20041201Ahern Direct.pdf

Idaho PubiiC UUlities Commission
Office of me SecretaryRECEIVED
Dean J. Miller
McDEVITT & MILLER LLP
420 West Bannock Street
O. Box 2564-83701
Boise, ID 83702
Tel: [phone]
Fax: [phone]
oe~mcdevitt- n1iller. COIn
NOV 3 0 2004
Boise, Idaho
Attorneys for Applicant
BEFORE THE IDAHO PUBLIC UTILITIES COMMISSION
IN THE MATTER OF THE APPLICATION
OF UNITED WATER IDAHO INC. FOR
AUTHORITY TO INCREASE ITS RATES
AND CHARGES FOR WATER SERVICE IN
THE STATE OF IDAHO
Case No. UWI-O4-
BEFORE THE IDAHO PUBLIC UTILITIES COMMISSION
DIRECT TESTIMONY OF PAULINE M. AHERN
TABLE OF CONTENTS
Paae
No.
INTRODUCTION
II.SUMMARY
III.GENERAL PRINCIPLES
IV.BUSINESS RISK
FINANCIAL RISK
VI.PROXY GROUPS
VII.COMMON EQU ITY COST RATE MODELS
The Efficient Market Hypothesis (EM H)
Discounted Cash Flow Model (DCF)
Theoretical Basis
Application of the DCF Model
Dividend Yield
Discrete Adjustment of Dividend Yield
Selection of Growth Rates
for Use in the DCF Model
The Risk Premium Model (RPM)
Theoretical Basis
Estimation of Expected Bond Yield
Estimation of the Equity Risk Premium
The Capital Asset Pricing Model (CAPM)
Theoretical Basis
Risk-Free Rate of Return
Market Equity Risk Premium
Comparable Earnings Model (CEM)
Theoretical Basis
Application of the CEM
VIII.RECOMMENDED COMMON EQUITY COST RATE
Appendix A to the Direct Testimony of Pauline M. Ahern
1 INTRODUCTION
Please state your name , occupation and business address.
My name is Pauline M. Ahern and I am a Vice President of AUS
Consultants - Utility Services.My business address is 155
Gaither Drive , P.O. Box 1050 , Moorestown , New Jersey 08057.
Please summarize educational background andyour
professional experience.
I am a graduate of Clark University, Worcester, MA , where
received a Bachelor of Arts degree with honors in Economics in
1973. In 1991 I received a Master of Business Administration
with high honors from Rutgers University.
In June 1988 I joined AUS Consultants - Utility Services as a
Financial Analyst and am now a Vice President.I am
responsible for the preparation of all fair rate of return and capital
structure exhibits for AUS Consultants - Utility Services. I have
offered expert testimony on behalf of investor-owned utilities
before nineteen state regulatory commissions. The details of
these appearances , as well as details of my educational
background , are shown in Appendix supplementing this
testimony.
I am also the Publisher of C. A. Turner Utility Reports
responsible for the production , publication distribution and
marketing of these reports. C. A. Turner Utility Reports provides
financial data and related ratios covering approximately 150
public utility companies on a monthly, quarterly, and annual
Pauline M. Ahern, Oi
United Water Idaho Inc.
basis. Coverage includes electric, combination gas and electric
gas distribution , gas transmission , telephone, water and
international utilities. The Reports are distributed to about 1 000
subscribers, which include utilities, state utility commissions
federal agencies, individuals, brokerage firms, attorneys and
public and collegiate libraries.
I also calculate and maintain the A.A. Index under contract
with the American Gas Association (A.
).
The A.A. Index
is a market capitalization weighted index of the common stocks
of about 70 corporate members of the A.
I have co-authored an article with Frank J. Hanley, President
AUS Consultants - Utility Services entitled "Comparable
Earnings: New Life for an Old Precept" which was published in
the American Gas Association Financial Quarterly Review
Summer 1994. I also assisted in the preparation of an article
authored by Frank J. Hanley and A. Gerald Harris entitled "Does
Diversification Increase the Cost of Equity Capital?" published in
the July 15, 1991 issue of Public Utilities Fortniahtly
I am a member of the Society of Utility and Regulatory Financial
Analysts, formerly the National Society of Rate of Return
Analysts , serving as Secretary/Treasurer for 2004-2006.
1992 , I was awarded the professional designation "Certified Rate
of Return Analyst" (CRRA) by the National Society of Rate of
Return Analysts. This designation is based upon education
Pauline M. Ahern, OJ 2
United Water Idaho Inc.
experience and the successful completion of a comprehensive
written examination.
I am an associate member of the National Association of Water
Companies (NAWC), serving on its Finance Committee and a
member of the Energy Association of Pennsylvania, formerly the
Pennsylvania Gas Association.
What is the purpose of your testimony?
The purpose is to provide testimony on behalf of United Water
Idaho , Inc. (United or the Company) as to the appropriate
common equity cost rate which it should be afforded the
opportunity to earn on the common equity financed portion of its
jurisdictional rate base.
What is your recommended common equity cost rate?
I recommend that the Idaho Public Utilities Commission (IPUC or
the Commission) authorize the Company the opportunity to earn
an overall rate of return based upon the consolidated capital
structure of United Waterworks , Inc., United's parent, consisting
of 55.100/0 long-term debt, 0.130/0 minority interest (preferred
stock) and 44.770/0 common equity at cost rates of 7.100/0, 5.000/0
and 11.200/0, respectively.
Have you prepared an exhibit which supports your overall
recommended fair rate of return?
Yes, I have. It has been marked for identification as Exhibit No.
12 and consists of 11 schedules , labeled (PMA-1) through (PMA-
Pauline M. Ahern, OJ 3
United Water Idaho Inc.
11). Hereinafter, references to Schedules within this. testimony
will be from this Exhibit, unless otherwise noted.
II. SUMMARY
Please summarize your recommended common equity cost rate
of 11.20/0.
I assessed the market-based cost rates of similar risk
companies, Le., proxy groups , for insight into a recommended
common equity cost rate applicable to United and suitable for
cost of capital purposes. Because United's common stock is not
publicly traded , market-based common equity cost rates cannot
be determined directly for United. Consequently, it is appropriate
to look to a proxy group or groups of similar risk companies
whose common stocks are actively traded for insight into an
appropriate common equity cost rate applicable to United and
then adjust the results upward to reflect United's greater risk
(vis-a-vis the proxy groups). Using other utilities of comparable
risk as proxies is consistent with the principles of fair rate of
return established in the Hope1 and Bluefield2 cases and adds
reliability to the informed expert judgment used in arriving at a
recommended common equity cost rate.Therefore I have
evaluated the market data of two proxy groups of water
Federal Power Commission v. Hope Natural Gas Co., 320 U.S. 591 (1944).
Bluefield Water Works Improvement Co. v. Public Servo Comm , 262 U.S. 679 (1922).
Pauline M. Ahern, Di 4
United Water Idaho Inc.
companies in arriving at my recommended common equity cost
rate. The bases of selection are described below. One group
consists of six C.A. Turner water companies, while the other
group consists of the three water companies included in Value
Line Investment Survey s Standard Edition (Value Line water
companies ).
My analysis reflects current capital market conditions and
results from the application of four well-tested market-based cost
of common equity models , the Discounted Cash Flow (DCF)
approach , the Risk Premium Model (RPM), the Capital Asset
Pricing Model (CAPM), and the Comparable Earnings Model
(CEM).
The results derived from each are summarized on page 2 of
Schedule (PMA-1) and are as follows:
Pauline M. Ahern, Di 5
United Water Idaho Inc.
Table
A. Turner
Proxy Group
Proxy Group of Three
of Six Value Line
Standard Edition
Water Coso Water Coso
Discounted Cash Flow Model 10.80/0 11.20/0
Risk Premium Model 11.11.
Capital Asset Pricing Model 10.10.
Comparable Earnings Model 14.14.
Range of Common Equity Cost Rate 10.11.20/0
Business Risk Adjustment
Range of Common Equity Cost Rate After
Adjustment for Business Risk 10.950/0 11.450
Midpoint 11 .20/0
Recommended Common Equity Cost Rate 11.20/0
After reviewing the cost rates based upon the four models , I
conclude that a common equity cost rate range of 10.80/0 -
11.20/0 before adjustment for United's greater business risk is
indicated based upon the application of all four models to both
proxy groups.
As will be discussed subsequently, United is smaller than the
average company in either proxy group. All else equal, small
size means greater business risk. After applying business risk
adjustments of 0.150/0 and 0.250/0 to the indicated common equity
Pauline M. Ahern, Di 6
United Water Idaho Inc.
cost rates based upon the much larger, less business risky proxy
groups, a range of common equity cost rate of 10.950/0 - 11.450/0
is indicated.My recommended common equity cost rate is
11./0 based upon the midpoint of this range , and is applicable
to the common equity financed portion of United's rate base.
