Appendix I to Part 504 - Procedures for the Computation of the Real Cost of Capital
10:4.0.1.1.4.0.1.8.1 : Appendix I
Appendix I to Part 504 - Procedures for the Computation of the Real
Cost of Capital
(a) The firm's real after-tax weighted average marginal cost of
capital (K) is computed with equation 1.
The terms in equation 1 are defined as follows:
Wd = Fraction of existing capital structure which is debt. Wp =
Fraction of existing capital structure which is preferred equity.
We = Fraction of existing capital structure which is common equity
and retained earnings. R d = Predicted nominal cost of long term
debt expressed as a fraction. R p = Predicted nominal cost of
preferred stock expressed as a fraction. R e = Predicted nominal
cost of common stock expressed as a fraction. INF = Percentage
change in the GNP implicit price deflator over the past 12 months
expressed as a fraction. fd = Flotation cost of debt expressed as a
fraction. fp = Flotation cost of preferred stock expressed as a
fraction. fe = Flotation cost of common stock expressed as a
fraction. t = Marginal federal income tax rate for the current
year.
(b) Information on parameters used in Equation 1. (1) The
parameters used in equation 1 will be the best practicable
estimates. They will be obtained from the firm, accepted rating
services (e.g., Standard & Poors, Moody's), government
publications, accepted financial publications, annual financial
reports and statements of firms, and investment bankers.
(2) The predicted nominal cost of debt (R d) may be estimated by
determining the current average yield on newly issued bonds -
industrial or utility as appropriate - which have the same rating
as the firm's most recent debt issue.
(3) The predicted nominal cost of preferred stock (R p) may be
estimated by determining the current average yield on newly issued
preferred stock - industrial or utility as appropriate - which has
the same rating as the firm's most recent preferred stock
issue.
(4)(A) The predicted nominal cost of common stock (R e) is
computed with equation 2.
Eq 2 R e = R f + B × R m where: R f = The risk free interest rate -
the average of the most recent auction rates of U.S. Government
13-week Treasury Bills, B = The “beta” coefficient - the
relationship between the excess return on common stock and the
excess return on the S&P 500 composite index, and R m = The
mean excess return on the S&P 500 composite index - the mean of
the difference between the return on the S&P 500 composite
index and the risk free interest rate for the years 1926-1976 as
computed by Ibbotson and Sinquefield(
1) - 9.2%
(B) The “beta” coefficient is computed with regression analysis
techniques. The regression equation is Equation 3.
(R et − R ft) = A + B(R mt − R ft) + e t Eq. 3 where
Rft = The risk free interest rate in month t -
the average of the yields on 13-week treasury bills auctioned in
month t.(
2) A = A constant which should not be significantly
different than zero.
e t = The error in month
t. PRCC t = Closing market prices of the firm's common stock at the
end of month t fully adjusted for splits and stock dividends.
DIVRATE t = The sum of the dividends paid in the fiscal year which
contain month t. V sp,t = The market value of “one share” of the
S&P 500 composite index at the end of month t. D sp,t = The
estimated monthly income received from holding “one share” of the
S&P 500 in month t.
The regression analysis is done with sixty months of data. The
first month (t = 1) is sixty months before the month in which the
firm's current fiscal year started. The last month (t = 60) is the
last month of the past fiscal year.
(5) Where the parameters specified above are not obtainable,
alternate parameters that closely correspond to those above may be
used. This may include substituting a bond yield for nominal cost
of preferred stock where the former is not available. Where the
capital structure does not consist of any debt, preferred equity,
or common equity, an alternate methodology to predict the firm's
real after-tax marginal cost of capital may be used.
Example of using alternate parameters that closely correspond to
those above are:
(A) In the case of industrials, who do not typically issue
preferred stock, the predicted nominal cost of preferred stock (R
P) can be estimated by determining the current average yield on
newly issued industrial bonds which have the same rating as the
firm's most recent debt issue.
(B) If necessary, the following assumptions can be made to
determine the nominal cost of debt or preferred stock and their
flotation costs.
(i) Where a company issued privately placed debt that was not
rated, the rating, applied to preferred stock could be used to
determine the cost of debt and its flotation cost.
(ii) Where a company issued privately placed preferred stock
that was not rated, the rating applied to debt could be used to
determine the cost of preferred stock and its flotation costs.
(iii) In the case where all issues were privately placed, the
current average yield on all newly issued debt or preferred could
be used to determine the cost of debt or preferred respectively,
and an average flotation cost, for debt or preferred, could be
used.
(C) Evidence Requirements. Copies of this calculation
with notations as to the source of the data must be submitted.
Footnotes
(1) Ibbotson, R.E. and R.A. Sinquefield, Stocks, Bonds,
Bills, and Inflation, Charlottesville, Va.: The Financial
Analysts Research Foundation, 1977, cited by Ernst & Whinney,
Costs of Capital and Rates of Return for Industrial Firms and
Class A&B Electric Utility Firms, June 1979, p. 3-8.
(2) As an option, R f t can be developed with the following
equation:
where: D t = The average annual yield on three
month U.S. Treasury bills reported in the
Survey of Current
Business auctioned in month t - which is reported using the
bank discount method. N = Number of days to maturity. [46 FR 59920,
Dec. 7, 1981]