the proper treatment of flotation costs in the...

Addressing Flotation Costs in the Cost of Capital

Randy Wright State Tax Commission of Missouri

[email protected]

Scott Dickman New Hampshire Dept. of Revenue

[email protected]

Norm Ross PacifiCorp

[email protected]

46th Annual Wichita Program Appraisal for Ad Valorem Taxation

of Communication, Energy and Transportation Properties

Session Outline • Foundational Concepts

• Sources for Flotation Cost Data

• Adjusting for Flotation Costs – The Math

• Commonly Stated Reasons for Not Adjusting the Cost of Capital for Flotation Costs

• One Final Issue…

Fees other than interest paid in order to obtain money

What are Flotation Costs?

Underwriting fees Printing costs Credit rating agency fees Legal fees Accounting fees Registration fees

Foundational Concepts

MARKET VALUE: a type of value, stated as an opinion, that presumes the transfer of a property…

The Appraisal Foundation, Uniform Standards of Professional Appraisal Practice, 2016-2017 Edition, p. 3.

The common definitions of market value all assume a sale of the subject property...

Appraisal Institute, The Appraisal of Real Estate, 14th ed., (Chicago, IL: 2013), p. 380, 408.

Buyer

Seller



Capital Source Rate Weight Result

Debt 4.00% x 40.00% = 1.60%Equity 10.00% x 60.00% = 6.00%

100.00% 7.60%

Weighted Average Cost of CapitalTotal

The cost of financing includes the interest rate and any points, discounts, equity participations, or other charges that the lender requires to increase the effective yield on the loan.

Appraisal Institute, The Appraisal of Real Estate, 14th ed., (Chicago, IL: 2013), p. 109

• Primary Markets

– Where Securities are Created and Marketed through Underwriters or Sold through Private Placement

– Where Securities are Sold from Issuer to Investor

– Where Corporations Go to Raise New Capital

• Secondary Markets

– NASDAQ, NYSE

– Where Securities are Sold from Investor to Investor

– Where Investors Go to Receive a Return on Capital


Bond Yield to Maturity Rates Inputs for CAPM, DCF, Risk Premium Models

Underwriting, Accounting, and Legal Fees, etc.

Foundational Concepts The total cost of capital includes the amounts paid out in the form of interest or dividends plus numerous other expenses incurred when issuing debt and equity securities

Partial Cost of Capital

Total Cost of Capital

Primary Markets Secondary Markets

YTM

1. Price Paid 2. Coupon Rate 3. Years until

Bond Matures 4. Payment

Frequency 5. Par Value

http://www.sec.gov/edgar/searchedgar/webusers.htm

EDGAR – The SEC’s Electronic Data Gathering, Analysis and Retrieval System

Sources for Flotation Cost Data…

http://www.sec.gov/edgar/searchedgar/webusers.htm


CIK Central Index Key

CFR Title 17, Part 230, Regulation C - GENERAL RULES AND REGULATIONS, SECURITIES ACT OF 1933 http://www.ecfr.gov/cgi-bin/text-idx?SID=5e0a497906fbedf3447029527b154bf1&mc=true&node=pt17.3.230&rgn=div5#se17.3.230_1424



Total Price to Public 4,192,142,500$

Discounts to Par 7,857,500$

Gross Bond Issue 4,200,000,000$

28,300,000$


Exelon’s Acquisition of Pepco Holdings Closed on March 23, 2016

Corporate Notes Common Shares Equity UnitsJune 2015 June 2014 June 2014

Gross Issue a 4,200,000,000$ 2,012,500,000$ 1,150,000,000$ 7,362,500,000$

Discounts from Par b 7,857,500$ 7,857,500$ Underwriting Discounts c 28,300,000$ 60,375,000$ 34,500,000$ 123,175,000$ Other Expenses d 5,900,000$ 600,000$ 400,000$ 6,900,000$

Total Flotation Costs e (b+c+d) 42,057,500$ 60,975,000$ 34,900,000$ 137,932,500$

Flotation Costs as a % f (e ÷ a) 1.0014% 3.0298% 3.0348%

Total

Public Utility Financing Tracker 2775 State Route 147, Vienna, IL 62995 (630) 569-0548 $375/Annually

If there are flotation costs, the issuing company receives only a portion of the capital provided by investors, with the remainder going to the underwriter. To provide investors with their required rate of return given that less money is available to the company than the amount the investors put up, then each dollar received must “work harder,” that is, it must earn a higher rate of return than the investors required on the funds they put up.

