Attribution Non-Commercial (BY-NC)

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Attribution Non-Commercial (BY-NC)

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This note compares the effect of leverage on the Weighted Average Cost of Capital

(WACC) and the Cost of Equity under the simplified Brennan Lally Capital Asset

Pricing Model (Brennan Lally CAPM) model and the Classical CAPM model.

For this comparison, we have calibrated the Brennan Lally CAPM with parameter

estimates for the risk-free rate of return, debt premium, leverage, asset beta, tax-

adjusted market risk premium (TAMRP) and tax rates as per the Commission’s straw

person example, which was based on the Revised Draft Guidelines.

For the purposes of this comparison, we have assumed that the asset beta estimate was

known and that the debt beta was equal to zero.

Holding all other parameter estimates constant, we have calculated the changes in

post-tax WACC of increasing leverage from 20% to 70%. In the analysis we assume

that equity betas1 change as per the standard formulae for the effects of leverage on

beta under the tax imputation system assumed in the Brennan-Lally model2 and the

tax system assumed in the Classical model.3 As noted, the underlying asset beta used

is the same for both the Classical and Brennan-Lally models. We have assumed a

TAMRP of 7% for the Brennan-Lally model and a MRP of 5.4% for the Classical

model.4

Figure 1 below illustrates that using the Brennan-Lally CAPM, post tax WACC

increases with leverage. The same figure also illustrates that using the classical

CAPM, post-tax WACC decreases as leverage increases.

1

The Harris & Pringle formula for leveraging the asset beta, to obtain the equity beta, has been used in

the simplified Brennan-Lally CAPM.

2

We note that, as leverage increases, the debt premium should also increase. However, such increase is

difficult to model as the function would be non-linear.

3

The traditional formula (Hamada) for leveraging the asset beta, to obtain the equity beta, has been

used in the classical CAPM.

4

Assuming 7% for the TAMRP is consistent with the Commission’s straw person example. We

derived the MRP for the classical model applying the following calculation: MRP = TAMRP – Rf(Ti),

i.e. 5.4=7-5.36*0.3.

1

Figure 1: Effects of Changes in Leverage on Post-tax WACC

Brennan-Lally versus Classical CAPM

7.75%

7.50%

7.25%

Post-Tax WACC

7.00%

6.75%

6.50%

20% 30% 40% 50% 60% 70%

Leverage

Brennan-Lally Classical

(WACC and Leverage dated 17 November 2009, as published on the Commission’s

website5), Dr Martin Lally identifies that the increase can be attributed to the effect of

the debt premium.

In case of the Classical model, as leverage increases, WACC decreases. This is the

standard result, which is usually described as reflecting the advantages to debt

provided by the tax system (i.e. interest is deductible to the firm in contrast to returns

to equity) in the absence of dividend imputation.

Figure 2 below illustrates that in the Brennan-Lally model the cost of equity increases

at a greater rate than in the Classical model.

5

http://www.comcom.govt.nz/IndustryRegulation/Part4/DecisionsList.aspx

2

Figure 2: Effects of Changes in Leverage on Cost of Equity

Brennan-Lally versus Classical CAPM

14%

12%

10%

Cost of Equity

8%

6%

4%

2%

0%

20% 30% 40% 50% 60% 70%

Leverage

Brennan-Lally Classical

For details of the formulae applied in the current analysis, please refer to Appendix 1.

For details of all parameter estimates, please refer to Appendix 2.

3

APPENDIX 1

Formulae used

Where

rd is the cost of debt capital

re: is the cost of equity capital

Tc is the corporate tax rate

L: is leverage

rd = rf +p

re= rf(1- Ti)+ βe ×TAMRP

βe= βa + βa ×L/(1-L)

Where

rf is the risk free rate of return

p is the debt premium

Ti is the investor tax rate

TAMRP is the tax-adjusted market risk premium

βe is the equity beta

βa is the asset beta

Classical

rd = rf +p

re= rf+ βe ×MRP

βe= βa + βa (1- Tc) ×L/(1-L)

Where

MRP is the market risk premium

4

APPENDIX 2

Details of Parameter Estimates

Debt premium 1.95% 1.95% 1.95% 1.95% 1.95% 1.95%

Leverage 20% 30% 40% 50% 60% 70%

Ba 0.40 0.40 0.40 0.40 0.40 0.40

Bd 0.00 0.00 0.00 0.00 0.00 0.00

TAMRP 7.0% 7.0% 7.0% 7.0% 7.0% 7.0%

Tc 30% 30% 30% 30% 30% 30%

Ti 30% 30% 30% 30% 30% 30%

Ke 7.25% 7.75% 8.42% 9.35% 10.75% 13.09%

Post-taxWACC 6.83% 6.96% 7.10% 7.23% 7.37% 7.51%

Vanilla WACC 7.26% 7.62% 7.98% 8.33% 8.69% 9.04%

Debt premium 1.95% 1.95% 1.95% 1.95% 1.95% 1.95%

Leverage 20% 30% 40% 50% 60% 70%

Ba 0.40 0.40 0.40 0.40 0.40 0.40

Bd 0.00 0.00 0.00 0.00 0.00 0.00

MRP 5.4% 5.4% 5.4% 5.4% 5.4% 5.4%

Tc 30% 30% 30% 30% 30% 30%

Ti 30% 30% 30% 30% 30% 30%

Ke 7.89% 8.16% 8.52% 9.03% 9.78% 11.04%

Post-tax WACC 7.34% 7.25% 7.16% 7.07% 6.98% 6.89%

Vanilla WACC 7.78% 7.91% 8.04% 8.17% 8.30% 8.43%

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