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HomeMy WebLinkAbout20160526McKenzie Exhibit 3.pdfDAVID J. MEYER VICE PRESIDENT AND CHIEF COUNSEL FOR REGULATORY & GOVERNMENTAL AFFAIRS AVISTA CORPORATION P.O. BOX 3727 1411 EAST MISSION AVENUE SPOKANE, WASHINGTON 99220-3727 TELEPHONE: (509) 495-4316 FACSIMILE: (509) 495-8851 DAVID.MEYER@AVISTACORP.COM BEFORE THE IDAHO PUBLIC UTILITIES COMMISSION IN THE MATTER OF THE APPLICATION ) CASE NO. AVU-E-16-03 OF AVISTA CORPORATION FOR THE ) AUTHORITY TO INCREASE ITS RATES ) AND CHARGES FOR ELECTRIC SEVICE ) EXHIBIT NO. 3 ELECTRIC CUSTOMERS IN THE ) STATE OF IDAHO ) ADRIEN M. MCKENZIE ) FOR AVISTA CORPORATION (ELECTRIC) 1 EXHIBIT NO. 3, SCHEDULE 1 QUALIFICATIONS OF ADRIEN M. MCKENZIE Q. WHAT IS THE PURPOSE OF THIS EXHIBIT? A. This exhibit describes my background and experience and contains the details of my qualifications. Q. PLEASE DESCRIBE YOUR QUALIFICATIONS AND EXPERIENCE. A. I received B.A. and M.B.A. degrees with a major in finance from The University of Texas at Austin, and hold the Chartered Financial Analyst (CFA®) designation. Since joining FINCAP in 1984, I have participated in consulting assignments involving a broad range of economic and financial issues, including cost of capital, cost of service, rate design, economic damages, and business valuation. I have extensive experience in economic and financial analysis for regulated industries, and in preparing and supporting expert witness testimony before courts, regulatory agencies, and legislative committees throughout the U.S. and Canada. I have personally sponsored direct and rebuttal testimony concerning the rate of return on equity (“ROE”) in proceedings filed with the Federal Energy Regulatory Commission (“FERC”), the Colorado Public Utilities Commission, the Hawaii Public Utilities Commission, the Idaho Public Utilities Commission, the Iowa Utilities Board, the Kansas State Corporation Commission, the Kentucky Public Service Commission, the Maryland Public Service Commission, the Montana Public Service Commission, the Nebraska Public Service Commission, the Ohio Public Utilities Commission, the Oregon Public Utilities Commission, the South Dakota Public Utilities Commission, the Virginia State Corporation Commission, the Washington Utilities and Transportation Commission, the West Virginia Public Service Commission, and the Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 1, Page 1 of 5 2 Wyoming Public Service Commission. My testimony addressed the establishment of risk-comparable proxy groups, the application of alternative quantitative methods, and the consideration of regulatory standards and policy objectives in establishing a fair ROE for regulated electric and gas utility operations. In connection with these assignments, my responsibilities have included critically evaluating the positions of other parties and preparation of rebuttal testimony, representing clients in settlement negotiations and hearings, and assisting in the preparation of legal briefs. In addition, over the course of my career I have worked with Dr. William Avera to prepare prefiled direct and rebuttal testimony in over 250 regulatory proceedings before FERC, the Canadian Radio-Television and Telecommunications Commission, and regulatory agencies in over 30 states.1 Prior to joining FINCAP, I was employed by an oil and gas firm and was responsible for operations and accounting. A resume containing the details of my qualifications and experience is attached below. 1 This testimony was sponsored by Dr. William Avera, who is President of FINCAP, Inc. Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 1, Page 2 of 5 3 ADRIEN M. McKENZIE FINCAP, INC. 3907 Red River Financial Concepts and Applications Austin, Texas 78751 Economic and Financial Counsel (512) 458–4644 FAX (512) 458–4768 fincap3@texas.net Summary of Qualifications Adrien McKenzie has an MBA in finance from the University of Texas at Austin and holds the Chartered Financial Analyst (CFA) designation. He has over 25 years experience in economic and financial analysis for regulated industries, and in preparing and supporting expert witness testimony before courts, regulatory agencies, and legislative committees throughout the U.S. and Canada. Assignments have included a broad range of economic and financial issues, including cost of capital, cost of service, rate design, economic damages, and business valuation. Employment Consultant, FINCAP, Inc. (June 1984 to June 1987) (April 1988 to present) Economic consulting firm specializing in regulated industries and valuation of closely-held businesses. Assignments have involved electric, gas, telecommunication, and water/sewer utilities, with clients including utilities, consumer groups, municipalities, regulatory agencies, and cogenerators. Areas of participation have included rate of return, revenue requirements, rate design, tariff analysis, avoided cost, forecasting, and negotiations. Develop cost of capital analyses using alternative market models for electric, gas, and telephone utilities. Prepare pre- filed direct and rebuttal testimony, participate in settlement negotiations, respond to interrogatories, evaluate opposition testimony, and assist in the areas of cross-examination and the preparations of legal briefs. Other assignments have involved preparation of technical reports, valuations, estimation of damages, industry studies, and various economic analyses in support of litigation. Manager, McKenzie Energy Company (Jan. 1981 to May. 1984) Responsible for operations and accounting for firm engaged in the management of working interests in oil and gas properties. Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 1, Page 3 of 5 4 Education M.B.A., Finance . The Impact of Construction Expenditures on Investor-Owned Electric Utilities B.B.A., Finance, University of Texas at Austin (Jan. 1981 to May 1982) Electives included capital market theory, portfolio management, and international economics and finance. Elected to Beta Gamma Sigma business honor society. Dean's List 1981-1982. Simon Fraser University, Vancouver, Canada and University of Hawaii at Manoa, Honolulu, Hawaii (Jan. 1979 to Dec 1980) Coursework in accounting, finance, economics, and liberal arts. Professional Associations Received Chartered Financial Analyst (CFA) designation in 1990. Member – CFA Institute. Bibliography “A Profile of State Regulatory Commissions,” A Special Report by the Electricity Consumers Resource Council (ELCON), Summer 1991. “The Impact of Regulatory Climate on Utility Capital Costs: An Alternative Test,” with Bruce H. Fairchild, Public Utilities Fortnightly (May 25, 1989). Presentations “ROE at FERC: Issues and Methods,” Expert Briefing on Parallels in ROE Issues between AER, ERA, and FERC, Jones Day (Sydney, Melbourne, and Perth, Australia) (April 15, 2014). Cost of Capital Working Group eforum, Edison Electric Institute (April 24, 2012). “Cost-of-Service Studies and Rate Design,” General Management of Electric Utilities (A Training Program for Electric Utility Managers from Developing Countries), Austin, Texas (October 1989 and November 1990 and 1991). Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 1, Page 4 of 5 5 Representative Assignments Mr. McKenzie has prepared and supported prefiled testimony submitted in over 250 regulatory proceedings. In addition to filings before regulators in over thirty state jurisdictions, Mr. McKenzie has considerable expertise in preparing expert analyses and testimony on the issue of ROE, and has broad experience in applying and evaluating the results of quantitative methods to estimate a fair ROE, including discounted cash flow approaches, the Capital Asset Pricing Model, risk premium methods, and other quantitative benchmarks. Other representative assignments have included the application of econometric models to analyze the impact of anti- competitive behavior and estimate lost profits; development of explanatory models for nuclear plant capital costs in connection with prudency reviews; and the analysis of avoided cost pricing for cogenerated power. Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 1, Page 5 of 5 Schedule 2 Page 1 of 49 I. DESCRIPTION OF QUANTITATIVE ANALYSES Q. What is the purpose of this exhibit? 1 A. Exhibit No. 3, Schedule 2 presents capital market estimates of the cost of equity. First, I examine the concept of the cost of equity, along with the risk- return tradeoff principle fundamental to capital markets. Next, I describe my applications of the Discounted Cash Flow (“DCF”), the traditional Capital Asset Pricing Model (“CAPM”), the Empirical Capital Asset Pricing Model (“ECAPM”), a risk premium analyses based on allowed ROEs for electric utilities, and reference to expected rates of return for electric utilities. This exhibit also presents an application of the DCF model to a group of low risk non-utility firms. A. Overview Q. What fundamental economic principle underlies 14 any evaluation of investors’ required return on equity 15 (“ROE”)? 16 A. The fundamental economic principle underlying the cost of equity concept is the notion that investors are risk averse. In capital markets where relatively risk-free assets are available (e.g., U.S. Treasury Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 2, Page 1 of 49 Schedule 2 Page 2 of 49 securities), investors can be induced to hold riskier assets only if they are offered a premium, or additional return, above the rate of return on a risk-free asset. Since all assets compete with each other for investor funds, riskier assets must yield a higher expected rate of return than safer assets to induce investors to hold them. Given this risk-return tradeoff, the required rate of return (k) from an asset (i) can be generally expressed as: ki = Rf +RPi 10 where: Rf = Risk-free rate of return, and RPi = Risk premium required to hold riskier asset i. Thus, the required rate of return for a particular asset at any point in time is a function of: 1) the yield on risk-free assets, and 2) its relative risk, with investors demanding correspondingly larger risk premiums for assets bearing greater risk. Q. Is there evidence that the risk-return tradeoff 19 principle actually operates in the capital markets? 20 A. Yes. The risk-return tradeoff can be readily documented in segments of the capital markets where required rates of return can be directly inferred from Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 2, Page 2 of 49 Schedule 2 Page 3 of 49 market data and where generally accepted measures of risk exist. Bond yields, for example, reflect investors’ 2 expected rates of return, and bond ratings measure the risk of individual bond issues. Comparing the observed yields on government securities, which are considered free of default risk, to the yields on bonds of various rating categories demonstrates that the risk-return tradeoff does, in fact, exist. Q. Does the risk-return tradeoff observed with 9 fixed income securities extend to common stocks and other 10 assets? 11 A. It is widely accepted that the risk-return tradeoff evidenced with long-term debt extends to all assets. Documenting the risk-return tradeoff for assets other than fixed income securities, however, is complicated by two factors. First, there is no standard measure of risk applicable to all assets. Second, for most assets – including common stock – required rates of return cannot be directly observed. Yet there is every reason to believe that investors exhibit risk aversion in deciding whether or not to hold common stocks and other Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 2, Page 3 of 49 Schedule 2 Page 4 of 49 assets, just as when choosing among fixed-income securities. Q. Is this risk-return tradeoff limited to 3 differences between firms? 