Brigham, Eugene, and Joel F. Houston, Fundamentals of Financial Management, (Mason, OH: Thompson South-Western, 2007), p. 341.

Adjusting for Flotation Costs - The Math

Issuance of $1,000 in Common Stock

RE = $100 / $1,000

RE = 10.00%

RE = $100 / $950

RE = 10.53%

Key Question: Given Flotation Costs, How Much Harder Does the $950 Have to Work? .53%


USE OF PROCEEDS

We expect to receive approximately $271 million in net proceeds…We intend to use the net proceeds of this offering…[when financing] the NMGC Acquisition…

New Mexico Gas Company

Natural Gas Distribution Company Serving Approximately 500,000 Customers

Transaction Closed in September 2014

Prospectus Common Gross Proceeds Net ProceedsIssuer Date Shares to Issuer Underwriting Other Exp. Total to Issuer

a b c (a x b) d e f (d + e) g (c - f) h (f ÷ c)

TECO Energy 07/01/14 15,500,000 18.10$ 280,550,000$ 9,468,640$ 350,000$ 9,818,640$ 270,731,360$ 3.50%

Divisor i (1 - h) 96.50%Pre Flotation Cost Equity Rate j 10.00%Flotation Cost Adjusted Equity Rate k (j ÷ i) 10.36%

ISSUANCE COSTS ASSOCIATED WITH EQUITY

Price to Public

Issuance CostsIssuance Cost %

Flotation Costs Associated with Equity


USE OF PROCEEDS

We anticipate our net proceeds from the sale of the bonds will be approximately $321.3 million…We intend to use the net proceeds… to finance…our purchase of a power block at the Union Power Station…

Union Power Station

Four Unit Combined Cycle Natural Gas Fired Electric Generation

Facility in Union County, Arkansas

Transaction Closed in March 2016

Prospectus Gross Bond Gross Proceeds Net ProceedsIssuer Date Issue to Issuer Underwriting Other Exp. Total to Issuer

a b c (a x b) d e f (d + e) g (c - f) h ((a - g) ÷ a)

Entergy, AR 01/05/16 325,000,000$ 0.9967 323,930,750$ 2,112,500$ 550,000$ 2,662,500$ 321,268,250$ 1.15%

Income Tax Rate i 38.00%Divisor j (1 - (h x (1-i))) 99.29%Pre Flotation Cost Debt Rate k 5.00%Flotation Cost Adjusted Debt Rate l (k ÷ j) 5.04%

Price to Public


ISSUANCE COSTS ASSOCIATED WITH DEBTFlotation Costs Associated with Debt

** 1 – (1.15% x (1 – 38%)) = 99.29%

**

Takeaways: • The cost of issuing stock should not be tax affected

because such costs are not deductible for income tax purposes

• The cost of issuing debt should be tax affected because such costs are deductible for income tax purposes

• Stock issuance costs should account for all direct costs of issuing new securities, including underwriting, legal, accounting, registration fees, etc.

• Debt related issuance costs should include all direct issuance costs as well as the impact of any premium or discount

Commonly Stated Reasons for Not Adjusting the Cost of Capital for Flotation Costs

1. Acquisitions are Typically Funded out of Retained Earnings

2. Flotation Costs are Immaterial

3. Flotation Costs Should be Accounted for as a Reduction in Cash Flows and Not as an Adjustment to the Rate

Reason 1: Are Acquisitions Typically Funded out of Retained Earnings?

Does the Typical Buyer Have Sufficient Cash So That There is No Need to Access the Capital Markets?

