20080919Hadaway Direct.pdf

RECEIVED
Z8SEP 19 AM 16= .4:8
IDAHO PUBLIC
UTILITIES COMMISSION
BEFORE THE IDAHO PUBLIC UTILITIES COMMISSION
IN THE MATTER OF THE )
APPLICATION OF ROCKY )
MOUNTAIN POWER FOR )
APPROVAL OF CHANGES TO ITS )
ELECTRIC SERVICE SCHEDULES )
AND A PRICE INCREASE OF $5.9 )
MILLION, OR 4.0 PERCENT )
CASE NO. PAC-E-08-07
Direct Testimony of Samuel C. Hadaway
ROCKY MOUNTAIN POWER
CASE NO. PAC-E-08-07
September 2008
1 Introduction and Qualifications
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Please state your name, occupation, and business address.
My name is Samuel C. Hadaway. I am a Principal in FINAN CO, Inc., Financial
Analysis Consultants, 3520 Executive Center Drive, Austin, Texas 78731.
On whose behalf are you testifying?
I am testifyng on behalf of Rocky Mountain Power (hereinafter the Company).
Please state your educational background and describe your professional
training and experience.
I have a Bachelor's degree in economics from Southern Methodist University, as
well as MBA and Ph.D. degrees with concentrations in finance and economics
from the University of Texas at Austin (UT Austin). For the past 25 years, I have
been an owner and full-time employee ofFINANCO, Inc. FINANCO provides
financial research concerning the cost of capital and financial condition for
regulated companies as well as financial modeling and other economic studies in
litigation support. In addition to my work at FINAN CO, I have served as an
adjunct professor in the McCombs School of Business at UT Austin and in what
is now the McCoy College of Business at Texas State University. In my prior
academic work, I taught economics and finance courses and I conducted research
and directed graduate students in the areas of investments and capital market
research. I was previously Director of the Economic Research Division at the
Public Utility Commission of Texas where I supervised the Commission's
finance, economics, and accounting staff, and served as the Commission's chief
financial witness in electric and telephone rate cases. I have taught courses at
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1 various utilty conferences on cost of capital, capital strcture, utility financial
2 condition, and cost allocation and rate design issues. I have made presentations
3 before the New York Society of Securty Analysts, the National Rate of Return
4 Analysts Forum, and various other professional and legislative groups. I have
5 sered as a vice president and on the board of directors of the Financial
6 Management Association.
7 A list of my publications and testimony I have given before varous
8 regulatory bodies and in state and federal courts is contained in my resume, which
9 is included as Appendix A.
10 Purpose and Summary of Testimony
11 Q.What is the purpose of your testimony?
12 A.The purpose of my testimony is to estimate the market required rate of return on
13 equity capital (ROE) for Rocky Mountain Power.
14 Q.Please state your ROE recommendation and summarize the results of your
15 cost of equity studies.
16 A.I estimate the cost of equity for Rocky Mountain Power to be 10.75 percent. My
17 discounted cash flow (DCF) analysis indicates an ROE range of 10.6 percent to
18 10.9 percent. My risk premium analysis indicates an ROE of 10.85 percent, with
19 other risk premium data indicating ROEs above 11.0 percent. Based on these
20 quantitative results and my further review of other economic data, I recommend a
21 point ROE estimate of 10.75 percent.
22 Q.How is your analysis structured?
23 In my DCF analysis, I apply a comparable company approach. Rocky Mountain
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1 Power's cost of equity canot be estimated directly from its own market data
2 because Rocky Mountain Power is a division of PacifiCorp, which is a wholly-
3 owned subsidiary of MidAmerican Energy Holdings Company. As such, Rocky
4 Mountain Power does not have publicly traded common stock or other
5 independent market data that would be required to estimate its cost of equity
6 directly. I begin my comparable company review with all the electrc utilities that
7 are included in the Value Line Investors Service (Value Line). Value Line is a
8 widely-followed, reputable source of financial data that is often used by regulatory
9 economists to estimate the cost of capitaL. To improve my peer group's
10 comparability with Rocky Mountain Power, I restricted the group to companies
11 with senior secured bond ratings of at least single-A by either Standard & Poor's
12 (S&P) or by Moody's. Rocky Mountain Power's bond ratings are A- from S&P
13 and A3 from Moody's. I also required the comparable companies to derive at least
14 70 percent of revenues from regulated utility sales, to have consistent financial
15 records not affected by recent mergers or restructuring, and to have a consistent
16 dividend record as required by the DCF modeL. The companies in my comparable
17 group are summarized in Exhibit NO.2.
18 In my risk premium analysis, I used Moody's average public utility bond
19 yields and projected single-A utilty bond interest rates. These rates are consistent
20 with Rocky Mountain Power's single-A bond rating. Under current market
21 conditions, I believe this combination of DCF and risk premium approaches is the
22 most reliable method for estimating Rocky Mountain Power's cost of equity. The
23 data sources and the details of my cost of equity studies are contained in Exhibits
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1 NO.2 through 6.
2 Q.How is the remainder of your testimony organized?
3 A.My testimony is divided into three additional sections. Following this
4 introduction, I review various methods for estimating the cost of equity. In this
5 section, I discuss comparable earings methods, risk premium methods, and the
6 discounted cash flow modeL. In the following section, I review general capital
7 market costs and conditions and discuss recent developments in the electric utility
8 industry that may affect the cost of capitaL. In the final section, I discuss the
9 details of my cost of equity studies and summarize my ROE recommendations.
10 Estimating the Cost of Equity Capital
11 Q.What is the purpose of this section of your testimony?
12 A.The purpose of this section is to present a general definition of the cost of equity
13 capital and to compare the strengths and weakesses of several of the most widely
14 used methods for estimating the cost of equity. Estimating the cost of equity is
15 fundamentally a matter of informed judgment, however, the varous models
16 provide a concrete link to actual capital market data and assist with defining the
17 varous relationships that underlie the ROE estimation process.
18 Q.Please define the term "cost of equity capital" and provide an overview of
19 the cost estimation process.
20 A.The cost of equity capital is the rate of return that equity investors expect to
21 receive. In concept it is no different than the cost of debt or the cost of preferred
22 stock. The cost of equity is the rate of return that common stockholders expect,
23 just as interest on bonds and dividends on preferred stock are the returns that
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1 investors in those securities expect. Equity investors expect a return on their
2 capital commensurate with the risks they take and consistent with returns that
3 might be available from other similar investments. Unlike returns from debt and
4 preferred stocks, however, the equity return is not directly observable in advance
5 and, therefore, it must be estimated or inferred from capital market data and
6 trading activity.
7 An example helps to ilustrate the cost of equity concept. Assume that an
8 investor buys a share of common stock for $20 per share. If the stock's expected
9 dividend is $1.00, the expected dividend yield is 5.0 percent ($1.00 / $20 = 5.0
10 percent). If the stock price is also expected to increase to $21.20 after one year,
11 this one dollar and 20 cent expected gain adds an additional 6.0 percent to the
12 expected total rate of return ($1.20 / $20 = 6.0 percent). Therefore, buying the
13 stock at $20 per share, the investor expects a total return of 1 1.0 percent: 5.0
14 percent dividend yield, plus 6.0 percent price appreciation. In this example, the
15 total expected rate of return at 11.0 percent is the appropriate measure of the cost
16 of equity capital, because it is this rate of return that caused the investor to commit
17 the $20 of equity capital in the first place. If the stock were riskier, or if expected
18 returns from other investments were higher, investors would have required a
19 higher rate of return from the stock, which would have resulted in a lower initial
20 purchase price in market trading.