4 A. No. The risk-return tradeoff principle applies not only to investments in different firms, but also to different securities issued by the same firm. The securities issued by a utility vary considerably in risk because they have different characteristics and priorities. As noted earlier, long-term debt is senior among all capital in its claim on a utility’s net revenues 11 and is, therefore, the least risky. The last investors in line are common shareholders. They receive only the net revenues, if any, remaining after all other claimants have been paid. As a result, the rate of return that investors require from a utility’s common stock, the most junior and 16 riskiest of its securities, must be considerably higher than the yield offered by the utility’s senior, long-term debt. Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 2, Page 4 of 49 Schedule 2 Page 5 of 49 Q. What does the above discussion imply with 1 respect to estimating the cost of common equity for a 2 utility? 3 A. Although the cost of common equity cannot be observed directly, it is a function of the returns available from other investment alternatives and the risks to which the equity capital is exposed. Because it is unobservable, the cost of equity for a particular utility must be estimated by analyzing information about capital market conditions generally, assessing the relative risks of the company specifically, and employing various quantitative methods that focus on investors’ current 12 required rates of return. These various quantitative methods typically attempt to infer investors’ required 14 rates of return from stock prices, interest rates, or other capital market data. B. Comparable Risk Proxy Group Q. How did you implement quantitative methods to 17 estimate the cost of common equity for Avista? 18 A. Application of quantitative methods to estimate the cost of equity requires observable capital market data, such as stock prices. Moreover, even for a firm with publicly traded stock, the cost of equity can only be estimated. As a result, applying quantitative models Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 2, Page 5 of 49 Schedule 2 Page 6 of 49 using observable market data produces an estimate that inherently includes some degree of observation error. Thus, the accepted approach to increase confidence in the results is to apply multiple quantitative methods such as the DCF and ECAPM to a proxy group of publicly traded utility companies that investors regard as risk- comparable. Q. What specific proxy group of utilities did you 8 rely on for your analyses? 9 A. In order to reflect the risks and prospects associated with Avista’s jurisdictional utility 11 operations, my DCF analyses focused on a reference group of other utilities composed of those companies included by The Value Line Investment Survey (“Value Line”) in its Electric Utilities Industry groups with: 1. S&P corporate credit ratings of BBB-, BBB, or BBB+; 2. Moody’s issuer ratings of Baa2, Baa1, or A3; 3. Value Line Safety Rank of “2” or “3”; 4. No involvement in a major merger or acquisition; and, 5. Currently paying common dividends with no recent dividend cuts. Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 2, Page 6 of 49 Schedule 2 Page 7 of 49 These criteria resulted in a proxy group composed of 16 companies, which I refer to as the “Utility Group.” Q. How did you evaluate the risks of the Utility 3 Group relative to Avista? 4 A. My evaluation of relative risk considered four objective, published benchmarks that are widely relied on in the investment community. Credit ratings are assigned by independent rating agencies for the purpose of providing investors with a broad assessment of the creditworthiness of a firm. Ratings generally extend from triple-A (the highest) to D (in default). Other symbols (e.g., "BBB+") are used to show relative standing within a category. Because the rating agencies’ evaluation 13 includes virtually all of the factors normally considered important in assessing a firm’s relative credit standing, 15 corporate credit ratings provide a broad, objective measure of overall investment risk that is readily available to investors. Although the credit rating agencies are not immune to criticism, their rankings and analyses are widely cited in the investment community and referenced by investors. Investment restrictions tied to credit ratings continue to influence capital flows, and credit ratings are also frequently used as a primary risk Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 2, Page 7 of 49 Schedule 2 Page 8 of 49 indicator in establishing proxy groups to estimate the cost of common equity. While credit ratings provide the most widely referenced benchmark for investment risks, other quality rankings published by investment advisory services also provide relative assessments of risks that are considered by investors in forming their expectations for common stocks. Value Line’s primary risk indicator is its Safety 8 Rank, which ranges from “1” (Safest) to “5” (Riskiest). 9 This overall risk measure is intended to capture the total risk of a stock, and incorporates elements of stock price stability and financial strength. Given that Value Line is perhaps the most widely available source of investment advisory information, its Safety Rank provides useful guidance regarding the risk perceptions of investors. The Financial Strength Rating is designed as a guide to overall financial strength and creditworthiness, with the key inputs including financial leverage, business volatility measures, and company size. Value Line’s 19 Financial Strength Ratings range from “A++” (strongest) 20 down to “C” (weakest) in nine steps. Finally, Value 21 Line’s beta measures a utility’s stock price volatility Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 2, Page 8 of 49 Schedule 2 Page 9 of 49 relative to the market as a whole. A stock that tends to respond less to market movements has a beta less than 1.00, while stocks that tend to move more than the market have betas greater than 1.00. Beta is the only relevant measure of investment risk under modern capital market theory, and is widely cited in academics and in the investment industry as a guide to investors’ risk 7 perceptions. Moreover, in my experience Value Line is the most widely referenced source for beta in regulatory proceedings. As noted in New Regulatory Finance: Value Line is the largest and most widely circulated independent investment advisory service, and influences the expectations of a large number of institutional and individual investors. . . . Value Line betas are computed on a theoretically sound basis using a broadly based market index, and they are adjusted for the regression tendency of betas to converge to 1.00.1 Q. How do the overall risks of your proxy group 20 compare with Avista? 21 A. Table 1 compares the Utility Group with Avista across five key indicators of investment risk: 1 Morin, Roger A., “New Regulatory Finance,” Public Utilities Reports at 71 (2006). Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 2, Page 9 of 49 Schedule 2 Page 10 of 49 TABLE 1 1 COMPARISON OF RISK INDICATORS 2 3 4 5 6 7 8 9 Q. What does this comparison indicate regarding 10 investors’ assessment of the relative risk associated with 11 your Utility Group? 12 A. As shown above, the BBB and Baa1 credit ratings corresponding to Avista are identical to the average credit ratings for the Utility Group. Similarly, the average Value Line Safety Rank for the Utility Group is the same as that assigned to the Company. With respect to Value Line’s Financial Strength, the average value for the 18 Utility Group indicates slightly more risk than for Avista, while Avista’s beta measure is essentially equal to the average for the proxy group. Considered together, this comparison of objective measures, which consider a broad spectrum of risks, including financial and business position, and exposure to firm-specific factors, indicates that investors would likely conclude that the overall investment risks for Avista are generally comparable to those of the firms in the Utility Group. Safety Financial S&P Moody's Rank Strength Beta Utility Group BBB Baa1 2 B++ 0.76 Avista BBB Baa1 2 A 0.75 Value Line Credit Rating Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 2, Page 10 of 49 Schedule 2 Page 11 of 49 C. Discounted Cash Flow Analyses Q. How are DCF models used to estimate the cost of 1 equity? 2 A. DCF models attempt to replicate the market valuation process that sets the price investors are willing to pay for a share of a company’s stock. The 5 model rests on the assumption that investors evaluate the risks and expected rates of return from all securities in the capital markets. Given these expectations, the price of each stock is adjusted by the market until investors are adequately compensated for the risks they bear. Therefore, we can look to the market to determine what investors believe a share of common stock is worth. By estimating the cash flows investors expect to receive from the stock in the way of future dividends and capital gains, we can calculate their required rate of return. That is, the cost of equity is the discount rate that equates the current price of a share of stock with the present value of all expected cash flows from the stock. The formula for the general form of the DCF model is as follows: t e t t e t ee k P k D k D k DP )1()1()1()1(2 2 1 1 0  Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 2, Page 11 of 49 Schedule 2 Page 12 of 49 where: P0 = Current price per share; Pt = Expected future price per share in period t; Dt = Expected dividend per share in period t; ke = Cost of common equity. Q. What form of the DCF model is customarily used 7 to estimate the cost of equity in rate cases? 8 A. Rather than developing annual estimates of cash flows into perpetuity, the DCF model can be simplified to a “constant growth” form:2 12 where: P0 = Current price per share; D1 = Expected dividend per share in the coming year; ke = Cost of equity; g = Investors’ long-term growth expectations. The cost of equity (Ke) can be isolated by rearranging terms: 21 2 The constant growth DCF model is dependent on a number of assumptions, which in practice are never strictly met. These include a constant growth rate for both dividends and earnings; a stable dividend payout ratio; the discount rate exceeds the growth rate; a constant growth rate for book value and price; a constant earned rate of return on book value; no sales of stock at a price above or below book value; a constant price-earnings ratio; a constant discount rate (i.e., no changes in risk or interest rate levels and a flat yield curve); and all of the above extend to infinity. gk DP e 1 0 gP Dke  0 1 Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 2, Page 12 of 49 Schedule 2 Page 13 of 49 This constant growth form of the DCF model recognizes that the rate of return to stockholders consists of two parts: 1) dividend yield (D1/P0), and 2) growth (g). In other words, investors expect to receive a portion of their total return in the form of current dividends and the remainder through price appreciation. Q. What steps are required to apply the DCF model? 7 A. The first step in implementing the constant growth DCF model is to determine the expected dividend yield (D1/P0) for the firm in question. This is usually calculated based on an estimate of dividends to be paid in the coming year divided by the current price of the stock. The second step is to estimate investors' long-term growth expectations (g) for the firm. The final step is to sum the firm's dividend yield and estimated growth rate to arrive at an estimate of its cost of equity. Q. How was the dividend yield for the Utility Group 17 determined? 18 A. Estimates of dividends to be paid by each of these utilities over the next twelve months, obtained from Value Line, served as D1. This annual dividend was then divided by a 30-day average stock price for each utility to arrive at the expected dividend yield. The expected Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 2, Page 13 of 49 Schedule 2 Page 14 of 49 dividends, stock prices, and resulting dividend yields for the firms in the Utility Group are presented on page 1 of Exhibit No. 3, Schedule 5. Q. What is the next step in applying the constant 4 growth DCF model? 