . " 49 MPENDLX A - Qualificationsof Dr. J. Randall Woolridge LIST OF EXHIBITS Exhibit -Title JRW- 1 Recommended Rate of Return JRW-2 The Impact of the 2003 Tax Law on Required Returns JRW-3 Summary Financial Statistics JRW-4 KPC's Capital Structure Ratios and Debt Cost Rates JRW-5 Public Utility Capital Cost Indicators JRW-6 Industry Average Betas JRW-7 DCF Study JRW-8 CAPM Study JRW-9 Historic Equity Risk Premium Evaluation JRW- 10 Rebuttal Exhibits .. 11- 1 Q. PLEASE STATE YBTJR FULL, NAME, ADDRESS, AND OCCUPATION. 2 A. My name is J. Randall Woolridge and my business address is 120 Haymaker Circle, State 3 College, PA 16801. I am a Professor of Finance and the Goldman, Sachs & Co. and Frank P. Smeal 4 Eiidowed LJniversity Fellow in Business Administration at the IJiiiversity Park Campus of the 5 Pennsylvania State University. I am also the Director of the Smeal College Trading Room and the 6 President of the Nittany Lion Fund, LLC. In addition, I am affiliated with the Columbia Group Inc., 7 a public utility consulting firm based in Georgetown, CT. A summary of my educational 8 background, research, and related business experience is provided in Appendix A. 9 10 I. SUBJECT OF TESTIMONY AND 11 SUMMARY OF RECOMMENDATIONS 12 13 Q. WHAT IS TIZE PURPOSE OF YOIJR TESTIMONY IN THIS PROCEEDING? 14 A. I have been asked by the Kentucky Office of Attorney General to provide an opinion as to 15 the cost of common equity capital for Kentucky Power Company ("KPC" or "Company") and to 16 evaluate KPC's rate of return testimony in this proceeding. 17 Q. PLEASE REVIEW YOUR COST OF CAPITAL RETURN FINDINGS. 18 A. I have arrived at a cost of equity capital of 8.75% for the Company by applying the 19 Discounted Cash Flow ("DCF") and Capital Asset Pricing Model ("CAPMY)approaches to two 20 groups of electric utility companies. Mr. Robert Herrkes is testifying as to the appropriate -2- 1 capitalization and senior equity cost rates for the Company. IJsing my equity cost rate of 8.75% and 2 Mr. Henkes’ capitalization ratios and senior capital cost rates, an overall fair rate of return of 6.8 1 % 3 is indicated for the Company. This is summarized in Exhibit-(JRW-1). 4 Q. PLEASE DISCUSS CAPITAL COSTS LN TODAY’S iYL4RKETtS. 5 A. Capital cost rates for 1J.S. corporations are currently at their lowest levels in more than 6 four decades. Corporate capital cost rates are determined by the level of interest rates and the 7 risk premium demanded by investors to buy the debt and equity capital of corporate issuers. The 8 base level of interest rates in the US economy is indicated by the rates on ten-year U.S. Treasury 9 bonds. The rates are provided in the graph below from 1953 to the present. As indicated, prior 10 to the secular decline in rates that began in 2002, the 10-year Treasury had not been in the 4-5 11 percent range since the 1960s. 12 Yields on Ten-Year Treasury Bonds 13 1953-Present 1 16.0 -I 14.0 -- 12.0 10.0 8.0 6.0 4.0 2.0 0.0 14 15 -3- 1 The second base component of the corporate capital cost rates is the risk premium. The 2 risk premium is the return premium required by investors to purchase riskier securities. Risk 3 premiums for bonds are the yield differentials between different bond classes as rated by 4 agencies such as Moody's and Standard and Poor's. The graph below provides the yield 5 differential between Baa-rate corporate bonds and 10-year Treasuries. This yield differential 6 peaked at 350 basis points (RPs) in 2002 and has declined significantly since that time. This 7 is an indication that the market price of risk has declined and therefore the risk premium has 8 declined in recent years. 9 Corporate Bond Yield Spreads 10 Baa-Rated Corporate Bond Yield Minus Ten-Year Treasury Bond Yield 11 12 Source: hnp://www.treas.gov/ofiices/domestic-finance/debt-m~agemen~interest-rate/index"html 13 14 The equity risk premium is the return premium required to purchase stocks as 15 opposed to bonds. Since the equity risk premium is not readily observable in the markets (as -4- 1 are bond risk premiums) and there are alternative approaches to estimating the equity 2 premium, it is the subject of much debate. One way to estimate the equity risk premium is to 3 compare the mean returns on bonds and stocks over long historic periods. Measured in this 4 manner, the equity risk premium has been in the 5-7 percent range. But recent studies by 5 leading academics indicate the fonvard-lookmg equity risk premium is in the 3-4 percent 6 range. These authors indicate that historic equity risk premiums are upwardly biased 7 measures of expected equity risk premiums. Jeremy Siegel, a Wharton finance professor and 8 author of the popular book Stocks for the Long Term, published a study entitled “The 9 Shrinking Equity Risk Premium.”’ He concludes: 10 The degree of the equity risk premium calculated .from data estimated 11 .from 1926 is unlikely to persist in the future. The real return on 12 fixed-income assets is likely to be significantly higher than estimated 13 on earlier data. This is confmed by the yields available on Treasury 14 index-linked securities, which currently exceed 4%. Furthermore, 15 despite the acceleration in earnings growth, the return on equities is 16 likely to fall from its historical level due to the very high level of 17 equity prices relative to fundamentals. 18 I 9 Even Alan Greenspan, the Chairman of the Federal Reserve Board, indicated in an October 20 14, 1999, speech on financial risk that the fact that equity risk premiums have declined 21 during the past decade is “not in dispute.” His assessment focused on the relationship 22 between information availability and equity risk premiums. 23 There can be little doubt that the dramatic improvements in 24 information technology in recent years have altered our approach to Jeremy J. Siegel, “The Shrinking Equity Risk Premium,” The Journal of PorfoZiu Management (Fall, 1999), p. 1.5. -5- 1 risk. Some analysts perceive that information technology has 2 permanently lowered equity premiums and, hence, permanently 3 raised the prices of the collateral that underlies all financial assets. 4 5 The reason, of course, is that information is critical to the 6 evaluation of risk. The less that is known about the currmt state of 7 a market or a venture, the less the ability to project future 8 outcomes and, hence, the more tliose potential outcomes will be 9 discounted. 10 11 The rise in the availability of real-time information has reduced the 12 uncertainties and thereby lowered the variances that we employ to 13 guide portfolio decisions. At least part of the observed fall in 14 equity premiums in our economy and others over the past five 15 years does not appear to be the result of ephemeral changes in 16 perceptions. It is presumably the result of a permanent technology- 17 driven increase in information availability, which by definition 18 reduces uncertainty and therefore risk premiums. This decline is 19 most evident in equity risk premiums. It is less clear in the 20 corporate bond market, where relative supplies of corporate and 21 Treasury bonds and other factors we cannot easily identify have 22 outweighed the effects of more readily available information about 23 borrowers. 24 25 In sum, the relatively low interest rates in today’s markets as well as the lower risk premiums 26 required by investors indicate that capital costs for 1J.S. companies are the lowest in decades. In 27 addition, the 2003 tax law further lowered capital cost rates for companies. 28 Q. HOW DID THX JOBS AND GROWH TAX RELIEF RECONCIZ,IATION ACT of 29 2003 REDUCE THE COST OF CAPITAL FOR COMPANIES? 30 A. On May 28’ of 2003, President Bush signed the .Jobs and Growth Ta.x Relief Reconciliation ’ Alan Greenspan, “Measuring Financial Risk in the Twenty-First Century,” Office of the Comptroller of the Currency Conference, October 14, 1999. -6- 1 Act of2003. The primary purpose of this legislation was to reduce taxes to enhance economic 2 growth. A primary component of the new tax law was a significant reduction in the taxation of 3 corporate dividends for individuals. Dividends have been described as “double-taxed.yy First, 4 corporations pay taxes on the income they earn before they pay dividends to investors, then 5 investors pay taxes on the dividends that they receive from corporations. One of the implications 6 of the double taxation of dividends is that, all else equal, it results in a higher cost of raising 7 capital for corporations. The tax legislation reduced the effect of double taxation of dividends by 8 lowering the tax rate on dividends from the 30 percent range (the average tax bracket for 9 individuals) to 15 percent.