Financial Inputs to

GRIM for the Water

Heater Rulemaking

Analysis

Notice: U.S. Department of Energy

This report was prepared by Arthur D. Little for the U.S. Office of Energy Efficiency

Department of Energy. This report represents Arthur D. Little's and Renewable Energy

best judgment in light of information made available to us. Any 1000 Independence Avenue, SW

use the reader makes of this report, or any reliance upon or Washington, DC 20585

decisions to be made based upon this report are the

responsibility of the reader. Arthur D. Little does not accept

any responsibility for damages, if any, suffered by the reader November 5, 1998

based upon this report.

Arthur D. Little, Inc.

955 L'Enfant Plaza, SW

Suite 8600

Washington, DC 20024

Reference 38250-12

EE-RM-97-900 COMMENT 38PP
Table of Contents

1.0 Introduction ................................................................................................ 1

2.0 GRIM M odel.................................................................................................2

3.0 Financial Inputs to GRIM ........................................................................... 2

3.1 Tax Rate .......................................................................................................... 3

3.2 W orking Capital .............................................................................................. 3

3.3 Selling, General and Administration (SG&A) ................................................ 4

3.4 Research and Development (R&D) ................................................................ 5

3.5 Depreciation .................................................................................................... 5

3.6 Capital Expenditures ....................................................................................... 6

3.7 Cost of Capital/Discount Rate ........................................................................ 6

EE-RM-97-900 COMMENT 38PP
List of Figures

Figure C-1 Using GRIM to perform an industry cash flow analysis ...................... 2

EE-RM-97-900 COMMENT 38PP
List of Tables

Table C -l A verage incom e tax rates ........................................................................................................... 2

Table C-2 Average working capital as a percentage of revenues ................................................................ 4

Table C-3 Selling, General and Administration (SG&A) ........................................................................... 4

Table C-4 Average R&D costs as a percentage of revenues ..................................................................... 5

Table C-5 Average depreciation expense as a percentage of revenues ....................................................... 6

Table C-6 Average capital expenditures as a percentage of revenues.........................................................6

Table C-7 Cost of debt and debt ratio ........................................ ............................. 7

Table C-8 Average rates of return (1990-96) and risk premiums (1926-94) on some securities

(figures in percent per year) ..................................................................... 8

Table C-9 Average Beta values for a Water Heater Manufacturer .............................................................. 9

iii

EE-RM-97-900 COMMENT 38PP
Financial Inputs to GRIM for the Water Heater Rulemaking Analysis

Abstract: The following table illustrates a representative financial structure to be used

for conducting the cashflow analysis of a "strawman " water heater manufacturer.

Assumptions for

Water Heaters

Scenario Description IWater Heaters

Base Year 1998 Beginning year for analytical purposes

Announcement Year 2000 Year in which the regulation announcement is made

Standard Year 20031Year in which the regulation takes effect

Tax Rate 35.8%

Discount Rate for NPV 7.88%

Inflation Rate per annum

Working Capital 12.91% of Revenue

Standard SG&A 11.06% of Revenue

Research and Development 2.1% of Revenue

Ordinary Depreciation 3.09%of Revenue

Ordinary Capital Expenditures -3.71% of Revenue

Financial Inputs to GRIM for the Water Heater Rulemaking Analysis

1.0 Introduction

The Department of Energy proposes to use the Government Regulatory Impact Model

(GRIM) to calculate the financial impacts of new standards on manufacturers of water

heaters.

Given the relatively small number of firms in the industry, the Department proposes to

create an industry cash flow analysis using a bottom-up approach. Essentially each

manufacturer would provide its own cash flow analysis to be aggregated with all other

manufacturer submittals. In order to facilitate individual manufacturer analysis, the

Department will prepare baseline scenarios for a strawman manufacturer using publicly

available financial information. The objective of this document is to outline and

document the basis of financial assumptions to be used in GRIM when performing the

cash flow analyses for a strawman water heater manufacturer. Manufacturers will be able

to modify relevant parameters to meet their own situation (price, cost, financial

parameters, shipments, etc.).

EE-RM-97-900 COMMENT 38PP
2.0 GRIM Model

The GRIM model is used to conduct a standard annual cash flow analysis that uses price,

quantity, and cost information to assess the impact of regulatory conditions on

manufacturer income and cash flow. This process is represented in Figure C-1.

Price _ I Manufacturing Costs

Quantity Financial Information

Cash Flow

Figure C-1. Using GRIM to perform an industry cash flow analysis

3.0 Financial Inputs to GRIM

Prior to initiating the cash-flow analysis, financial data on variables such as tax rate,

working capital, depreciation, cost of capital, etc., need to be input into GRIM. To obtain

estimates for these inputs DOE has analyzed information available from publicly

available sources of firm-specific financial information for major water heater

manufacturers-SEC-10K Reports, Dun and Bradstreet Company Data Reports, and

Standard & Poor's (S&P) Stock Reports and Value Line Reports.