21 Each day market rates of return and prices change to reflect new investor
22 expectations and requirements. For example, when interest rates on bonds and
23 savings accounts rise, utility stock prices usually fall. This is true, at least in par,
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because higher interest rates on these alternative investments make utilty stocks
relatively less attractive, which causes utility stock prices to decline in market
trading. This competitive market adjustment process is quick and continuous, so
that market prices generally reflect investor expectations and the relative
attractiveness of one investment versus another. In this context, to estimate the
cost of equity one must apply informed judgment about the relative risk of the
company in question and knowledge about the risk and expected rate of return
characteristics of other available investments as well.
How does the market account for risk differences among the various
investments?
Risk-return tradeoffs among capital market investments have been the subject of
extensive financial research. Literally dozens of textbooks and hundreds of
academic articles have addressed the issue. Generally, such research confirms the
common sense conclusion that investors wil take additional risks only if they
expect to receive a higher rate of return. Empirical tests consistently show that
returns from low risk securities, such as U.S. Treasury bils, are the lowest; that
returns from longer-term Treasury bonds and corporate bonds are increasingly
higher as risks increase; and generally, returns from common stocks and other
more risky investments are even higher. These observations provide a sound
theoretical foundation for both the DCF and risk premium methods for estimating
the cost of equity capitaL. These methods attempt to capture the well founded
risk-return principle and explicitly measure investors' rate of return requirements.
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Q.Can you ilustrate the capital market risk-return principle that you just
described?
Yes. The following graph depicts the risk-return relationship that has become
widely known as the Capital Market Line (CML). The CML offers a graphical
representation of the capital market risk-return principle. The graph is not meant
to illustrate the actual expected rate of return for any particular investment, but
merely to ilustrate in a general way the risk-return relationship.
Risk-Return Tradeoffs
CL.::20%..
Q)0:\00 15%Q)..ro0:
"0 10%
Q)..u
Q)0.5%xW
The Capital Market Line
Common
Stocks
Investment
Grade Bonds
Higher Risk ~
As a continuum, the CML can be viewed as an available opportnity set for
investors. Those investors with low risk tolerance or investment objectives that
mandate a low risk profile should invest in assets depicted in the lower left-hand
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1 portion ofthe graph. Investments in this area, such as Treasury bils and short-
2 maturity, high quality corporate commercial paper, offer a high degree of investor
3 certainty. In nominal terms (before considering the potential effects of inflation),
4 such assets are virtally risk-free.
5 Investment risks increase as one moves up and to the right along the CML.
6 A higher degree of uncertainty exists about the level of investment value at any
7 point in time and about the level of income payments that may be received.
8 Among these investments, long-term bonds and preferred stocks, which offer
9 priority claims to assets and income payments, are relatively low risk, but they are
10 not risk-free. The market value oflong-term bonds, even those issued by the U.S.
11 Treasury, often fluctuates widely when governent policies or other factors cause
12 interest rates to change.
13 Farther up the CML continuum, common stocks are exposed to even more
14 risk, depending on the nature of the underlying business and the financial strength
15 of the issuing corporation. Common stock risks include market-wide factors, such
16 as general changes in capital costs, as well as industr and company specific
17 elements that may add further to the volatilty of a given company's performance.
18 As I wil ilustrate in my risk premium analysis, common stocks typically are
19 more volatile (have higher risk) than high quality bond investments and, therefore,
20 they reside above and to the right of bonds on the CML graph. Other more
21 speculative investments, such as stock options and commodity futures contracts,
22 offer even higher risks (and higher potential returns). The CML's depiction of the
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risk-return tradeoffs available in the capital markets provides a useful perspective
for estimating investors' required rates of return.
How is the fair rate of return in the regulatory process related to the
estimated cost of equity capital?
The regulatory process is guided by fair rate of return principles established in the
U.S. Supreme Court cases, Bluefield Water Works and Hope Natural Gas. There
the Court stated:
A public utility is entitled to such rates as wil permit it to earn a
return on the value of the property which it employs for the
convenience of the public equal to that generally being made at the
same time and in the same general part of the country on
investments in other business undertakings which are attended by
corresponding risks and uncertainties; but it has no constitutional
right to profits such as are realized or anticipated in highly
profitable enterprises or speculative ventures. Bluefield Water
W()rks & Improvement Company v. Public Service Commission of
West Virginia, 262 U.S. 679, 692-693 (1923).
From the investor or company point of view, it is important that
there be enough revenue not only for operating expenses, but also
for the capital costs of the business. These include service on the
debt and dividends on the stock. By that standard the return to the
equity owner should be commensurate with returns on investments
in other enterprises having corresponding risks. That return,
moreover, should be sufficient to assure confidence in the financial
integrty of the enterprise, so as to maintain its credit and to attract
capitaL. Federal Power Commission v. Hope Natural Gas Co., 320
U.S. 591,603 (1944).
Based on these principles, the fair rate of return should closely parallel investor
opportnity costs as discussed above. If a utilty is allowed a fair opportity to
earn its market cost of equity, neither its stockholders nor its customers should be
disadvantaged.
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What specifc methods and capital market data are used to evaluate the cost
of equity?
Techniques for estimating the cost of equity normally fall into three groups:
comparable earnings methods, risk premium methods, and DCF methods. The
first set of estimation techniques, the comparable earnings methods, has evolved
over time. The original comparable earings methods were based on book
accounting returs. This approach developed ROE estimates by reviewing
accounting returns for unregulated companies thought to have risks similar to
those of the regulated company in question. These methods have generally been
rejected because they assume that the unregulated group is earing its actual cost
of capital, and that its equity book value is the same as its market value. In most
situations these assumptions are not valid, and, therefore, accounting-based
methods do not generally provide reliable cost of equity estimates.
More recent comparable earnings methods are based on historical stock
market returns rather than book accounting returns. While this approach has some
merit, it too has been criticized because there can be no assurance that historical
retus actually reflect current or future market requirements. Also, in practical
application, eared market returns tend to fluctuate widely from year to year. For
these reasons, a current cost of equity estimate (based on the DCF model or a risk
premium analysis) is usually required.
The second set of estimation techniques is grouped under the heading of
risk premium methods. These methods begin with currently observable market
returns, such as yields on governent or corporate bonds, and add an increment to
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account for the additional equity risk. The capital asset pricing model (CAPM)
2 and arbitrage pricing theory (APT) model are more sophisticated risk premium
3 approaches. The CAPM and APT methods estimate the cost of equity directly by
4 combining the "risk-free" governent bond rate with explicit risk measures to
5 determine the risk premium required by the market. Although these methods are
6 widely used in academic cost of capital research, their additional data
7 requirements and their potentially questionable underlying assumptions have
8 detracted from their use in most regulatory jurisdictions. The basic risk premium
9 methods provide a useful parallel approach with the DCF model and assure
10 consistency with other capital market data in the cost of equity estimation process.
