## Financial Inputs to GRIM forthe Water Heater Rulemaking Analysis

Notice: U.S. Department of Energy This report was prepared by Arthur D. Littlefor 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 usethe 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 responsibilityfor damages, if any, suffered by the reader November 5, 1998 based upon this report.

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### Table of Contents

1.0 Introduction................................................................................................ 1 2.0 GRIM Model.................................................................................................2 3.0 Financial Inputs to GRIM ........................................................................... 2 3.1 Tax Rate
.......................................................................................................... 3 3.2 Working 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 ofCapital/Discount Rate
........................................................................ 6

### List of Figures

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

### List of Tables

Table C-l A verage incometax rates
........................................................................................................... 2 Table C-2 Average working capital as a percentage ofrevenues ................................................................ 4 Table C-3 Selling, General and Administration (SG&A)
........................................................................... 4 Table C-4 Average R&D costs as a percentage ofrevenues ..................................................................... 5 Table C-5 Average depreciation expense as a percentage ofrevenues ....................................................... 6 Table C-6 Average capital expenditures as a percentage ofrevenues.........................................................6 Table C-7 Cost ofdebt and debt ratio
........................................ ............................. 7 Table C-8 Average rates ofreturn (1990-96) andrisk premiums (1926-94) on some securities (figures in percent per year)
..................................................................... 8 Table C-9 Average Beta values for a Water Heater Manufacturer
.............................................................. 9

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### Financial Inputs to GRIM forthe Water Heater Rulemaking Analysis Abstract: The following tableillustratesarepresentative financial structureto be used forconductingthe cashflowanalysisofa "strawman" waterheater manufacturer.
Assumptions for WaterHeaters Scenario Description IWater Heaters Base Year 1998 Beginningyearforanalytical purposes Announcement Year 2000 Yearin which theregulationannouncementis made Standard Year 20031Year in which theregulation takes effect Tax Rate 35.8% Discount Rate forNPV 7.88% Inflation Rate perannum Working Capital 12.91% ofRevenue
Standard SG&A 11.06% ofRevenue Research and Development 2.1% ofRevenue Ordinary Depreciation 3.09%ofRevenue Ordinary Capital Expenditures -3.71% ofRevenue
Financial Inputsto GRIM forthe Water Heater Rulemaking Analysis 1.0 Introduction The Department ofEnergy proposes to use the Government Regulatory Impact Model (GRIM) to calculate the financial impacts ofnew standards onmanufacturers ofwater heaters. Given the relatively small number offirms in the industry, the Department proposes to create an industry cash flow analysis using abottom-up approach. Essentially each manufacturer would provide its own cash flow analysis to be aggregated with all other manufacturer submittals. In orderto facilitate individual manufacturer analysis, the Department will prepare baseline scenarios for a strawman manufacturer using publicly available financial information. The objective ofthis document is to outline and document the basis offinancial 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 theirown situation (price, cost, financial parameters, shipments, etc.).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 theimpact ofregulatory conditions on manufacturer income and cash flow. Thisprocess isrepresented in Figure C-1.

Price

_I Manufacturing Costs
Quantity Financial Information

Cash Flow Figure C-1. Using GRIM to perform an industry cash flowanalysis 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 ofcapital, etc., need to be inputinto GRIM. To obtain estimates for these inputs DOEhas analyzed information available from publicly available sources offirm-specific financial information formajor 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 ahomogeneous group. However, for the purpose of the GRIM cash flow analysis, only the water heater segment ofeach firm's operations is considered. Thus financial information relevant to the GRIM analysis should be representative ofplant level statistics to the extent possible. Where firm specific data are to be used these should be drawn onlyfrom firms with a substantial portion oftheir 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 ofthe 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 ofthe 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.
2The tables inthe 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 theperiod 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 maynot be reflected bythe "effective" tax rate on financial reports. Thetax rate for theindustry composite, as reported by Value Line is higher than for the manufacturer. Table C-1. Average income tax rates Manufacturer Avg.TaxRate Year A 35.8% 1995-1997 Value Line 40.0% 1990-1996
The Department proposes using an income tax rate of35.8% 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 ofa company's capital that must be maintained in order to under take day-to-day operations ofthe company without experiencing liquidity problems. Because cash inflows and outflows are not synchronized, a firm needs to maintain access to cash either from its ownliquidity portfolio, orfrom back-up liquidity. This capital cannotbe used inthe investing activities ofthe company. Table C-2 presents average working capital maintained by a major water heater manufacturer as a percentage ofits annual revenues over the period 1996-1997. Working capital is also presented for the home appliance industry composite asreported by Value Line. Working capital is calculated by subtracting current liabilities from current assets ofthe firm, where the current assets and liabilities are obtained from the firm's annual balance sheets.