Water heater manufacturers are not a homogeneous group. However, for the purpose of

the GRIM cash flow analysis, only the water heater segment of each firm's operations is

considered. Thus financial information relevant to the GRIM analysis should be

representative of plant level statistics to the extent possible. Where firm specific data are

to be used these should be drawn only from firms with a substantial portion of their

operations concentrated in water heater manufacturing.

Value Line and Standard and Poor's (S&P) composite industry statistics for the home

appliance industry were reviewed. Value Line's statistics for the home appliance

industry are a composite of the following companies: Whirlpool, Maytag, Fedders Corp.,

Black and Decker, Toro and National Presto Industries. In S&P reports, appliance

manufacturers are included in the "Household Furnishings and Appliance" industry. The

S&P statistics are a composite of the following companies: Armstrong World, Basset

Furniture, Fedders Corp., Maytag, Mohasco, Roper, Rubbermaid, Whirlpool, White

Consolidated Industries and Zenith Electronics. Given the composition of the industry

composites, water heater manufacturer specific financial information was given greater

weight.

2

EE-RM-97-900 COMMENT 38PP
The tables in the following sub-sections present historical financial data obtained from

the sources previously described.

3.1 Tax Rate

Firms pay an annual tax, levied by the federal and state governments, based on income.

Taxable income and the income taxes paid are presented as separate line items in a

company's income statement. Table C-1 presents the effective income tax rates for one

water heater manufacturer over the period 1995-1997. This information was obtained

from the manufacturers' income statements, by dividing the income taxes paid by the

taxable income. The marginal tax rates paid by diversified manufacturers for their water

heater operations is difficult to estimate and may or may not be reflected by the

"effective" tax rate on financial reports. The tax rate for the industry composite, as

reported by Value Line is higher than for the manufacturer.

Table C-1. Average income tax rates

Manufacturer Avg. Tax Rate Year

A 35.8% 1995-1997

Value Line 40.0% 1990-1996

The Department proposes using an income tax rate of 35.8% as an input to GRIM. This

value is based on the manufacturer average tax rate.

3.2 Working Capital

Working capital is defined as the difference between a firm's short-term (or current)

assets and short-term (or current) liabilities. It is the part of a company's capital that

must be maintained in order to under take day-to-day operations of the company without

experiencing liquidity problems. Because cash inflows and outflows are not

synchronized, a firm needs to maintain access to cash either from its own liquidity

portfolio, or from back-up liquidity. This capital cannot be used in the investing activities

of the company.

Table C-2 presents average working capital maintained by a major water heater

manufacturer as a percentage of its annual revenues over the period 1996-1997. Working

capital is also presented for the home appliance industry composite as reported by Value

Line. Working capital is calculated by subtracting current liabilities from current assets

of the firm, where the current assets and liabilities are obtained from the firm's annual

balance sheets.

3

EE-RM-97-900 COMMENT 38PP
Table C-2. Average working capital as a percentage of revenues

Manufacturer Working Capital as Year

: ____% of Revenues ____

A 28.3% 1997

A 12.91% 1996

Value Line 6.76% 1990-1996

Based on information available in Table C-2, the Department will assume working

capital to be 12.91% of revenues for input into GRIM.

In general, companies will strive to lower their working capital to the lowest amount

possible to free up as much cash flow as possible for revenue-generating investing

activities. According to Standard & Poor's, in the last few years improved workingcapital management techniques have greatly reduced the investment that has traditionally

been required.

3.3 Selling, General and Administration (SG&A)

Table C-3 presents average SG&A expenses for a major water heater manufacturer as a

percentage of its annual revenues. The data has been averaged over four years, 1994

through 1997. SG&A information is presented as a line item in individual

manufacturers' income statements, presented in SEC 10-K reports.

Table C-3. Average SG&A expense as a percentage of revenues

Manufacturer SG&A as % of Year

Revenues

A 11.06 1991-1997

Selling costs include any expense or class of expense incurred in selling or marketing. In

a manufacturing firm, selling costs include both marketing (order getting) costs and

logistics (order-filling) costs. Marketing costs include market research, advertising,

point-of-sale promotions, and salespersons' compensation and travel costs. Logistics

costs include warehousing and delivery costs as well as record-keeping costs associated

with processing an order.

General and Administrative (G&A) costs are expenses incurred for the general direction

of the enterprise. G&A costs include the cost of service and staff units (such as the

personnel office) and general corporate costs, including compensation of top

management and donations to charitable organizations.

The Department proposes using a value 11.06% of revenues for SG&A expense as an

input to GRIM.

