Cost of Capital

- Position Paper -
June 2001








Civil Aviation Authority
CAA House, 45-59 Kingsway, London WC2B 6TE

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TABLE OF CONTENTS
Executive Summary...................................................................................................................5
Responses ..................................................................................................................................6
1. Introduction .......................................................................................................................7
2. Risk free rate .................................................................................................................... 12
3. Equity risk premium........................................................................................................ 14
4. Beta .................................................................................................................................. 16
5. Debt premium.................................................................................................................. 18
6. Gearing and tax................................................................................................................ 19
Effective versus statutory tax rates............................................................................................................... 19
Gearing ............................................................................................................................................................. 20
7. Summary: cost of capital estimates ................................................................................ 21
8. Specific airport factors .....................................................................................................22
9. Incremental costs estimates and the cost of capital........................................................23
10.
Conclusion ...................................................................................................................24
11.
Attachment 1 ................................................................................................................25
12.
Attachment 2 ................................................................................................................26

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Executive Summary
The cost of capital is a key regulatory parameter for capital intensive businesses such as airports.
While the price cap is to be set in terms of the Civil Aviation Authority’s (CAA) statutory duties for
the 2003-08 period the long term nature of airport investment problems and opportunities suggests
that a long term view be taken to the maximum extent appropriate. The CAA envisages that a
conventional approach be taken drawing on best regulatory practice and the latest Competition
Commission (CC) decisions in respect of generic parameters, up-dated to take account of the latest
data. Firm-specific parameters have to be estimated from available data with a degree of judgement
involved. Estimates for congested airports with major new projects in the pipeline may differ from
airports with capacity available. The paper lays out the initial CAA analysis and evidence as clearly as
possible to allow argument, analysis and empirical evidence to be submitted by interested parties.
Ultimately a judgement will have to be made by the CAA consistent with achieving its statutory
objectives.

The paper presents preliminary estimates of the real pre-tax cost of capital for the designated airports
of 6.1%-9.2%. The CAA is open to arguments and evidence on the assumptions that it has adopted
for these estimates.

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Responses

This paper is intended as a note outlining the CAA’s current thinking on the cost of capital.
Comments are not explicitly requested, but those interested parties who wish to comment on the
issues raised in this paper should be sent in writing by 16 July 2001 to:

Susie Talbot
Economic Regulation Group
Civil Aviation Authority
CAA House
45-59 Kingsway
London
WC2B 6TE

Email: talbots@caaerg.co.uk
Fax: 020 7453 6244

All responses will be treated as public information unless otherwise specified. If a response is made
in confidence it should indicate that.

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1. Introduction
1.1
The cost of capital reflects the opportunity cost of funds for investment in companies. If
their investments were expected to earn a return below their cost of capital, investors would
have superior alternatives for their funds. They could find other projects with the same
expected return but lower risk, projects with the same risk, but a higher expected return, or
projects with a higher risk and a higher expected return which still made a better opportunity
than airports. It may be worth noting that arguments are often made about risks affecting the
cost of capital that on closer analysis are project cash-flow risks and uncertainties. The
expected cost of capital is often a critical issue in the regulation of capital-intensive utilities via
RPI-X regulation where small changes in the cost of capital can have a major impact on the
price cap. This is the case for airports. The cost of capital is also very important and relevant
for incremental cost estimates.
1.2
The CAA is not envisaging a formal consultation on this document but would welcome
views, argument, analysis and evidence that would assist the CAA in coming to a final view
on this issue. The CAA is conscious that where airport capacity is under heavy pressure and
investment is the priority it will be important that the estimate used has a low risk of being
too low rather than being too high. This balancing of risk is consistent with maximising
regulatory certainty so as to provide a sound basis for long term investment in desired
capacity.
1.3
There remains intense debate on how several of the key components of the cost of capital
should be estimated for regulatory purposes. The issue has been given considerable
prominence in recent regulatory decisions, particularly the CC’s decisions over the appeals by
two water companies. The CAA proposes to draw on what we consider to be regulatory best
practice in coming to a conclusion on the key issues affecting the generic elements of the cost
of capital (the risk free rate and the equity risk premium). Our focus will be the framework
provided by the capital asset pricing model (CAPM) applied on a weighted average cost of
capital basis (WACC)1. We are not proposing to use other techniques such as dividend
growth2 or arbitrage pricing models, although we have examined recent relevant literature3.
We would of course welcome any evidence based on these approaches that assists the CAA in
coming to a final view on the appropriate cost of capital in this review. This is not a precise
science and judgement will be needed in coming to a view on this issue as an integral part of
the final regulatory decision given the CAA’s statutory objectives.

