Opinion ID: 1961637
Heading Depth: 1
Heading Rank: 4

Heading: AT&T's Cost of Equity.

Text: 1. General considerations. Determining the cost of equity is one of the more difficult computations in the rate-making process. The Commission must concern itself with many economic variables and evaluate conflicting evidence interpreting and applying those variables. Because of the complexity of the task, the Law Court necessarily defers to the regulatory expertise of the Commission if the Commission's decision is supported by substantial evidence. We do not attempt to second-guess the Commission on matters falling within its realm of expertise. Our review is limited to determining in the light of the record whether the Commission's conclusions are unreasonable, unjust or unlawful. The utility has the burden of proving that the Commission has erred. 35 M.R.S.A. § 307 (1978); Central Maine Power Co., 156 Me. at 299, 163 A.2d at 765. Whatever method is used by the Commission, its objective should be to achieve a proper balance between the right of the utility's investors to earn a fair return on their investment and the right of the ratepayers to a fair charge based on the value of the services provided by the utility. Federal Power Commission v. Hope Natural Gas Co., 320 U.S. 591, 603, 64 S.Ct. 281, 288, 88 L.Ed. 333 (1944). The return on investment calculated by the Commission must not be so unreasonably low as to be confiscatory. Central Maine Power Co. v. Public Util. Comm'n, 153 Me. 228, 250, 136 A.2d 726, 739 (1957). As this Court said in the 1978 NET Case, 390 A.2d at 35, the Commission must be guided by the following principles: First, the return must be commensurate with returns on investments in other business enterprises having corresponding risks and uncertainties. Second, the return must be sufficient to assure confidence in the financial integrity of the business enterprise so as to maintain its credit and enable it to attract capital. 2. The testimony. Only three witnesses gave testimony directly bearing on the cost of equity for AT&T. In supplemental direct testimony, NET witness John Cogswell recommended an unadjusted cost of approximately 15.8% for AT&T equity using a version of the discounted-cash-flow (DCF) method for determining cost of equity and a cost of 16.5% to 18.0% using a so-called return-spreads method. [13] Mark Langsom, a witness presented by the United States Department of Defense, believed that the appropriate cost of equity for AT&T was in the range of 13.0% to 14.0% using a comparative-earnings approach. The final witness who testified directly on the cost of equity for AT&T was staff witness Caroline Smith, an economic consultant. Using the DCF method, she recommended a cost of equity for AT&T in the range of 12.5% to 13.5%. Three of NET's witnesses, William Kraas, Robert Johnson and John Cogswell, testified on the cost of equity for NET without regard to double leveraging. Employing various methods, they concluded that the cost of equity for NET lies in the range of 15.3% to 20.1%. The Commission considered and rejected their testimony, reasoning that such evidence was inappropriate because the approaches used by those witnesses focused on NET directly without recognition of its ownership by AT&T. Having decided that the double-leverage formulation was the most appropriate method for determining the cost of NET equity, the Commission found that any evidence or method which failed to account for the double-leverage component in its cost-of-equity calculations was neither appropriate nor useful. On the evidence presented, the Commission found the bare cost of equity for AT&T to be 14.4%, using the discounted-cash-flow method. [14] NET challenges that finding in a number of respects. First, NET contends that the Commission arbitrarily disregarded most of the testimony of its witnesses concerning the cost of both AT&T and NET equity and capriciously refused to consider any testimony other than Cogswell's and Smith's DCF approaches for determining the cost of AT&T equity. It is unnecessary to review the testimony of each of the witnesses. The acceptance of one witness's testimony and the rejection of another's is within the sound discretion of the Commission. The Commission's order reflects consideration of all the evidence presented on AT&T's cost of equity and states adequately the Commission's reasons for deciding as it did. That the Commission chose to rely principally on the DCF method to determine the cost of AT&T equity as the basis for its double-leverage approach to determining the cost of NET equity is not ground for setting aside its decision. [15] 3. Discounted-cash-flow analysis: bare cost of equity. Discounted-cash-flow analysis involves the computation of a capitalization rate