Australia Post: Consolidated Weighted Average Cost of Capital Partners... · Weighted Average Cost...

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Australia Post: Consolidated Weighted Average Cost of Capital

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Consolidated WACC 1

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Executive Summary

The scope of this report is to evaluate the Consolidated WACC (Weighted Average Cost of Capital) for Australia Post as a whole. This report reviews:

• The appropriate method to determine consolidated WACC; • The application of the consolidated WACC; and • Key assumptions and limitation in the application of the consolidated WACC.

In deriving the WACC, the risk of the overall business was determined with reference to the Capital Asset Pricing Model (CAPM). The WACC was estimated under four different approaches depending on the treatment of tax and imputation credits. The nominal WACC under each of the four approaches is shown below.

Asset BetaPre Corporate

TaxPost Tax - Classical

Post Tax - Imputation Vanilla WACC

Australia Post Consolidated 0.52 10.3% 8.1% 7.2% 8.7%

We recommend adoption of the Vanilla-WACC method. We believe this method provides the best estimate of the inherent business risk of the enterprise. The consolidated WACC under other methods includes an adjustment for tax or imputation cashflows. We note that the consolidated WACC has limitations when used for investment valuation purposes and is, for the most part, a reference tool used to assess Australia Post’s current risk position as a whole relative to other investments. The Consolidated WACC may be used to assess the value of Australia Post as a whole in particular circumstances. Where consolidated cashflows are discounted in a valuation model, the Consolidated WACC may be applied. However, there is an implicit assumption that the business mix will not change over time. Note when applying the Consolidated WACC there is an implicit assumption that future projects are of similar nature and risk to that of Australia Post as it is today. This is the case with any company.

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Table of Contents

1 Cost of Capital ........................................................................................................................ 4 1.1 Preface and Introduction ................................................................................................. 4 1.2 The Weighted Average Cost of Capital (WACC) ............................................................ 5 1.3 Definitions of the WACC and Net Cash Flows ................................................................ 6 1.4 Taxes and Imputation Tax Credits .................................................................................. 8 1.5 Parameters of the WACC and their Estimation ............................................................... 8 1.6 Risk and the Cost of Capital ............................................................................................ 9 1.7 CAPM and Risk ............................................................................................................. 11 1.8 Leveraging and De-leveraging Formulae in the Context of CAPM ............................... 13

2 Capital Asset Pricing Model (CAPM) Parameters ................................................................ 14 2.1 Risk Free Rate .............................................................................................................. 14 2.2 Determination of the Equity Beta .................................................................................. 14 2.3 Debt Betas and the Cost of Debt Capital in the WACC ................................................ 15 2.4 The Market Risk Premium (MRP) ................................................................................. 16 2.5 Security Market Line ...................................................................................................... 17

3 Estimation of WACC ............................................................................................................. 19 3.1 Market and Fundamental Risk - Characteristics of Infrastructure Assets ..................... 19 3.2 WACC Estimation Process............................................................................................ 20 3.3 Australia Post Overview ................................................................................................ 21 3.4 Australia Post Consolidated Group WACC - Application .............................................. 23 3.5 Result ............................................................................................................................ 25

4 Application of WACC ............................................................................................................ 26 4.1 Application - Treatment of Cashflows ........................................................................... 26 4.2 Tax and Imputation Credits ........................................................................................... 28 4.3 Allowances for Specific Risk ......................................................................................... 29 4.4 Signals for Update of WACC ......................................................................................... 30

5 Conclusion and Summary ..................................................................................................... 31

6 Appendix A – Definitions of WACC ....................................................................................... 32 6.1 Definitions ...................................................................................................................... 32 6.2 Before tax Cost of Capital ............................................................................................. 32 6.3 After tax Cost of Capital ................................................................................................ 33

7 Appendix B – Imprecision In Equity Beta and Regulatory Approach ................................... 35

8 Appendix C - Comparable Listed Post Offices ..................................................................... 38

9 Appendix D - Comparable Company Descriptions ............................................................... 39

10 Appendix E - Comparison to ACCC Methodology ................................................................ 42 10.1 Relationship of Post with the ACCC .............................................................................. 42 10.2 ACCC Determination of Efficient Pricing ....................................................................... 42 10.3 ACCC Calculation of WACC ......................................................................................... 43 10.4 Recent ACCC Decisions from Other Industries ............................................................ 43

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1 Cost of Capital

1.1 Preface and Introduction

The cost of capital for a consolidated entity largely reflects the same principles as that used for a single purpose or “pure-play” entity. The key determinants and concepts to apply are:

- The notion of opportunity cost for the use of capital for equivalent purposes will determine cost of capital and risk assessment;

