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Module 3 Cost of Capital

Prof. Z. Y. Dong, Dr. Jin Ma

Copyright notice

COMMONWEALTH OF AUSTRALIA

Copyright Regulations 1969

WARNING

Portions of this material have been reproduced and communicated

to you by or on behalf of the University of Sydney pursuant to Part

VB of Copyright Act 1968 (the Act). The material in this

communication may be subject to copyright under the Act. Any

further reproduction or communication of this material by you may

be the subject of copyright protection under the Act.

Outlines

Investments

Net Present Value

important

Under regulation, the regulator must determine (1) which

operating expenses are appropriate (2) whether customers are

paying prices that ensure sufficient long-run security of supply.

Based on these two considerations, the regulator could decide

whether the price is appropriate;

Under regulation, a utility is allowed to recover reasonable costs

incurred in the provision of service;

Under deregulation, generators are not guaranteed cost recovery,

but most transmitters and distributors remain regulated; So the

regulator must have a clear idea on the cost and how this cost

can be recovered so as to encourage investments;

However, one of the most difficult tasks of an electricity utility is

to determine its cost of capital.

4

can involves two sources:

Borrow funds from financial institutions, this is

called debt capital;

capital is easy: the rate of interest charged by financial

institutions;

firm or from profits earned by the firm, this is

called equity capital;

firm earn on their equity;

regulator must decide the appropriate rate of

return to charge customers to remunerate the

providers of equity capital. So the service can

be sustainable.

Capital market

For simplicity, we assume there is a single

market for financial capital;

Firms who want to borrow money enter this

market and announce how much they are

willing to borrow at each rate of interest.

Investors also enter this market and announce

how much they are willing to lend at each rate of

interest;

Market equilibrium

(interest) rate and total

level of capital

demanded are

determined by the

intersection of demand

for financial capital by

firms and the supply of

financial capital by

investors.

If the interest rate is

low, supply would be

less and demands on

capital would be high.

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Demand behaviour

If a firm purchases a unit capital, he must make sure

that the increase in his revenue that this unit capital

produces at least no less than the cost of that unit

capital; So it is worthwhile to attract the capital in;

If the increase of the revenue is higher than the cost

of capital that produces this increase of the revenue,

that firm will continue to demand capital inputs until

the revenue increase that the capital produces is just

equal to the price of the capital (that is its marginal

revenue product)

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Investor

maximize their well-being; They are rational

investors;

We assume investors prefer certainty to

uncertainty;

certain outcome, most individuals would prefer the equivalent

certain outcome.

For example, consider the choice between (1) receiving 100$ with

probability one half and 0$ with probability one half and (2) 50$

with probability 1. Most individuals would choose the latter.

10

So decisions of investors

projects that are more risky.

Thus an electric utility decision maker has to

determine:

First, the risk class of each investment;

Second, the appropriate rate of return on

capital for the appropriate risk classes

the investor would look for high rate of

return to protect them from the risk.

11

Risk-free interest rate is also called (nominal)

rate of interest on the risk-free investment,

i.e., one investment that always pays a

known return to the lender; such as the

securities sold by the government; For a

stable government, this investment can be

seen as no risk;

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interest rate Rf:

rate i

The other component compensates investors

because they are unable to use the funds while the

capitals are being used by the borrower; This is

called real risk-free interest rate rf

13

If inflation is low (e.g. less than 5%) and the

real risk-free rate is low (e.g. less than 3%),

will be small, e.g.

, we often

approximate

14

premium (RP) to compensate them for the unknown

rate of return

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of return

is equivalently, for example, to a risk-free

rate rf=5% and a risk premium RP=5%;

If the rate of inflation is 10%, then the

nominal (risky) interest rate would be at least

20% with stable inflation.

If the rate of inflation is high, this item cannot

be neglected.

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most widely accepted method of project

evaluation in modern finance;

The most important concept around NPV

maximization is: time value of money,

i.e., that money in hand today has a

different value than the same amount one

year ago or one year from now.

So when we talk about money to be

invested, we should discount all of them

from future into the present.

17

neglect the transaction costs, i.e., the rental

rate on financial capital (money) is the same

for the borrower and the lender.

For example, if the real (risk) interest rate is

10% per year, the firm pays 10% per year to

the investor; There are no extra cost.

Actually, this is an assumption of a perfect

capital market.

18

So

Or we rewrite it into:

is denoted as the discounting factor

19

For year t

Here we use compounding: the return earned from a

previous period will be put into investment to earn the

return in the next period.

20

21

22

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If we discount by breaking the periods into subperiods, for example, into months.

Under monthly discounting, the annual rate of 10%

is divided by 12, or, 0.833% per month.

If we compound monthly, the annual rate would be:

10% annual rate;

24

If we discount by breaking the periods into days.

Under daily discounting, the annual rate of 10% is

divided by 365, or, 0.0274% per day.

If we compound daily, the annual rate would be:

compounding monthly;

25

Now we discount by breaking the periods into even

smaller time intervals.

We separate one year into m periods, the annual

rate of 10% is divided by m and when

, we

actually compound continuously

That is the limit that we can have for an effective annual rate;

compounding and daily compounding is almost indistinguishable from continuous

26

compounding.

Investment (I)

assume we invest uniformly each year.

We discount our investments into the present value:

If we invest until year T, we can add all the terms together and get:

27

Investment (II)

what amount must be collected each year to recover our

investment?

Since

28

Investment (III)

r=10% and we want to recover our investment in 30 years

(say, the life cycle of this product that we invest in) , use

means our average annual profit cannot be less than $106.08;

If it is less than this value under reasonable cause, the

regulator should consider compensation if necessary to

encourage the investments in this product.

29

Investment (IV)

have to collect at every period in the foreseeable future

becomes

Since

In this case, r=10% and the present investment is $1000;

the annual payment would be $100. It gives a very close

estimate to the annual payment for long recovery periods

(e.g., 30 years) but with much simpler calculation.

30

maximize their profits in each period;

But firms, particular those owning physical capital

with long productive lives, such as electricity

generation capacity, must make decision based on

future profits.

So we have to extend our behavioural assumption

from single-period profit maximization to multi-period

profit maximization.

31

periods, Since

32

cost (FC), this approach assumes that costs including

FC are incurred in each future period.

In most cases, some costs, such as capital costs,

must be spent in the current period so revenues can

be received in the future.

If the fixed cost is incurred in the first period and

variable costs are spent in the future periods, then.

present.

33

PRt>0 or we may lose money in some years, such as

PRt<0; However, if NPV > 0, we earn profits in

average. A positive NPV implies positive discounted

profit to the present.

34

projects (e.g., power plants) with positive NPV

because all projects with positive NPV imply positive

discounted profits.

The investors will

then begin by investing in the project with the highest

NPV;

This is often referred to as maximizing Net Present Value

principle in multi-periods framework.

35

Summary

evaluate cost of capital, which is very

important at the planning stage;

When we evaluate the cost of capital, we should keep the time

value of money in mind;

We have learned one most important method on investment

evaluations, i.e., net present value method.

36

Thank you!

37

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