3Table C-2. Average working capital as apercentage of revenues Manufacturer Working Capital as Year : ____% ofRevenues

____ 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 tobe 12.91% ofrevenues for input into GRIM. In general, companies will strive to lower their working capital tothe 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 ofits 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 orclass ofexpense 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 ofthe enterprise. G&A costs include the cost ofservice and staffunits (such as the personnel office) and general corporate costs, including compensation oftop management and donations to charitable organizations. The Department proposes using a value 11.06% ofrevenues for SG&A expense as an input to GRIM.

43.4 Research and Development (R&D) Table C-4 presents theR&D costs incurred by a major water heater manufacturer as a percentage ofits annual revenues. The R&D cost data hasbeen averaged overthe past four years, 1991 through 1997. Table C-4. Average R&D costsas apercentage of revenues Manufacturer Avg. R&D Cost as % ofRevenues (1991-1997) A 2.11 The separate disclosure ofresearch and development expense is a relatively recent requirement. Formerly, most companies included this expense as apart ofgeneral and administrative expenses. Because the amount spent on research and development can provide an important clue as to how energetic the company is inkeeping its products and processes up to date, Federal Accounting Standards Board (FASB) requires thatthis amount be reported separately ifit is material. Based on the information in Table C-4, the Department proposes using R&D expense as 2.11% ofrevenues 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 alimited number offuture accounting periods. A fraction ofthe cost ofthese assets is therefore properly chargeable asexpense in each of the accounting periods in which the assets provide service to the firm. The accounting process for this gradual conversion ofplant and equipment capitalized cost into expense iscalled depreciation. Table C-5 presents average depreciation fora major water heater manufacturer as a percentage ofits annual revenues. The data hasbeen averaged over eight years, 1990 through 1997. Depreciation ispresented as a separate line item in the manufacturers' income statements as presented in SEC 10-K reports.

5Table C-5. Average depreciation expense as apercentage of revenues. Manufacturer Depreciation as % Year ofRevenues A 3.09 1991-1997 Value Line 3.66 1990-1996 Based on information in Table 5, the Department proposes using a value of3.09% 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 ofthe operation ofan 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 ofits annual revenues. The data has been averaged over eight years, 1991 through 1997. The table also presents data from the 1992 Census ofManufactures. Table C-6. Average capital expenditures as apercentage of revenues Manufacturer CapitalExpenditures Year as %ofRevenues A 3.71 1995-1997 Census ofManufactures 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 ofManufacturer A. Based on information in Table C-6, the Department proposes using capital expenditures as 3.71% ofbase year revenues for input into GRIM.
3.7 Cost of Capital/Discount Rate Cost ofcapital is a measure ofa company's cost ofusing capital that it raises either through loans (i.e., debt) or by issuing equity. It is the minimum rate ofreturn that must be earned on new investments that will not dilute the equity ofthe shareholders. This rate ofreturn is often referred to as the discount rate, hurdle rate, or the opportunity cost ofcapital. The company cost ofcapital is a weighted average ofthe returns that investors expect from various debt and equity securities issued by the firm. It iscalculated as the cost of
6debt capital (which is then adjusted for the income tax effect ofdebt financing) plus the cost ofequity capital, weighted by the relative amount ofeach in acompany's capital structure. For the purpose ofcharacterizing financial impacts ofregulations on manufacturers using GRIM, theDepartment proposes usingthe company cost ofcapital to discount future cash flows for arriving at the water heater industry value. In order to calculate thecompany cost ofcapital, it is essential to identify a company's cost ofraising debt, cost ofraising capital through issuing equity, and the capital structure ofthe company. Capital structure ofa company gives information about the amount of debt versus the amount ofequity in the company. Cost of debt: Cost ofdebt is a weighted average cost ofdebtbased on all forms ofdebt financing outstanding. Information on the amount ofdebt 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 ofcredit available from a group ofbanks. In addition the company can raise debtthrough offering corporate bonds. The company's corporate bonds have been rated by Moody's rating services. Debt ratio is defined as the ratio oflong-term debtto total long-term capital (i.e., longterm debt plus equity), and illustrates a company's capital structure. Table C-7. Cost ofdebt and debt ratio Manufacturer DebtRatio CostofDebt 1997 1997 A 0.281 6.73% Cost of equity: Cost ofequity isthe rate ofreturn thatequity investors expect to earn on their investments in a company's stock. These expectations are reflected in the market price ofthe company's stock. One way ofestimating the cost ofequity is by using the capital assetpricing model (CAPM). The CAPM is based on the premise that the expected or the required rate ofreturn on any firm's common stock equals the riskless rate ofinterest plus apremium for risk. The CAPM is widely used by large corporations to estimate their costs ofequity.' Another method that could be used to determine the cost ofequity is the historical rate ofreturn tothe stockholder. According to the CAPM, the cost ofequity, or, the expected return for equity, is determined as: cost ofequity = riskless rate + beta * [riskpremium] where:

IFor more information on CAPM refer to Chapters 7, 8 and 9 ofCorporateFinanceby Brealey, R.A., and Myers, S.C.; and the article entitled Does Capital Asset PricingModel Work by Mullins, D.W., published in the Harvard Business Review. 7riskless rateis usually the short-term Treasury bill rate, or the long-term government bond rate adjusted for the riskpremium over Treasury bills, risk premiumis the difference between the expected return on the market portfolio and the riskless rate, and beta is ameasure ofthe sensitivity ofa 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 ofrisk. 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 ofTreasury bills are relatively stable. However, investors cannot lock in areal rate ofreturn; 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.) Aninvestor who switches from government bonds to common stocks has adirect share inthe risks ofthe enterprise, and hence accepts the additional default risk. Investors who accepted the extra risk of common stocks received, on average, apremium of 8.5 % a year overthe return on Treasury bills. Table C-8. Average rates of return (1990-96) and riskpremiums (1926-94) on some securities (figures in percent per year) Portfolio Average Annual Average Risk RateofReturn2 Premium3 (Nominal) (Extrareturn 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 ofbeta for a water heatermanufacturer. The data has been averaged over theperiod 1990-97. The values ofbeta are obtained from financial services provided by the DowJones Company. They measure the sensitivity ofa stock's price to overall fluctuations in the S&P 500 stock index. Beta measures the sensitivity of the return on an individual stock tothe return on the market portfolio. A stock with a beta of 1tends to move up and down the same percentage as the market. Stocks with a beta coefficient less than 1tend to move in percentage terms lessthan the market. Similarly, a stockwith a betathat ishigher than 1will 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, andInflation, 1994 Yearbook 8Table C-9. Average Beta values foraWater Heater Manufacturer Manufacturer Beta (1990-97) A 0.84 Using CAPM to calculate the cost ofequity, thefollowing results are obtained for the water heater manufacturer: Manufacturer A: Cost ofequity= (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 ofequity for Manufacturer A is 9.43%. Weighted Average Cost ofCapital (WACC) is defined as: WACC = (1-tax rate) * cost ofdebt * [debt/(debt+equity)] + cost ofequity * [equity/(debt+equity)] Manufacturer A: WACC = [(1-0.358) * 6.73 * 0.281 ] + [9.43 * (1-0.281)] = 7.99% The weighted average cost ofcapital accounts for inflation, asreal values ofcost 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 ofthe WACC were obtained from Ibbotson Associates, a company that tracks the industry cost ofcapital for over 300 industries. Their analysis reports a WACC of 11.6% for the household appliance industry (represented by the SIC code 363) inthe year 1997. Adjusting for inflation (2.2% in 1997), the WACC net ofinflation would be 9.4 %. The Department proposes using aWACC of7.99% as the real cost ofcapital for discounting future cash flows in GRIM, i.e. the discount rate for the industry NPV.

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