11 The third set of estimation techniques, based on the DCF model, is the
12 most widely used regulatory cost of equity estimation method. Like the risk
13 premium approach, the DCF model has a sound basis in theory, and many argue
14 that it has the additional advantage of simplicity. I wil describe the DCF model
15 in detail below, but in essence its estimate ofthe investor required ROE is simply
16 the sum of the expected dividend yield and the expected long-term dividend (or
17 price) growth rate. While dividend yields are easy to obtain, estimating long-term
18 growth is more difficult. Because the constant growth DCF model also requires
19 very long-term growth estimates (technically to infinity), some argue that its
20 application is too speculative to provide reliable results, resulting in the preference
21 for the multistage growth DCF analysis.
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Of the three estimation methods, which do you believe provides the most
reliable results?
From my experience, a combination of discounted cash flow and risk premium
methods provides the most reliable approach. While the caveat about estimating
long-term growth must be observed, the DCF model's other inputs are readily
obtainable, and the model's results typically are consistent with capital market
behavior. The risk premium methods provide a good parallel approach to the
DCF model and further ensure that current market conditions are accurately
reflected in the cost of equity estimate.
Please explain the DCF modeL.
The DCF model is predicated on the concept that stock prices represent the
present value or discounted value of all future dividends that investors expect to
receive. In the most general form, the DCF model is expressed in the following
formula:
Po = Di/(I+k) + D2/(1+ki +... + Dcx(1+k)OO (1)
where Po is today's stock price; Di, D2, etc. are all future dividends and k is the
discount rate, or the investor's required rate of return on equity. Equation (1) is a
routine present value calculation based on the assumption that the stock's price is
the present value of all dividends expected to be paid in the future.
Under the additional assumption that dividends are expected to grow at a
constant rate "g" and that k is strictly greater than g, equation (1) can be solved for
k and rearranged into the simple form:
k = Di/Po + g (2)
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Equation (2) is the familiar constant growth DCF model for cost of equity
estimation, where D1/Po is the expected dividend yield and g is the long-term
expected dividend growth rate.
Under circumstances when growth rates are expected to fluctuate or when
future growth rates are highly uncertain, the constant growth model may not give
reliable results. Although the DCF model itself is stil valid (equation (1) is
mathematically correct), under such circumstances the simplified form of the
model must be modified to capture market expectations accurately.
Recent events and current market conditions in the electric utilty industry
as discussed later appear to challenge the constant growth assumption of the
traditional DCF modeL. Since the mid-1980s, dividend growth expectations for
many electric utilities have fluctuated widely. In fact, over one-third of the
electric utilities in the U.S. have reduced or eliminated their common dividends
over this time period. On the other hand, some of these companies have
reestablished their dividends, producing exceptionally high growth rates. Under
these circumstances, long-term growth rate estimates may be highly uncertain, and
estimating a reliable "constant" growth rate for many companies is often difficult.
Can the DCF model be applied when the constant growth assumption is
violated?
Yes. When growth expectations are uncertain, the more general version of the
model represented in equation (1) should be solved explicitly over a finite
"transition" period while uncertainty prevails. The constant growth version of the
model can then be applied after the transition period, under the assumption that
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1 more stable conditions wil prevail in the future. There are two alteratives for
2 dealing with the nonconstant growth transition period.
3 Under the "terminal price" nonconstant growth approach, equation (1) is
4 written in a slightly different form:
5 Po = Di/(1 +k) + D2/(1 +ki + ... + PT/(l +k) T (3)
6 where the variables are the same as in equation (1) except that PT is the estimated
7 stock price at the end ofthe transition period T. Under the assumption that
8 normal growth resumes after the transition period, the price PT is then expected to
9 be based on constant growth assumptions. With the terminal price approach, the
10 estimated cost of equity, k, is just the rate of retu that investors would expect to
11 ear if they bought the stock at today's market price, held it and received
12 dividends through the transition period (until period T), and then sold it for price
13 PT. In this approach, the analyst's task is to estimate the rate of retu that
14 investors expect to receive given the current level of market prices they are
15 wiling to pay.
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16 Under the "multistage" nonconstant growth approach, equation (1) is
17 simply expanded to incorporate two or more growth rate periods, with the
18 assumption that a permanent constant growth rate can be estimated for some point
19 in the future:
20 Po = Do(1 +gl)/(1 +k) + ... + Do(1 +gi)n/(1 +k)n+
... +(Do(1 +gTiT+I)/(k-gT))/(1 +k)T (4)21
22 where the variables are the same as in equation (1), but gi represents the growth
23 rate for the first period, g2 for a second period, and gT for the period from year T
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(the end of the transition period) to infinity. The first two growth rates are simply
estimates for fluctuating growth over "n" years (typically 5 or 1 0 years) and gT is a
constant growth rate assumed to prevail forever after year T. The difficult task for
analysts in the multistage approach is determining the varous growth rates for
each period.
Although less convenient for exposition purposes, the nonconstant growth
models are based on the same valid capital market assumptions as the constant
growth version. The nonconstant growth approach simply requires more explicit
data inputs and more work to solve for the discount rate, k. Fortately, the
required data are available from investment and economic forecasting services,
and computer algorithms can easily produce the required solutions. Both constant
and nonconstant growth DCF analyses are presented in the following section.
Please explain the risk premium methodology.
Risk premium methods are based on the assumption that equity securities are
riskier than debt and, therefore, that equity investors require a higher rate of
return. This basic premise is well supported by legal and economic distinctions
between debt and equity securities, and it is widely accepted as a fundamental
capital market principle. For example, debt holders' claims to the earnings and
assets of the borrower have priority over all claims of equity investors. The
contractual interest on mortgage debt must be paid in full before any dividends
can be paid to shareholders, and secured mortgage claims must be fully satisfied
before any assets can be distributed to shareholders in banptcy. Also, the
guaranteed, fixed-income natue of interest payments makes year-to-year returs
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from bonds typically more stable than capital gains and dividend payments on
stocks. All these factors demonstrate the more risky position of stockholders and
support the equity risk premium concept.
Are risk premium estimates of the cost of equity consistent with other
current capital market costs?
Yes. The risk premium approach is especially useful because it is founded on
current market interest rates, which are directly observable. This feature assures
that risk premium estimates of the cost of equity begin with a sound basis, which
is tied directly to current capital market costs.
Is there similar consensus about how risk premium data should be
employed?
No. In regulatory practice, there is often considerable debate about how risk
premium data should be interpreted and used. Since the analyst's basic task is to
gauge investors' required returns on long-term investments, some argue that the
estimated equity spread should be based on the longest possible time period.
Others argue that market relationships between debt and equity from several
decades ago are irrelevant and that only recent debt-equity observations should be
given any weight in estimating investor requirements. There is no consensus on
this issue. Since analysts canot observe or measure investors' expectations
directly, it is not possible to know exactly how such expectations are formed or,
therefore, to know exactly what time period is most appropriate in a risk premium
analysis.
The important point is to answer the following question: "What rate of
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return should equity investors reasonably expect relative to returns that are
currently available from long-term bonds?" The risk premium studies and
analyses I discuss later address this question. My risk premium recommendation
is based on an intermediate position that avoids some of the problems and
concerns that have been expressed about both very long and ver short periods of
analysis with the risk premium modeL.
Please summarize your discussion of cost of equity estimation techniques.