$1.5

$0.2 $0.3 $0.7

$0.3

$2.0

$0.1

$1.9

$0.1 $0.6

$0.0 $0.2 $0.4

$0.7 $0.5

$7.4

$0.5

$8.7

$6.1

$2.0

$8.6

$10.9

$2.3

$12.8

$1.5

$5.3

$8.2

$9.6

$0

$2

$4

$6

$8

$10

$12

$14

AES AEP CNP ED D DUK EIX EXC FE NEE NI PCG PEG SO

In b

illio

ns

Cash and Cash EquivalentsRetained Earnings

Source: SEC Form 10-K - Data as of December 31, 2014

On Average, Cash Represents < 11% of Retained Earnings


Takeaway: The Balance within a Company’s Retained Earnings Account Does Not Represent the Amount of Available or Unspent Cash


Cash - $151m or 2.8% of Reinvested Earnings

Year Capital Issuer Gross Offering Use of Proceeds

1997 Senior Notes CalEnergy Company $350,000,000 Acquisition of interest in international power generation projects1998 Senior Notes CalEnergy Company $100,000,000 Acquisition of MidAmerican Energy Holdings Company1998 Senior Notes CalEnergy Company $215,000,000 Acquisition of MidAmerican Energy Holdings Company1998 Senior Notes CalEnergy Company $260,000,000 Acquisition of MidAmerican Energy Holdings Company1998 Senior Notes CalEnergy Company $450,000,000 Acquisition of MidAmerican Energy Holdings Company1998 Senior Notes CalEnergy Company $475,000,000 Acquisition of MidAmerican Energy Holdings Company1999 Notes PPL Corp. $500,000,000 Acquisition of Montana Power's Generation Assets2000 Notes Allegheny Energy, Inc. $165,000,000 Acquisition of Mountaineer Gas Company2000 Notes KeySpan Corp. $700,000,000 Acquisition of Eastern Enterprises and EnergyNorth, Inc.2000 Notes KeySpan Corp. $700,000,000 Acquisition of Eastern Enterprises and EnergyNorth, Inc.2000 Notes KeySpan Corp. $250,000,000 Acquisition of Eastern Enterprises and EnergyNorth, Inc.2001 Senior Notes DTE Energy Company $250,000,000 Acquisition of MCN Energy Group, Inc.2001 Senior Notes DTE Energy Company $500,000,000 Acquisition of MCN Energy Group, Inc.2001 Senior Notes DTE Energy Company $600,000,000 Acquisition of MCN Energy Group, Inc.2001 Notes Energy East Corp. $250,000,000 Acquisition of RGS Energy2001 Notes FirstEnergy Corp $1,000,000,000 Acquisition of GPU, Inc.2001 Notes FirstEnergy Corp $1,500,000,000 Acquisition of GPU, Inc.2001 Notes FirstEnergy Corp $1,500,000,000 Acquisition of GPU, Inc.2001 Senior Notes Utilicorp United $250,000,000 Various, Including acquisitions (i.e., St. Joseph Light & Power)2002 Senior Notes Dominion Resources $300,000,000 Acquisition of Cove Point LNG Partnership from Williams Companies2002 Senior Notes Dominion Resources $300,000,000 Acquisition of Cove Point LNG Partnership from Williams Companies2002 Notes Energy East Corp. $400,000,000 Acquisition of RGS Energy2003 Notes Black Hills Corp. $250,000,000 Acquisition of Mallon Resources Corporation, Cogeneration Faciltiy2006 Notes National Grid $1,000,000,000 Acquisition of KeySpan2006 Senior Notes NRG Energy, Inc $1,200,000,000 Acquisition of Texas Genco LLC2006 Senior Notes NRG Energy, Inc $2,400,000,000 Acquisition of Texas Genco LLC2008 Senior Notes UGI Utilities $108,000,000 Acquisition of PPL Gas2009 Notes Black Hills Corp. $250,000,000 Acquisition of Aquila Electric and Gas properties

Debt Securities

Do Buyers Typically Issue New Securities When Acquiring Centrally Assessed Property?

Do Buyers Typically Issue New Securities When Acquiring Centrally Assessed Property?