III. GENERAL PRINCIPLES
What general principles have you considered in arriving at your
recommended common equity cost rate of 11./0.
In unregulated industries marketplace competition is the
principal determinant of the price of a product or service. In the
case of regulated public utilities, regulation must act as a
substitute Consequently,for marketplace competition.
marketplace data must be relied upon to assure that the utility
can fulfill its obligations to the public and provide adequate
service at all times. This requires a level of earnings sufficient to
maintain the integrity of presently invested capital and permit the
attraction of needed new capital at reasonable cost
competition with other comparable-risk firms. These standards
for a fair rate of return have been established by the U.
Supreme Court in the Hope and Bluefield cases cited previously.
Consequently, in my determination of a fair rate of return , I have
Pauline M. Ahern, Di 7
United Water Idaho Inc.
made every effort to also evaluate data gathered from the
marketplace for water utilities similar in risk to United.
IV. BUSINESS RISK
Please define business risk and explain why it is important to the
determination of a fair rate of return?
Business risk incorporates all of the risks of a firm other than
financial risk, which will be discussed subsequently. Examples
of business risk include specific aspects of the operational and
regulatory environment which have a direct bearing on earnings
such as taxes and other cost increases construction
requirements, litigation and the potential for growth in revenue.
Business risk is important to the determination of a fair rate of
return because the greater the level of risk, the greater the rate
of return investors demand , consistent with the basic financial
precept of risk and return.
Please discuss the business risks facing the water industry in
general.
Regarding the business risks facing the water industry, Value
Line Investment Survey3 observes:
The Safe Drinking Water Act (SDWA) of 1974 remains
Value Line Investment Survey, July 30, 2004.
Pauline M. Ahern, OJ 8
United Water Idaho Inc.
the authority related to the safety and purity of drinkingwater. Its amendment in 1996 authorized the
Environmental Protection Agency EPA) to step up local
compliance levels. However, the regulatory environment
has only grown more onerous of late. With security
measures being tightened in the wake of recent terrorist
activity, governing law makers have insisted that the EP
work with local and state governments to test for
impurities in drinking water and to regulate the levels of
contaminants that are acceptable. And , with these
standards only likely to become more stern in the years
ahead, as the threat of bioterrorism against our water
pipelines increases, capital budgets are likely to
increased. It is estimated that it will take hundreds
billions of dollars to renovate existing pipelines.
Unfortunately, tight federal budgets are inhibiting the
government from helping fund the needed improvements.
Moody 4 also notes that:
We expect that the credit quality of the investor-owned
S. water utilities will likely deteriorate over the next
several years , due to ongoing large capital spending
requirements in the industry. Larger capital expenditures
facing the water utility industry result from the following
factors:
Continued federal and state environmental
compliance requirements;
Higher capital investments for constructing
modern water treatment and filtration
facilities;
Ongoing improvement of maturing
distribution and delivery infrastructure; and
Heightened security measures for
emergency preparedness designed
prevent potential terrorist acts.
Given the overwhelming importance of protecting the
4 Moody s Investors Service Global Credit Research. "The Water Utility Industry: Risks Rise for Last U.
Requlated Monopolv , Special Comment, February 1998, pp. 1 and 6.
Pauline M. Ahern , Di 9
United Water Idaho Inc.
public health , the water utility industry remains regulated
by the federal and state regulatory agencies. As a resultof this importance, the level of state regulators
responsiveness is critical in enabling the water utilities to
maintain their financial integrity. In addition , when utilities
are permitted a fair rate of return and timely rate
adjustments to reflect the costs of providing this essential
service, they will be more able to implement the
necessary safeguards to protect the public health.
In addition , because the water industry is much more capital-
intensive than the electric, natural gas or telephone industries
the investment required to produce a dollar of revenue is greater.
Thus, the challenge to water utilities is significant.
In addition, the water utility industry, as well as the electric
and natural gas utility industries , faces the need for increased
funds to finance the increasing security costs required to protect
the water supply and infrastructure from potential terrorist attacks
in the post-September 11 , 2001 world.
In view of the foregoing, it is clear that the water utility
industry s high degree of capital intensity coupled with the need
for substantial infrastructure capital spending and increased anti-
terrorism security spending, require regulatory support in the
form of adequate and timely rate relief so water utilities will be
able to successfully meet the challenges they face.
Does United face additional extraordinary business risk?
Pauline M. Ahern, Di 10
United Water Idaho Inc.
Yes. The Company faces four specific risk factors. The first is
due to the uncertainty surrounding its future supply portfolio due
to water rights issues. The second is due to the substantial
variations in weather conditions in Idaho. The third is due to the
Company s smaller size vis-a-vis the companies in my two proxy
groups. Finally, the fourth is due to the significant growth in
United's customer base, necessitating significant additions to
rate base.
Please discuss the uncertainty surrounding United'supply
portfolio.
The Company s supply portfolio consists of both surface water
and ground water rights which are difficult and increasingly
expensive to acquire or modify.The Company continually
struggles to protect these rights all the time.Currently the
Company is attempting to bring security to its water rights
through regulatory activity, such as its Integrated Municipal
Application Package (IMAP). In addition , the Snake Rive Basin
Watershed Adjudication presents increased uncertainty, and
hence , risk to United because of the risk of the potential loss of
existing water rights in the Basin once the Adjudication process
is complete. Exacerbating the risk to United's supply portfolio is
Pauline M. Ahern, Oi 11
United Water Idaho Inc.
the issue of conjunctive management, whereby certain ground
water rights may be deemed linked to surface water rights and
therefore potentially unavailable to supply water to United under
certain conditions.Consequently, the Company faces the
potential of spending a significant, but uncertain amount of
dollars in the near future to realign its water rights portfolio.
Coupled with the significant customer growth in its service
territory and United's obligation to provide water service when
requested , this poses a risk to United for water supply planning
purposes and hence pressures United's revenues and cash
flows.
Please discuss the weather conditions faced by United.
The Company s service territory enjoys an arid desert climate
which has a significant effect upon United's revenues.The
majority of its annual revenues are realized during the summer
months due to customer s dependence upon United for their
summer irrigation supply. Average monthly production in the
summer climbs to four times that of the winter months.
addition the territory onlybecauseservicereceives
approximately 11-12 inches of annual precipitation , United'
annual revenues are particularly sensitive to unusually cool or
Pauline M. Ahern, Di 12
United Water Idaho Inc.
wet weather in the summer. As new customers draw less water
conservation efforts become increasingly successful, and high
flow fixtures in older residences are being replaced by low flow
fixtu res.Even without summer weather fluctuations average
winter consumption is down when compared with history and the
Company expects that it will continue to decline. Nevertheless
United must continue to manage is water rights and build new
rate base to meet its increasing number of customers and
anticipated summer loads , furthering pressuring revenues and
cash flows.
Please explain why size has a bearing on business risk.
United's smaller size, Le., total capital of $120.665 million at
June 30, 2004 (see page 3 of Schedule (PMA-1) vis-a-vis
average total capital of $502.690 million and $865.130 million in
2003 for the proxy group of six C.A. Turner water companies and
proxy group of three Value Line water companies (see page 3 of
Schedule (PMA-1) indicates greater relative business risk
because all else equal, size has a bearing on risk.
Smaller companies are less capable of coping with
significant events which affect sales , revenues and earnings.
The loss of revenues from a few larger customers, or from
Pauline M. Ahern, OJ
United Water Idaho Inc.
declining consumption due to conservation or weather, for
example, would have a greater effect on a small company than
on a much larger company with a larger customer base.
Because United is the regulated utility to whose rate base the
Commission s ultimately allowed overall cost of capital and fair
rate of return will be applied , the relevant risk reflected in the
cost of capital must be that of United , including the impact of its
small size on common equity cost rate. Size is an important
factor which affects common equity cost rate, and United is
significantly smaller than the average company in the proxy
group based upon total investor-provided capital as shown
below:
Pauline M. Ahern, OJ 14
United Water Idaho Inc.
Table 2
2003 Times TimesTotal Greater than Market Greater than
Capital The Company Capitalization(.11 the Company($ millions) ($ Millions)
Proxy Group of Six
A. Turner
Water Companies
Proxy Group of Three
Value Line Water Coso 865.130
United Water Idaho, Inc. 119.049
$559.824
980.864
121.982(2)
120.154(3)
$502.690
(1) From Schedule (PMA-1), page 3.
(2) Based upon the proxy group of six C.A. Turner water companies.
(3) Based upon the proxy group of three Value Line water companies.