Estimating the cost of equity is one of the most controversial issues in utility
ratemaking. Because actual investor requirements are not directly observable,
several methods have been developed to assist in the estimation process. The
comparable earnings method is the oldest but perhaps least reliable. Its use of
accounting rates of return, or even historical market returns, mayor may not
reflect current investor requirements. Differences in accounting methods among
companies and issues of comparability also detract from this approach.
The DCF and risk premium methods have become the most widely
accepted in regulatory practice. A combination of the DCF model and a review of
risk premium data, in my opinion, provides the most reliable cost of equity
estimate. While the DCF model does require judgment about future growth rates,
the dividend yield is straightforward, and the model's results are generally
consistent with actual capital market behavior. For these reasons, I wil rely on a
combination of the DCF model and a risk premium analysis in the cost of equity
studies that follow.
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1 Fundamental Factors That Affect the Cost of Equity
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What is the purpose of this section of your testimony?
In this section, I review recent capital market conditions and industry and
company-specific factors that should be reflected in the cost of capital estimate.
What has been the recent experience in the U.S. capital markets?
Exhibit No.3, page 1, provides a review of anual interest rates and rates of
inflation in the U.S. economy over the past ten years. During that time inflation
and fixed income market costs declined and, generally, have been lower than rates
that prevailed in the previous decade. Inflation, as measured by the Consumer
Price Index ("CPI"), until 2003 had remained at historically low levels not seen
consistently since the early 1960s. Since 2003, however, inflation rates have
increased with the average for 2004 though 2006 similar to the longer-term
historical average, which is above 3 percent. The inflation rate for 2007 was even
higher at 4.1 percent and, with the large recent increases in energy and food
prices, for the twelve months ended July 2008, the CPI increased 5.6 percent.
These inflationar pressures exert a direct influence on capital market
expectations and result in a higher cost of capitaL.
The Federal Reserve System's monetary policy options are currently
limited by rising inflation and simultaneously weak economic conditions. During
the period from mid-2004 until mid-2006, the Federal Reserve System increased
the short-term Federal Funds interest rate 17 times, raising it from 1 percent to
5.25 percent. In late 2007, in response to the extreme turbulence in the sub-prime
credit markets, the Federal Reserve Open Market Committee began aggressively
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reducing the Federal Funds rate. Since September 2007, the rate has been lowered
seven times to its current level of2.0 percent. With rising inflation expectations,
however, and low market tolerance for additional risk, long-term corporate
interest rates have not declined over the past two years. Furthermore, estimates
for the coming year are for additional interest rate increases.
How have long-term interest rates changed over the past two years?
The following table provides the month-by-month interest rates paid by utilities
and the U.S. Treasury:
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Month
Jan-06
Feb-06
Mar-06
Apr-06
May-06
Jun-06
Jul-06
Aug-06
Sep-06
Oct-06
Nov-06
Dec-06
Jan-07
Feb-07
Mar-07
Apr-07
May-07
Jun-07
Jul-07
Aug-07
Sep-07
Oct-07
Nov-07
Dec-07
Jan-08
Feb-08
Mar-08
Apr-08
May-08
Jun-08
Ju1-08
Aug-08
Table 1
Long-Term Interest Rate Trends
Single-A
Utilty Rate
5.75
5.82
5.98
6.29
6.42
6.40
6.37
6.20
6.00
5.98
5.80
5.81
5.96
5.90
5.85
5.97
5.99
6.30
6.25
6.24
6.18
6.11
5.97
6.16
6.02
6.22
6.21
6.29
6.28
6.38
6.40
6.37
30-Year Single-A
Treasury Rate Utilty SpreadNO NO
4.54 1.28
4.73 1.25
5.06 1.23
5.20 1.22
5.15 1.25
5.13 1.24
5.00 1.20
4.85 1.15
4.85 1.13
4.69 1.11
4.68 1.13
4.85 1.11
4.82 1.08
4.72 1.13
4.87 1.10
4.90 1.09
5.20 1.10
5.11 1.14
4.93 1.31
4.79 1.39
4.77 1.34
4.52 1.45
4.53 1.63
4.33 1.69
4.52 1.70
4.39 1.82
4.44 1.85
4.60 1.68
4.69 1.69
4.57 1.83
4.50 1.87
Sources: Mergent Bond Record (Utilty Rates); ww.federalreserve.gov(TresuryRates).
Hadaway, Di - 20
Rocky Mountain Power
2
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6
7
8
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10
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12
13
14 Q.
15 A.
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17
18
19
20
21
22
23
The data in Table 1 show that in August 2008 long-term single-A utility interest
rates were near the highest levels paid in the past two years. More important,
recent market turbulence from the sub-prime lending crisis and concerns about
renewed inflation have increased interest rates spreads (the differences between
utilty borrowing costs and U.S. Treasury interest rates) dramatically. While the
Federal Reserve System has reduced short-ter borrowing rates for banks (the
Fed Funds rate) and the "flght to safety" experence has driven down some U.S.
Treasury rates, corporate borrowers have seen just the opposite trend. Increased
risk aversion has caused significantly higher borrowing costs for corporations
such as Rocky Mountain Power. While the effects of market turbulence are not
always well captured in financial models for estimating the rate of return, the
evolving long-term borrowing cost relationships for corporate entities should be
considered explicitly in estimates of the going cost of equity capitaL.
What levels of interest rates are forecast for the comig year?
Both corporate and governent interest rates are expected to rise further from
present levels. Exhibit No.3, page 3, provides Standard & Poor's most recent
economic forecast from its Trends & Projections publication for August 2008.
S&P forecasts resumed economic growth after the first quarter of2009. For 2008,
growth in real Gross Domestic Product (GDP) is projected at only 1.7 percent
with nominal GDP (real GDP plus inflation) at 4.0 percent. For 2009, nominal
GDP growth is projected at 3.1 percent. These projected growth rates compare to
a real rate for 2007 of2.0 percent and a nominal rate of 4.8 percent. S&P also
forecasts that interest rates wil rise from current levels. The summar interest
Hadaway, Di - 21
Rocky Mountain Power
1
2
3
4
5
6
7
8
9
10 Q.
11 A.
12
13
14
rate data are presented in the following table:
Table 2
Standard & Poor's Interest Rate Forecast
August 2008 Average Average
Average 2008 Est. 2009 Est.Treasury Bils 1.7% 1.8% 2.4%10-Yr. T-Bonds 3.9% 3.9% 4.5%30-Yr. T-Bonds 4.5% 4.5% 4.9%Aaa Corporate Bonds 5.6% 5.6% 6.1 %
Sources: www.federalreserve.gov, (August 2008 Averages);
Standard & Poor's Trends & Projections, August 2008, page 8
(Projected Rates).
The data in Table 2 show that interest rates in 2009 are projected to increase from
current levels. The average 30-year-term Treasury bond rate for 2009 is projected
by S&P to reach 4.9 percent in this period, relative to the current level of 4.5.
Similarly, the rate on corporate bonds is expected to increase from 5.6 percent to
6.1 percent, a rise of 50 basis points. These increasing interest rate trends offer
important perspective for judging the cost of capital in the present case and
ilustrate why the return on equity must be set at a level sufficient to reflect these
rising costs.
How have utilty stocks performed during the past several years?
