Opinion ID: 2290707
Heading Depth: 1
Heading Rank: 4

Heading: Cost of Stock Capital. Debt Ratio.

Text: The company has outstanding a funded debt capital of $135,000,000 represented by long term bonds, and an equity capital of $165,000,000 represented by common stock with a par value of $100 per share. It has financed its extensive post-war construction program by temporary loans from the American Telephone and Telegraph Company in the amount of $94,800,000, and now wishes to procure new capital in the amount of $125,000,000 by selling long term bonds and common stock for the purpose of paying these temporary loans and getting further funds to continue its construction program. It is not permitted to sell stock at less than par. Its present debt ratio, including the temporary loans, is 57.7%. In procuring the new capital the company's management has determined that in its judgment it should be so funded as to result in a 35% debt ratio. The commission determined the aggregate annual cost of the company's present funded debt to be 3.57%, and that the future cost of debt capital will be 3.12%. These figures are not in dispute here. The commission finds that the present cost of equity capital is high, and that the present cost of debt capital is low and that there is an ample supply of capital funds in institutions, such as banks and insurance companies, where legal restrictions deny investment in common stock equity. While recognizing that rate making proceedings should be designed to enable the company to achieve a capital structure which is balanced and elastic, composed of such classes of securities that will enable it to obtain new capital and afford it a considered selection as to the mode of finance which would be most favorable under current market conditions, the commission conceives it to be the duty of the company as a public service enterprise to adopt the most economical methods of financing, consistent with maintaining that degree of flexibility in capital structure necessary to assure its future ability to sell any securities that may be desirable and states that recognition of these principles does not compel it to submit to the extravagant requests of a utility for equity capital under market conditions which do not justify its exclusive use as a means of fulfilling the company's financial requirements, and that the maintenance of a low debt ratio should be compatible with the interest of the rate payer as well as that of the investor. The commission finds that a present debt ratio of 45% would be entirely consonant with the economic well being of the company, and states: There is no question that the debt ratio may be further reduced economically with proper consideration to both the consumer and the investor as market conditions change to afford more favorable opportunities to increasing equity capital. For the computation of the cost of money, we, therefore, accept the debt ratio of 45% as proper after examination of comparative debt ratios in other utility industries, consideration of the relative stability of net telephone earnings, and the nature and quantity of the petitioner's telephone plant in general. We feel that the proper balance in this respect is 45-55% ratio of debt to equity rather than the 33 1/3% to 66 2/3% ratio which has been the historical yardstick of the Bell System, in times when market conditions and income tax requirements were considerably less demanding. The principal contention in opposition to the decision of the commission is that debt ratio is a matter for the exclusive determination of management. The answer to this is aptly put in the recent case of New England T. & T. Co. v. Department of Public Utilities, Mass., 97 N.E.2d 509, 514 as follows: But we think that in this instance, in the circumstances now existing and especially in proceedings upon the `cost of capital' theory, the debt ratio is not a matter of that kind. This company is in effect seeking additional capital and higher rates in order to obtain and support such additional capital. Debt ratio substantially affects the manner and cost of obtaining new capital. It seems to us that to say the department could not even consider debt ratio would be to blind its eyes to one of the elements in the problem before it. From the standpoint of the company it might be better to have no debt capital at all. An honest board of directors might think so and at least from the standpoint of loyalty to the company's interest it would be difficult to say that they had abused their discretion. Yet the evidence shows that such a decision under present conditions might well double or even triple the cost of new capital and increase correspondingly the burden laid upon the public for obtaining it. Surely the department could give consideration to this matter. We recognize the dangers from long term debt, but we are not prepared to say that the finding that a present debt ratio of 45% would be consonant with the economic well being of the company is not justified. This exception is not sustained. On the basis of a 45% debt ratio the company is authorized to procure the additional $125,000,000 of capital by issuing bonds to the amount of $56,250,000 and common stock to the amount of $68,750,000. When such bonds and stock are sold it will have a total debt capital of $191,250,000 and a common stock capital of $233,750,000. The commission arrived at the figure of 6.65% as the cost of present and future equity or stock capital, and found that on the basis of such total capitalization the composite cost of capital would be 5.21%. To this latter figure it added one-half of 1% to take care of uncertain economic factors, and arrived at the figure of 5.71% as the maximum that the investor can expect. This last figure the commission adjusted down on account of shortcomings in the company's telephone service and its loss of subscribers due to increased rates, and arrived at the figure of 5.5% as the rate of return and the point where the interests of the consumer and the investor are equitably balanced. According to a computation in the State's brief this would afford a return of 7.2% upon the proposed total stock capital of $233,750,000. The State says that applying the historical pay out ratio of the company enough is left over for a 7% dividend upon stock. In its findings of what would be an adequate return upon equity capital the commission disregarded the evidence of the company's expert witnesses that under prevailing conditions new stock could not be sold unless the rate of return thereon was substantially more than 7%, and based its conclusion upon the 5.94% average earnings-price ratio of the company for the period of 1939 to and including 1946, to which it added 12% to cover cost of issuing new stock, under-pricing and a possible rise in the cost of equity capital, thus arriving at the figure of 6.65% as the estimated cost of present and future equity capital. We need not go into the merits of the period selected for arriving at the average earnings-price ratio, and for the purposes of our discussion we will assume the correctness of the commission's conclusions quoted below, which were in part based upon a book not in evidence: In analyzing the cost of equity capital, the State's witness Lindahl placed considerable reliance on earnings-price ratios of the company in computing the cost of equity capital. We recognize that the relationship of earnings to market price over any given period cannot be accepted blindly as the only test of the investor's appraisal of any particular stock. We find that the long-term ratio of available earnings to the market price of common stock is