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
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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