I have also performed a study of the market capitalization of
the proxy groups of six C.A. Turner water companies and three
Value Line water companies. The results are shown on page 5
the market(PMA-1 )whichSchedule summarizes
capitalizations as of October 7 2004.
United's common stock is not publicly traded. Consequently,
I have assumed that if it were publicly traded , its consolidated
common shares would be selling at the same market-to-book
ratios as the average market-to-book ratios for the two proxy
groups , or 225./0 and 222.40/0, respectively (at October 7
2004). Because all of United's capital is carried on its books as
common equity, its ratemaking capital structure is based upon its
parent's , United Waterworks, capital structure as shown on page
1 of Schedule (PMA-1). Therefore I have allocated United'
Pauline M. Ahern, Di
United Water Idaho Inc.
total capital at June 30, 2004 by United Waterworks' common
equity ratio (based upon total investor-provided capital) at June
, 2004 as detailed in Note 4 on page 5 of Schedule (PMA-1),
to arrive at an allocated common equity balance at June 30
2004 of $54.022 million. Based upon estimated common equity
of $54.022 million , United's market capitalization is estimated at
$121.982 million based upon the six C.A. Turner water
companies and $120.154 million based upon the three Value
Line water companies as of October 7 , 2004. .In contrast , the
market capitalizations of the average C.A. Turner water company
were $559.824 million and $980.864 million on October 7 , 2004
respectively, or 4.6 and 8.2 times larger than United estimated
market capitalization. It is conventional wisdom , supported by
actual returns over time, and a general premise contained in
basic finance textbooks , that smaller companies tend to be more
risky causing investors returnsexpectgreater
compensation for that risk.
Does the financial literature affirm a relationship between size
and common equity cost rate?
Yes. Brigham5 states that:
A number of researchers have observed that portfolios
of small-firms have earned consistently higher average
Eugene F. Brigham Fundamentals of Financial Manaqement. Fifth Edition The Dryden Press, 1989,
623.
Pauline M. Ahern, Oi 16
United Water Idaho Inc.
returns than those of large-firms stocks; this is called
small-firm effect." On the surface , it would seem to be
advantageous to the small firms to provide average
returns in a stock market that are higher than those of
larger firms. In reality, it is bad news for the small firm;
what the small-firm effect means is that the capital
market demands higher returns on stocks of small firms
than on otherwise similar stocks of the large firms.
(italics added)
Please discuss the risk which United faces due to the significant
growth in its customer base.
United serves approximately 75 000 customers in the city of
Boise and surrounding areas in Ada and Canyon counties.
United has recently experienced significant growth in its
customer base , growing at an annual rate of 2.00/0-50/0 or 1 600
to 1 800 new residential customers annually. In addition , rate
base will have grown more than 41 % since the last rate case in
2000, from $99 million in 2000 to $140 million in 2005, due in
large part to the construction of the Columbia Water Treatment
Plant as well as several other projects during 2000 to 2004.
Also , operating expenses, excluding depreciation and property
taxes , have increased 250/0 from $11 million to 13.8 million.
addition , the Company future capital plans call for an
expansion in its source of supply to meet continued customer
growth by implementing Aquifer Storage and Recovery (ASR),
Pauline M. Ahern, Oi
United Water Idaho Inc.
the drilling of new wells and increasing the capacity of the
Columbia Water Treatment Plant.
The uncertainty surrounding United's supply portfolio, significant
variations in weather conditions and system demands
continuing growth in customer base , United's aggressive capital
plan and increasing operating expenses, all contribute to the
uncertainty and pressure on revenues, earnings and cash flows
which when combined with its small size create a greater
business risk compared to the two proxy groups.
V. FINANCIAL RISK
Please define financial risk and explain why it is important to the
determination of a fair rate of return.
Financial risk is the additional risk created by the introduction of
senior capital , Le., debt and preferred stock, into the capital
structure. In other words, the higher the proportion of senior
capital in the capital structure, the higher the financial risk.
Utilities formerly were considered to have much less
business risk vis-a-vis unregulated enterprises, and, as a result
a larger percentage of debt capital was acceptable to investors.
In June 2004 S&P revised its utility financial guidelines and
assigned new business profile scores to U.S. utility and power
Pauline M. Ahern, OJ 18
United Water Idaho Inc.
companies to better reflect the relative business risk among
companies in the sector. S&P's revised financial guidelines to
the bond rating process for utilities can be found in Schedule
(PMA-2), page 14 , while pages 1 through 9 describe the utility
bond rating process.As shown on page 14, S&P's revised
financial guidelines to utilities establish financial target ratios for
ten levels of business position/profile with "1" being considered
lowest risk and "10" being highest risk.
As shown on Schedule (PMA-9), page 2, the average S&P
credit ratings (issuer credit rating) and business profiles of the six
A. Turner water companies and three Value Line water
companies are A+ and "6" and A and ", respectively.
How can one measure the combined business and financial
risks, Le., investment risk of an enterprise?
Similar bond ratings/issue credit reflect similar combined
business and financial risks, Le., total risk. Although the specific
business or financial risks may differ between companies, the
same bond rating indicates that the combined risks are similar as
the bond rating process reflects acknowledgment of all
diversifiable business and financial risks.For example S&P
expressly states that the bond rating process encompasses a
Pauljne M. Ahern , Oi
United Water Idaho Inc.
qualitative analysis of business and financial risks (see pages 3
through 10 of Schedule (PMA-2)). There is no perfect single
proxy, such as bond rating or common stock ranking, by which
one can differentiate common equity risk between companies.
However, the bond rating provides a useful means
compare/differentiate common equity risk between companies
because it is the result of a thorough and comprehensive
analysis of all diversifiable business and financial risks , Le.
investment risk.
VI. PROXY GROUPS
Please explain how you chose the proxy group of six C.A. Turner
water companies.
The basis of selection for the proxy group of six C.A. Turner
water companies is that those companies meet the following
criteria: 1) they are included in the Water Company Group of
A. Turner Public Utility Reports (October 2004); 2) they have
Value Line or Thomson FN/First Call consensus projected
growth rates in earnings per share; and 3) they have more than
700/0 of their 2003 operating revenues derived from water
operations. Six companies met all of these criteria.
Please describe Schedule (PMA-3).
Pauline M. Ahern, OJ 20
United Water Idaho Inc.
Schedule (PMA-3) contains comparative capitalization and
financial statistics for the six C.A. Turner water companies for the
years 1999 through 2003. The schedule consists of three pages.
Page 1 contains a summary of the comparative data for the
years 1999-2003, while page 2 contains notes relevant to page
, as well as the basis of selection and names of the individual
companies in the proxy group.Page 3 contains the capital
structure ratios based upon total capital (including short-term
debt) by company and on average for the years 1999-2003.
During the five-year period ending 2003, the achieved
average earnings rate on book common equity for this group
ranged between 8.970/0 in 2003, and 10.820/0 in 1999 , and
averaged 10.160/0.The five-year average market/book ratio
ending 2003 was 212.980/0. The five-year ending 2003 average
common equity ratio based upon total investor-provided capital
(including short-term debt) was 43.090/0, while the five-year
average dividend payout ratio was 80.170/0.
Funds from operations/interest coverage excluding all
AFUDC ranged between 3.10 and 3.38 times and averaged 3.
times during the five-year period.
Pauline M. Ahern, Oi
United Water Idaho Inc.
Please explain how you chose the proxy group of three Value
Line water companies.
The basis of selection for the proxy group of three Value Line
water companies was to include those companies which are part
of Value Line s (Standard Edition) Water Utility Industry Group.
Please describe Schedule (PMA-4).
Schedule (PMA-4) contains comparative capitalization and
financial statistics for the three Value Line water companies for
the years 1999 through 2003. The schedule consists of three
pages. Page 1 contains a summary of the comparative data for
the years 1999-2003, while page 2 contains notes relevant to
page 1 , as well as the basis of selection and names of the
individual companies in the proxy group.Page 3 contains the
capital structure ratios based upon total capital (including short-
term debt) by company and on average for the years 1999-2003.
During the five-year period ending 2003, the achieved
average earnings rate on book common equity for this group
ranged between 8.860/0 in 2003, and 11.370/0 in 2000 , and
averaged 10.600/0.The five-year average markeUbook ratio
ending 2003 was 219.340/0. The five-year ending 2003 average
common equity ratio based upon total investor-provided capital
Pauline M. Ahern, Oi 22
United Water Idaho Inc.
(including short-term debt) was 43.010/0, while the five-year
average dividend payout ratio was 75.160/0.
Funds from operations/interest coverage , excluding all
AFUDC ranged between 3.40 and 3.63 times and averaged 3.
times during the five-year period.