Year Capital Issuer Gross Offering Use of Proceeds

1999 Common AES Corp $800,625,000 Acquisition of CILCORP and Drax1999 Preferred CMS Energy $300,875,000 Acquisition of Panhandle Companies1999 Preferred OGE Energy Corp. $200,000,000 Acquisition of Transok pipeline.2000 Common Dynegy $467,500,000 Reduce debt resulting from Illinova acquisition.2001 Common Allegheny Energy, Inc. $598,300,000 Fund subsidiary's acquisition of 3 generating facilities in IL, IN, and TN.2001 Preferred Energy East Corp. $300,000,000 Acquisition of RGS Energy2001 Common Utilicorp United $297,600,000 Various, Including acquisitions (i.e., St. Joseph Light & Power)2002 Common Ameren $222,750,000 Acquisition of CILCORP2002 Common Ameren $294,000,000 Acquisition of CILCORP2002 Common Aquila $281,250,000 Prefund Cogentrix acquisition2003 Common Black Hills Corp $108,000,000 Acquisition of Mallon Resources Corp.2003 Common Constellation Energy $227,700,000 Acquisition of R.E. Ginna Nuclear Power Plant2004 Common Ameren $875,000,008 Acquisition of Illinois Power2004 Common Ameren $420,000,000 Acquisition of Illinois Power2004 Common PNM Resources $90,984,000 Acquisition of Texas-New Mexico Power2005 Common Pinnacle West $222,600,000 Acquisition of Sundance Power Plant2005 Equity Units PNM Resources $215,000,000 Acquisition of Texas-New Mexico Power2006 Common PNM Resources $153,950,000 Acquisition of Twin Oaks2007 Common ITC Holdings $280,000,000 Acquisition of IP&L Transmission Assets2008 Common Unitil $40,000,000 Acquisition of Northern Utilities and Granite State2009 Common Unitil $48,000,000 Acquisition of Northern Utilities and Granite State2010 Equity Units PPL Corp. $1,000,000,000 Acquisition of E.ON's Kentucky Utilities Group2010 Common PPL Corp. $2,160,000,000 Acquisition of E.ON's Kentucky Utilities Group

Equity Securities

1. In Friday’s mail, your bank notifies you that your 5.00% mortgage interest rate will now be 5.15%

2. Next Monday, upon arriving at work, your boss informs you that your salary has been reduced by 3%

3. Next Tuesday’s WSJ reports that a company representing 3% of your retirement portfolio is bankrupt

Reason 2: Are Flotation Costs Material?

Indifference Something Other than Indifference

Expense

Income

Net Worth

Do Seemingly Small Amounts Matter to Investors?

0.3% Difference in Rate of Return = $208,000, or 8.5%

Market Value The most probable price…with the buyer and seller each acting prudently, knowledgeably, and for self-interest...

Appraisal Institute, The Appraisal of Real Estate, 14th ed., (Chicago, IL: 2013), p. 58.

$88 $315

$905

$2,434

$89 $326

$958

$2,642

$-

$500

$1,000

$1,500

$2,000

$2,500

$3,000

35 45 55 65

Tho

usan

ds

Age

Bob's Roth IRA - 10.0% ROI

Sue's Roth IRA - 10.3% ROI

Source: 2016 Investment Company Fact Book, 56th Edition, Investment Company Institute, p. 45. (WWW.ICIFACTBOOK.ORG)


Flotation Costs are Not Immaterial in Amount

Prospectus Common Shares Gross Proceeds Net ProceedsIssuer Date or Equity Units to Issuer Underwriting Other Exp. Total to Issuer

a b c (a x b) d e f (d + e) g (c - f) h (f ÷ c)

PPL Corp 06/24/10 103,500,000$ 24.00$ 2,484,000,000$ 74,520,000$ 500,000$ 75,020,000$ 2,408,980,000$ 3.02%PPL Corp 06/24/10 23,000,000$ 50.00$ 1,150,000,000$ 34,500,000$ 500,000$ 35,000,000$ 1,115,000,000$ 3.04%

PPL Corp 04/13/11 92,000,000$ 25.30$ 2,327,600,000$ 69,828,000$ 1,000,000$ 70,828,000$ 2,256,772,000$ 3.04%PPL Corp 04/13/11 19,550,000$ 50.00$ 977,500,000$ 29,325,000$ 1,000,000$ 30,325,000$ 947,175,000$ 3.10%

6,939,100,000$ 211,173,000$ 6,727,927,000$

ISSUANCE COSTS ASSOCIATED WITH EQUITY

Price to Public


Issuance Costs Associated with PPL’s Acquisition of E.On’s U.S. Business

Reason 3: Should Flotation Costs be Accounted for as a Reduction in Cash Flows and Not as a Rate Adjustment?