a reliable indication of the price of common stock capital. It is true that the earnings-price ratio at any given instant may be affected by a variety of circumstances including yield to stockholders in dividends, anticipated future yields, prosects of capital gain, current political factors, price trends in the general market, debt ratio of the company to its total capitalization, and, sometimes emotions, fears and hopes. However, in the long run with a reasonable period of time considered, influences of these factors tend to be reduced, leaving the average earnings-price ratio over an extended period of time as a fair standard upon which to predicate anticipated cost of equity See Barnes, The Economics of Public Utility Regulation, page 539. The company itself employs the earnings-price ratio theory in its consideration of capital requirements of other industries and, in particular, in the comparison of the capital requirements of electric utilities. We accept it for, in our judgment, it reflects the substantial factors weighed by an investor with respect to the securities of the subject corporation, including the earnings themselves, dividends, contributions to surplus account, financial stability of the enterprise and confidence in management. We agree about the usefulness of the earnings-price ratio theory, and that under normal conditions the average earnings-price ratio over an extended period of time may be a fair standard upon which to predicate the anticipated cost of equity capital. The commission finds that at the conclusion of the formal hearings in this cause, which was November 21, 1949, the market value of the company's stock was somewhat below par. The evidence of monthly averages shows that beginning with January, 1947, this stock went from 111 gradually down to 94 at the end of the year, and that during 1948 there were only two months when the average price rose to par or above. In June of that year it was 101, and in July 100. In the first four months of 1949 it averaged between 94 and 96. Obviously the company cannot sell any new stock unless the stock rises to par or above. The witnesses differ somewhat as to the amount above par it must go to market a new issue of stock, but all agree that it must go up a substantial amount before the contemplated issue of 687,500 shares can be sold. Assuming that the American company will take the full 68.92% to which it is entitled out of any new stock issued, although it is not bound to take any and might not do so, there is the necessity of selling a large block to the general public somewhat in excess of the total of 211,959 shares traded during the eight year test period. The question therefore arises as to what is the true standard upon which to base the cost of equity capital. Is it to be based upon the expectation that sometime in the future the market price will rise sufficiently to sell this stock, or is it to be based upon more immediate market conditions? We believe that the correct answer is given in New England T. & T. Co. v. Department of Public Utilities, supra. In that case the Massachusetts department of public utilities had used the average earnings-price ratio during the period from 1938 to 1946, one year longer than here, and found that 6% upon the company's common stock was fair, reasonable, adequate for the company's needs, and likely under normal and representative conditions to maintain the price of the common stock at or above its par of 100. Except that our commission made more upward adjustments there is no difference in the theory followed. Speaking of this finding by the department the court states: This may or may not be true, but it does not reach to the real point. The question was not what return might maintain the stock at par in some hoped for representative period. The question was a much more immediate and practical one. Here is one of our greatest and most necessary public utilities. It cannot be permitted to fail in its service to the public. It was legally and morally bound to increase its service to meet an insistent public demand. It did so by borrowing $120,000,000 on demand notes from a source which fortunately was available to it. It must repay this money in the near future. It cannot expect to retain this borrowed money indefinitely as part of its capital structure. Its only means of repayment is by obtaining new capital. Concededly it must not increase its debt ratio. It must therefore sell a substantial amount of stock. On the evidence it can do this only if it is allowed a return on stock capital substantially larger than the 6% allowed by the department. There is another matter which is of vital importance. It will be noted from the portion of the findings quoted in our discussion of property held for future use, that the erection of a number of important new central office buildings has been postponed, presumably for financial reasons. In speaking of the quality of telephone service in Vermont the commission states that modern telephone equipment has been slow in finding its way into the company's Vermont plant, and that the State is still burdened with some 57 hand-ringing magneto telephone exchanges, and there are an excessive number of subscribers on rural lines. But the commission also states that the company has been keenly aware of the deficiencies in service and has made an honest effort to improve the service according to its ability. These deficiencies cannot be remedied without funds to do the work. Shall improvements be deferred until the company's stock can be sold at the return fixed by the commission at some indefinite time in the future, or should a sufficient return be allowed to sell the required stock now? It is to be hoped that the company's stock will make a much better showing in the stock market at the time when this cause is reheard, so that it can then be sold at a lower rate of return than in 1949, when this cause was heard. If it does not it will be evident that investors have lost interest in this stock, as intimated in the opinion of the Supreme Judicial Court of Massachusetts, or that investors during the present stock market boom prefer to buy stock in industrial corporations as a hedge against the current inflation, rather than in utilities. At such time the price of the company's stock may be influenced somewhat by the allowance upon the rate base of $244,185,500 in Massachusetts, which includes reinvested surplus, of a minimum return of 6.23%. The Massachusetts case was a suit in equity, unlike our proceeding. The court there found from the evidence that a return of nothing less than 8.5% will suffice to attract new stock capital at a debt ratio of 45%, and taking 3.45% as the composite net return on debt capital, arrived at the composite net return on both debt and stock capital of 6.23%. It was of the opinion that a net return of less than 8.5% on stock capital or less than 6.23% on both kinds of capital is below the level where confiscation begins. It also found that the company was entitled to a like return upon its reinvested surplus. The result was that the court directed that the order of the department of public utilities be so modified as to provide for a net return of at least 8.5% on stock capital and 6.23% on reinvested surplus. Nothing stated above conflicts with our holdings in the former case, 115 Vt. 494, 512, 513, 66 A.2d 135, relative to a fair and reasonable return upon the company's investment. It was error for the commission to base its conclusions upon the earnings-price ratio theory in its determination of the cost of equity capital, and to disregard the evidence of the company's expert witnesses.