VII. COMMON EQUITY COST RATE MODELS
A. The Efficient Market Hvpothesis (EMH)
Are the cost of common equity models you use market-based
models, and hence based upon the EMH?
Yes. The DCF model is market-based in that market prices are
utilized in developing the dividend yield component of the model.
The RPM is market-based in that the bond ratings and expected
bond yields used in the application of the RPM reflect the
market's assessment of risk. In addition , the use of betas to
determine the equity risk premium also reflects the market's
assessment of risk as betas are derived from regression
analyses of market prices. The CAPM is market-based for many
of the same reasons that the RPM is market-based Le., the use
of expected bond (Treasury bond) yields and betas. The CEM is
market-based in that the process of selecting the comparable
risk non-utility companies is based upon statistics which result
from regression analyses of market prices. Therefore, all the
cost of common equity models I utilize are market-based models,
Pauline M. Ahern, OJ 23
Unjted Water Idaho Inc.
and hence based upon the EMH.
Please describe the conceptual basis of the EMH.
The Efficient Market Hypothesis (EM H), which is the foundation
of modern investment theory, was pioneered by Eugene
Fama6 in 1970. An efficient market is one in which security
prices reflect all relevant information all the time. This implies
that prices adjust instantaneously to new information, thus
reflecting the intrinsic fundamental economic value of a security.
The generally-accepted "semistrong" form of the EMH
asserts that all publicly available information is fully reflected in
securities prices Le.fundamental analysis cannot enable
investor to "outperform the market"This means that all
perceived risks are taken into account by investors in the prices
the pay for securities.Investors are aware of all publicly-
available information, including bond ratings, discussions about
companies by bond rating agencies and investment analysts as
well as the various cost of common equity methodologies
(models) discussed in the financial literature. In an attempt to
emulate investor behavior, no single common equity cost rate
model should be relied upon in determining a cost rate of
common equity and the results of multiple cost of common equity
6 Fama, Eugene F.
, "
Efficient Capital Markets: A Review of Theory and Empirical Work"Journal of Finance, May
1970, pp. 383-417.
7 Morin, Roger A Requlatorv Finance - Utilities' Cost of Capital.Public Utility Reports, Inc., Arlington, VA, 1994
136.
Pauline M. Ahern, OJ 24
United Water Idaho Inc.
models should be taken into account.In addition , there
substantial support in the academic literature for the need to rely
upon more than one cost of common equity model in arriving at a
recommended common equity cost rate.
In view of the foregoing, it is clear that investors are aware of all
of the models available for use in determining a common equity
cost rate. The EMH requires the assumption that, collectively,
investors use them all.
B. Discounted Cash Flow Model (DCF)
1. Theoretical Basis
What is the theoretical basis of the DCF model?
The theory of the DCF model is that the present value of an
expected future stream of net cash flows during the investment
holding period can be determined by discounting the cash flows
at the cost of capital , or the capitalization rate. DCF theory
suggests that an investor buys a stock for an expected total
return rate which is expected to be derived from cash flows
received in the form of dividends plus appreciation in market
price (the expected growth rate). Thus , the dividend yield on
market price plus a growth rate equals the capitalization rate
Le., the total return rate expected by investors.
Pauline M. Ahern, Oi 25
United Water Idaho Inc.
2. Application of the DCF Model
a. Dividend Yield
Please describe the dividend yield you used in your application
of the DCF model.
The unadjusted dividend yields are based upon an average of a
recent spot date (October 7 , 2004) as well as an average of the
three months ended September 30, 2004 , respectively, which
are shown on Schedule (PMA-5). The average unadjusted yield
is 3.40/0 for the six C.A. Turner water companies and 3.30/0 for
the three Value Line water companies.
b. Discrete Adjustment of Dividend Yield
Please explain the dividend growth component shown on
Schedule (PMA-5), Column 2.
Because dividends are paid quarterly, or periodically, as
opposed to continuously (daily), an adjustment to the dividend
yield must be made. This is often referred to as the discrete , or
the Gordon Periodic, version of the DCF model.
Since the various companies in the proxy group increase
their quarterly dividend at various times during the year, a
reasonable assumption is to reflect one-half the annual dividend
growth rate in the D1 expression , or D1/2. This is a conservative
approach which does not overstate the dividend yield which
should be representative of the next twelve-month period.
Therefore, the actual average dividend yields in Column 1 on
Pauline M. Ahern , OJ 26
United Water Idaho Inc.
Schedule (PMA-5) have been adjusted upward to reflect one-half
the growth rates shown in Column 4.
c. Selection of Growth Rates for Use in the DCF Model
Please explain the basis of the growth rates for the proxy groups
of six C.A. Turner water companies and three Value Line water
companies which you use in your application of the DCF model.
Schedule (PMA-7) indicates that about 79.00/0 and 70.00/0 of the
common shares of the proxy groups of six C.A. Turner water
companies and three Value Line water companies , respectively
are held by individuals as opposed to institutional investors.
Individual investors are particularly likely to place great
significance on the opinions expressed by financial information
services, such as Value Line which is readily accessible in most
public libraries and Thomson FN/First Call which is easily
accessible via the Internet.
Forecasts by analysts , including Value Line, are typically
limited to five years. Thus, it is appropriate to use five-year
historical growth rates in earnings per share (EPS) and dividends
per share (DPS) as well as the sum of internal and external
growth in per share value (BR + SV) in conjunction with analysts
five-year projected growth in EPS and five-year projected growth
in BR + SV when determining a growth rate for use in the DCF
model. The historical growth rates in EPS and DPS are from
Value Line or calculated in a manner similar to Value Line , while
Pauline M. Ahern , OJ 27
United Water Idaho Inc.
the projected growth rates in earnings are from Value Line and
Thomson FN/First Call forecasts. Thomson FN/First Call growth
rate estimates are not available for DPS and internal growth , and
they do not include the Value Line projections.
All of these growth rates are summarized for the companies
in the proxy group on page 1 , Schedule (PMA-8). Supporting
growth rate data are detailed on pages 2 through 8 of Schedule
(PMA-8). Pages 8 through 12 of Schedule (PMA-8) contain all of
the most current Value Line Investment Survey data for the
companies in the proxy groups.
Please summarize the DCF model results.
As shown on Schedule (PMA-5), the results of the application of
the DCF model are 10.80/0 for the proxy group of six C.A. Turner
water companies and 11./0 for the proxy group of three Value
Line water companies. In arriving at conclusions of indicated
common equity cost rates for the proxy groups I included only
those DCF results which are greater than 200 basis points above
the average prospective yield on Moody s A rated public utility
bonds of 6.80/0, or 8./0, based upon Blue Chip Financial
Forecasts' October 1 2004 consensus forecast of about
economists of the expected yield on Aaa rated corporate bonds
of 6./0 as discussed subsequently and derived in Note 3
page 6 of Schedule (PMA-9).It is necessary to adjust the
average Aaa rated corporate bond yield to be equivalent to a
Pauline M. Ahern, OJ 28
United Water Idaho Inc.
Moody s A2 rated public utility bond. As detailed in Note 2 on
page 1 of Schedule (PMA-9), an adjustment to the average
prospective yield on Aaa rated corporate bonds of 0./0 was
required. Thus, the average prospective yield on Moody s A
rated public utility bonds is 6./0.
Based upon a review of recent authorized returns on
common equity (ROE) in New York vis-a-vis concurrent
estimates of the forecasted average yield on A rated public utility
bonds I determined that the equity risk premium implicit in
recent IPUC authorized ROEs is between approximately 335 and
361 basis points. In accordance with the EMH, investors are
aware of these implicit equity risk premia and , in my opinion
would not consider returns providing an equity risk premium of
only 200 basis points above the prospective average yield on A
rated public utility bonds of 6.80/0 or 8./0.
C. The Risk Premium Model (RPM)
1. Theoretical Basis
Please describe the theoretical basis of the RPM.
Risk Premium theory indicates that the cost of common equity
capital is greater than the prospective company-specific cost rate
for long-term debt capital. In other words , the cost of common
equity equals the expected cost rate for long-term debt capital
plus a risk premium to compensate common shareholders for the
added risk of being unsecured and last-in-line for any claim on
Pauline M. Ahern, OJ 29
United Water Idaho Inc.
the corporation s assets and earnings.
Have you performed RPM analyses of common equity cost rate
for the proxy groups of six C.A. Turner water companies and
three Value Line water companies?