This way of dealing with flotation costs is discussed in textbooks that focus on the valuation of a project, not on the purchase of an entire unit of operating property

Financing a project is different than financing a purchase

$ Cost of

Financing

Cash Flows

Market Value

$ Amount to Be

Financed Deducting flotation costs from

cash flows is problematic because the value of property must be known in order to estimate the amount of flotation costs that will be incurred in a transaction

The $ Cost of Financing Cannot be Known Without

Knowing Value

Revenues 2,000.00$ Revenues 2,000.00$ Less: Operating Expenses (666.67)$ Less: Operating Expenses (666.67)$ Less: Depreciation (250.00)$ Less: Depreciation (250.00)$

1,083.33$ 1,083.33$

Less: Income Taxes (333.33)$ 750.00$

Cost Weight Extended Cost Weight Extended

Debt Rate 5.00% 50% 2.50% Debt Rate 5.00% 50% 2.50%Equity Rate 10.00% 50% 5.00% Equity Rate 10.00% 50% 5.00%

Income Tax Component 3.33%

7.50% 10.83%

NOI $750.00 EBIT $1,083.33k 7.50% Pre Tax Rate 10.83%

= $10,000.00

Capital SourceRate

Income Taxes Deducted from Income Stream

Income Taxes Accounted for in Capitalization Rate

= = $10,000.00

Weighted Average Cost of Capital Pre Tax Cost of Capital

Income Stream Income Stream

EBIT

RateCapital Source

Net Operating Income

EBIT

=

Takeaway: The location of an Income or Expense Item, Whether it be in the Income Stream or in the Rate, Should Not Impact the Resulting Value Estimate

Reason 3: Should Flotation Costs be Accounted for as a Reduction in Cash Flows and Not as a Rate Adjustment?

Unadjusted Cost of Equity 10.00% Unadjusted Cost of Equity 10.00%Flotation Cost Rate 5.00% Flotation Cost Rate 5.00%Flotation Adjusted Cost of Equity 10.53% Return on Investment 10.00%Return on Investment 10.00%

Gross Proceeds From Stock Sale 1,000.00$ Gross Proceeds From Stock Sale 1,000.00$ Less: Flotation Costs 50.00$ Less: Flotation Costs 50.00$ Net Proceeds from Stock Sale 950.00$ Net Proceeds from Stock Sale 950.00$

Operating Property Purchased 950.00$ Operating Property Purchased 950.00$

Required $ ROI $100.00 Return on Return of Total CashFloat Adj. Rate 10.53% Year Investment Investment Return

1 95.00$ 95.00$ 190.00$ 2 85.50$ 95.00$ 180.50$ 3 76.00$ 95.00$ 171.00$ 4 66.50$ 95.00$ 161.50$ 5 57.00$ 95.00$ 152.00$ 6 47.50$ 95.00$ 142.50$ 7 38.00$ 95.00$ 133.00$ 8 28.50$ 95.00$ 123.50$ 9 19.00$ 95.00$ 114.00$

10 9.50$ 95.00$ 104.50$ NPV @ 10.00% 950.00$

Projected Cash Flows

950.00$

Accounting for the Impact of Flotation Costs in the Rate

Accounting for the Impact of Flotation Costs in Cash Flows

Assumptions: Assumptions:

Takeaway: While the Location Shouldn’t Impact Value, Adjusting the Rate is

Best Since Flotation Costs are a Function of the Resulting Value Estimate

Required $ ROI $100.00 Unadjusted Rate 10.00%

1,000.00$

The $1,000.00 result is wrong as that amount represents the value of the stock purchased by the investor, not the value of the property

purchased with the net proceeds of such stock.

