Insights Into Double Leverage

1. Insights Into Double Leverage Roger A. Morin, PhD Emeritus Professor of Finance Robinson College of Business, Georgia State University Distinguished Professor of Finance for Regulated Industry Center for the Study of Regulated Industry Chairman & CEO Utility Research International

2. Presentation Content • Basic Notion of Double Leverage • Alternative Approaches to Determine the Cost of Capital for a Subsidiary of a Parent • Conceptual Issues • Practical Issues • Conclusions

4. Cost of CapitalFundamental Principle = Cost of Capital Return

5. Cost of CapitalFundamental Principle = Opportunity Cost Cost of Capital

6. What Is Double Leverage? “Double Leverage”: Situation where there is initial leverage (debt) on the earnings for the operating company's common stock and then additional leverage for the holding company's common stock to the extent that the holding company obtains part of the funds invested in the subsidiary's common stock from debt sources.

7. Schematic Parent Company D Kdp Assets Operating Company K E Kep D Kds 7 Assets Kes E

8. Two Methods of Computing Subsidiary Cost of Capital • Stand-Alone or Independent Company Approach • Double Leverage Approach

9. Stand-Alone Approach Operating Company D Kd 9 Assets E Ke

10. Stand-Alone Approach Operating Company Kd = 10% D = 0.50 10 Assets E = 0.50 Ke = 20%

11. STAND-ALONE APPROACHCalculations to Determine the Allowed Return

12. Double Leverage Approach Parent Company D Kdp Assets Operating Company K E Kep D Kds 12 Assets Kes E

13. Double Leverage Approach Parent Company Kdp = 10% D = 0.25 13 Assets Kep = 15% E = 0.75

16. Double Leverage Approach Parent Company D Kdp Assets Operating Company K E Kep D Kds 16 Assets Kes E

17. Modified Double Leverage Approach Parent Company Kdp D Assets Operating Company K E Kep D Kds 17 Assets ? Retained Earnings Kes ? Parent Equity Kes

19. Assessment of Double Leverage • Conceptual Issues • Conceptual validity • Hope & Bluefield • Multiple Estimates of ROE • Multiple Subsidiaries Issue • Fairness • Capital Attraction • Questionable assumptions • Is Double Leverage A Tautology?

20. Returnsgranted an equity investor must be based on the risksto which the investor's capital is exposed and not on the investor's source of funds. Cost of Capital (Return) depends on USE of funds and not on the SOURCE of funds

21. Return is a Function of Risk

22. Assessment of Double Leverage • Conceptual Issues • Conceptual validity • Hope & Bluefield • Multiple Estimates of ROE • Multiple Subsidiaries Issue • Fairness and Capital Attraction • Questionable assumptions • Double Leverage: A Tautology

23. Bluefield “A public utility is entitled to such rates as will 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…”

24. Hope “…By that standard the return to the equity owner should be commensurate with returns on investments in other enterprises having corresponding risks.”

25. Assessment of Double Leverage • Conceptual Issues • Conceptual validity • Hope & Bluefield • Multiple Estimates of ROE • Multiple Subsidiaries Issue • Fairness and Capital Attraction • Questionable assumptions • Double Leverage: A Tautology

26. Parent Company Kdp D Assets Operating Company K E Kep D Kds 26 Assets ? Retained Earnings Kes ? Parent Equity Kes

27. X Parent Company Kdp D Assets Operating Company K E Kep D Kds 27 Assets ? Ke

28. Operating Company D Kd 28 Assets Ke

29. Assessment of Double Leverage • Conceptual Issues • Conceptual validity • Hope & Bluefield • Multiple Estimates of ROE • Multiple Subsidiaries Issue • Fairness • Capital Attraction • Questionable assumptions • Double Leverage: A Tautology

30. Operating SubsidiariesDifferent Risk A B

31. Operating Subsidiaries Different Risk Operating Company A Operating Company B D Kd = 6% Kd = 8% D 31 Assets Assets E Ke = 10% E Ke = 12%

32. Assessment of Double Leverage • Conceptual Issues • Conceptual validity • Hope & Bluefield • Multiple Estimates of ROE • Multiple Subsidiaries Issue • Fairness • Capital Attraction • Questionable assumptions • Double Leverage: A Tautology

33. Assessment of Double Leverage • Conceptual Issues • Conceptual validity • Hope & Bluefield • Multiple Estimates of ROE • Multiple Subsidiaries Issue • Fairness • Capital Attraction • Is Double Leverage A Tautology?

34. Assessment of Double Leverage • Conceptual Issues • Conceptual validity • Hope & Bluefield • Multiple Estimates of ROE • Multiple Subsidiaries Issue • Fairness • Capital Attraction • Is Double Leverage A Tautology?

35. Is Double Leverage a Tautology? Cash Flows to Parent Bondholders & Shareholders = Cash Flows From Parent’s Equity in Each Subsidiary n KdpDp + KepEp = Σ KesEs s n KdpDp / V + KepEp / V = Σ KesEs/V s n But Σ Es = V s n KdpDp / V + KepEp / V = WACCparent = Σ Kes s

36. Is Double Leverage a Tautology? Cash Flows to Parent Bondholders & Shareholders = Cash Flows From Parent’s Equity in Each Subsidiary KdpDp + KepEp = Ke1E1 + Ke2E2 KdpDp / V + Kep Ep / V = Ke1E1 / V + Ke2E2/ V WACC parent= Ke1E1 / V + Ke2E2/ V WACC parent = Weighted Avg of Equity costs of the two Subsidiaries

37. Is Double Leverage a Tautology? WACC parent = Wtd. Avg. of Equity costs of all Subsidiaries WACC parent Wtd. Avg. of Equity costs of all Subsidiaries

38. Conclusion It is not the parent's WACC that determines the subsidiary's cost of equity because the parent's WACC is itself a weighted average of equity costs of all subsidiaries. Double leverage confuses the direction of cause and effect. The equity cost of subsidiaries must be found on a stand-alone basis.

39. Conclusions • Conceptual Issues • Conceptual validity • Hope & Bluefield • Multiple Estimates of ROE • Multiple Subsidiaries Issue • Fairness • Capital Attraction • Questionable assumptions • Logical Circularity of Double Leverage

40. 11.88% becomes the DL allowed return on the subsidiary's total assets. Only with this allowed rate of return, according to the tenets of DL does the parent's equity receive the assumed rate of return of 15%: the parent receives $100 x 11.88% = $11.88, less the interest cost of $6.25, or $5.63, on an equity investment of $37.50, which is a 15% return. And, so it seems, the parent receives the required rate of return. The fundamental flaw is that the assumptions of the example are internally inconsistent and illogical. When an illustration is constructed with an assumed subsidiary cost of equity, the assumed parent cost of equity must be consistent with it. It is not the parent's WACC which determines the subsidiary's cost of equity because the parent's cost of capital is itself a weighted average of equity costs of all subsidiaries. Previous equation makes it clear that the parent Ke is determined by the subsidiary cost of equity, and that parent capital costs cannot determine subsidiary capital costs. Given the cost of debt Kdp, the subsidiary's cost of equity Kes and the amounts of capital, the above equation implies that the parent equity cost consistent with a 20% subsidiary cost of equity is 23.33%: [$50 x 20% - $12.50 x 10%]/ $37.50 = 23.33%