Yes. The results of my applications of the RPM are summarized
on page 1 of Schedule (PMA-9).On Line No.. page 1
Schedule (PMA-9), I show the average expected yield on A rated
public utility bonds of 6./0.On Line No.I show the
adjustments, if necessary, that need to be made to the average
80/0 expected A rated utility bond yield so that the expected
yield of 6.80/0 in Line No.5 is reflective of the average Moody
bond rating of A2 for the two proxy groups of water companies
as shown on page 2 of Schedule (PMA-9). On Line No.6 of
page 1 , my conclusions of an equity risk premia applicable to
each proxy group are shown , while the total risk premium
common equity cost rates are shown on Line No.
2. Estimation of Expected Bond Yield
Please explain the basis of the expected bond yield of 6.80/0
applicable to the average company in each proxy group.
Because the cost of common equity is prospective, a prospective
yield on similarly-rated long-term debt is essential. As shown on
Schedule (PMA-9), page 2 , the average Moody s bond rating for
both proxy groups of water companies is A2. I relied upon a
consensus forecast of about 50 economists of the expected yield
Pauline M. Ahern , Oi 30
United Water Idaho Inc.
on Aaa rated corporate bonds for the six calendar quarters
ending with the first calendar quarter of 2006 as derived from the
October 1 , 2004 Blue Chip Financial Forecasts (shown on page
7 of Schedule (PMA-9). As shown on Line No.1 of page 1 of
Schedule (PMA-9), the average expected yield on Moody s Aaa
rated corporate bonds is 6.30/0. It is necessary to adjust that
average yield to be equivalent to a Moody s A2 rated public utility
bond. Consequently, an adjustment to the average prospective
yield on Aaa rated corporate bonds of 0./0 was required. It is
shown on Line No., page 1 of Schedule (PMA-9) and explained
in Note 2 at the bottom of the page. After adjustment, the
expected bond yield applicable to a Moody s A rated public utility
bond is 6.80/0 as shown on Line No.3, page 1 of Schedule (PMA-
9).
Because the average Moody s bond rating for the two proxy
groups of water companies is A2 , no adjustment to the 6.80/0
prospective yield on A rated public utility bonds is necessary.
Therefore, the expected proxy group specific bond yield is 6.80/0.
3. Estimation of the Equitv Risk Premium
Please explain the method utilized to estimate the equity risk
premium.
I evaluated the results of two different historical equity risk
premium studies, as well as Value Line s forecasted total annual
market return in excess of the prospective yield on high grade
Pauline M. Ahern, OJ 31
United Water Idaho Inc.
corporate bonds, as detailed on pages 5 , 6 and 8 of Schedule
(PMA-9). As shown on Line No.3, page 5 of Schedule (PMA-9),
the mean equity risk premia based on both of the studies are
20/0 applicable to the proxy group of six C.A. Turner water
companies and 4.40/0 applicable to the proxy group of three
Value Line water companies. These estimates are the result of
an average of beta-derived historical equity risk premia and
forecasted total market equity risk premia as well as the mean
historical equity risk premium applicable to public utilities with
bonds rated A based upon holding period returns.
The basis of the beta-derived equity risk premia applicable
to the proxy group is shown on page 6 of Schedule (PMA-9).
Beta-determined equity risk premia should receive substantial
weight because betas are derived from the market prices of
common stocks over a recent five-year period and are a
meaningful measure of prospective risk relative to the market as
a whole.
The total market equity risk premium utilized is 6.40/0 and is
based upon an average of both the long-term historical and
forecasted market risk premia of 6.30/0 and 6.40 , respectively,
as shown on page 6 of Schedule (PMA-9).To derive the
historical market equity risk premium I used the most recent
Ibbotson Associates' data on holding period returns for the S&P
500 Composite Index and the average annual yield on Moody
Pauline M. Ahern, Oi 32
United Water Idaho Inc.
Aaa and Aa corporate bonds covering the period 1926-2003.
The use of holding period returns over a very long period of time
is useful in the beta approach because it is consistent with the
long-term investment horizon presumed by the DCF model.
Consequently, the long-term arithmetic mean total return rates
on the market as a whole of 12.40/0 and arithmetic mean yield
(income return) on corporate bonds of 6.1 % were used , as
shown at Line Nos. 1 and 2 of page 6 of Schedule (PMA-9).
shown on Line No.3 of page 6 , the resultant long-term historical
equity risk premium on the market as a whole is 6.30/0.
I used arithmetic mean return rates and yields (income
returns) because they are appropriate for cost of capital
purposes because ex-post (historical) total returns and equity
risk premium spreads differ in size and direction over time. The
arithmetic mean provides insight into the variance and standard
deviation of such returns as it captures the prospect for variance
in returns , thus providing the valuable insight needed by
investors to estimate future risk when making a current
investment.Absent such valuable insight into the potential
variance of returns , investors cannot meaningfully evaluate
prospective risk.
The basis of the forecasted market equity risk premium can
be found on Line Nos. 4 through 6 on page 6 of Schedule (PMA-
9). It is derived from an average of the most recent 3 months
Pauline M. Ahern, Oi 33
United Water Idaho Inc.
(using the months of July 2004 through August 2004) and a
recent spot (October 1 , 2000) median market price appreciation
potentials by Value Line as explained in detail in Note 1 on page
of Schedule (PMA-10).The average expected price
appreciation is 520/0 which translates to 11.040/0 per annum and
when added to the average (similarly calculated) dividend yield
of 1.700/0 equates to a forecasted annual total return rate on the
market as a whole of 12.740/0, rounded to 12.70/0. Thus, this
methodology is consistent with the use of the 3.:.month and spot
dividend yields in my application of the DCF model. To derive
the forecasted total market equity risk premium of 6.40/0 shown
on Schedule (PMA-9), page 6 , Line No., the October 1 , 2004
forecast of about 50 economists of the expected yield on
Moody s Aaa rated corporate bonds for the six calendar quarters
ending with the first calendar quarter 2006 of 6.30/0 from Blue
Chip Financial Forecasts was deducted from the Value Line total
market return of 12.70/0. The calculation resulted in an expected
market risk premium of 6.40/0.
The average of the historical and projected market equity
risk premia of 6.30/0 and 6.40/0 is 6.450/0 , rounded to 6.40/0.
On page 9 of Schedule (PMA-9), the most current Value
Line betas for the companies in the two proxy groups are shown.
Applying the average betas to the average market equity risk
premium of 6.40/0 for the six C.A. Turner water companies and
Pauline M. Ahern , Oi 34
United Water Idaho Inc.
the three Value Line water companies results in beta adjusted
equity risk premia of 4.40/0 and 4., respectively, as shown on
Schedule (PMA-9), page 6, Line No.
mean equity risk premium of 4./0 applicable to
companies with A rated public utility bonds was calculated based
upon holding period returns from a study using public utilities , as
shown on Line No., page 5 of Schedule (PMA-9), and detailed
on page 8 of the same schedule.
The equity risk premia applicable to the two proxy groups of
water companies are the average of the proxy group-specific
beta-derived premium and that based upon the holding period
returns of public utilities with A rated bonds, as summarized on
Schedule (PMA-9), page 5, Le., 4.20/0 and 4.40/0 for the three
Value Line water companies, respectively.
What are the RPM calculated common equity cost rates?
They are 11.00/0 for the six C.A. Turner water companies and
11.20/0 for the three Value Line water companies as shown on
Schedule (PMA-9), page
D. The Capital Asset Pricina Model (CAPM)
1. Theoretical Basis
Please explain the theoretical basis of the CAPM.
CAPM theory defines risk as the covariability of a security
returns with the market's returns. This covariability is measured
by beta
),
an index measure of an individual security
Pauline M. Ahern, OJ 35
United Water Idaho Inc.
variability relative to the market. A beta less than 1.0 indicates
lower variability while a beta greater than 1.0 indicates greater
variability than the market.
The CAPM assumes that all other risk, Le., all non-market or
unsystematic risk, can be eliminated through diversification. The
risk that cannot be eliminated through diversification is called
market, or systematic, risk. The CAPM presumes that investors
require compensation for risks that cannot be eliminated through
diversification. Systematic risks are caused by macroeconomic
and other events that affect the returns on all assets.
Essentially, the model is applied by adding a risk-free rate of
return to a market risk premium. This market risk premium is
adjusted proportionately to reflect the systematic risk of the
individual security relative to the market as measured by beta.
The traditional CAPM model is expressed as:
Where:
Rf + ~(Rm - Rf)
Return rate on the common stock
Risk-free rate of return
Return rate on the market as a whole
Adjusted beta (volatility of the security
relative to the market as a whole)
Pauline M. Ahern, Di 36
United Water Idaho Inc.
Numerous tests of the CAPM have confirmed its validity. These
tests have measured the extent to which security returns and
betas are related as predicted by the CAPM. However, Morin
observes that while the results support the notion that beta is
related to security returns it has been determined that the
empirical Security Market Line (SML) described by the CAPM is
not as steeply sloped as the predicted SML. Morin8 states:
With few exceptions, the empirical studies agree that
... low-beta securities earn returns somewhat higher than
the CAPM would predict, and high-beta securities earn
less than predicted.