4

EE-RM-97-900 COMMENT 38PP
3.4 Research and Development (R&D)

Table C-4 presents the R&D costs incurred by a major water heater manufacturer as a

percentage of its annual revenues. The R&D cost data has been averaged over the past

four years, 1991 through 1997.

Table C-4. Average R&D costs as a percentage of revenues

Manufacturer Avg. R&D Cost

as % of Revenues

(1991-1997)

A 2.11

The separate disclosure of research and development expense is a relatively recent

requirement. Formerly, most companies included this expense as a part of general and

administrative expenses. Because the amount spent on research and development can

provide an important clue as to how energetic the company is in keeping its products and

processes up to date, Federal Accounting Standards Board (FASB) requires that this

amount be reported separately if it is material.

Based on the information in Table C-4, the Department proposes using R&D expense as

2.11% of revenues for input into GRIM.

3.5 Depreciation

Plant and manufacturing equipment assets have limited useful lives; that is, they will

provide service to the firm over a limited number of future accounting periods. A

fraction of the cost of these assets is therefore properly chargeable as expense in each of

the accounting periods in which the assets provide service to the firm. The accounting

process for this gradual conversion of plant and equipment capitalized cost into expense

is called depreciation.

Table C-5 presents average depreciation for a major water heater manufacturer as a

percentage of its annual revenues. The data has been averaged over eight years, 1990

through 1997. Depreciation is presented as a separate line item in the manufacturers'

income statements as presented in SEC 10-K reports.

5

EE-RM-97-900 COMMENT 38PP
Table C-5. Average depreciation expense as a percentage of revenues.

Manufacturer Depreciation as % Year

of Revenues

A 3.09 1991-1997

Value Line 3.66 1990-1996

Based on information in Table 5, the Department proposes using a value of 3.09% of

revenues for depreciation expense as an input into GRIM.

3.6 Capital Expenditures

These are the expenditures made for additions to fixed assets, like plant, equipment, etc.,

intended to benefit future accounting periods (in contrast with other expenditures that

benefit the current period). These expenditures are aimed at increasing the capacity,

efficiency, life span, or economy of the operation of an existing fixed asset, or, in some

cases, to build entirely new assets.

Table C-6 presents average capital expenditures for a major water heater manufacturer as

a percentage of its annual revenues. The data has been averaged over eight years, 1991

through 1997. The table also presents data from the 1992 Census of Manufactures.

Table C-6. Average capital expenditures as a percentage of revenues

Manufacturer Capital Expenditures Year

as % of Revenues

A 3.71 1995-1997

Census of Manufactures 0.71 1992

The Department has no corresponding value for depreciation from the Census of

Manufactures. Hence the Department proposes to use the capital expenditure information

available from the 10-K financial reports of Manufacturer A. Based on information in

Table C-6, the Department proposes using capital expenditures as 3.71% of base year

revenues for input into GRIM.

3.7 Cost of Capital/Discount Rate

Cost of capital is a measure of a company's cost of using capital that it raises either

through loans (i.e., debt) or by issuing equity. It is the minimum rate of return that must

be earned on new investments that will not dilute the equity of the shareholders. This

rate of return is often referred to as the discount rate, hurdle rate, or the opportunity cost

of capital.

The company cost of capital is a weighted average of the returns that investors expect

from various debt and equity securities issued by the firm. It is calculated as the cost of

6

EE-RM-97-900 COMMENT 38PP
debt capital (which is then adjusted for the income tax effect of debt financing) plus the

cost of equity capital, weighted by the relative amount of each in a company's capital

structure. For the purpose of characterizing financial impacts of regulations on

manufacturers using GRIM, the Department proposes using the company cost of capital

to discount future cash flows for arriving at the water heater industry value.

In order to calculate the company cost of capital, it is essential to identify a company's

cost of raising debt, cost of raising capital through issuing equity, and the capital structure

of the company. Capital structure of a company gives information about the amount of

debt versus the amount of equity in the company.

Cost of debt: Cost of debt is a weighted average cost of debt based on all forms of debt

financing outstanding. Information on the amount of debt outstanding and the interest

rate at which it was issued was obtained from SEC 10-K financial statements and

Moody's reports for a major publicly traded water heater manufacturer. The water heater

manufacturer has a line of credit available from a group of banks. In addition the

company can raise debt through offering corporate bonds. The company's corporate

bonds have been rated by Moody's rating services.

Debt ratio is defined as the ratio of long-term debt to total long-term capital (i.e., longterm debt plus equity), and illustrates a company's capital structure.