Utilty stock prices have fluctuated widely. The Dow Jones Utility Average
(DJUA) has ranged between about 200 and 500 durng the past six years. The
wider fluctuations in more recent years are vividly ilustrated in the following
graph ofDJUA prices over the past 25 years.
Hadaway, Di - 22
Rocky Mountain Power
1
2
3
4
5
6
7
8 Q.
9 A.
10
11
Dow Jones Utilty Average
(Monthly Closing Prices)
600
500
400
300
200
100
o
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Widely fluctuating prices for natural gas as well as recent increases in coal prices
and other uncertainties have created further unsettling conditions. These factors
and continuing concerns for the more competitive market environment for all
utility services wil likely create further uncertainties and market volatility for
utility shares. In this environment, investors' return expectations and requirements
for providing capital to the utility industr remain high relative to the longer-term
traditional view of the utility industry.
What is the industry's current fundamental position?
Many electric utilities are attempting to return to their core businesses and hope to
see more stable results over the next several years. S&P reflects this sentiment in
its most recent Electric Utilty Industry Survey:
Hadaway, Di - 23
Rocky Mountain Power
1 Standard & Poor's Industry Surveys
2
3
4
5
6
7
8
9
We expect the performance of both the electric utility sector
and the individual companies within the sector to remain
volatile over the next several years. However, we believe the
stocks wil be less volatile than they were in the first few years
of the decade.. .. The performance of the sector, however, wil
remain sensitive to the macroeconomic environment and
market forces surounding it. (Standard & Poor's Industry
Surveys, Electric Utilities, August 14,2008, p. 4)
10 Value Line notes electric utilties' relatively poor performance this year:
11 Value Line Investors' Survey
12
13
14
15
16
As a group, utility stocks have held up better than the overall
market in recent weeks, but have performed just as poorly since
the start of 2008. Many of these equities appear to be fully
valued or even overvalued. (Value Line Investment Survey,
Electric Utility (West) Industry, August 8, 2008, p. 1781.
17 Price volatility for utility shares and credit market gyations make it all the more
18 diffcult to estimate the fair, on-going cost of capitaL.
19 Over the past several years, the greatest consideration for utilty investors
20 has been the industr's transition to competition. With the passage of the National
21 Energy Policy Act in 1992 and the Federal Energy Regulatory Commission's
22 (FERC) Order 888 in 1996, the stage was set for vastly increased competition in
23 the electric utility industry. The 1992 Act's mandate for open access to the
24 transmission grd and FERC's implementation through Order 888 effectively
25 opened the market for wholesale electricity to competition. Previously protected
26 utility service terrtory and lack of transmission access in some parts of the
27 country had limited the availability of competitive bulk power prices. The Energy
28 Policy Act and Order 888 have essentially eliminated such constraints for
29 incremental power needs.
Hadaway, Di - 24
Rocky Mountain Power
1
2
3
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7
8
9
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11
12 Q.
13
14 A.
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23
In addition to wholesale issues at the federal level, many states
implemented retail access and have opened their retail markets to competition.
Prior to the Western energy crisis, investors' concerns had focused principally on
appropriate transition mechanisms and the recovery of stranded costs. More
recently, however, provisions for dealing with power cost adjustments have
become a larger concern. The Western energy crisis refocused market concerns
and contrbuted significantly to increased market risk perceptions for companies
without power cost recovery provisions. As expected, the opening of previously
protected utility markets to competition, and the uncertainty created by the
removal of regulatory protection, has raised the level of uncertainty about
investment returns across the entire industry.
Is Rocky Mountain Power affected by these same market uncertainties and
increasing utilty capital costs?
Yes. To some extent all electric utilities are being affected by the industry's
transition to competition. Although retail deregulation has not occurred in Idaho,
Rocky Mountain Power's operations have been significantly affected by transition
and restructuring events around the country. In fact, the uncertainty associated
with the changes that are transforming the utility industr as a whole, as viewed
from the perspective of the investor, remain a factor in assessing any utility's
required ROE, including the ROE from Rocky Mountain Power's operations in
Idaho. For Rocky Mountain Power specifically, its use oflong-term purchased
power agreements can significantly impact the Company's credit quality and
perceived financial risk because credit rating agencies view such contracts as debt
Hadaway, Di - 25
Rocky Mountain Power
1
2
3
4 Q.
5
6 A.
7
8
9
10
11
12
13
14
15
16
17
18 Q.
19
20 A.
21
22
equivalents. The Company's equity infusions and its efforts to strengten the
equity component of its capital strcture are constructive efforts to mitigate this
debt equivalent risk caused by its long-term power contracts.
How do capital market concerns and financial risk perceptions affect the cost
of equity capital?
As I discussed previously, equity investors respond to changing assessments of
risk and financial prospects by changing the price they are wiling to pay for a
given security. When risk perceptions increase or financial prospects decline,
investors refuse to pay the previously existing market price for a company's
securities. Market supply and demand forces then establish a new lower price.
The lower market price tyically translates into a higher cost of capital through a
higher dividend yield requirement as well as the potential for increased capital
gains if prospects improve. In addition to market losses for prior shareholders, the
higher cost of capital is transmitted directly to the company by the need to issue
more shares to raise any given amount of capital for future investment. The
additional shares also impose additional future dividend requirements and, all else
equal, would reduce future earnings per share growth prospects.
How have regulatory commissions responded to these changing market and
industry conditions?
Over the past five years, allowed equity returns have generally followed interest
rate changes. The following table summarizes the overall average ROEs allowed
for electric utilities since 2004:
Hadaway, Di - 26
Rocky Mountain Power
Authorized Electric Utilty Equity Returns
2004 2005 2006
11.00% 10.51% 10.38%
10.54% 10.05% 10.68%
10.33% 10.84% 10.06%
10.91 % 10.75% 10.39%
10.75% 10.54% 10.36%
1 st Quarter
2nd Quarter
3rd Quarter
4th Quarter
Full Year Average
Average Utility
Debt Cost
Indicated Average
Risk Premium
6.20%5.67%6.08%
4.55%4.87%4.28%
2007
10.27%
10.27%
10.02%
10.56%
10.36%
2008
10.50%
10.57%
10.53%
6.11%6.32%
4.25%4.21%
Source: Regulatory Focus, Regulatory Research Associates, Inc., Major Rate Case
Decisions, July 2, 2008.
Since 2004, equity risk premiums (the difference between allowed equity retus
2 and utility interest rates) have ranged from 4.21 percent to 4.87 percent. At the
3 low end of this risk premium range, with an allowed equity risk premium of 4.21
4 percent, the indicated cost of equity is 10.77 percent (6.56 projected single-A
5 interest rate + 4.21 % risk premium = 10.77%)1. At the upper end of this risk
6 premium range, with an allowed equity risk premium of 4.87 percent, the
7 indicated cost of equity is 11.43 percent (6.56 projected single-A interest rate +
8 4.87% risk premium = 11.43%).
9 Cost of Equity Capital for Rocky Mountain Power
10 Q.What is the purpose of this section of your testimony?
11 A.The purpose of this section is to present my quantitative studies of the cost of
12 equity capital for Rocky Mountain Power and to discuss the details and results of
13 my analysis.