Therefore the empirical evidence suggests that the
expected return on a security is related to its risk by the following
approximation:
RF + x f3(RM - RF) + (1-x) f3(RM - RF)
where x is a fraction to be determined empirically. ...the
value of x that best explains the observed relationship is
between 0.25 and 0.30. If x = 0., the equation
becomes:
RF + 0.25(RM - RF) + 0.75 f3(RM - RF)9
In view of theory and practical research , I have applied both the
traditional CAPM and the empirical CAPM to the companies in
!!t, at p. 321.
, at pp. 335-336.
Pauline M. Ahern, Oi 37
United Water Idaho Inc.
the proxy group and averaged the results.
2. Risk-Free Rate of Return
Please describe your selection of a risk-free rate of return.
My applications of the traditional and empirical CAPM are
summarized on Schedule (PMA-10), page 1. As shown on Line
Nos. 1 and 4, the risk-free rate adopted for both applications is
50/0. It is based upon the average consensus forecast of the
reporting economists in the October 1 , 2004 of Blue Chip
Financial Forecasts as shown in Note 2, page 4 , of the expected
yields on long-term U.S. Treasury bonds for the six quarters
ending with the first calendar quarter 2006.
Why is the prospective yield on long-term U.S. Treasury Bonds
appropriate for use as the risk-free rate?
The yield on long-term T -Bonds is almost risk-free and its term is
consistent with the long-term cost of capital to public utilities
measured by the yields on A rated public utility bonds, and is
consistent with the long-term investment horizon inherent
utilities' common stocks. Therefore , it is consistent with the long-
term investment horizon presumed in the standard DCF model
employed in regulatory ratemaking.
3. Market EQuitv Risk Premium
Please explain the estimation of the expected equity risk
premium for the market.
After estimating investors' expected total return rate for the
Pauline M. Ahern , Oi 38
United Water Idaho Inc.
market I subtract the expected risk-free rate to arrive at an
expected equity risk premium for the market, some proportion of
which must be allocated to the companies in the proxy group
through the use of beta. As shown on Schedule (PMA-10), page
, Line No., the proportional market equity risk premium , based
on the traditional CAPM , is 4.70/0 for the proxy group of six C.
Turner water companies and 5.00/0 for the proxy group of three
Value Line water companies.Applying the empirical CAPM
results in an equity risk premium of 5.30/0 for the six C.A. Turner
water companies and 5.80/0 for the three Value Line water
companies as shown on Line No.5 on page 1 of Schedule
(PMA-10). The total market equity risk premium utilized was
20/0 and is based upon an average of the long-term historical
and projected market risk premia.
The basis of the projected median market equity risk
premium is explained in detail in Note 1 on page 3 of Schedule
(PMA-10).As previously discussed it is derived from an
average of the most recent 3 months (using the months of July
2004 through August 2004) and a recent spot (October 1 , 2004)
- 5 year median total market price appreciation projections
from Value Line, and the long-term historical average from
Ibbotson Associates. The appreciation projections by Value Line
plus average dividend yield equate to a forecasted annual total
return rate on the market of 12./0. The long-term historical
Pauline M. Ahern, Oi 39
United Water Idaho Inc.
return rate of 12.40/0 on the market as a whole is from Ibbotson
Associates Stocks. Bonds. Bills and Inflation - Valuation Edition
2004 Yearbook. In each instance, the relevant risk-free rate was
deducted from the total market return rate. For example, from
the Value Line projected total market return of 12.70/0, the
forecasted average risk-free rate of 5.50/0 was deducted
indicating a forecasted market risk premium of 7./0. From the
Ibbotson Associates' long-term historical total return rate of
12.40/0, the long-term historical income return rate on long-term
s. Government Securities of 5.20/0 was deducted indicating an
historical equity risk premium of 7.20/0. Thus , the average of the
projected and historical total market risk premia of 7.20/0 and
20/0, respectively, is 7.20/0.
What are the results of your applications of the traditional and
empirical CAPM to the proxy group?
As shown on Schedule (PMA-10), Line No.3 of page 1 , the
traditional CAPM cost rates are 10.20/0 for the proxy group of six
A. Turner water companies and 10.50/0 for the proxy group of
three Value Line water companies. And , as shown on Line No.
of page 1 , the empirical CAPM cost rates are 10.80/0 for the
proxy group of six C.A. Turner water companies and 11.1 % for
the three Value Line water companies. The traditional and
empirical CAPM cost rates are shown individually by company
on pages 2 and 3 of Schedule (PMA-10). As shown on Line No.
Pauline M. Ahern, Oi 40
United Water Idaho Inc.
, the CAPM cost rate applicable to the proxy group of six water
companies is 10.50/0 and an 10.80/0 CAPM cost rate is applicable
to the proxy group of three Value Line water companies based
upon the traditional and empirical CAPM results.
E. Comparable EarninQs Model (CEM)
1. Theoretical Basis
Please describe your application of the Comparable Earnings
Model and how it is used to determine common equity cost rate.
My applications of the CEM are summarized on Schedule (PMA-
11) which consists of six pages. Pages 1 and 2 show the CEM
results for the proxy group of six C.A. Turner water companies,
while pages 3 and 4 show the CEM results for the proxy group of
three Value Line water companies. Pages 5 and 6 contain the
notes related to pages 1 through 4.
The comparable earnings approach is derived from the
corresponding risk" standard of the landmark cases of the U.
Supreme Court.Therefore it is consistent with the Hope
doctrine that the return to the equity investor should
commensurate with returns on investments in other firms having
corresponding risks.
The CEM is based upon the fundamental economic concept
of opportunity cost which maintains that the true cost of an
investment is equal to the cost of the best available alternative
use of the funds to be invested. The opportunity cost principle is
Pauline M. Ahern, Oi 41
United Water Idaho Inc.
also consistent with one of the fundamental principles upon
which regulation rests: that regulation is intended to act as a
surrogate for competition and to provide a fair rate of return to
investors.
The CEM is designed to measure the returns expected to be
earned on the book common equity, in this case net worth, of
similar risk enterprises. Thus, it provides a direct measure of
return, since it translates into practice the competitive principle
upon which regulation rests. In my opinion, it is inappropriate to
use the achieved returns of regulated utilities of similar risk
because to do so would be circular and inconsistent with the
principle of equality of risk with non-price regulated firms.
The difficulty in application of the CEM is to select a proxy
group of companies which are similar in risk, but are not price
regulated utilities. Consequently, the first step in determining a
cost of common equity using the comparable earnings model is
to choose an appropriate proxy group of non-price regulated
firms which is broad-based in order to obviate any company-
specific aberrations but excludes utilities.
2. Application of the CEM
Please describe your application of the CEM.
My application of the CEM is market-based in that the selection
of non-price regulated firms of comparable risk is based upon
Pauline M. Ahern, Oi 42
United Water Idaho Inc.
statistics derived from the market prices paid by investors.
I have chosen proxy groups of eighty-one and ninety-nine
domestic , non-price regulated firms to reflect both the systematic
and unsystematic risks of each proxy group, respectively. The
proxy group of eighty-one non-utility companies is listed on
pages and 2 of Schedule (PMA-11), while the companies in
the proxy group of ninety-nine non-utility companies are listed on
pages 3 and 4. The criteria used in the selection of these proxy
companies were that they be domestic non-utility companies and
have a meaningful rate of return on net worth , common equity or
partners' capital reported in Value Line (Standard Edition) for
each of the five years ended 2003, or projected for 2007-2009.
Value Line betas were used as a measure of systematic risk.
The residual standard error, or the standard error of the estimate
from the regression equation from which each company s beta
was derived , was used as a measure of each firm s specific, Le.
unsystematic risk. The residual standard error reflects the extent
to which events specific to a company s operations will affect its
stock price and , therefore is a measure of diversifiable
unsystematic, company-specific risk.In essence, companies
which have similar betas and residual standard errors, have
similar investment risk, i., the sum of systematic (market) risk
as reflected by beta and unsystematic (business and financial)
risk as reflected by the residual standard error, respectively.
Pauline M. Ahern, OJ 43
United Water Idaho Inc.
Those statistics are derived from regression analyses using
market prices which under the EMH reflect all relevant risks.
The application of these criteria results in proxy group of non-
price regulated firms similar in risk to the average company in
the proxy group.
Using a Value Line , Inc. database dated September 16
2004 , the proxy groups of eighty-one and ninety-nine non-price
regulated companies were chosen based upon ranges of
unadjusted beta and residual standard error. The ranges were
based upon the average standard deviations of the unadjusted
beta and the average residual standard errors for the proxy
groups of six C.A. Turner water companies and three Value Line
water companies as explained in Notes 1 and 9 on page 5 of
Schedule (PMA-11).