5 A. The next step is to evaluate long-term growth expectations, or “g”, for the firm in question. In 7 constant growth DCF theory, earnings, dividends, book value, and market price are all assumed to grow in lockstep, and the growth horizon of the DCF model is infinite. But implementation of the DCF model is more than just a theoretical exercise; it is an attempt to replicate the mechanism investors used to arrive at observable stock prices. A wide variety of techniques can be used to derive growth rates, but the only “g” that 15 matters in applying the DCF model is the value that investors expect. Q. What are investors most likely to consider in 18 developing their long-term growth expectations? 19 A. Implementation of the DCF model is solely concerned with replicating the forward-looking evaluation of real-world investors. In the case of utilities, dividend growth rates are not likely to provide a Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 2, Page 14 of 49 Schedule 2 Page 15 of 49 meaningful guide to investors’ current growth 1 expectations. This is because utilities have significantly altered their dividend policies in response to more accentuated business risks in the industry, with the payout ratios falling significantly from historical levels. As a result, dividend growth in the utility industry has lagged growth in earnings as utilities conserve financial resources to provide a hedge against heightened uncertainties. A measure that plays a pivotal role in determining investors’ long-term growth expectations are future trends in earnings per share (“EPS”), which provide the source 12 for future dividends and ultimately support share prices. The importance of earnings in evaluating investors’ 14 expectations and requirements is well accepted in the investment community, and surveys of analytical techniques relied on by professional analysts indicate that growth in earnings is far more influential than trends in dividends per share (“DPS”). The availability of projected EPS growth rates also is key to investors relying on this measure as compared to future trends in DPS. Apart from Value Line, investment Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 2, Page 15 of 49 Schedule 2 Page 16 of 49 advisory services do not generally publish comprehensive DPS growth projections, and this scarcity of dividend growth rates relative to the abundance of earnings forecasts attests to their relative influence. The fact that securities analysts focus on EPS growth, and that DPS growth rates are not routinely published, indicates that projected EPS growth rates are likely to provide a superior indicator of the future long-term growth expected by investors. Q. Do the growth rate projections of security 10 analysts consider historical trends? 11 A. Yes. Professional security analysts study historical trends extensively in developing their projections of future earnings. Hence, to the extent there is any useful information in historical patterns, that information is incorporated into analysts’ growth 16 forecasts. Q. Did Professor Myron J. Gordon, who originated 18 the DCF approach, recognize the pivotal role that earnings 19 play in forming investors’ expectations? 20 A. Yes. Dr. Gordon specifically recognized that “it is the growth that investors expect that should be 22 used” in applying the DCF model and he concluded: Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 2, Page 16 of 49 Schedule 2 Page 17 of 49 A number of considerations suggest that investors may, in fact, use earnings growth as a measure of expected future growth.”3 Q. Are analysts’ assessments of growth rates 4 appropriate for estimating investors’ required return 5 using the DCF model? 6 A. Yes. In applying the DCF model to estimate the cost of common equity, the only relevant growth rate is the forward-looking expectations of investors that are captured in current stock prices. Investors, just like securities analysts and others in the investment community, do not know how the future will actually turn out. They can only make investment decisions based on their best estimate of what the future holds in the way of long-term growth for a particular stock, and securities prices are constantly adjusting to reflect their assessment of available information. Any claims that analysts’ estimates are not relied 18 upon by investors are illogical given the reality of a competitive market for investment advice. The market for investment advice is intensely competitive, and securities analysts are personally and professionally motivated to provide the most accurate assessment possible of future 3 Gordon, Myron J., “The Cost of Capital to a Public Utility,” MSU Public Utilities Studies at 89 (1974). Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 2, Page 17 of 49 Schedule 2 Page 18 of 49 growth trends. If financial analysts’ forecasts do not 1 add value to investors’ decision making, then it is irrational for investors to pay for these estimates. Those financial analysts who fail to provide reliable forecasts will lose out in competitive markets relative to those analysts whose forecasts investors find more credible. The reality that analyst estimates are routinely referenced in the financial media and in investment advisory publications (e.g., Value Line) implies that investors use them as a basis for their expectations. While the projections of securities analysts may be proven optimistic or pessimistic in hindsight, this is irrelevant in assessing the expected growth that investors have incorporated into current stock prices, and any bias in analysts’ forecasts – whether pessimistic or optimistic – is irrelevant if investors share analysts’ views. 17 Earnings growth projections of security analysts provide the most frequently referenced guide to investors’ views 19 and are widely accepted in applying the DCF model. As explained in New Regulatory Finance: Because of the dominance of institutional investors and their influence on individual Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 2, Page 18 of 49 Schedule 2 Page 19 of 49 investors, analysts’ forecasts of long-run growth rates provide a sound basis for estimating required returns. Financial analysts exert a strong influence on the expectations of many investors who do not possess the resources to make their own forecasts, that is, they are a cause of g [growth]. The accuracy of these forecasts in the sense of whether they turn out to be correct is not an issue here, as long as they reflect widely held expectations.4 Q. What are security analysts currently projecting 11 in the way of growth for the firms in the Utility Proxy 12 Group? 13 A. The projected EPS growth rates for each of the firms in the Utility Group reported by Value Line, IBES, and Zacks Investment Research (“Zacks”) are displayed on page 2 of Exhibit No. 3, Schedule 5.5 Q. How else are investors’ expectations of future 18 long-term growth prospects often estimated for use in the 19 constant growth DCF model? 20 A. In constant growth theory, growth in book equity will be equal to the product of the earnings retention ratio (one minus the dividend payout ratio) and the earned rate of return on book equity. Furthermore, if the earned rate of return and the payout ratio are constant over time, growth in earnings and dividends will be equal to 4 Morin, Roger A., “New Regulatory Finance,” Public Utilities Reports, Inc. at 298 (2006) (emphasis added). 5 Formerly I/B/E/S International, Inc., IBES growth rates are now compiled and published by Thomson Reuters. Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 2, Page 19 of 49 Schedule 2 Page 20 of 49 growth in book value. Despite the fact that these conditions are seldom, if ever, met in practice, this “sustainable growth” approach may provide a rough guide 3 for evaluating a firm’s growth prospects and is frequently 4 proposed in regulatory proceedings. The sustainable growth rate is calculated by the formula, g = br+sv, where “b” is the expected retention 7 ratio, “r” is the expected earned return on equity, “s” is 8 the percent of common equity expected to be issued annually as new common stock, and “v” is the equity 10 accretion rate. Under DCF theory, the “sv” factor is a 11 component of the growth rate designed to capture the impact of issuing new common stock at a price above, or below, book value. The sustainable, “br+sv” growth rates 14 for each firm in the Utility Group are summarized on page 2 of Exhibit No. 3, Schedule 5, with the underlying details being presented on Exhibit No. 3, Schedule 6.6 Q. Are there significant shortcomings associated 18 with the “br+sv” growth rate? 19 A. Yes. First, in order to calculate the sustainable growth rate, it is necessary to develop 6 Because Value Line reports end-of-year book values, an adjustment factor was incorporated to compute an average rate of return over the year, which is consistent with the theory underlying this approach. Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 2, Page 20 of 49 Schedule 2 Page 21 of 49 estimates of investors’ expectations for four separate 1 variables; namely, “b”, “r”, “s”, and “v.” Given the 2 inherent difficulty in forecasting each parameter and the difficulty of estimating the expectations of investors, the potential for measurement error is significantly increased when using four variables, as opposed to referencing a direct projection for EPS growth. Second, empirical research in the finance literature indicates that sustainable growth rates are not as significantly correlated to measures of value, such as share prices, as are analysts’ EPS growth forecasts.7 The “sustainable 11 growth” approach was included for completeness, but 12 evidence indicates that analysts’ forecasts provide a 13 superior and more direct guide to investors’ growth 14 expectations. Q. What cost of equity estimates were implied for 16 the Utility Group using the DCF model? 17 A. After combining the dividend yields and respective growth projections for each utility, the resulting cost of equity estimates are shown on page 3 of Exhibit No. 3, Schedule 5. 7 Morin, Roger A., “New Regulatory Finance,” Public Utilities Reports, Inc., at 307 (2006). Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 2, Page 21 of 49 Schedule 2 Page 22 of 49 Q. In evaluating the results of the constant growth 1 DCF model, is it appropriate to eliminate estimates that 2 are extreme outliers? 3 A. Yes. In applying quantitative methods to estimate the cost of equity, it is essential that the resulting values pass fundamental tests of reasonableness and economic logic. Accordingly, DCF estimates that are implausibly low or high should be eliminated when evaluating the results of this method. Q. How did you evaluate DCF estimates at the low 10 end of the range? 11 A. I based my evaluation of DCF estimates at the low end of the range on the fundamental risk-return tradeoff, which holds that investors will only take on more risk if they expect to earn a return to compensate them for the greater uncertainty. Because common stocks lack the protections associated with an investment in long-term bonds, a utility’s common stock imposes far 18 greater risks on investors. As a result, the rate of return that investors require from a utility’s common stock is considerably higher than the yield offered by senior, long-term debt. Consistent with this principle, DCF results that are not sufficiently higher than the Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 2, Page 22 of 49 Schedule 2 Page 23 of 49 yields available on less risky utility bonds must be eliminated. Q. Have similar tests been applied by regulators? 