Table C-7. Cost of debt and debt ratio

Manufacturer Debt Ratio Cost of Debt

1997 1997

A 0.281 6.73%

Cost of equity: Cost of equity is the rate of return that equity investors expect to earn on

their investments in a company's stock. These expectations are reflected in the market

price of the company's stock. One way of estimating the cost of equity is by using the

capital asset pricing model (CAPM). The CAPM is based on the premise that the

expected or the required rate of return on any firm's common stock equals the riskless

rate of interest plus a premium for risk. The CAPM is widely used by large corporations

to estimate their costs of equity.' Another method that could be used to determine the

cost of equity is the historical rate of return to the stockholder.

According to the CAPM, the cost of equity, or, the expected return for equity, is

determined as:

cost of equity = riskless rate + beta * [risk premium]

where:

I For more information on CAPM refer to Chapters 7, 8 and 9 of Corporate Finance by Brealey, R.A., and

Myers, S.C.; and the article entitled Does Capital Asset Pricing Model Work by Mullins, D.W., published

in the Harvard Business Review.

7

EE-RM-97-900 COMMENT 38PP
riskless rate is usually the short-term Treasury bill rate, or the long-term government

bond rate adjusted for the risk premium over Treasury bills,

risk premium is the difference between the expected return on the market portfolio and

the riskless rate, and

beta is a measure of the sensitivity of a company's stock to market movements.

Table C-8 presents yields on Treasury bills and government bonds, and the average risk

premium associated with these securities. Each portfolio offers different degrees of risk.

Treasury bills are about as safe an investment as one can make. There is little risk of

default, and their short maturity means that the prices of Treasury bills are relatively

stable. However, investors cannot lock in a real rate of return; there is still some

uncertainty about inflation. By switching to long-term government bonds, investors

acquire an asset whose prices fluctuate as interest rates vary. (Bond prices fall when

interest rates rise and rise when interest rates fall.) An investor who switches from

government bonds to common stocks has a direct share in the risks of the enterprise, and

hence accepts the additional default risk. Investors who accepted the extra risk of

common stocks received, on average, a premium of 8.5 % a year over the return on

Treasury bills.

Table C-8. Average rates of return (1990-96) and risk premiums (1926-94) on some

securities (figures in percent per year)

Portfolio Average Annual Average Risk

Rate of Return 2 Premium3

(Nominal) (Extra return vs.

Treasury bills)

: (____~___________ (1990-96) (1926-94)

Treasury bills 5.00 0

Government bonds (10 yr.) 7.06 1.5

Common stocks (S&P 500 index) 8.5

Table C-9 presents average values of beta for a water heater manufacturer. The data has

been averaged over the period 1990-97. The values of beta are obtained from financial

services provided by the Dow Jones Company. They measure the sensitivity of a stock's

price to overall fluctuations in the S&P 500 stock index. Beta measures the sensitivity of

the return on an individual stock to the return on the market portfolio. A stock with a

beta of 1 tends to move up and down the same percentage as the market. Stocks with a

beta coefficient less than 1 tend to move in percentage terms less than the market.

Similarly, a stock with a beta that is higher than 1 will tend to move up and down more

than the market.

2 Based on data from the Federal Reserve Statistical Release.

3Source: Ibbotson Associates, Inc., Stocks, Bonds, Bills, and Inflation, 1994 Yearbook

8

EE-RM-97-900 COMMENT 38PP
Table C-9. Average Beta values for a Water Heater Manufacturer

Manufacturer Beta

(1990-97)

A 0.84

Using CAPM to calculate the cost of equity, the following results are obtained for the

water heater manufacturer:

Manufacturer A: Cost of equity= (7.06-1.5) + 0.84 * (8.5) = 12.7%

[riskless rate] beta * [risk premium]

Adjusting for inflation (averaging 3.27% per year over the period 1990-97), the real cost

of equity for Manufacturer A is 9.43%.

Weighted Average Cost of Capital (WACC) is defined as:

WACC = (1-tax rate) * cost of debt * [debt/(debt+equity)] +

cost of equity * [equity/(debt+equity)]

Manufacturer A: WACC = [(1-0.358) * 6.73 * 0.281 ] + [9.43 * (1-0.281)] = 7.99%

The weighted average cost of capital accounts for inflation, as real values of cost of

equity and debt are used in the calculation. In calculating WACC it is assumed that the

manufacturer maintains the same capital structure in the future, i.e. future debt ratios

remain the same as in the past (see Table C-7).

Independent estimates of the WACC were obtained from Ibbotson Associates, a company

that tracks the industry cost of capital for over 300 industries. Their analysis reports a

WACC of 11.6% for the household appliance industry (represented by the SIC code 363)

in the year 1997. Adjusting for inflation (2.2% in 1997), the WACC net of inflation

would be 9.4 %.

The Department proposes using a WACC of 7.99% as the real cost of capital for

discounting future cash flows in GRIM, i.e. the discount rate for the industry NPV.

9

EE-RM-97-900 COMMENT 38PP