I The single-A utility interest rate of 6.56% is equal to the forecasted 30-year Treaury bond rate of 4.9% frm Exhibit
No.3, page 3, plus the average single-A utility spread over long-term Treauries of i .66% for the i 2 months ended August
2008 from Exhibit No.3, page 2.
Hadaway, Di - 27
Rocky Mountain Power
1 Q.
2 A.
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
How are your studies organized?
In the first part of my analysis, I apply three versions of the DCF model to a 16-
company group of electric utilities based on the selection criteria discussed
previously. In the second part of my analysis, I present my risk premium study
and I review risk premium results from the longer-term Ibbotson Stocks, Bonds,
Bils, and Inflation market data (Ibbotson data) now published by Morningstar,
Inc.
My DCF analysis is based on three versions of the DCF modeL. In the first
version of the DCF model, I use the constant growth format with long-term
expected growth based on analysts' estimates of five-year utility earnings growth.
While I continue to endorse a longer-term growth estimation approach based on
growth in overall gross domestic product, I show the traditional DCF results
because this is the approach that has traditionally been used by many regulators.
In the second version of the DCF model, for the estimated growth rate, I use the
estimated long-term GDP growth rate. In the third version of the DCF model, I
use a two-stage growth approach, with stage one based on Value Line's three-to-
five-year dividend projections and stage two based on long-term projected growth
in GDP. The dividend yields in all three of the annual models are from Value
Line's projections of dividends for the coming year and stock prices are from the
three-month average for the months that correspond to the Value Line editions
from which the underlying financial data are taken.
Hadaway, Di - 28
Rocky Mountain Power
1 Q.
2
3 A.
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32
Why do you believe the long-term GDP growth rate should be used to
estimate long-term growth expectations in the DCF model?
Growth in nominal GDP (real GDP plus inflation) is the most general measure of
economic growth in the U.S. economy. For long time periods, such as those used
in the Ibbotson Associates rate of return data, GDP growth has averaged between
5 percent and 8 percent per year. From this observation, Professors Brigham and
Houston offer the following observation concerning the appropriate long-term
growth rate in the DCF Model:
Expected growth rates var somewhat among companies, but
dividends for mature firms are often expected to grow in the future
at about the same rate as nominal gross domestic product (real
GDP plus inflation). On this basis, one might expect the dividend
of an average, or "normal," company to grow at a rate of 5 to 8
percent a year. (Eugene F. Brigham and Joel F. Houston,
Fundamentals of Financial Management, 11 th Ed. 2007, page
298.)
Other academic research on corporate growth rates offers similar conclusions
about GDP growth as well as concerns about the long-term adequacy of analysts'
forecasts:
Our estimated median growth rate is reasonable when compared to
the overall economy's growth rate. On average over the sample
period, the median growth rate over 10 years for income before
extraordinary items is about 10 percent for all firms. ... After
deducting the dividend yield (the median yield is 2.5 percent per
year), as well as inflation (which averages 4 percent per year over
the sample period), the growt in real income before extraordinar
items is roughly 3.5 percent per year. This is consistent with the
historical growth rate in real gross domestic product, which has
averaged about 3.4 percent per year over the period 1950-1998.
(Louis K. C. Chan, Jason Karceski, and Josef Lakonishok, "The
Level and Persistence of Growth Rates," The Journal of Finance,
April 2003, p. 649)
Hadaway, Di - 29
Rocky Mountain Power
1
2
3
4
5
6
7
8
9
10
11
12
13
14 Q.
15 A.
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17
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20
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22
23
24
25
26
IBES long-term growth estimates are associated with realized
growth in the immediate short-term future. Over long horizons,
however, there is little forecastability in earnings, and analysts'
estimates tend to be overly optimistic. ... On the whole, the
absence of predictability in growth fits in with the economic
intuition that competitive pressures ultimately work to correct
excessively high or excessively low profitability growth. (Ibid,
page 683)
These findings support the notion that long-term growth expectations are more
closely predicted by broader measures of economic growth than by near-term
analysts' estimates. Especially for the very long-term growth rate requirements of
the DCF model, the growth in nominal GDP should be considered an important
input.
How did you estimate the expected long-run GDP growth rate?
I developed my long-term GDP growth forecast from nominal GDP data
contained in the St. Louis Federal Reserve Ban data base. That data for the
period 1947 through 2007 is summarized in my RMP Exhibit NO.4. As shown at
the bottom ofthat exhibit, the overall average for the period was 7.0 percent. The
data also show, however, that in the more recent years since 1980, lower inflation
has resulted in lower overall GDP growth. For this reason I gave more weight to
the more recent years in my GDP forecast. This approach is consistent with the
concept that more recent data should have a greater effect on expectations and
with generally lower near- and intermediate-term growth rate forecasts that
presently exist. Based on this approach, my overall forecast for long-term GDP
growth is 50 basis points lower than the long-term average, at a level of 6.5
percent.
Hadaway, Di - 30
Rocky Mountain Power
1 Q.
2 A.
3
4
5
6
7
8
9
10
11
12
13 Q.
14 A.
15
16
17 Q.
18 A.
19
20
21
22
23
Please summarize the results of your DCF analyses.
The DCF results for my comparable company group are presented in Exhibit No.
5. The traditional constant growth DCF model results, with the projected growth
rate based on analysts' forecasts, are shown in the first column on page 1 of that
exhibit. That analysis indicates an ROE of 10.7 percent to 10.9 percent. In the
second column of page 1, I recalculate the constant growth results with long-term
forecasted growth in GDP as the projected growt rate. That analysis also
indicates an ROE of 10.8 percent to 10.9 percent. Finally, in the third column of
page 1, I present the multistage DCF results. The multistage model indicates an
ROE range of 10.6 percent to 10.7 percent. Based on all three versions ofthe
DCF model, my analysis supports a reasonable ROE range of 10.6 percent to 10.9
percent.
What are the results of your risk premium studies?
The details and results of my risk premium studies are shown in my Exhibit NO.6.
These studies and other risk premium data indicate an ROE range of 10.85 percent
to 11.06 percent.
How are your risk premium studies structured?
My risk premium studies are divided into two pars. First, I compare electric
utility authorized ROEs for the period 1980-2007 to contemporaneous long-term
utility interest rates. The differences between the average authorized ROEs and
the average interest rate for the year is the indicated equity risk premium. I then
add the indicated equity risk premium to the forecasted single-A utility bond
interest rate to estimate ROE. Because there is a strong inverse relationship
Hadaway, Di - 31
Rocky Mountain Power
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17 Q.
18
19 A.
20
21
22
23
between risk premiums and interest rates (when interest rates are high, risk
premiums are low and vice versa), further analysis is required to estimate the
current risk premium leveL.
The inverse relationship between risk premiums and interest rate levels is
well documented in numerous, well-respected academic studies. These studies
typically use regression analysis or other statistical methods to predict or measure
the risk premium relationship under varyng interest rate conditions. On page 2 of
Exhibit No.6, I provide regression analyses of the allowed annual equity risk
premiums relative to interest rate levels. The negative and statistically significant
regression coefficients confirm the inverse relationship between risk premiums
and interest rates. This means that when interest rates rise by one percentage
point, the cost of equity increases, but by a smaller amount. Similarly, when
interest rates decline by one percentage point, the cost of equity declines by less
than one percentage point. I use this negative interest rate change coefficient in
conjunction with current interest rates to estimate the appropriate current equity
risk premium.
