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Discussion Capitalisanecessaryfactorofproductionandhasacost. Estimatingafirm’scostofcapitdinvolves determining the cost of the various capital components, then applying these costs to the capitalization ratio of the firm to arrive at a WACC. The more common components of capital are debt, preferred stock, and common equity. Calculatingthecostofdebtandpreferredstockisarelativelystraightforwardprocedure. Inthecaseof a regulated utility, common practice is to use the embedded’ cost (actual interest obligation of debt as a percentage of the principal amount outstanding and the annual dividend obligation of preferred stock as a percentage of the net proceeds from the sale of that stock) because the rate base of regulated utilities is embedded (Phillips 1988). EPRI’s 1993TAG recommends using a before-tax nominal cost of debt of 9.1% and a nominal cost of preferred stock of 8.4% (EPRI June 1993). Instead of calculating the cost of debt and preferred stock on an embedded basis, a competitive private firm would want to use the marginal cost or the cost of newly issued debt and preferred stock. This is the case because a competitive firm should finance projects in such a way that the Marginal Cost of Capital(MCC)isminimized. Thefirmshouldtakeonnewprojectsonlyifthenetpresentvaluesofcash flows are positive when evaluated using the MCC (Weston and Brigham 1981). The cost of new debt can be calculated by dividing the yearly interest amount, after accounting for income tax preferences: by the sales price of the debt, after accounting for any flotation costs? The cost of new preferred stock is calculated by dividing the stated dividend by the sales price of the issue after accounting for flotation costs (Ruegg and Petewsen 1987). Estimating the cost of equity for a fum is more complicatedthancalculating the cost of debt and preferred stock. For regulated utilities, EPRI’s TAG 1993 recommends using a nomind cost of equity (common stock) of 13.0%. Three approaches for determining the cost of equity are most commonly used: eamings/price (e/p) ratios, discounted cash flow (DCF) models, and the Capital Asset Pricing Model (CAPM). These methods can be applied to both regulated utilities and competitive firms. The use of e/p ratios and the CAPM is not as predominant as using DCFs and as such, they are not covered in this manual. For more information on the CAPM, see the Uncertainty and Risk subsection in Section 2. Weston covers both models in greater detail (Weston and Brigham 1981). The equation for calculating the cost of equity (rate of return on common equity) using the DCF model is as €allows: f k , = Cvp + g = rate of return on common equity d = current dividend per share (2-4 Where: rec P g = currentmarketpricepershare = expected growth rate of dividends per share. ’Embedded is defined as average or fully distributed. 61ncometaxpreferences in this instance refers to the tax deductibility of the interest related to debt. 7Flotation costs refer to the costs required when acquiring debt. This may be in the form of commissions paid and other costs. 10PDF Image | A Manual for the Economic Evaluation of Energy Efficiency and Renewable Energy Technologies
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