3 A. Yes. The Federal Energy Regulatory Commission (“FERC”) has noted that adjustments are justified where applications of the DCF approach produce illogical results. FERC evaluates DCF results against observable yields on long-term public utility debt and has recognized that it is appropriate to eliminate estimates that do not sufficiently exceed this threshold.8 FERC affirmed that: The purpose of the low-end outlier test is to exclude from the proxy group those companies whose ROE estimates are below the average bond yield or are above the average bond yield but are sufficiently low that an investor would consider the stock to yield essentially the same return as debt. In public utility ROE cases, the Commission has used 100 basis points above the cost of debt as an approximation of this threshold, but has also considered the distribution of proxy group companies to inform its decision on which companies are outliers. As the Presiding Judge explained, this is a flexible test.9 8 See, e.g., Southern California Edison Co., 131 FERC ¶ 61,020 at P 55 (2010) (“SoCal Edison”). 9 Martha Coakley et al., v. Bangor Hydro-Electric Company, et al., Opinion No. 531, 147 FERC ¶ 61,234 at P 122 (2014). Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 2, Page 23 of 49 Schedule 2 Page 24 of 49 Q. What interest rate benchmark did you consider in 1 evaluating the DCF results for Avista? 2 A. As noted earlier, the S&P and Moody’s ratings 3 for Avista are BBB and Baa1, respectively, which fall in the triple-B rating category. Accordingly, I referenced average yields on triple-B utility bonds as my benchmark in evaluating low-end results. Monthly yields on Baa bonds reported by Moody’s averaged approximately 5.4% over the six months ending March 2016.10 Q. What else should be considered in evaluating DCF 10 estimates at the low end of the range? 11 A. As indicated earlier, while long-term bond yields have declined substantially in response to the Federal Reserve’s stimulus policies, it is generally 14 expected that long-term interest rates will rise as the economy returns to a more normal pattern of growth. As shown in Table 2 below, forecasts of IHS Global Insight and the EIA imply an average triple-B bond yield of approximately 7.3 percent over the period 2016-2020: 10 Moody’s Investors Service, http://credittrends.moodys.com/chartroom.asp?c=3. Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 2, Page 24 of 49 Schedule 2 Page 25 of 49 TABLE 2 1 IMPLIED BBB BOND YIELD 2 The increase in debt yields anticipated by IHS Global Insight and EIA is also supported by the widely-referenced Blue Chip Financial Forecasts, which projects that yields on corporate bonds will climb on the order of 200 basis points through 2020.11 Q. What does this test of logic imply with respect 26 to the DCF estimates for the Utility Group? 27 A. Adding FERC’s 100 basis-point premium to the historical and projected average utility bond yields implies a low-end threshold on the order of 6.4% to 8.3%. As highlighted on page 3 of Exhibit No. 3, Schedule 5, 11 Blue Chip Financial Forecasts, Vol. 34, No. 12 (Dec. 1, 2015). 2016-20 Projected Aa Utility Yield IHS Global Insight (a)5.67% EIA (b)6.17% Average 5.92% Current Baa - Aa Yield Spread (c)1.33% Implied Baa Utility Yield 7.25% (a) (b) (c)Based on monthly average bond yields from Moody's Investors Service for the six-month period Oct. 2015 - Mar. 2016. IHS Global Insight, The U.S. Economy: The 30-Year Focus (Third-Quarter 2015). Energy Information Administration, Annual Energy Outlook 2015 (April 2015). Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 2, Page 25 of 49 Schedule 2 Page 26 of 49 after considering this test and the distribution of individual estimates, I eliminated low-end DCF estimates ranging from 5.3% to 6.9%. Based on my professional experience and the risk-return tradeoff principle that is fundamental to finance, it is inconceivable that investors are not requiring a substantially higher rate of return for holding common stock. As a result, consistent with the threshold established by historical and projected utility bond yields, these values provide little guidance as to the returns investors require from utility common stocks and should be excluded. Q. Do you also recommend excluding estimates at the 12 high end of the range of DCF results? 13 A. Yes. The upper end of the cost of common equity range produced by the DCF analysis presented on page 3 of Exhibit No. 3, Schedule 5 was set by a cost of equity estimate of 15.1 percent. Considering the balance of the remaining estimates, I elected to exclude this value in evaluating the results of the DCF model for the Utility Group. Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 2, Page 26 of 49 Schedule 2 Page 27 of 49 Q. What cost of equity is implied by your DCF 1 results for the Utility Group? 2 A. As shown on page 3 of Exhibit No. 3, Schedule 5 and summarized in Table 3, below, after eliminating illogical low-end values, application of the constant growth DCF model resulted in the following cost of equity estimates: TABLE 3 8 DCF RESULTS – UTILITY GROUP 9 D. Capital Asset Pricing Model Q. Please describe the CAPM. 17 A. The CAPM is a theory of market equilibrium that measures risk using the beta coefficient. Assuming investors are fully diversified, the relevant risk of an individual asset (e.g., common stock) is its volatility relative to the market as a whole, with beta reflecting the tendency of a stock’s price to follow changes in the 23 market. A stock that tends to respond less to market movements has a beta less than 1.00, while stocks that Growth Rate Average Midpoint Value Line 9.1% 10.4% IBES 9.4% 9.5% Zacks 9.1% 9.3% br + sv 8.3% 9.1% Cost of Equity Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 2, Page 27 of 49 Schedule 2 Page 28 of 49 tend to move more than the market have betas greater than 1.00. The CAPM is mathematically expressed as: Rj = Rf +βj(Rm - Rf) where: Rj = required rate of return for stock j; Rf = risk-free rate; Rm = expected return on the market portfolio; and, βj = beta, or systematic risk, for stock j. Like the DCF model, the CAPM is an ex-ante, or forward- looking model based on expectations of the future. As a result, in order to produce a meaningful estimate of investors’ required rate of return, the CAPM must be applied using estimates that reflect the expectations of actual investors in the market, not with backward-looking, historical data. Q. Why is the CAPM approach an appropriate 16 component of evaluating the cost of equity for Avista? 17 A. The CAPM approach generally is considered to be the most widely referenced method for estimating the cost of equity among academicians and professional practitioners, with the pioneering researchers of this method receiving the Nobel Prize in 1990. Because this is the dominant model for estimating the cost of equity outside the regulatory sphere, the CAPM provides important Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 2, Page 28 of 49 Schedule 2 Page 29 of 49 insight into investors’ required rate of return for 1 utility stocks, including Avista. Q. How did you apply the CAPM to estimate the cost 3 of common equity? 4 A. Application of the CAPM to the Utility Group based on a forward-looking estimate for investors’ 6 required rate of return from common stocks is presented on Exhibit No. 3, Schedule 7. In order to capture the expectations of today’s investors in current capital markets, the expected market rate of return was estimated by conducting a DCF analysis on the dividend paying firms in the S&P 500. The dividend yield for each firm was obtained from Value Line, and the growth rate was equal to the average of the earnings growth projections for each firm published by IBES and Value Line, with each firm’s dividend yield 16 and growth rate being weighted by its proportionate share of total market value. Based on the weighted average of the projections for the individual firms, current estimates imply an average growth rate over the next five years of 8.4%. Combining this average growth rate with a year-ahead dividend yield of 2.7% results in a current cost of common equity estimate for the market as a whole Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 2, Page 29 of 49 Schedule 2 Page 30 of 49 (Rm) of approximately 11.1%. Subtracting a 2.8% risk-free rate based on the average yield on 30-year Treasury bonds for the six months ending March 2016 produced a market equity risk premium of 8.3%. Q. What was the source of the beta values you used 5 to apply the CAPM? 6 A. As in the development of my proxy group discussed above, I relied on the beta values reported by Value Line, which in my experience is the most widely referenced source for beta in regulatory proceedings. Q. What else should be considered in applying the 11 CAPM? 12 A. As explained by Morningstar: One of the most remarkable discoveries of modern finance is the finding of a relationship between firm size and return. On average, small companies have higher returns than larger ones. . . . The relationship between firm size and return cuts across the entire size spectrum; it is not restricted to the smallest stocks.12 Because empirical research indicates that the CAPM does not fully account for observed differences in rates of return attributable to firm size, a modification is required to account for this size effect. 12 Morningstar, “Ibbotson SBBI 2014 Classic Yearbook,” at p. 99 (footnote omitted). Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 2, Page 30 of 49 Schedule 2 Page 31 of 49 According to the CAPM, the expected return on a security should consist of the riskless rate, plus a premium to compensate for the systematic risk of the particular security. The degree of systematic risk is represented by the beta coefficient. The need for the size adjustment arises because differences in investors’ 6 required rates of return that are related to firm size are not fully captured by beta. To account for this, Morningstar has developed size premiums that need to be added to the theoretical CAPM cost of equity estimates to account for the level of a firm’s market capitalization in 11 determining the CAPM cost of equity. These premiums correspond to the size deciles of publicly traded common stocks, and range from a premium of 5.6% for a company in the first decile (market capitalization less than $209.9 million), to a reduction of 36 basis points for firms in the tenth decile (market capitalization greater than $22.0 billion).13 Accordingly, my CAPM analyses incorporated an adjustment to recognize the impact of size distinctions, as measured by the average market capitalization for the respective proxy groups. 13 Duff & Phelps, “2016 Valuation Handbook – Guide to Cost of Capital (Preview Version),” John Wiley & Sons (2016). Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 2, Page 31 of 49 Schedule 2 Page 32 of 49 Q. What cost of equity is indicated for the Utility 1 Group using the CAPM approach? 2 A. As shown on page 1 of Exhibit No. 3, Schedule 7, after adjusting for the impact of firm size, the forward- looking application of the CAPM approach implied an average cost of equity of 9.7 percent for the Utility Group, with a midpoint cost of equity estimate of 9.6 percent. Q. Did you also apply the CAPM using forecasted 9 bond yields? 10 A. Yes. As discussed earlier, there is widespread consensus that interest rates will increase materially as the economy continues to strengthen. Accordingly, in addition to the use of current bond yields, I also applied the CAPM based on the forecasted long-term Treasury bond yields developed based on projections published by Value Line, IHS Global Insight and Blue Chip. As shown on page 2 of Exhibit No. 3, Schedule 7, incorporating a forecasted Treasury bond yield for 2016-2020 implied an average cost of equity of 10.0% after adjusting for the impact of relative size.14 14 The midpoint of the size adjusted CAPM cost of equity range based on projected bond yields was 9.9%. Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 2, Page 32 of 49 Schedule 2 Page 33 of 49 E. Empirical Capital Asset Pricing Model Q. How does the ECAPM approach differ from 1 traditional applications of the CAPM? 2 A. Empirical tests of the CAPM have shown that low- beta securities earn returns somewhat higher than the CAPM would predict, and high-beta securities earn less than predicted. In other words, the CAPM tends to overstate the actual sensitivity of the cost of capital to beta, with low-beta stocks tending to have higher returns and high-beta stocks tending to have lower risk returns than predicted by the CAPM.15 This empirical finding is widely reported in the finance literature, as summarized in New 11 Regulatory Finance: As discussed in the previous section, several finance scholars have developed refined and expanded versions of the standard CAPM by relaxing the constraints imposed on the CAPM, such as dividend yield, size, and skewness effects. These enhanced CAPMs typically produce a risk-return relationship that is flatter than the CAPM prediction in keeping with the actual observed risk-return relationship. The ECAPM makes use of these empirical relationships.16 As discussed in New Regulatory Finance, based on a review of the empirical evidence, the expected return on a 15 Because the betas of utility stocks, including Avista, are generally less than 1.0, this implies that cost of equity estimates based on the traditional CAPM would understate the cost of equity. 16 Morin, Roger A., “New Regulatory Finance,” Public Utilities Reports at 189 (2006). Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 2, Page 33 of 49 Schedule 2 Page 34 of 49 security is related to its risk by the ECAPM, which is represented by the following formula: Rj = Rf + 0.25(Rm - Rf) + 0.75[βj(Rm - Rf)] 3 This ECAPM equation, and the associated weighting factors, recognize the observed relationship between standard CAPM estimates and the cost of capital documented in the financial research, and correct for the understated returns that would otherwise be produced for low beta stocks. Q. What cost of equity estimates were indicated by 10 the ECAPM? 11 A. My applications of the ECAPM were based on the same forward-looking market rate of return, risk-free rates, and beta values discussed earlier in connections with the CAPM. As shown on page 1 of Exhibit No. 3, Schedule 8, applying the forward-looking ECAPM approach to the firms in the Utility Group results in an average cost of equity estimate of 10.1 percent after incorporating the size adjustment corresponding to the market capitalization of the individual utilities. As shown on page 2 of Exhibit No. 3, Schedule 8, incorporating a forecasted Treasury bond yield for 2016- Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 2, Page 34 of 49 Schedule 2 Page 35 of 49 2020 implied a cost of equity of approximately 10.4 percent after adjusting for the impact of relative size. F. Risk Premium Approach Q. Please briefly describe the risk premium method. 3 A. The risk premium method of estimating investors’ 4 required rate of return extends to common stocks the risk- return tradeoff observed with bonds. The cost of equity is estimated by first determining the additional return investors require to forgo the relative safety of bonds and to bear the greater risks associated with common stock, and by then adding this equity risk premium to the current yield on bonds. Like the DCF model, the risk premium method is capital market oriented. However, unlike DCF models, which indirectly impute the cost of equity, risk premium methods directly estimate investors’ 14 required rate of return by adding an equity risk premium to observable bond yields. Q. Is the risk premium approach a widely accepted 17 method for estimating the cost of equity? 18 A. Yes. The risk premium approach is based on the fundamental risk-return principle that is central to finance, which holds that investors will require a premium in the form of a higher return in order to assume Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 2, Page 35 of 49 Schedule 2 Page 36 of 49 additional risk. This method is routinely referenced by the investment community and in academia and regulatory proceedings, and provides an important tool in estimating a fair ROE for Avista. Q. How did you implement the risk premium method? 5 A. I based my estimates of equity risk premiums for electric utilities on surveys of previously authorized ROEs. Authorized ROEs presumably reflect regulatory commissions’ best estimates of the cost of equity, however 9 determined, at the time they issued their final order. Moreover, allowed ROEs are an important consideration for investors and have the potential to influence other observable investment parameters, including credit ratings and borrowing costs. Thus, this data provides a logical and frequently referenced basis for estimating equity risk premiums for regulated utilities. Q. Is it circular to consider risk premiums based 17 on authorized returns in assessing a fair ROE for Avista? 18 A. No. In establishing authorized ROEs, regulators typically consider the results of alternative market-based approaches, including the DCF model. Because allowed risk premiums consider objective market data (e.g., stock prices, dividends, beta, and interest rates), and are not Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 2, Page 36 of 49 Schedule 2 Page 37 of 49 based strictly on past actions of other regulators, this mitigates concerns over any potential for circularity. Q. How did you implement the risk premium approach 3 using surveys of allowed rates of return? 4 A. The ROEs authorized for electric utilities by regulatory commissions across the U.S. are compiled by Regulatory Research Associates and published in its Regulatory Focus report. On page 3 of Exhibit No. 3, Schedule 9, the average yield on public utility bonds is subtracted from the average allowed rate of return on common equity for electric utilities to calculate equity risk premiums for each year between 1974 and 2015. Over this 42-year period, these equity risk premiums for electric utilities averaged 3.62 percent, and the yield on public utility bonds averaged 8.48 percent. Q. Is there any capital market relationship that 16 must be considered when implementing the risk premium 17 method? 18 A. Yes. There is considerable evidence that the magnitude of equity risk premiums is not constant and that equity risk premiums tend to move inversely with interest rates. In other words, when interest rate levels are relatively high, equity risk premiums narrow, and when Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 2, Page 37 of 49 Schedule 2 Page 38 of 49 interest rates are relatively low, equity risk premiums widen. The implication of this inverse relationship is that the cost of equity does not move as much as, or in lockstep with, interest rates. Accordingly, for a 1 percent increase or decrease in interest rates, the cost of equity may only rise or fall, say, 50 basis points. Therefore, when implementing the risk premium method, adjustments may be required to incorporate this inverse relationship if current interest rate levels diverge from the average interest rate level represented in the data set. Q. Has this inverse relationship been documented in 12 the financial research? 13 A. Yes. This inverse relationship between equity risk premiums and interest rates has been widely reported in the financial literature.17 For example, New Regulatory Finance documented this inverse relationship: Published studies by Brigham, Shome, and Vinson (1985), Harris (1986), Harris and Marston (1992, 1993), Carelton, Chambers, and Lakonishok (1983), Morin (2005), and McShane (2005), and others demonstrate that, beginning in 1980, risk premiums varied inversely with the level of 17 See, e.g., Brigham, E.F., Shome, D.K., and Vinson, S.R., “The Risk Premium Approach to Measuring a Utility’s Cost of Equity,” Financial Management (Spring 1985); Harris, R.S., and Marston, F.C., “Estimating Shareholder Risk Premia Using Analysts’ Growth Forecasts,” Financial Management (Summer 1992). Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 2, Page 38 of 49 Schedule 2 Page 39 of 49 interest rates – rising when rates fell and declining when rates rose.18 Other regulators have also recognized that the cost of equity does not move in tandem with interest rates.19 Q. What are the implications of this relationship 5 under current capital market conditions? 6 A. As noted earlier, bond yields are at unprecedented lows. Given that equity risk premiums move inversely with interest rates, these uncharacteristically low bond yields also imply a sharp increase in the equity risk premium that investors require to accept the higher uncertainties associated with an investment in utility common stocks versus bonds. In other words, higher required equity risk premiums offset the impact of declining interest rates on the ROE. Q. What cost of equity is implied by the risk 16 premium method using surveys of allowed ROEs? 17 A. Because risk premiums move inversely with interest rates and current bond yields are significantly lower than the average over the study period, it is 18 Morin, Roger A., “New Regulatory Finance,” Public Utilities Reports, at 128 (2006). 19 See, e.g., California Public Utilities Commission, Decision 08-05- 035 (May 29, 2008); Entergy Mississippi Formula Rate Plan FRP-5, http://www.entergy-mississippi.com/content/price/tariffs/emi_frp.pdf; Martha Coakley et al., 147 FERC ¶ 61,234 at P 147 (2014). Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 2, Page 39 of 49 Schedule 2 Page 40 of 49 necessary to adjust the average equity risk premium over the study period to reflect the impact of changes in bond yields. Based on the regression output between the interest rates and equity risk premiums displayed on page 4 of Exhibit No. 3, Schedule 9, the equity risk premium for electric utilities increased approximately 43 basis points for each percentage point drop in the yield on average public utility bonds. As illustrated on page 1 of Exhibit No. 3, Schedule 9, with the yield on average public utility bonds for the six months ending March 2016 being 4.59 percent,20 this implied a current equity risk premium of 5.29 percent for electric utilities. Adding this equity risk premium to the yield on Baa utility bonds of 5.41 percent produces a current cost of equity of approximately 10.7 percent.21 Q. What cost of equity was produced by the risk 16 premium approach after incorporating forecasted bond 17 yields? 18 A. As shown on page 2 of Exhibit No. 3, Schedule 9, incorporating a forecasted yield for 2016-2020 and adjusting for changes in interest rates since the study 20 The average utility bond yield encompasses data for Moody’s AA, A, and Baa rating categories. 21 Reference to the Baa utility bond yield corresponds to Avista’s credit ratings. Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 2, Page 40 of 49 Schedule 2 Page 41 of 49 period implied an equity risk premium of 4.50 percent for electric utilities. Adding this equity risk premium to the average implied yield on Baa public utility bonds for 2016-2020 of 7.25 percent resulted in an implied cost of equity of approximately 11.7 percent. G. Expected Earnings Approach Q. What other analyses did you conduct to estimate 6 the cost of common equity? 7 A. As noted earlier, I also evaluated the cost of common equity using the expected earnings method. Reference to rates of return available from alternative investments of comparable risk can provide an important benchmark in assessing the return necessary to assure confidence in the financial integrity of a firm and its ability to attract capital. This expected earnings approach is consistent with the economic underpinnings for a fair rate of return established by the U.S. Supreme Court in Bluefield and Hope. Moreover, it avoids the complexities and limitations of capital market methods and instead focuses on the returns earned on book equity, which are readily available to investors. Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 2, Page 41 of 49 Schedule 2 Page 42 of 49 Q. What economic premise underlies the expected 1 earnings approach? 