How do the results of your risk premium study compare to levels found in
other published risk premium studies?
Based on my risk premium studies, I am conservatively recommending a lower
risk premium than is often found in other published risk premium data. For
example, the most widely followed risk premium data are provided in the
Morningstar Ibbotson ("Ibbotson") data studies. These data, for the period 1926-
2007, indicate an arthmetic mean risk premium of 6.1 percent for common stocks
Hadaway, Di - 32
Rocky Mountain Power
1
2
3
4
5
6
7
8
9
10 Q.
11 A.
versus long-term corporate bonds. Under the assumption of geometric mean
compounding, the Ibbotson risk premium for common stocks versus corporate
bonds is 4.5 percent. Based on the more conservative geometric mean risk
premium, the Ibbotson data indicate a cost of equity of 11.06 percent (6.56%
forecasted debt cost + 4.5% risk premium = 11.06%). Based on the arithmetic
risk premium, the Ibbotson data indicate a cost of equity of over 12 percent
(6.56% forecasted debt cost + 6.1 % risk premium = 12.66%). Although I do not
use the Ibbotson data in my final ROE estimates, I do review the data for their
perspective on the overall market cost of equity capitaL.
Please summarize the results of your cost of equity analysis.
The following table summarizes my results:
Summary of Cost of Equity Estimates
DCF Analysis
Constant Growth (Analysts' Growth)
Constant Growth (GDP Growth)
Multistage Growth Model
Reasonable DCF Range
Indicated Cost
10.7%-10.9%
10.8%-10.9%
10.6%-10.7%
10.6%-10.9%
Risk Premium Analysis
Utility Debt + Risk Premium
Risk Premium (6.56% + 4.29%)
Ibbotson Risk Premium Analysis
Risk Premium (6.56% + 4.5%)
Indicated Cost
10.85%
11.06%
Rocky Mountain Power Estimated ROE 10.75%
Hadaway, Di - 33
Rocky Mountain Power
1 Q.
2
3 A.
4
5
6
7
8
9
10
11
12
13 Q.
14 A.
How should these results be interpreted to determine the fair cost of equity
for Rocky Mountain Power?
Caution should be exercised in interpreting the basic quantitative DCF and risk
premium results, because they are based on recent historically low points in the
economic cycle. Under such conditions, economic projections should also be
considered. Resumed economic growth and higher expected interest rates suggest
that the use of a lower DCF range would fail to recognize the ongoing risks and
uncertainties that exist in the electrc utilty industr business as well as the
uncertainties Rocky Mountain Power is currently facing. From this perspective,
and with consideration of the Company's large on-going capital requirements, the
fair and reasonable cost of equity capital for Rocky Mountain Power is 10.75
percent.
Does this conclude your testimony?
Yes, it does.
Hadaway, Di - 34
Rocky Mountain Power
lOOSEP l 9. AM 10: 4S
IDAHO PUßLiC
UTILITIES COMMiSSION
Case No. PAC-E-08-07
Exhibit NO.2
Witness: Samuel C. Hadaway
BEFORE THE IDAHO PUBLIC UTILITIES COMMISSION
ROCKY MOUNTAIN POWER
Exhibit Accompanying Direct Testimony of Samuel C. Hadaway
Comparable Company Fundamentals
September 2008
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Case No. PAC-E-08-07
Exhibit NO.3
Witness: Samuel C. Hadaway
BEFORE THE IDAHO PUBLIC UTILITIES COMMISSION
ROCKY MOUNTAIN POWER
Exhibit Accompanying Direct Testimony of Samuel C. Hadaway
Capital Market Information
September 2008
ZBB,SEP /19 .l.u
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Case No. PAC-E-08-07
Exhibit No.4
Witness: Samuel C. Hadaway
BEFORE THE IDAHO PUBLIC UTILITIES COMMISSION
ROCKY MOUNTAIN POWER
Exhibit Accompanying Direct Testimony of Samuel C. Hadaway
GDP Growth Rate
September 2008
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Exhibit NO.3 Page 2 of 3
Case No. PAC-E-Oa-Q7
Witness: Samuel C. Hadaway
Rocky Mountain Power
Long-Term Interest Rate Trends
Month
Jan-06
Feb-06
Mar-06
Apr-06
May-06
Jun-06
Jul-06
Aug-06
Sep-06
Oct-06
Nov-06
Dec-06
Jan-07
Feb-07
Mar-07
Apr-07
May-07
Jun-07
Jul-07
Aug-07
Single-A
Utilty Rate
5.75
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6.00
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6.24
30- Year Single-A
Treasury Rate Utilty SpreadND ND
4.54 1.28
4.73 1.25
5.06 1.23
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5.15 1.25
5.13 1.24
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4.93 1.31
Sep-07 6.1S 4.79 1.39
Oct-07 6.11 4.77 1.34
Nov-07 5.97 4.52 1.45
Dec-07 6.16 4.53 1.63
Jan-OS 6.02 4.33 1.69
Feb-OS 6.22 4.52 1.70
Mar-08 6.21 4.39 1.82
Apr-08 6.29 4.44 1.S5
May-08 6.2S 4.60 1.68
Jun-OS 6.38 4.69 1.69
Jul-OS 6.40 4.57 I.S3
Aug-OS 6.37 4.50 I.S7
Most Recent 12 Month Aver age 1.66
Sources: Mergent Bond Record (Utilty Rates); ww.federalreserve.gov (Treasury Rates).