that indicates the investor's required return. That rate, or the bare cost of equity, is determined by combining the anticipated dividend yield with the expected growth rate in dividends per share. (a) Dividend yield. The first step in DCF analysis is calculating of the dividend yield which is expressed as a percentage by dividing the appropriate dividend by the estimated market price of the stock. In this case, the Commission took official notice of the current annual dividend of $5.40 for AT&T common stock and found a representative average market price of $50.87 for that stock. Combination of the two figures produced an annual dividend yield of 10.6%. NET does not specifically challenge the propriety or reasonableness of this finding. (b) Expected growth rate. The second step in DCF analysis is determination of the expected growth rate in dividends per share. On this determination the parties disagree. The Commission found an expected long-term growth rate of 3.8%. NET contends that this finding was unreasonable, confiscatory and without sufficient support in the evidence. On the contrary, we find that the Commission's determination is reasonable in result and methodology and supported by substantial evidence in the record. We sustain the Commission's finding that the expected growth rate of AT&T stock is 3.8%. In finding an expected growth rate of 3.8% for AT&T, the Commission relied principally on an historical-growth-period analysis presented by staff witness Smith, who analyzed long-term growth rates in earnings, dividends and book value over a ten-year period beginning in 1962 and ending in 1972. From that data, Smith concluded that the long-term expected growth rate in AT&T dividends is 3.5%. The Commission rejected Smith's result because her analysis was limited to a ten-year period ending in 1972. Accordingly, the Commission analyzed the growth rate in AT&T dividends over a twenty-year period, 1960 to 1980, deciding as a result that a growth rate of 3.8% was reasonable. According to the Commission, its finding of a 3.8% growth rate by means of a historical-period analysis was confirmed and supported by the implicit-growth-rate methodology used by NET witness Cogswell. Under that method, AT&T's payout ratio over a number of years is combined with the equity return over a number of years. Cogswell used the payout ratio over the past twenty years (60%) and the equity return on the two most recent years (13%) to reach an implicit growth rate of 5.2% (13% return × 40% retained = 5.2% growth). This he described as being at the bottom of the reasonable range of investor expectations. However, the Commission found Cogswell's analysis faulty in combining a payout ratio over a twenty-year period with an equity return over only a two-year period. Instead, the Commission compared the average payout ratio (62%) over the 1960-1980 period with the average equity return (10.1%) over that same period, thereby obtaining an implicit growth rate of 3.8% (10.1% return × 38% retained = 3.8% growth). That finding tended to confirm the Commission's finding of growth rate based on its historical-period analysis. Having found the dividend yield to be 10.6% and the growth rate to be 3.8%, the Commission determined the bare cost of equity for AT&T under DCF analysis to be 14.4% (10.6% + 3.8% = 14.4%). Contrary to NET's assertions, the DCF analysis used by the Commission is an appropriate method in this case for determining the bare cost of equity, and the historical-growth period studied by the Commission was a reasonable method for determining the equity-growth rate of AT&T. Choice of ratemaking methods to compute such variables as bare cost of equity, at least in the realm where rational persons could disagree, belongs to the Commission. Mars Hill & Blaine Water Co. v. Public Util. Comm'n, Me., 397 A.2d 570, 585 (1979). The evidence of record is sufficient to support the Commission's analysis and finding. 4. Discounted-cash-flow analysis continued: dilution. As traditionally used, DCF analysis yields a bare cost of equity which may not be a wholly adequate measure of a utility's actual cost of equity. See, e.g., 1978 NET Case, 390 A.2d at 36-37; cf. Mars Hill & Blaine Water Co., 397 A.2d at 587 (discussing bare cost of equity but not deciding whether use of DCF requires dilution adjustment). If, after deduction of the costs of issuance, the net proceeds of a public sale of the utility's stock amount to less than the stock's book value, the issuance of stock results in the utility's receiving less from investors than the book value of its present stock, with the effect of reducing the overall average book value of each share of stock. The net result is a dilution of the book value of existing shares. Accordingly, the return on equity