By Way of Review…

1. Acquisitions are Not Typically Funded out of Retained Earnings

2. Flotation costs are Immaterial Material

3. Flotation Costs Should Not be Accounted for as a Reduction in Cash Flows…

One Final Issue…

…Which Concerns a Method Used in the Regulatory Context to Account for

Flotation Costs

The Method is Not Suitable in This Context

+ 5.00% KE = + 5.00%

KE =

Net Expected Flotation Cost Adjusted Expected FlotationPrice Per Income Payout Plowback Dividend Flotation Adjusted Dividend Growth Adjusted

Share Per Share Ratio Ratio Per Share Cost Rate Price/Share Yield Rate Cost of Equitya b c d e f g h i j

(1 - c) (b x c) a x (1 - f) (e ÷ g) (b ÷ a) x d (h + i)

ACME Utility 100.00$ 10.00$ 0.00% 100.00% -$ 5.00% 95.00$ 0.00% 10.00% 10.00%ACME Utility 100.00$ 10.00$ 50.00% 50.00% 5.00$ 5.00% 95.00$ 5.26% 5.00% 10.26%ACME Utility 100.00$ 10.00$ 100.00% 0.00% 10.00$ 5.00% 95.00$ 10.53% 0.00% 10.53%

Net Expected Unadjusted FlotationPrice Per Income Payout Plowback Dividend Flotation Dividend Expected Equity Adjusted

Share Per Share Ratio Ratio Per Share Cost Rate Yield Growth Rate Cost Cost of Equitya b c d e f g h i j

(1 - c) (b x c) (e ÷ a) (b ÷ a) x d (g + h) i ÷ (1 - f)

ACME Utility 100.00$ 10.00$ 0.00% 100.00% -$ 5.00% 0.00% 10.00% 10.00% 10.53%ACME Utility 100.00$ 10.00$ 50.00% 50.00% 5.00$ 5.00% 5.00% 5.00% 10.00% 10.53%ACME Utility 100.00$ 10.00$ 100.00% 0.00% 10.00$ 5.00% 10.00% 0.00% 10.00% 10.53%

Standard DCF Formula

+ 5.00% KE = +

D1P0

$5.00

Flotation Cost Adjustment Applied to Total Unadjusted Equity Rate

Flotation Cost Adjusted DCF Formula

+ g

Flotation Cost Adjustment Applied Only to Dividend Yield Component

KE =KE =

KE =

KE =

KE =

g

5.00%

D1P0 - FC

$5.00$100.00 - $5.00

5.26%

10.26%10.00%

5.00%

$100.00

+

This alternative DCF formula is inadequate in this context as it wrongly assumes that…

1. A company that pays no dividends can issue common stock at no cost

2. The cost of issuing new stock increases as the dividend payout ratio increases

Takeaway: In this context, the modified DCF method does not fully account for f flotation costs whenever the payout ratio is assumed to be less than 100%

Disburs. Receipts

Yr Buy Stock

Dividends Net Cash Position

Stock Issuance

Rate of Return Earnings

Buy Assets

Dividends

Net Cash Position

(1,000.00)$ (1,000.00)$ 950.00$ (950.00)$ -$ 1 97.50$ 97.50$ 10.26% 97.50$ (97.50)$ -$

200 97.50$ 97.50$ 10.26% 97.50$ (97.50)$ -$

IRR 9.75%

Disburs. Receipts

Yr Buy Stock

Dividends Net Cash Position

Stock Issuance

Rate of Return Earnings

Buy Assets

Dividends

Net Cash Position

(1,000.00)$ (1,000.00)$ 950.00$ (950.00)$ -$ 1 100.00$ 100.00$ 10.53% 100.00$ (100.00)$ -$

200 100.00$ 100.00$ 10.53% 100.00$ (100.00)$ -$

IRR 10.00%

Takeaway: A 10.53% Equity Rate Will Allow Stock Investors to Receive a 10.00% Return on Investment

Is a 10.26% Flotation Cost Adjusted Equity Rate Sufficient?

Is a 10.53% Flotation Cost Adjusted Equity Rate Sufficient?

Stock Investor Utility CompanyReceipts Disburs.

A 10.26% Equity Rate Will Not Allow Stock Investors to Receive a 10.00% Return on InvestmentTakeaway:

Stock Investor Utility CompanyReceipts Disburs.

Questions?

the proper treatment of flotation costs in the...

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