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Rocky Mountain Power
Exhibit NO.4 Page 1 of 1
Rocky Mountain Power Case No. PAC.E-08-Q7
GOP Growth Rate Forecast
Witness: Samuel C. Hadaway
Nominal %GOP Price %%
GOP Change Deflator Change CPI Change
1947 244.2 15.5 22.3
1948 269.2 10.2%16.4 5.6%24.1 7.7%
1949 267.3 -0.7%16.4 .0.2%23.8 -1.0%
1950 293.8 9.9%16.5 1.0%24.1 1.1%
1951 339.3 15.5%17.7 7.2%26.0 7.9%
1952 358.5.6%18.0 1.7%26.6 2.3%
1953 379.4 5.9%18.2 1.2%26.8 0.8%
1954 380.4 0.3%18.4 1.0%26.9 0.3%
1955 414.8 9.0%18.7 1.8%26.8 -0.2%
1956 437.5 5.5%19.4 3.5%27.2 1.4%
1957 461.1 5.4%20.0 3.3%28.1 3.4%
1958 467.2 1.3%20.5 2.3%28.9 2.7%
1959 506.6 8.4%20.8 1.2%29.2 1.0%
1960 526.4 3.9%21.0 1.4%29.6 1.5%
1961 544.7 3.5%21.3 1.1%29.9 1.0%
1962 585.6 7.5%21.6 1.4%30.3 1.2%
1963 617.8 5.5%21.8 1.1%30.6 1.3%
1964 663.6 7.4%22.1 1.5%31.0 1.3%
1965 719.1 8.4%22.5 1.8%31.6 1.6%
1966 787.8 9.5%23.2 2.8%32.5 3.0%
1967 832.6 5.7%23.9 3.1%33.4 2.7%
1968 910.0 9.3%24.9 4.3%34.8 4.2%
1969 984.6 8.2%26.1 5.0%36.7 5.4%
1970 1038.5 5.5%27.5 5.3%38.8 5.9%
1971 1127.1 8.5%28.9 5.0%40.5 4.2%
1972 1238.3 9.9%30.2 4.3%41.8 3.3%
1973 1382.7 11.7%31.8 5.6%44.4 6.3%
1974 1500.0 8.5%34.7 9.1%49.3 11.0%
1975 1638.3 9.2%38.0 9.4%53.8 9.1 %
1976 1825.3 11.4%40.2 5.8%56.9 5.8%
1977 2030.9 11.3%42.7 6.3%60.6 6.5%
1978 2294.7 13.0%45.7 7.0%65.2 7.6%
1979 2563.3 11.7%49.5 8.3%72.6 11.3%
1980 2789.5 8.8%54.0 9.1 %82.4 13.5%
1981 3128.4 12.1%59.1 9.4%90.9 10.4%
1982 3255.0 4.0%62.7 6.1%96.5 6.2%
1983 3536.7 8.7%65.2 3.9%99.6 3.2%
1984 3933.2 11.2%67.6 3.8%103.9 4.4%
1985 4220.3 7.3%69.7 3.0%107.6 3.5%
1986 4462.8 5.7%71.2 2.2%109.7 1.9%
1987 4739.5 6.2%73.2 2.7%113.6 3.6%
1988 5103.8 7.70/.75.7 3.4%118.3 4.1%
1989 5484.4 7.5%78.6 3.8%123.9 4.8%
1990 5803.1 5.8%81.6 3.9%130.7 5.4%
1991 5995.9 3.3%84.4 3.5%136.2 4.2%
1992 6337.8 5.7%86.4 2.3%140.3 3.0%
1993 6657.4 5.0%88.4 2.3%144.5 3.0%
1994 7072.2 6.2%90.3 2.1 %148.2 2.6%
1995 7397.7 4.6%92.1 2.0%152.4 2.8%
1996 7816.8 5.7%93.8 1.9%156.9 2.9%
1997 8304.3 6.2%95.4 1.7%160.5 2.3%
1998 8747.0 5.3%96.5 1.1%163.0 1.5%
1999 9268.4 6.0%97.9 1.4%166.6 2.2%
2000 9817.0 5.9%100.0 2.2%172.2 3.4%
2001 10128.0 3.2%102.4 2.4%177.0 2.8%
2002 10469.6 3.4%104.2 1.7%179.9 1.6%
2003 10960.8 4.7%106.4 2.1%184.0 2.3%
2004 11685.9 6.6%109.5 2.9%188.9 2.7%
2005 12433.9 6.4%113.0 3.2%195.3 3.4%
2006 13194.7 6.1 %116.6 3.2%201.6 3.2%
2007 13843.0 4.9%119.7 2.7%207.3 2.9%
10-Year Average 5.2%2.3%2.6%
20.Year Average 5.5%2.5%3.1 %
30-Year Average 6.6%3.5%4.2%
40.Year Average 7.3%4.1%4.7%
50-Year Average 7.1%3.7%4.1%
60-Year Average 7.0%3.5%3.8%
Average of Periods 6.5%3.3%3.8%
Sourc: St. Louis Federal Resrve Bank, ww.researc.sttouisfed.org
ZOOlSEP 19 AM U): "9
IDAHO PUBLIC
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Case No. PAC-E-08-07
Exhibit NO.5
Witness: Samuel C. Hadaway
BEFORE THE IDAHO PUBLIC UTILITIES COMMISSION
ROCKY MOUNTAIN POWER
Exhibit Accompanying Direct Testimony of Samuel C. Hadaway
Discounted Cashflow Analysis
September 2008
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Exhibit NO.5 Page 3 of 5
Case No. PAC-E-08-07
Witness: Samuel C. Hadaway
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Exhibit No.5 Page 4 of 5
Case No. PAC-E-08-07
Witness: Samuel C. Hadaway
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Exhibit NO.5 Page 5 of 5
Case No. PAG-E-QS-07
Witness: Samuel C. Hadaway
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IDAHO PU ieUTILITIES co ISStON
Case No. PAC-E-08-07
Exhibit NO.6
Witness: Samuel C. Hadaway
BEFORE THE IDAHO PUBLIC UTILITIES COMMISSION
ROCKY MOUNTAIN POWER
Exhibit Accompanying Direct Testimony of Samuel C. Hadaway
Risk Premium Analysis
September 2008
Rock Mountain Powr
Exhibit NO.6 Page 1 of 2
Case No. PAC-E-08-07
Witness: Samue C. Hadaay
Rocky Mountain Power
Risk Premium Analysis
MOODY'S AVERAGE AUTHORIZED INDICATED
PUBLIC UTILITY ELECTRIC RISK
BOND YIELD (1)RETURNS (2)PREMIUM
1980 13.15%14.23%1.08%
1981 15.62%15.22%-0.40%
1982 15.33%15.78%0.45%
1983 13.31%15.36%2.05%
1984 14.03%15.32%1.29%
1985 12.29%15.20%2.91%
1986 9.46%13.93%4.47%
1987 9.98%12.99%3.01%
1988 10.45%12.79%2.34%
1989 9.66%12.97%3.31%
1990 9.76%12.70%2.94%
1991 9.21%12.55%3.34%
1992 8.57%12.09%3.52%
1993 7.56%11.41%3.85%
1994 8.30%11.34%3.04%
1995 7.91 %11.55%3.64%
1996 7.74%11.39%3.65%
1997 7.63%11.40%3.77%
1998 7.00%11.66%4.66%
1999 7.55%10.77%3.22%
2000 8.14%11.43%3.29%
2001 7.72%11.09%3.37%
2002 7.53%11.16%3.63%
2003 6.61%10.97%4.36%
2004 6.20%10.75%4.55%
2005 5.67%10.54%4.87%
2006 6.08%10.36%4.28%
2007 6.11%10.36%4.25%
AVERAGE 9.23%12.40%3.17%
INDICATED COST OF EQUITY
PROJECTED SINGLE-A UTILITY BOND YIELD*6.56%
MOODY'S AVG ANNUAL YIELD DURING STUDY 9.23%
INTEREST RATE DIFFERENCE -2.67%
INTEREST RATE CHANGE COEFFICIENT -41.83%
ADUSTMENT TO AVG RISK PREMIUM 1.12%
BASIC RISK PREMIUM 3.17%
INTEREST RATE ADJUSTMENT 1.12%
EQUITY RISK PREMIUM 4.29%
PROJECTED SINGLE-A UTILITY BOND YIELD*6.56%
INDICATED EQUITY RETURN 10.85%
(1) Moody's Investors Servce
(2) Regulatory Focus, Regulatory Researc Assoiates. Inc.
.Projeced single-A bond yield is 166 basis points over projected long-term Treasury bond rate of 4.9% frm
Exhibit RMP _(SCH-2), p. 3. The single-A spread is for the 12 moths ended Aug 200 from Exhibit RMP _(SCH-2), p. 2.
Rocy Mountain Powr
Exhibit No. 6 Page 2 of 2
Case No. PAC-E-08-07
Witnss: Samuel C. Haday
Rocky Mountain Power
Risk Premium Analysis
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Interest Rates (1980-2007)
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.
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Average Utilty Interest Rates