1 See Attachment 1 for the conventional formula.
2 Attachment 2 provides an example of this methodology.
3 See, for example, “New Facts in Finance” John H. Cochrane June 1999 gsbwww.uchicago.edu/fac/finance/papers/

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1.4
In this review the CAA will “model” the airport businesses with a view to forming the
appropriate price cap on a cash-flow basis. In this framework the cost of capital takes its
technically correct role (in the capital asset pricing model) as a discount rate (as opposed to a
target rate of return). Estimating the cost of capital requires estimates or judgements on the
following:
• the return demanded on risk-free assets;
• the equity risk premium;
• airport company betas;
• the debt premium;
• gearing;
• treatment of tax.
1.5
We first cover the two generic components of CAPM: the risk free rate and the equity risk
premium. The estimations are in real terms. The distinction between using a post-tax pre-
financing cost of capital, using a post-tax, post-financing cost–of-capital and pre-tax cost of
capital (and calculating a ‘tax wedge’ in the cost of capital) is largely one of presentation
provided they are handled consistently.
1.6
Table 1 shows an overview of approaches adopted in recent decisions of other regulators and
the Competition Commission on the components of the cost of capital.

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Table 1: An overview of approaches adopted by other regulators and the MMC/CC

Institution Cas
e
Basis

of
Risk free rate, Equity risk Equity
Debt premium, Approach to
WACC,
estimation
%
premium, % Beta
%
gearing
%
MMC
BAA, 1996
Real pre-tax. 3.5-3.8.
4.0-5.0.
0.7-0.9.
0.3-0.8.
Estimated, but
6.4-8.3.
not optimal.
(30%)
MMC Cellnet
/
Nominal
6.5-6.8
3.5-5.0 1.27
0.7-1.0. (9.1%). 14.9-17.8.
Vodafone, 1998 pre- tax.
(nominal);
(4 year
Planned level
(nominal)
3.5-3.8 (real).
average,
LBS)
Ofwat Water


and
Real post-
2.5-3.0. 3.0-4.0.
0.7-0.8.
1.5-2.0 Optimal
(50%)
4.6-6.2.
sewerage charges, tax.
Nov. 1999
Ofgem
PES review, Dec. Real pre-tax. 2.25-2.75.
3.25-3.75.
1.0.
1.85-1.7 (adj.
Optimal (50%) 6.0-6.9.
1999.
From 1.4 to
reflect LT
debt).
CC
Sutton and East Real pre-tax 3.0
4.0
0.7 - 1.0 1.5 - 1.9
25% - 50%
7.3
Surrey Water
August 2000
ORR October
2000
Real pre-tax 3.0
4.0
1.1 - 1.3 1.5 - 1.75
50%
6.9 - 8.2
(based on CC
(to reflect
(assumed)
central values)
impact of
gearing)

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Document Outline

• Cost of Capital
• Executive Summary
• Responses
• Introduction
• Risk free rate
• Equity risk premium
• Beta
• Debt premium
• Gearing and tax
  • • Effective versus statutory tax rates
    • Gearing
• Summary: cost of capital estimates
• Specific airport factors
• Incremental costs estimates and the cost of capital
• Conclusion
• Attachment 1
  • • • • • • • • Weighted Average Cost of Capital
• Attachment 2
  • • • • • • • • Dividend Growth Model: Fama and French

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