must be high enough to compensate for that dilution of value if and when new shares are issued. Market-to-book ratio represents the measure of how much greater the market value of the stock must be over its book value in order to prevent dilution of the investment of existing shareholders. Although NET witness Cogswell testified that a market-to-book ratio of at least 1.1 would be required, the Commission refused to provide such an adjustment. The Commission stated that it had no responsibility to provide such a margin, reasoning that it need not make a market-to-book ratio adjustment where the utility has not shown that a new public issuance of equity is likely in the immediate or near future. Since NET had presented no persuasive evidence that such a public issuance was impending or even reasonably probable in the foreseeable future, the Commission held that a market-to-book ratio adjustment was unwarranted. NET argues that the Commission erred in so holding. It is a fundamental precept of Maine public utility law that a regulated utility has a constitutional right to earn a sufficient return to maintain its credit and to obtain additional capital when needed to enable it to serve its public. Central Maine Power Co. v. Public Util. Comm'n, 153 Me. 228, 251, 136 A.2d 726, 740 (1957), quoting New England Tel. & Tel. Co. v. Department of Public Utilities, 327 Mass. 81, 94, 97 N.E.2d 509, 516 (1951). Consequently, in determining the fair rate of return, proper consideration must be given to the prevention of dilution in order to enable the utility to obtain additional capital if and when needed. Where DCF analysis is used, the Commission should consider a market-to-book ratio where evidence warranting such an adjustment is presented, see 1978 NET Case, 390 A.2d at 36-37, and failure to do so and to make a compensatory adjustment may result in confiscation. Maine Water Co. v. Public Util. Comm'n, Me., 388 A.2d 493, 496 (1978). The Commission found that the evidence of record did not support the proposition that a new public issuance of equity by AT&T was likely to occur during the period of effectiveness of the new rates. NET's evidence had consisted of market letters from investment analysts which, while supportive of a dilution allowance in general, did not tend to show that a public issuance of common equity by AT&T was at all imminent. Indeed, one of those market letters, dated October, 1980, concluded by saying, It is quite clear that the Company will do no equity financing outside of these plans [ viz., a dividend reinvestment plan and an employee savings plan] in the foreseeable future. There is no evidence in the record to suggest that the Commission knew or should have known, before it issued its decree, about the stock issuance by AT&T that actually occurred in June, 1981, a few months after the Commission rendered its decree. From this record it cannot be held as a matter of law that NET met its burden of proving that a new common equity issuance was so likely in the then foreseeable future that the Commission was required to factor a dilution allowance into its determination of AT&T's cost of equity. 5. Confiscation argument on cost of capital. Finally, NET objects to the Commission's findings of a 14.4% cost of equity for AT&T and a 13.15% cost of equity for NET as confiscatory. NET contends that this is evident when the Commission's findings are compared with higher cost-of-equity figures found by certain other utility commissions and with its own actual cost of debt incurred after promulgation of the Commission's order. This argument is unpersuasive because it ignores two salient principles of Maine public utility law; namely, first, that we review the Commission's determinations on the basis of standards heretofore elaborated by this Court and not on the basis of what other utility commissions have found, 1978 NET Case, 390 A.2d at 38, and, second, we will not review the reasonableness of the Commission's findings on the basis of evidence outside the record introduced for the first time on appeal. See Central Maine Power Co. v. Public Util. Comm'n, Me., 433 A.2d 331, 343 n. 6 (1981). Hence the actual cost of debt incurred by NET after promulgation of the Commission's order is not relevant in this appeal. This Court has no basis for holding that the Commission's findings on AT&T's or NET's cost of capital are confiscatory in effect. See Camden & Rockland Water Co. v. Maine Public Util. Comm'n, Me., 432 A.2d 1284, 1286-87 (1981). C. Summary. We uphold, as reasonable and supported by substantial evidence, the Commission's use of the double-leverage formulation in determining NET's cost of equity, its finding of 14.4% as the cost of equity for AT&T, and its finding of 13.15% as the cost of equity for NET.