2 A. The simple, but powerful concept underlying the expected earnings approach is that investors compare each investment alternative with the next best opportunity. If the utility is unable to offer a return similar to that available from other opportunities of comparable risk, investors will become unwilling to supply the capital on reasonable terms. For existing investors, denying the utility an opportunity to earn what is available from other similar risk alternatives prevents them from earning their opportunity cost of capital. In this situation the government is effectively taking the value of investors’ 13 capital without adequate compensation. The expected earnings approach is consistent with the economic rationale underpinning established regulatory standards, which specifies a methodology to determine an ROE benchmark based on earned rates of return for a peer group of other utilities. Q. How is the expected earnings approach typically 20 implemented? 21 A. The traditional comparable earnings test identifies a group of companies that are believed to be Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 2, Page 42 of 49 Schedule 2 Page 43 of 49 comparable in risk to the utility. The actual earnings of those companies on the book value of their investment are then compared to the allowed return of the utility. While the traditional comparable earnings test is implemented using historical data taken from the accounting records, it is also common to use projections of returns on book investment, such as those published by recognized investment advisory publications (e.g., Value Line). Because these returns on book value equity are analogous to the allowed return on a utility’s rate base, this 10 measure of opportunity costs results in a direct, “apples 11 to apples” comparison. Moreover, regulators do not set the returns that investors earn in the capital markets, which are a function of dividend payments and fluctuations in common stock prices, both of which are outside their control. Regulators can only establish the allowed ROE, which is applied to the book value of a utility’s investment in 18 rate base, as determined from its accounting records. This is directly analogous to the expected earnings approach, which measures the return that investors expect the utility to earn on book value. As a result, the Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 2, Page 43 of 49 Schedule 2 Page 44 of 49 expected earnings approach provides a meaningful guide to ensure that the allowed ROE is similar to what other utilities of comparable risk will earn on invested capital. This expected earnings test does not require theoretical models to indirectly infer investors’ 5 perceptions from stock prices or other market data. As long as the proxy companies are similar in risk, their expected earned returns on invested capital provide a direct benchmark for investors’ opportunity costs that is independent of fluctuating stock prices, market-to-book ratios, debates over DCF growth rates, or the limitations inherent in any theoretical model of investor behavior. Q. What rates of return on equity are indicated for 13 utilities based on the expected earnings approach? 14 A. Value Line’s projections imply an average rate 15 of return on common equity for the electric utility industry of 10.8 percent over its 2019-2021 forecast horizon.22 Meanwhile, for the firms in the Utility Group specifically, the year-end returns on common equity projected by Value Line over its forecast horizon are shown on Exhibit No. 3, Schedule 10. Consistent with the 22 The Value Line Investment Survey (Feb. 19, Mar. 18, & Apr. 29, 2016). Recall that Value Line reports return on year-end equity so the equivalent return on average equity would be higher. Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 2, Page 44 of 49 Schedule 2 Page 45 of 49 rationale underlying the development of the br+sv growth rates, these year-end values were converted to average returns using the same adjustment factor discussed earlier and developed on Exhibit No. 3, Schedule 6. As shown on Exhibit No. 3, Schedule 10, Value Line’s projections for 5 the Utility Group suggest an average ROE of approximately 10.1 percent, with a midpoint value of 10.8 percent. II. LOW RISK NON-UTILITY DCF Q. What other proxy group did you consider in 8 evaluating a fair ROE for Avista? 9 A. Consistent with underlying economic and regulatory standards, I also applied the DCF model to a reference group of low-risk companies in the non-utility sectors of the economy. I refer to this group as the “Non-Utility Group”. Q. Do utilities compete with non-regulated firms 15 for capital? 16 A. Yes. The cost of capital is an opportunity cost based on the returns that investors could realize by putting their money in other alternatives. Clearly, the total capital invested in utility stocks is only the tip of the iceberg of total common stock investment, and there are a plethora of other enterprises available to investors Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 2, Page 45 of 49 Schedule 2 Page 46 of 49 beyond those in the utility industry. Utilities must compete for capital, not just against firms in their own industry, but with other investment opportunities of comparable risk. Indeed, modern portfolio theory is built on the assumption that rational investors will hold a diverse portfolio of stocks, not just companies in a single industry. Q. Does consideration of the results for the Non-8 Utility Group make the estimation of the cost of equity 9 using the DCF model more reliable? 10 A. Yes. The estimates of growth from the DCF model depend on analysts’ forecasts. It is possible for utility 12 growth rates to be distorted by short-term trends in the industry, or by the industry falling into favor or disfavor by analysts. The result of such distortions would be to bias the DCF estimates for utilities. Because the Non-Utility Group includes low risk companies from many industries, it diversifies away any distortion that may be caused by the ebb and flow of enthusiasm for a particular sector. Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 2, Page 46 of 49 Schedule 2 Page 47 of 49 Q. What criteria did you apply to develop the Non-1 Utility Group? 2 A. The comparable risk proxy group was composed of those U.S. companies followed by Value Line that: 1) pay common dividends; 2) have a Safety Rank of “1”; 3) have a Financial Strength Rating of “A” or 7 greater; 4) have a beta of 0.70 or less; and 5) have investment grade credit ratings from S&P. Q. How do the overall risks of this Non-Utility 12 Group compare with the Utility Group and Avista? 13 A. As illustrated in Table 4 below, the average credit ratings, Safety Rank, Financial Strength Rating, and beta for the Non-Utility Group suggest less risk than for Avista and the proxy group of utilities. TABLE 4 18 COMPARISON OF RISK INDICATORS 19 20 21 22 23 24 25 26 When considered together, a comparison of these objective measures, which consider a broad spectrum of risks, Safety Financial S&P Moody's Rank Strength Beta Non-Utility Group A- A2 1 A+ 0.68 Utility Group BBB Baa1 2 B++ 0.76 Avista BBB Baa1 2 A 0.75 Value Line Credit Rating Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 2, Page 47 of 49 Schedule 2 Page 48 of 49 including financial and business position, relative size, and exposure to company-specific factors, indicates that investors would likely conclude that the overall investment risks for the Utility Group and Avista are greater than those of the firms in the Non-Utility Group. The twelve companies that make up the Non-Utility Group are representative of the pinnacle of corporate America. These firms, which include household names such as Coca-Cola, McDonalds, and Wal-Mart, have long corporate histories, well-established track records, and exceedingly conservative risk profiles. Many of these companies pay dividends on a par with utilities, with the average dividend yield for the group approaching 3 percent. Moreover, because of their significance and name recognition, these companies receive intense scrutiny by the investment community, which increases confidence that published growth estimates are representative of the consensus expectations reflected in common stock prices. Q. What were the results of your DCF analysis for 19 the Non-Utility Group? 20 A. I applied the DCF model to the Non-Utility Group using the same analysts EPS growth projections described earlier for the Utility Group, with the results being Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 2, Page 48 of 49 Schedule 2 Page 49 of 49 presented in Exhibit No. 3, Schedule 11. As summarized in Table 5, below, application of the constant growth DCF model resulted in the following cost of equity estimates: TABLE 5 DCF RESULTS – NON-UTILITY GROUP As discussed earlier, reference to the Non-Utility Group is consistent with established regulatory principles. Required returns for utilities should be in line with those of non-utility firms of comparable risk operating under the constraints of free competition. Because the actual cost of equity is unobservable, and DCF results inherently incorporate a degree of error, the cost of equity estimates for the Non-Utility Group provide an important benchmark in evaluating a fair ROE for Avista. The DCF results for the Non-Utility Group support my conclusion that the 9.9 percent requested ROE for Avista’s 20 utility operations is a conservative estimate of a fair return. Growth Rate Average Midpoint Value Line 9.6% 10.1% IBES 10.3% 10.7% Zacks 10.5% 11.2% Cost of Equity Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 2, Page 49 of 49 ROE ANALYSES Schedule 3 Page 1 of 1 SUMMARY OF RESULTS Utility DCF Average Midpoint Value Line 9.1%10.4% IBES 9.4%9.5% Zacks 9.1%9.3% Internal br + sv 8.3%9.1% Non-Utility DCF Value Line 9.6%10.1% IBES 10.3%10.7% Zacks 10.5%11.2% CAPM Historical Bond Yield 9.7%9.6% Projected Bond Yield 10.0%9.9% Empirical CAPM Historical Bond Yield 10.1%10.1% Projected Bond Yield 10.4%10.4% Utility Risk Premium Historical Bond Yields 10.7% Projected Bond Yields 11.7% Expected Earnings Industry 10.8% Proxy Group 10.1%10.8% Cost of Equity Recommendation Cost of Equity Range 9.5%--10.7% Flotation Cost Adjustment Dividend Yield Flotation Cost Percentage Adjustment ROE Recommendation 9.62%--10.82% 3.6% 3.3% 0.12% Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 3, Page 1 of 1 CAPITAL STRUCTURE Schedule 4 Page 1 of 1 UTILITY GROUP Common Common Company Debt Preferred Equity Debt Other Equity 1 ALLETE 46.8%0.0%53.2%42.5%0.0%57.5% 2 Ameren Corp.50.7%0.0%49.3%49.5%0.5%50.0% 3 American Elec Pwr 52.2%0.0%47.8%49.0%0.0%51.0% 4 Avista Corp.50.7%0.0%49.3%50.0%0.0%50.0% 5 CMS Energy Corp.69.7%0.0%30.3%65.5%0.0%34.5% 6 DTE Energy Co.51.4%0.0%48.6%53.5%0.0%46.5% 7 Edison International 45.7%8.2%46.1%45.0%7.0%48.0% 8 El Paso Electric Co.52.7%0.0%47.3%57.0%0.0%43.0% 9 Great Plains Energy 50.3%0.5%49.1%44.0%0.5%55.5% 10 IDACORP, Inc.45.6%0.0%54.4%47.0%0.0%53.0% 11 NorthWestern Corp.52.7%0.0%47.3%50.0%0.0%50.0% 12 Otter Tail Corp.45.2%0.0%54.8%44.5%0.0%55.5% 13 PG&E Corp.49.0%0.8%50.2%47.5%1.0%51.5% 14 Portland General Elec.49.4%0.0%50.6%47.0%0.0%53.0% 15 Sempra Energy 52.7%0.1%47.2%52.5%0.0%47.5% 16 Westar Energy 46.3%0.0%53.7%50.0%0.0%50.0% Average 50.7%0.6%48.7%49.7%0.6%49.8% Ex. CMS Energy Co.49.4%0.6%49.9%48.6%0.6%50.8% (a)Company Form 10-K and Annual Reports. (b)The Value Line Investment Survey (Feb. 19, Mar. 18, & Apr. 29, 2016). Value Line Projected (b)At Fiscal Year-End 2015 (a) Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 4, Page 1 of 1 CONSTANT GROWTH DCF - UTILITY GROUP Schedule 5 Page 1 of 3 DIVIDEND YIELD (a)(b) Company Price Dividends Yield 1 ALLETE 55.91$ 2.10$ 3.8% 2 Ameren Corp.48.86$ 1.73$ 3.5% 3 American Elec Pwr 65.26$ 2.30$ 3.5% 4 Avista Corp.40.10$ 1.38$ 3.4% 5 CMS Energy Corp.41.48$ 1.26$ 3.0% 6 DTE Energy Co.88.94$ 3.04$ 3.4% 7 Edison International 70.76$ 1.99$ 2.8% 8 El Paso Electric Co.44.68$ 1.24$ 2.8% 9 Great Plains Energy 31.62$ 1.08$ 3.4% 10 IDACORP, Inc.73.57$ 2.12$ 2.9% 11 NorthWestern Corp.60.46$ 2.02$ 3.3% 12 Otter Tail Corp.28.63$ 1.25$ 4.4% 13 PG&E Corp.58.68$ 1.84$ 3.1% 14 Portland General Elec.39.24$ 1.28$ 3.3% 15 Sempra Energy 103.01$ 3.08$ 3.0% 16 Westar Energy 49.41$ 1.52$ 3.1% Average 3.3% (a)Average of closing prices for 30 trading days ended Apr. 22, 2016. (b)The Value Line Investment Survey, Summary & Index (Apr. 29, 2016). Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 5, Page 1 of 3 CONSTANT GROWTH DCF - UTILITY GROUP Schedule 5 Page 2 of 3 GROWTH RATES (a)(b)(c)(d) br+sv Company V Line IBES Zacks Growth 1 ALLETE 4.0%6.0%6.0%3.3% 2 Ameren Corp.5.0%6.6%6.7%3.6% 3 American Elec Pwr 4.5%4.6%5.1%3.6% 4 Avista Corp.5.0%5.0%5.0%3.5% 5 CMS Energy Corp.6.0%7.2%6.4%5.4% 6 DTE Energy Co.4.5%5.1%5.6%3.7% 7 Edison International 3.5%3.0%5.4%5.5% 8 El Paso Electric Co.2.5%7.0%6.7%3.6% 9 Great Plains Energy 4.5%7.1%6.6%2.6% 10 IDACORP, Inc.3.0%4.0%4.0%3.7% 11 NorthWestern Corp.6.5%5.0%5.0%4.6% 12 Otter Tail Corp.6.0%6.0%NA 5.7% 13 PG&E Corp.12.0%6.0%4.4%5.3% 14 Portland General Elec.5.5%6.5%6.6%3.8% 15 Sempra Energy 10.0%7.8%8.0%8.2% 16 Westar Energy 6.0%5.3%5.2%7.2% (a)The Value Line Investment Survey (Feb. 19, Mar. 18, & Apr. 29, 2016). (b) (c) (d)See Schedule 6. Earnings Growth www.finance.yahoo.com (Apr. 20, 2016). www.zacks.com (Apr. 20, 2016). Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 5, Page 2 of 3 CONSTANT GROWTH DCF - UTILITY GROUP Schedule 5 Page 3 of 3 COST OF EQUITY ESTIMATES (a)(a)(a)(a) br+sv Company V Line IBES Zacks Growth 1 ALLETE 7.8%9.8%9.8%7.1% 2 Ameren Corp.8.5%10.1%10.2%7.1% 3 American Elec Pwr 8.0%8.1%8.6%7.1% 4 Avista Corp.8.4%8.4%8.4%6.9% 5 CMS Energy Corp.9.0%10.3%9.4%8.5% 6 DTE Energy Co.7.9%8.5%9.0%7.1% 7 Edison International 6.3%5.8%8.2%8.3% 8 El Paso Electric Co.5.3%9.8%9.5%6.3% 9 Great Plains Energy 7.9%10.5%10.0%6.0% 10 IDACORP, Inc.5.9%6.9%6.9%6.6% 11 NorthWestern Corp.9.8%8.3%8.3%7.9% 12 Otter Tail Corp.10.4%10.4% NA 10.1% 13 PG&E Corp.15.1%9.1%7.5%8.4% 14 Portland General Elec.8.8%9.8%9.9%7.1% 15 Sempra Energy 13.0%10.8%11.0%11.2% 16 Westar Energy 9.1%8.3%8.3%10.2% Average (b)9.1%9.4%9.1%8.3% Midpoint (c)10.4%9.5%9.3%9.1% (a)Sum of dividend yield (Schedule 5, p. 1) and respective growth rate (Schedule 5, p. 2). (b)Excludes highlighted figures. (c)Average of low and high values. Earnings Growth Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 5, Page 3 of 3 BR+SV GROWTH RATE Schedule 6 Page 1 of 2 UTILITY GROUP (a)(a)(a)(b)(c)(d)(e) Adjustment --------- "sv" Factor -------- Company EPS DPS BVPS b r Factor Adjusted r br s v sv br + sv 1 ALLETE $3.75 $2.40 $43.25 36.0%8.7%1.0196 8.8%3.2%0.0093 0.1762 0.16%3.3% 2 Ameren Corp.$3.25 $2.05 $34.00 36.9%9.6%1.0173 9.7%3.6%- 0.2444 0.00%3.6% 3 American Elec Pwr $4.25 $2.75 $44.25 35.3%9.6%1.0215 9.8%3.5%0.0049 0.2625 0.13%3.6% 4 Avista Corp.$2.50 $1.60 $28.50 36.0%8.8%1.0203 9.0%3.2%0.0142 0.1857 0.26%3.5% 5 CMS Energy Corp.$2.50 $1.60 $19.25 36.0%13.0%1.0344 13.4%4.8%0.0128 0.4500 0.58%5.4% 6 DTE Energy Co.$5.75 $3.70 $60.25 35.7%9.5%1.0238 9.8%3.5%0.0083 0.2697 0.22%3.7% 7 Edison International $5.00 $2.60 $45.00 48.0%11.1%1.0253 11.4%5.5%- 0.4000 0.00%5.5% 8 El Paso Electric Co.$2.50 $1.50 $29.50 40.0%8.5%1.0168 8.6%3.4%0.0040 0.3059 0.12%3.6% 9 Great Plains Energy $2.00 $1.30 $27.50 35.0%7.3%1.0154 7.4%2.6%0.0019 0.0833 0.02%2.6% 10 IDACORP, Inc.$4.50 $2.70 $49.75 40.0%9.0%1.0201 9.2%3.7%0.0013 0.2346 0.03%3.7% 11 NorthWestern Corp.$4.00 $2.32 $39.50 42.0%10.1%1.0199 10.3%4.3%0.0076 0.2818 0.21%4.6% 12 Otter Tail Corp.$2.10 $1.33 $20.25 36.7%10.4%1.0335 10.7%3.9%0.0388 0.4600 1.79%5.7% 13 PG&E Corp.$4.50 $2.35 $44.25 47.8%10.2%1.0277 10.5%5.0%0.0162 0.1955 0.32%5.3% 14 Portland General Elec.$2.75 $1.60 $31.00 41.8%8.9%1.0208 9.1%3.8%0.0026 0.1143 0.03%3.8% 15 Sempra Energy $8.25 $3.90 $61.25 52.7%13.5%1.0298 13.9%7.3%0.0172 0.5288 0.91%8.2% 16 Westar Energy $3.10 $1.70 $28.55 45.2%10.9%1.0128 11.0%5.0%0.0551 0.3989 2.20%7.2% (h) -------------- 2020 ------------- Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 6, Page 1 of 2 BR+SV GROWTH RATE Schedule 6 Page 1 of 2 Page 2 of 2 UTILITY GROUP (a)(a)(f)(a)(a)(f)(g)(a)(a)(h)(a)(a)(g) --------------- 2015 ------------- --------------- 2020 -------------Chg ---- Common Shares ---- Company Eq Ratio Tot Cap Com Eq Eq Ratio Tot Cap Com Eq Equity High Low Avg.M/B 2015 2020 Growth 1 ALLETE 53.7%$3,389 $1,820 57.5%$3,850 $2,214 4.0%$60.00 $45.00 $52.50 1.214 49.10 51.00 0.76% 2 Ameren Corp.49.7%$13,968 $6,942 50.0%$16,500 $8,250 3.5%$50.00 $40.00 $45.00 1.324 242.63 242.63 0.00% 3 American Elec Pwr 50.0%$35,625 $17,813 51.0%$43,300 $22,083 4.4%$70.00 $50.00 $60.00 1.356 491.00 500.00 0.36% 4 Avista Corp.50.0%$3,060 $1,530 50.0%$3,750 $1,875 4.1%$40.00 $30.00 $35.00 1.228 62.31 66.00 1.16% 5 CMS Energy Corp.31.4%$12,534 $3,936 34.5%$16,100 $5,555 7.1%$40.00 $30.00 $35.00 1.818 277.10 287.00 0.70% 6 DTE Energy Co.50.0%$17,600 $8,800 46.5%$24,000 $11,160 4.9%$95.00 $70.00 $82.50 1.369 179.50 185.00 0.61% 7 Edison International 46.7%$24,352 $11,372 48.0%$30,500 $14,640 5.2%$85.00 $65.00 $75.00 1.667 325.81 325.81 0.00% 8 El Paso Electric Co.47.3%$2,151 $1,017 43.0%$2,800 $1,204 3.4%$50.00 $35.00 $42.50 1.441 40.44 41.00 0.28% 9 Great Plains Energy 49.1%$7,441 $3,653 55.5%$7,675 $4,260 3.1%$35.00 $25.00 $30.00 1.091 154.40 155.75 0.17% 10 IDACORP, Inc.54.4%$3,783 $2,058 53.0%$4,750 $2,518 4.1%$75.00 $55.00 $65.00 1.307 50.34 50.60 0.10% 11 NorthWestern Corp.46.9%$3,409 $1,599 50.0%$3,900 $1,950 4.1%$65.00 $45.00 $55.00 1.392 48.17 49.50 0.55% 12 Otter Tail Corp.57.6%$1,051 $605 55.5%$1,525 $846 6.9%$45.00 $30.00 $37.50 1.852 37.86 42.00 2.10% 13 PG&E Corp.50.4%$46,723 $23,548 51.5%$60,300 $31,055 5.7%$65.00 $45.00 $55.00 1.243 492.03 525.00 1.31% 14 Portland General Elec.52.2%$4,329 $2,260 53.0%$5,250 $2,783 4.2%$40.00 $30.00 $35.00 1.129 88.79 89.80 0.23% 15 Sempra Energy 47.3%$24,963 $11,807 47.5%$33,500 $15,913 6.1%$155.00 $105.00 $130.00 2.122 248.30 258.50 0.81% 16 Westar Energy 50.0%$6,596 $3,298 50.0%$7,500 $3,750 2.6%$55.00 $40.00 $47.50 1.664 131.69 155.00 3.31% (a)The Value Line Investment Survey (Feb. 19, Mar. 18, & Apr. 29, 2016). (b)Computed using the formula 2*(1+5-Yr. Change in Equity)/(2+5 Yr. Change in Equity). (c)Product of average year-end "r" for 2020 and Adjustment Factor. (d)Product of change in common shares outstanding and M/B Ratio. (e)Computed as 1 - B/M Ratio. (f)Product of total capital and equity ratio. (g)Five-year rate of change. (h)Average of High and Low expected market prices divided by 2020 BVPS. -------- 2020 Price -------- Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 6, Page 2 of 2 CAPM - CURRENT BOND YIELD Schedule 7 Page 1 of 2 UTILITY GROUP (a)(b)(c)(d)(e)(f) Size Div Proj.Cost of Risk-Free Risk Unadjusted Market Size Adjusted Company Yield Growth Equity Rate Premium Beta Ke Cap Adjustment Ke 1 ALLETE 2.7%8.4%11.1%2.8%8.3%0.80 9.4%2,672.0$ 1.49%10.9% 2 Ameren Corp.2.7%8.4%11.1%2.8%8.3%0.75 9.0%11,273.6$ 0.57%9.6% 3 American Elec Pwr 2.7%8.4%11.1%2.8%8.3%0.70 8.6%30,572.9$ -0.36%8.3% 4 Avista Corp.2.7%8.4%11.1%2.8%8.3%0.75 9.0%2,411.5$ 1.49%10.5% 5 CMS Energy Corp.2.7%8.4%11.1%2.8%8.3%0.75 9.0%10,914.7$ 0.57%9.6% 6 DTE Energy Co.2.7%8.4%11.1%2.8%8.3%0.75 9.0%52,521.9$ -0.36%8.7% 7 Edison International 2.7%8.4%11.1%2.8%8.3%0.70 8.6%17,451.9$ 0.57%9.2% 8 El Paso Electric Co.2.7%8.4%11.1%2.8%8.3%0.75 9.0%22,155.2$ -0.36%8.7% 9 Great Plains Energy 2.7%8.4%11.1%2.8%8.3%0.80 9.4%3,407.6$ 0.99%10.4% 10 IDACORP, Inc.2.7%8.4%11.1%2.8%8.3%0.80 9.4%6,521.8$ 0.86%10.3% 11 NorthWestern Corp.2.7%8.4%11.1%2.8%8.3%0.70 8.6%5,451.8$ 0.86%9.5% 12 Otter Tail Corp.2.7%8.4%11.1%2.8%8.3%0.85 9.9%27,858.5$ -0.36%9.5% 13 PG&E Corp.2.7%8.4%11.1%2.8%8.3%0.70 8.6%22,682.1$ -0.36%8.3% 14 Portland General Elec.2.7%8.4%11.1%2.8%8.3%0.80 9.4%9,487.1$ 0.86%10.3% 15 Sempra Energy 2.7%8.4%11.1%2.8%8.3%0.85 9.9%3,935.5$ 0.99%10.8% 16 Westar Energy 2.7%8.4%11.1%2.8%8.3%0.75 9.0%6,800.7$ 0.86%9.9% Average 9.1%9.7% Midpoint (g)9.2%9.6% (a)Weighted average for dividend-paying stocks in the S&P 500 based on data from www.valueline.com (Mar. 9, 2016). (b) (c) (d)The Value Line Investment Survey (Feb. 19, Mar. 18, & Apr. 29, 2016). (e)www.valueline.com (retrieved Apr. 25, 2016). (f)Duff & Phelps, "2016 Valuation Handbook - Guide to Cost of Capital (Preview Version)," John Wiley & Sons (2016). (g)Average of low and high values. Market Return (Rm) Average of weighted average earnings growth rates from IBES and Value Line Investment Survey for dividend-paying stocks in the S&P 500 based on data from http://finance.yahoo.com (retrieved Mar. 9, 2016). and www.valueline.com (Mar. 9, 2016). Average yield on 30-year Treasury bonds for the six-months ending Mar. 2016 based on data from the Federal Reserve at http://www.federalreserve.gov/releases/h15/data.htm. Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 7, Page 1 of 2 CAPM - PROJECTED BOND YIELD Schedule 7 Page 2 of 2 UTILITY GROUP (a)(b)(c)(d)(e)(f) Size Div Proj.Cost of Risk-Free Risk Unadjusted Market Size Adjusted Company Yield Growth Equity Rate Premium Beta Ke Cap Adjustment Ke 1 ALLETE 2.7%8.4%11.1%4.1%7.0%0.80 9.7%2,672.0$ 1.49%11.2% 2 Ameren Corp.2.7%8.4%11.1%4.1%7.0%0.75 9.4%11,273.6$ 0.57%9.9% 3 American Elec Pwr 2.7%8.4%11.1%4.1%7.0%0.70 9.0%30,572.9$ -0.36%8.6% 4 Avista Corp.2.7%8.4%11.1%4.1%7.0%0.75 9.4%2,411.5$ 1.49%10.8% 5 CMS Energy Corp.2.7%8.4%11.1%4.1%7.0%0.75 9.4%10,914.7$ 0.57%9.9% 6 DTE Energy Co.2.7%8.4%11.1%4.1%7.0%0.75 9.4%52,521.9$ -0.36%9.0% 7 Edison International 2.7%8.4%11.1%4.1%7.0%0.70 9.0%17,451.9$ 0.57%9.6% 8 El Paso Electric Co.2.7%8.4%11.1%4.1%7.0%0.75 9.4%22,155.2$ -0.36%9.0% 9 Great Plains Energy 2.7%8.4%11.1%4.1%7.0%0.80 9.7%3,407.6$ 0.99%10.7% 10 IDACORP, Inc.2.7%8.4%11.1%4.1%7.0%0.80 9.7%6,521.8$ 0.86%10.6% 11 NorthWestern Corp.2.7%8.4%11.1%4.1%7.0%0.70 9.0%5,451.8$ 0.86%9.9% 12 Otter Tail Corp.2.7%8.4%11.1%4.1%7.0%0.85 10.1%27,858.5$ -0.36%9.7% 13 PG&E Corp.2.7%8.4%11.1%4.1%7.0%0.70 9.0%22,682.1$ -0.36%8.6% 14 Portland General Elec.2.7%8.4%11.1%4.1%7.0%0.80 9.7%9,487.1$ 0.86%10.6% 15 Sempra Energy 2.7%8.4%11.1%4.1%7.0%0.85 10.1%3,935.5$ 0.99%11.0% 16 Westar Energy 2.7%8.4%11.1%4.1%7.0%0.75 9.4%6,800.7$ 0.86%10.2% Average 9.4%10.0% Midpoint (g)9.5%9.9% (a)Weighted average for dividend-paying stocks in the S&P 500 based on data from www.valueline.com (Mar. 9, 2016). (b) (c) (d)The Value Line Investment Survey (Feb. 19, Mar. 18, & Apr. 29, 2016). (e)www.valueline.com (retrieved Apr. 25, 2016). (f)Duff & Phelps, "2016 Valuation Handbook - Guide to Cost of Capital (Preview Version)," John Wiley & Sons (2016). (g)Average of low and high values. Market Return (Rm) Average yield on 30-year Treasury bonds for 2016-20 based on data from the Value Line Investment Survey, Forecast for the U.S. Economy (Mar. 4, 2016); IHS Global Insight, The U.S. Economy: The 30-Year Focus (Third-Quarter 2015); & Blue Chip Financial Forecasts, Vol. 34, No. 6 (Dec. 1, 2015). Average of weighted average earnings growth rates from IBES and Value Line Investment Survey for dividend-paying stocks in the S&P 500 based on data from http://finance.yahoo.com (retrieved Mar. 9, 2016). and www.valueline.com (Mar. 9, 2016). Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 7, Page 2 of 2 EMPIRICAL CAPM - CURRENT BOND YIELD Schedule 8 Page 1 of 2 UTILITY GROUP (a)(b)(c)(d)(e)(d)(f)(g) Size Div Proj.Cost of Risk-Free Risk Total Unadjusted Market Size Adjusted Company Yield Growth Equity Rate Premium Weight RP1 Beta Weight RP 2 RP Ke Cap Adjustment Ke 1 ALLETE 2.7%8.4%11.1%2.8%8.3%25%2.1%0.80 75%5.0%7.1%9.9%2,672.0$ 1.49%11.3% 2 Ameren Corp.2.7%8.4%11.1%2.8%8.3%25%2.1%0.75 75%4.7%6.7%9.5%11,273.6$ 0.57%10.1% 3 American Elec Pwr 2.7%8.4%11.1%2.8%8.3%25%2.1%0.70 75%4.4%6.4%9.2%30,572.9$ -0.36%8.9% 4 Avista Corp.2.7%8.4%11.1%2.8%8.3%25%2.1%0.75 75%4.7%6.7%9.5%2,411.5$ 1.49%11.0% 5 CMS Energy Corp.2.7%8.4%11.1%2.8%8.3%25%2.1%0.75 75%4.7%6.7%9.5%10,914.7$ 0.57%10.1% 6 DTE Energy Co.2.7%8.4%11.1%2.8%8.3%25%2.1%0.75 75%4.7%6.7%9.5%52,521.9$ -0.36%9.2% 7 Edison International 2.7%8.4%11.1%2.8%8.3%25%2.1%0.70 75%4.4%6.4%9.2%17,451.9$ 0.57%9.8% 8 El Paso Electric Co.2.7%8.4%11.1%2.8%8.3%25%2.1%0.75 75%4.7%6.7%9.5%22,155.2$ -0.36%9.2% 9 Great Plains Energy 2.7%8.4%11.1%2.8%8.3%25%2.1%0.80 75%5.0%7.1%9.9%3,407.6$ 0.99%10.8% 10 IDACORP, Inc.2.7%8.4%11.1%2.8%8.3%25%2.1%0.80 75%5.0%7.1%9.9%6,521.8$ 0.86%10.7% 11 NorthWestern Corp.2.7%8.4%11.1%2.8%8.3%25%2.1%0.70 75%4.4%6.4%9.2%5,451.8$ 0.86%10.1% 12 Otter Tail Corp.2.7%8.4%11.1%2.8%8.3%25%2.1%0.85 75%5.3%7.4%10.2%27,858.5$ -0.36%9.8% 13 PG&E Corp.2.7%8.4%11.1%2.8%8.3%25%2.1%0.70 75%4.4%6.4%9.2%22,682.1$ -0.36%8.9% 14 Portland General Elec.2.7%8.4%11.1%2.8%8.3%25%2.1%0.80 75%5.0%7.1%9.9%9,487.1$ 0.86%10.7% 15 Sempra Energy 2.7%8.4%11.1%2.8%8.3%25%2.1%0.85 75%5.3%7.4%10.2%3,935.5$ 0.99%11.2% 16 Westar Energy 2.7%8.4%11.1%2.8%8.3%25%2.1%0.75 75%4.7%6.7%9.5%6,800.7$ 0.86%10.4% Average 9.6%10.1% Midpoint (h)9.7%10.1% (a)Weighted average for dividend-paying stocks in the S&P 500 based on data from www.valueline.com (Mar. 9, 2016). (b) (c) (d)Morin, Roger A., "New Regulatory Finance," Public Utilities Reports, Inc. at 190 (2006). (e)The Value Line Investment Survey (Feb. 19, Mar. 18, & Apr. 29, 2016). (f)www.valueline.com (retrieved Apr. 25, 2016). (g)Duff & Phelps, "2016 Valuation Handbook - Guide to Cost of Capital (Preview Version)," John Wiley & Sons (2016). (h)Average of low and high values. Average of weighted average earnings growth rates from IBES and Value Line Investment Survey for dividend-paying stocks in the S&P 500 based on data from http://finance.yahoo.com (retrieved Mar. 9, 2016). and www.valueline.com (Mar. 9, 2016). Average yield on 30-year Treasury bonds for the six-months ending Mar. 2016 based on data from the Federal Reserve at http://www.federalreserve.gov/releases/h15/data.htm. Market Return (Rm)Market Beta Adjusted RPUnadjusted RP Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 8, Page 1 of 2 EMPIRICAL CAPM - PROJECTED BOND YIELD Schedule 8 Page 2 of 2 UTILITY GROUP (a)(b)(c)(d)(e)(d)(f)(g) Size Div Proj.Cost of Risk-Free Risk Total Unadjusted Market Size Adjusted Company Yield Growth Equity Rate Premium Weight RP1 Beta Weight RP 2 RP Ke Cap Adjustment Ke 1 ALLETE 2.7%8.4%11.1%4.1%7.0%25%1.8%0.80 75%4.2%6.0%10.1%2,672.0$ 1.49%11.5% 2 Ameren Corp.2.7%8.4%11.1%4.1%7.0%25%1.8%0.75 75%3.9%5.7%9.8%11,273.6$ 0.57%10.4% 3 American Elec Pwr 2.7%8.4%11.1%4.1%7.0%25%1.8%0.70 75%3.7%5.4%9.5%30,572.9$ -0.36%9.2% 4 Avista Corp.2.7%8.4%11.1%4.1%7.0%25%1.8%0.75 75%3.9%5.7%9.8%2,411.5$ 1.49%11.3% 5 CMS Energy Corp.2.7%8.4%11.1%4.1%7.0%25%1.8%0.75 75%3.9%5.7%9.8%10,914.7$ 0.57%10.4% 6 DTE Energy Co.2.7%8.4%11.1%4.1%7.0%25%1.8%0.75 75%3.9%5.7%9.8%52,521.9$ -0.36%9.4% 7 Edison International 2.7%8.4%11.1%4.1%7.0%25%1.8%0.70 75%3.7%5.4%9.5%17,451.9$ 0.57%10.1% 8 El Paso Electric Co.2.7%8.4%11.1%4.1%7.0%25%1.8%0.75 75%3.9%5.7%9.8%22,155.2$ -0.36%9.4% 9 Great Plains Energy 2.7%8.4%11.1%4.1%7.0%25%1.8%0.80 75%4.2%6.0%10.1%3,407.6$ 0.99%11.0% 10 IDACORP, Inc.2.7%8.4%11.1%4.1%7.0%25%1.8%0.80 75%4.2%6.0%10.1%6,521.8$ 0.86%10.9% 11 NorthWestern Corp.2.7%8.4%11.1%4.1%7.0%25%1.8%0.70 75%3.7%5.4%9.5%5,451.8$ 0.86%10.4% 12 Otter Tail Corp.2.7%8.4%11.1%4.1%7.0%25%1.8%0.85 75%4.5%6.2%10.3%27,858.5$ -0.36%10.0% 13 PG&E Corp.2.7%8.4%11.1%4.1%7.0%25%1.8%0.70 75%3.7%5.4%9.5%22,682.1$ -0.36%9.2% 14 Portland General Elec.2.7%8.4%11.1%4.1%7.0%25%1.8%0.80 75%4.2%6.0%10.1%9,487.1$ 0.86%10.9% 15 Sempra Energy 2.7%8.4%11.1%4.1%7.0%25%1.8%0.85 75%4.5%6.2%10.3%3,935.5$ 0.99%11.3% 16 Westar Energy 2.7%8.4%11.1%4.1%7.0%25%1.8%0.75 75%3.9%5.7%9.8%6,800.7$ 0.86%10.6% Average 9.9%10.4% Midpoint (h)9.9%10.4% (a)Weighted average for dividend-paying stocks in the S&P 500 based on data from www.valueline.com (Mar. 9, 2016). (b) (c) (d)Morin, Roger A., "New Regulatory Finance," Public Utilities Reports, Inc. at 190 (2006). (e)The Value Line Investment Survey (Feb. 19, Mar. 18, & Apr. 29, 2016). (f)www.valueline.com (retrieved Apr. 25, 2016). (g)Duff & Phelps, "2016 Valuation Handbook - Guide to Cost of Capital (Preview Version)," John Wiley & Sons (2016). (h)Average of low and high values. Market Return (Rm)Market Average yield on 30-year Treasury bonds for 2016-20 based on data from the Value Line Investment Survey, Forecast for the U.S. Economy (Mar. 4, 2016); IHS Global Insight, The U.S. Economy: The 30-Year Focus (Third-Quarter 2015); & Blue Chip Financial Forecasts, Vol. 34, No. 6 (Dec. 1, 2015). Beta Adjusted RPUnadjusted RP Average of weighted average earnings growth rates from IBES and Value Line Investment Survey for dividend-paying stocks in the S&P 500 based on data from http://finance.yahoo.com (retrieved Mar. 9, 2016). and www.valueline.com (Mar. 9, 2016). Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 8, Page 2 of 2 ELECTRIC UTILITY RISK PREMIUM Schedule 9 Page 1 of 4 CURRENT BOND YIELD Current Equity Risk Premium (a)Avg. Yield over Study Period 8.48% (b)Average Utility Bond Yield 4.59% Change in Bond Yield -3.89% (c)Risk Premium/Interest Rate Relationship -0.4281 Adjustment to Average Risk Premium 1.67% (a)Average Risk Premium over Study Period 3.62% Adjusted Risk Premium 5.29% Implied Cost of Equity (b)Baa Utility Bond Yield 5.41% Adjusted Equity Risk Premium 5.29% Risk Premium Cost of Equity 10.70% (a)Schedule 9, page 3. (b) (c)Schedule 9, page 4. Average bond yield on all utility bonds and Baa subset for six-months ending Mar. 2016 based on data from Moody's Investors Service at www.credittrends.com. Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 9, Page 1 of 4 ELECTRIC UTILITY RISK PREMIUM Schedule 9 Page 2 of 4 PROJECTED BOND YIELD Current Equity Risk Premium (a)Avg. Yield over Study Period 8.48% (b)Average Utility Bond Yield 2016-2020 6.43% Change in Bond Yield -2.05% (c)Risk Premium/Interest Rate Relationship -0.4281 Adjustment to Average Risk Premium 0.88% (a)Average Risk Premium over Study Period 3.62% Adjusted Risk Premium 4.50% Implied Cost of Equity (b)Baa Utility Bond Yield 2016-2020 7.25% Adjusted Equity Risk Premium 4.50% Risk Premium Cost of Equity 11.74% (a)Schedule 9, page 3. (b) (c)Schedule 9, page 4. Yield on all utility bonds and Baa subset based on data from IHS Global Insight, The U.S. Economy: The 30-Year Focus (Third-Quarter 2015); Energy Information Administration, Annual Energy Outlook 2015 (April 2015); & Moody's Investors Service at www.credittrends.com. Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 9, Page 2 of 4 ELECTRIC UTILITY RISK PREMIUM Schedule 9 Page 3 of 4 AUTHORIZED RETURNS (a)(b) Allowed Average Utility Risk Year ROE Bond Yield Premium 1974 13.10%9.27%3.83% 1975 13.20%9.88%3.32% 1976 13.10%9.17%3.93% 1977 13.30%8.58%4.72% 1978 13.20%9.22%3.98% 1979 13.50%10.39%3.11% 1980 14.23%13.15%1.08% 1981 15.22%15.62%-0.40% 1982 15.78%15.33%0.45% 1983 15.36%13.31%2.05% 1984 15.32%14.03%1.29% 1985 15.20%12.29%2.91% 1986 13.93%9.46%4.47% 1987 12.99%9.98%3.01% 1988 12.79%10.45%2.34% 1989 12.97%9.66%3.31% 1990 12.70%9.76%2.94% 1991 12.55%9.21%3.34% 1992 12.09%8.57%3.52% 1993 11.41%7.56%3.85% 1994 11.34%8.30%3.04% 1995 11.55%7.91%3.64% 1996 11.39%7.74%3.65% 1997 11.40%7.63%3.77% 1998 11.66%7.00%4.66% 1999 10.77%7.55%3.22% 2000 11.43%8.09%3.34% 2001 11.09%7.72%3.37% 2002 11.16%7.53%3.63% 2003 10.97%6.61%4.36% 2004 10.75%6.20%4.55% 2005 10.54%5.67%4.87% 2006 10.36%6.08%4.28% 2007 10.36%6.11%4.25% 2008 10.46%6.65%3.81% 2009 10.48%6.28%4.20% 2010 10.34%5.56%4.78% 2011 10.29%5.13%5.16% 2012 10.17%4.26%5.91% 2013 10.02%4.55%5.47% 2014 9.92%4.41%5.51% 2015 9.85%4.37%5.48% Average 12.10%8.48%3.62% (a) (b)Moody's Investors Service. Major Rate Case Decisions, Regulatory Focus , Regulatory Research Associates; UtilityScope Regulatory Service, Argus.Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 9, Page 3 of 4 ELECTRIC UTILITY RISK PREMIUM Schedule 9 Page 4 of 4 REGRESSION RESULTS SUMMARY OUTPUT Regression Statistics Multiple R 0.9270912 R Square 0.8594981 Adjusted R Square 0.8559856 Standard Error 0.0050171 Observations 42 ANOVA df SS MS F Significance F Regression 1 0.006159143 0.006159 244.6937 1.2107E-18 Residual 40 0.001006833 2.52E-05 Total 41 0.007165976 Coefficients Standard Error t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0% Intercept 0.0725018 0.002446981 29.62907 7.81E-29 0.06755625 0.07744732 0.067556248 0.077447316 X Variable 1 -0.4281032 0.027367621 -15.6427 1.21E-18 -0.48341523 -0.37279118 -0.48341523 -0.37279118 Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 9, Page 4 of 4 EXPECTED EARNINGS APPROACH Schedule 10 Page 1 of 1 UTILITY GROUP (a)(b)(c)Mid-Year Expected Return Adjustment Adjusted Return Company on Common Equity Factor on Common Equity 1 ALLETE 8.5%1.0196 8.7% 2 Ameren Corp.9.5%1.0173 9.7% 3 American Elec Pwr 10.0%1.0215 10.2% 4 Avista Corp.9.0%1.0203 9.2% 5 CMS Energy Corp.13.0%1.0344 13.4% 6 DTE Energy Co.9.5%1.0238 9.7% 7 Edison International 11.5%1.0253 11.8% 8 El Paso Electric Co.8.5%1.0168 8.6% 9 Great Plains Energy 7.5%1.0154 7.6% 10 IDACORP, Inc.9.0%1.0201 9.2% 11 NorthWestern Corp.10.0%1.0199 10.2% 12 Otter Tail Corp.10.5%1.0335 10.9% 13 PG&E Corp.10.0%1.0277 10.3% 14 Portland General Elec.9.0%1.0208 9.2% 15 Sempra Energy 13.5%1.0298 13.9% 16 Westar Energy 9.5%1.0128 9.6% Average 10.1% Midpoint (d)10.8% (a)The Value Line Investment Survey (Feb. 19, Mar. 18, & Apr. 29, 2016). (b)Adjustment to convert year-end return to an average rate of return from Schedule 6. (c)(a) x (b). (d)Average of low and high values. Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 10, Page 1 of 1 DCF MODEL - NON-UTILITY GROUP Schedule 11 Page 1 of 3 DIVIDEND YIELD (a)(b) Company Industry Group Price Dividends Yield 1 Church & Dwight Household Products 92.26$ 1.42$ 1.5% 2 Coca-Cola Beverage 45.78$ 1.40$ 3.1% 3 ConAgra Foods Food Processing 44.41$ 1.00$ 2.3% 4 Gen'l Mills Food Processing 62.12$ 1.84$ 3.0% 5 Kellogg Food Processing 76.17$ 2.08$ 2.7% 6 Kimberly-Clark Household Products 134.97$ 3.68$ 2.7% 7 McDonald's Corp.Restaurant 124.26$ 3.60$ 2.9% 8 PepsiCo, Inc.Beverage 102.07$ 2.87$ 2.8% 9 Procter & Gamble Household Products 82.70$ 2.65$ 3.2% 10 Sysco Corp.Wholesale Food 46.28$ 1.24$ 2.7% 11 Target Corp.Retail Store 81.87$ 2.30$ 2.8% 12 Wal-Mart Stores Retail Store 68.09$ 2.00$ 2.9%92.26$ Average 2.7% (a)Average of closing prices for 30 trading days ended Apr. 15, 2016. (b)The Value Line Investment Survey, Summary & Index (Apr. 15, 2016). Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 11, Page 1 of 3 DCF MODEL - NON-UTILITY GROUP Schedule 11 Page 2 of 3 GROWTH RATES (a)(b)(c) Company V Line IBES Zacks 1 Church & Dwight 7.50%8.52%9.26% 2 Coca-Cola 4.00%2.20%5.96% 3 ConAgra Foods 6.00%6.98%8.13% 4 Gen'l Mills 5.00%5.42%6.82% 5 Kellogg 5.00%4.53%6.62% 6 Kimberly-Clark 10.00%7.30%7.14% 7 McDonald's Corp.4.50%9.92%9.02% 8 PepsiCo, Inc.6.00%6.50%7.75% 9 Procter & Gamble 6.50%6.23%6.43% 10 Sysco Corp.10.50%9.76%8.00% 11 Target Corp.9.00%11.35%10.54% 12 Wal-Mart Stores 1.50%0.04%3.47% (a) (b) (c)www.zacks.com (Retreived Apr. 20, 2016). Earnings Growth Rates The Value Line Investment Survey (Jan. 29, Feb. 26, Mar. 25, & Apr. 22, 2016). www.finance.yahoo.com (retreived Apr. 20, 2016). Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 11, Page 2 of 3 DCF MODEL - NON-UTILITY GROUP Schedule 11 Page 3 of 3 DCF COST OF EQUITY ESTIMATES (a)(a)(a) Company V Line IBES Zacks 1 Church & Dwight 9.0%10.1%10.8% 2 Coca-Cola 7.1%5.3%9.0% 3 ConAgra Foods 8.3%9.2%10.4% 4 Gen'l Mills 8.0%8.4%9.8% 5 Kellogg 7.7%7.3%9.4% 6 Kimberly-Clark 12.7%10.0%9.9% 7 McDonald's Corp.7.4%12.8%11.9% 8 PepsiCo, Inc.8.8%9.3%10.6% 9 Procter & Gamble 9.7%9.4%9.6% 10 Sysco Corp.13.2%12.4%10.7% 11 Target Corp.11.8%14.2%13.3% 12 Wal-Mart Stores 4.4%3.0%6.4% Average (b)9.6%10.3%10.5% Midpoint (c)10.1%10.7%11.2% (a) (b)Excludes highlighted figures. (c)Average of low and high values. Cost of Equity Estimates Sum of dividend yield (Schedule 11, p. 1) and respective growth rate (Schedule 11, p. 2). Exhibit No. 3 Case No. AVU-E-16-03 A. McKenzie, Avista Schedule 11, Page 3 of 3