Once proxy groups of non-price regulated companies are
selected , it is then necessary to derive returns on book common
equity, net worth or partners' capital for the companies in the
groups. I have measured these returns using the rate of return
on net worth common equity or partners' capital reported by
Value Line (Standard Edition). It is reasonable to measure these
returns over both the most recent historical five-year period as
well as those projected over the ensuing five-year period
consistent with the use of historical and projected growth rates in
the DCF model.
Pauline M. Ahern , Di 44
United Water Idaho Inc.
What are your conclusions of CEM cost rate?
The CEM cost rate is 16.20/0 for the proxy group of six C.
Turner water companies as shown on page 2 of Schedule (PMA-
11) and 16.00/0 for the proxy group of three Value Line water
companies as shown on page 4 of Schedule (PMA-11). Note
that I have applied a test of significance (Student's t-statistic) to
determine whether any of the historical or projected returns are
significantly different from their respective means at the 950/0
confidence level. As a result, the historical and projected means
of several companies have been excluded.
I have also eliminated from the total group of eighty-one and
ninety-nine companies, all those rates of return which are greater
than 20./0 or less than 200 basis points above the current
prospective yield of 6.80/0 on Moody s A rated public utility bonds
(see page 1 of Schedule (PMA-9)), or 8./0. Such elimination
results in an arithmetic mean return rate of 15./0 on
historical five-year basis and 13./0 on a projected five-year
basis for the six C.A. Turner water companies and 14.40/0 and
13.60/0, respectively, for the three Value Line water companies.
rely upon the midpoint of the arithmetic mean historical five-year
and projected five-year rates of return of 14.20/0 and 14.1 % for
each proxy group, respectively, excluding those rates of return in
excess of 20.00/0 or less than 8.80/0 as my CEM conclusion.
Pauline M. Ahern, OJ 45
United Water Idaho Inc.
VIII. RECOMMENDED COMMON EQUITY COST RATE
What is your recommended common equity cost rate?
It is 11./0, based upon a range of common equity cost rates of
10.80/0 - 11.20/0 before business risk adjustment based upon the
common equity cost rates resulting from all four cost of common
equity models consistent with the EMH which logically mandates
the use of multiple C0st of common equity models.
In formulating the range of common equity cost rate of 10.80/0
- 11.20/0, I reviewed the results of the application of four different
cost of common equity models, namely, the DCF, RPM , CAPM
and CEM for the proxy groups. I employ all four cost of common
equity models as primary tools in arriving at my recommended
common equity cost rate because no single model is so
inherently precise that it can be relied upon solely, to the
exclusion of other theoretically sound models. As discussed
above, all four models are based upon the Efficient Market
Hypothesis (EMH), and therefore , have application problems
associated with them. The EMH , as also previously discussed
requires the assumption that investors rely upon multiple cost of
common equity models.Moreover, as demonstrated in this
testimony, the prudence of using multiple cost of common equity
models is supported in the financial literature. Therefore, none
should be relied upon exclusively to estimate investors' required
rate of return on common equity.
Pauline M. Ahern , OJ 46
United Water Idaho Inc.
The results of the four cost of common equity models applied
to the proxy groups of six C.A. Turner water companies and
three Value Line water companies are shown on Schedule
(PMA-1), page 1 and summarized below:
Table 3
Proxy Group Proxy Group ofof Six Three Value Line
A. Turner Standard Edition
Water Coso Water Companies
Discounted Cash Flow Model
Risk Premium Model
Capital Asset Pricing Model
Comparable Earnings Model
10.80/0
11.
10.
14.
11.20/0
11.
10.
14.
Range of Indicated Common EquityCost Rate 10.80/0 11 .20/0
Business Risk Adjustment
Range of Equity Cost Rate After Adjustment
For Business Risk 10.950/0
Midpoint 11.
Recommended Common Equity Cost Rate .1j .
Based upon these common equity cost rate results
conclude that a common equity cost rate range of 10.80/0 - 11.20/0
is indicated based upon the use of multiple common equity cost
rate models and before any adjustment for United'greater
relative business risk as shown on Line No., page
Schedule (PMA-1).
Pauline M. Ahern, OJ 47
United Water Idaho Inc.
These cost rates are applicable to the much larger, less
business risky, proxy groups. However, as discussed previously,
United bears more business risk than the average proxy group
company because of its small size vis-a-vis the proxy groups
and the particular risk factors affecting the Company, as
previously discussed. Therefore, it is necessary to upwardly
adjust the range of common equity cost rate of 10.80/0 - 11.20/0
based upon the proxy groups. Therefore, based upon United'
small relative size I have added business risk adjustments of
150/0 (15 basis points) relative to the indicated common equity
cost rate of 10.80/0 for the six C.A. Turner water companies and
250/0 (25 basis points) relative to the indicated common equity
cost rate of 11./0 for the three Value Line water companies
which are conservatively realistic. The adjustments are based
upon data contained in Chapter 7 entitled
, "
Firm Size and
Return" from Ibbotson Associates Stocks. Bonds. Bills and
Inflation-Valuation Edition 2004 Yearbook. The determinations
are based on the size premia for decile portfolios of New York
Stock Exchange (NYSE), American Stock Exchange (AM EX)
and NASDAQ listed companies for the 1926-2003 period and
related data shown on pages 6 through 18 of Schedule (PMA-1).
The average size premium for the ih and 8th deciles, between
which the proxy group of six water companies falls , and for the
6th decile in which the proxy group of three Value Line water
Pauline M. Ahern , OJ 48
United Water Idaho Inc.
companies falls , have been compared to the average size
premium for the 9th and 10th deciles between which United falls
if its stock were traded and sold at the October 7 , 2004 average
market/book ratios of 226.1 % experienced by the six C.A. Turner
water companies and 222.40/0 experienced by the three Value
Line water companies. As shown on page 2 of Schedule (PMA-
1), the size premium spreads between the six C.A. Turner water
companies and United is 2.71 % and 3.030/0 between the three
Value Line water companies and United.Thus, 0.150/0 and
250/0 are extremely conservative and reasonable estimates of
the magnitude of the adjustments needed to reflect the business
risk differential between United and each proxy group,
respectively, based upon United'increased business risk
relative to that of the proxy groups due to United's small relative
size negligible customer growth and extraordinarily large
expected capital expenditures over the next four years.
Consequently, as shown on page 3 of Schedule (PMA-1) at Line
No.9 and Table 3 above , the indicated common equity cost rate
range based upon the total proxy groups, including the business
risk adjustment based upon United's greater relative business
risk is 10.950/0 - 11.450 , with a midpoint of 11.20/0, which is also
my recommended common equity cost rate. In my opinion , such
a cost rate is both reasonable and conservative, given United'
small size and extraordinary business risk as previously
Pauline M. Ahern, OJ 49
United Water Idaho Inc.
discussed.
Does that conclude your direct testimony?
Yes.
Pauline M. Ahern, Oi 50
United Water Idaho Inc.
APPENDIX A
PROFESSIONAL QUALIFICATIONS
PAULINE M. AHERN, CRRA
VICE PRESIDENT
AUS CONSULTANTS - UTILITY SERVICES
PROFESSIONAL QUALIFICATIONS
PAULINE M. AHERN, CRRA
VICE PRESIDENT
AUS CONSULTANTS - UTILITY SERVICES
PROFESSIONAL EXPERIENCE
1996-Present
As a Vice President, I continue to prepare fair rate of return and cost of capital exhibits,
as well as submitting testimony on same before state public utility commissions. I continue to
provide assistance and support throughout the entire ratemaking litigation process.
As the Publisher of C.A. Turner Utility Reports, I am responsible for the production
publishing, and distribution of the reports. C.A. Turner Utility Reports provides financial data
and related ratios for about 200 public utilities, Le., electric combination gas and electric,
natural gas distribution , natural gas transmission , telephone, and water utilities, on a monthly,
quarterly and annual basis. C.A. Turner Utility Reports has about 1 000 subscribers including
utilities many state regulatory commissions, federal agencies, individuals, brokerage firms,
attorneys, as well as public and academic libraries. The publication has continuously provided
financial statistics on the utility industry since 1930.
As the Publisher of C.A. Turner Utility Reports, I supervise the production , publishing,
and distribution of the AGA Rate Service publications under license from the American Gas
Association. I am also responsible for maintaining and calculating the performance of the AGA
Index, a market capitalization weighted index of the common stocks of the approximately 90
corporate members of the AGA. In addition , I supervise the production of a quarterly survey of
investor-owned water company rate case activity on behalf of the National Association of Water
Companies.
1994-1996
As an Assistant Vice President, I prepared fair rate of return and cost of capital exhibits
which are filed along with expert testimony before various state and federal public utility
regulatory bodies. These supporting exhibits include the determination of an appropriate
ratemaking capital structure and the development of embedded cost rates of senior capital. The
exhibits also support the determination of a recommended return on common equity through the
use of various market models, such as , but not limited to Discounted Cash Flow analysis
Capital Asset Pricing Model and Risk Premium Methodology, as well as an assessment of the
risk characteristics of the client utility. I also assisted in the preparation of responses to any
interrogatories received regarding such testimonies filed on behalf of client utilities. Following
the filing of fair rate of return testimonies, I assisted in the evaluation of opposition testimony in
order to prepare interrogatory questions, areas of cross-examination, and rebuttal testimony. I
also evaluated and assisted in the preparation of briefs and exceptions following the hearingprocess. I have submitted testimony before state public utility commissions regarding
appropriate capital structure ratios and fixed capital cost rates.
1990-1994
As a Senior Financial Analyst, I supervised two analysts in the preparation of fair rate of
return and cost of capital exhibits which are filed along with expert testimony before various
state and federal public utility regulatory bodies. The team also assisted in the preparation of
interrogatory responses.
I evaluated the final orders and decisions of various commissions to determine whether
further actions are warranted and to gain insight which may assist in the preparation of future
rate of return studies.
I assisted in the preparation of an article authored by Frank J. Hanley and A. Gerald
Harris entitled "Does Diversification Increase the Cost of Equity Capital?" published in the July
15, 1991 issue of Public Utilities Fortniqhtly
I co-authored an article with Frank J. Hanley entitled "Comparable Earnings: New Life
for an Old Precept" which was published in the American Gas Association Financial Quarterly
Review, Summer 1994.
I was awarded the professional designation "Certified Rate of Return Analyst" (CRRA)
by the National Society of Rate of Return Analysts (now the Society of Utility and Regulatory
Financial Analysts (SURF A)). This designation is based upon education, experience and the
successful completion of a comprehensive examination.
As Administrator of Financial Analysis for C. A. Turner Utility Reports, which reports
financial data for over 200 utility companies and has approximately 1 000 subscribers, I oversee
the preparation of this monthly publication , as well as the annual publication Financial Statistics
- Public Utilities.
1988-1990
As a Financial Analyst, I assisted in the preparation of fair rate of return studies including
capital structure determination, development of senior capital cost rates, as well as the
determination of an appropriate rate of return on equity. I also assisted in the preparation of
interrogatory responses , interrogatory questions of the opposition , areas of cross-examination
and rebuttal testimony. I also assisted in the preparation of the annual publication A. Turner
Utility Reports - Financial Statistics -Public Utilities
1973-1975
As a research assistant in the Research Department of the Regional Economics Division
of the Federal Reserve Bank of Boston, I was involved in the development and maintenance of
econometric models to simulate regional economic conditions in New England in order to study
the effects of among other things, the energy crisis of the early 1970's and property tax
revaluations on the economy of New England. I was also involved in the statistical analysis and
preparation of articles for the New Enqland Economic Review. Also, I acted as assistant editor
for New Enqland Business Indicators
1972
As a research assistant in the Office of the Assistant Secretary for International Affairs,
S. Treasury Department, Washington , D., I developed and maintained econometric models
which simulated the economy of the United States in order to study the results of various
alternate foreign trade policies so that national trade policy could be formulated and
recommended.
I am also a member of the Society of Utility and Regulatory Financial Analysts (formerly
the National Society of Rate of Return Analysts).
Clients Served
I have offered expert testimony before the following commissions:
Arkansas
California
Delaware
Florida
Hawaii
Illinois
Indiana
Maine
Maryland
Michigan
Missouri
New Jersey
New York
North Carolina
Ohio
Pennsylvania
South Carolina
Virginia
Washington
I have sponsored testimony on the rate of return and capital structure effects of merger
and acquisition issues for:
California-American Water Company New Jersey-American Water Company
I have sponsored testimony on fair rate of return and related issues for:
Audubon Water Company
Carolina Pines Utilities , Inc.
Carolina Water Service , Inc.
Consumers Illinois Water Company
Consumers Maine Water Company
Consumers New Jersey Water Company
Elizabethtown Water Company
Emporium Water Company
GTE Hawaiian Telephone Inc.
Greenridge Utilities, Inc.
Long Neck Water Company
Middlesex Water Company
Missouri-American Water Company
Mt. Holly Water Company
Nero Utility Services, Inc.
New Jersey-American Water Company
Pinelands WasteWater Company
Pittsburgh Thermal
Sussex Shores Water Company
Thames Water Americas
Tidewater Utilities, Inc.
Transylvania Utilities, Inc.
Twin Lakes Utilities, Inc.
United Utility Companies
United Water Arkansas , Inc.
United Water Delaware, Inc.
United Water Indiana,lnc.
United Water Virginia, Inc.
United Water West Lafayette , Inc.
Utilities , Inc. of Florida
Wellsboro Electric Company
Western Utilities, Inc.
I have sponsored testimony on capital structure and senior capital cost rates for the
following clients:
Alpena Power Company
Arkansas-Western Gas Company
Associated Natural Gas Company
PG Energy Inc.
United Water Delaware, Inc.
Washington Natural Gas Company
I have assisted in the preparation of rate of return studies on behalf of the following
clients:
Algonquin Gas Transmission Company
Arkansas-Louisiana Gas Company
Arkansas Western Gas Company
Artesian Water Company
Associated Natural Gas Company
Atlantic City Electric Company
Bridgeport-Hydraulic Company
Cambridge Electric Light Company
Carolina Power & Light Company
Citizens Gas and Coke Utility
City of Vernon , CA
Columbia Gas/Gulf Transmission Coso
Commonwealth Electric Company
Commonwealth Telephone Company
Rate of Return Study Clients, Continued
Conestoga Telephone & Telegraph Co.
Connecticut Natural Gas Corporation
Consolidated Gas Transmission Company
Consumers Power Company
CWS Systems, Inc.
Delmarva Power & Light Company
East Honolulu Community Services, Inc.
Equitable Gas Company
Equitrans, Inc.
Florida Power & Light Company
Gary Hobart Water Company
Gasco, Inc.
GTE Alaska, Inc.
GTE Arkansas , Inc.
GTE California , Inc.
GTE Florida, Inc.
GTE Hawaiian Telephone
GTE North, Inc.
GTE Northwest, Inc.
GTE Southwest, Inc.
Great Lakes Gas Transmission loP.
Hawaiian Electric Company
Hawaiian Electric Light Company
IES Utilities Inc.
Illinois Power Company
Interstate Power Company
Iowa Electric Light and Power Company
Iowa Southern Utilities Company
Kentucky-West Virginia Gas Company
Lockhart Power Company
Middlesex Water Company
Milwaukee Metropolitan Sewer District
Mountaineer Gas Company
National Fuel Gas Distribution Corp.
National Fuel Gas Supply Corp.
Newco Waste Systems of NJ, Inc.
New Jersey-American Water Company
New Jersey Natural Gas Company
New York-American Water Company
North Carolina Natural Gas Corp.
Northumbrian Water Company
Ohio-American Water Company
Oklahoma Natural Gas Company
Orange and Rockland Utilities
Paiute Pipeline Company
PECO Energy Company
Penn-York Energy Corporation
Pennsylvania-American Water Co.
PG Energy Inc.
Philadelphia Electric Company
South Carolina Pipeline Company
Southwest Gas Corporation
Stamford Water Company
Tesoro Alaska Petroleum Company
United Telephone of New Jersey
United Utility Companies
United Water Arkansas, Inc.
United Water Delaware lnc.
United Water Idaho, Inc.
United Water Indiana, Inc.
United Water New Jersey, Inc.
United Water New York, Inc.
United Water Pennsylvania , Inc.
United Water Virginia, Inc.
United Water West Lafayette , Inc.
Vista-United Telecommunications Corp.
Valley Energy, Inc. PA Division
Washington Natural Gas Company
Washington Water Power Corporation
Waste Management of New Jersey
Transfer Station A
Wellsboro Electric Company
Western Reserve Telephone Company
Western Utilities, Inc.
EDUCATION:
1973 - Clark University - B.A. - Honors in Economics
1991 - Rutgers University - M.A. - High Honors
PROFESSIONAL AFFILIATIONS:
Society of Utility and Regulatory Financial Analysts (serve as SecretarylTreasurer from 2004-
2006 )
Energy Association of Pennsylvania
National Association of Water Companies Member of the Finance Committee