- Assets, not liabilities (ie. debt and equity) determine risk; - Determination of capital base (ie. what constitutes investable assets) is an important

component. The discussion which follows details these concepts. Key areas of difference when considering a consolidated WACC against WACC in a pure-play entity are noted. Opportunity Cost Concept and Cost of Capital The cost of capital is the cost of servicing the capital (referred to as the capital base) of an asset, project or company (a collection of assets). The cost of capital is most commonly used as a discount rate to capitalise net cash flows to give a present value. It is also used as a bench mark rate of return, a regulatory rate of allowable returns to capital and as an ex-post measure of performance. Like all costs in economics, the cost of capital is an opportunity cost. It is the return that could be obtained when investing the capital in the next best alternative use (in the same risk class) for that capital. Further, because the value of an investment is dependent on future benefits (the past is only relevant insofar as it reflects or is reflected in the future), the cost of capital when used to capitalise net cash flows is an ex-ante or expected rate. As an ex-ante concept it should be clearly distinguished from the ex-post concept which is typically referred to as the rate of return on capital to distinguish it from the cost of capital. At any point of time, the cost of capital is determined by the intersection of the demand and supply curves for capital. The differences between investments’, projects’ or companies’ costs of capital at any point of time reflect differences in their risk class; higher risk, requiring greater compensation and therefore a greater cost of capital, and conversely. Across time, adjusting for risk differences, the differences in rates reflect the “time rate of discount” or the “risk free rate”. In a fully informed market, in equilibrium, it is the nature of the risk associated with the cash flows generated by the assets and not the assets themselves nor the source of capital, which determines the cost of capital. The source of capital simply determines the ordering of claims on the cash flows and assets in the event of liquidation. It is the assets (the Asset side of the Balance Sheet) or more accurately the cash flows generated by those assets that distinguish the cost of capital between projects, investments or companies. The source of capital (the Financial Obligations side of the Balance Sheet) simply determines the “packaging” of the cash flows and associated risks amongst the providers of funds. The assets generate these cash flows and their associated risks.

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Any definition or estimation of the cost of capital requires identification of the capital base for which the cost of capital is the return or payment for the use of that capital. Capital simply reflects a store of value and as such all assets whether physical or intellectual can be represented as capital. However, whether they are part of the capital base for which a cost of capital is required really depends on the nature of the decision or use of the capital. For example, the interest on short term debt might be treated as an operating expense and the capital value of such debt would not belong in the capital base. In contrast, the long term debt may belong in the capital base and its interest becomes a component of the cost of capital. At an extreme we could even capitalise labour and treat it in much the same way, that is, expense it as we would the interest on debt with the liability becoming part of the capital base. Typically, we would look to the financial obligations side of the balance sheet in order to determine what might constitute the capital obligations of an entity or capital base and then decide what is an appropriate definition of the cost of capital to service those obligations. The reason for this is that we can only access the costs of capital from the Financial Obligations side of the Balance Sheet and it is rare that a single source of capital is dedicated to and the sole collateral of a specific asset or investment. In this process, care must be taken not to double count certain costs in the valuation equation. For example, it is common to find trade creditors listed in the balance sheet as a liability and yet we would rarely include the value of the trade creditors as part of the capital base in assessing the cost of capital. This is because the cost of servicing the trade creditors is typically incurred and accounted for in the cost of goods sold and to include trade creditors in the capital base and attribute revenue to service those trade creditors would be to double count that cost. Although assets or, more accurately, the cash flows generated by assets determine differences in the costs of capital we can only get a measure of this cost from the sources of capital (Financial Obligations) and these are rarely dedicated to specific asset, instead they are usually backed by a variety of assets (a “floating charge”). Therefore we must rely on an average, or more accurately a weighted average, cost of capital, reflecting the average cost of capital for the assets that support the various classes of capital and estimated as a weighted (by value) of the types of capital.

1.2 The Weighted Average Cost of Capital (WACC)

The cost of various components of the firm's capital structure, in broad terms debt and equity, weighted by the proportion of them to the firm's total assets is the firm’s weighted cost of capital. It is simply defined as:

WACC = Re.V

S + Rd.

V

D … (1)

Where, Re is the expected or required return on equity; Rd is the expected or required return on debt;

S is the market value of equity; D is the market value of debt; and V=S+D is the value of the capital base.

The purpose in estimating a WACC is to estimate the cost of capital for the assets of Australia Post. The WACC is often the only way to obtain such an estimate. The capital structure is only relevant to the extent that we have to estimate the WACC via the “titles” (securities) to the assets. The relationship of the firm's cost of capital with its capital structure is such that it is assumed that the capital structure of the firm is optimal or does not affect the cost of capital. That is, we are

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assuming that the market-place expects that the firm will maintain the capital structure for which we are deriving the cost of capital and moreover, there is no alternative capital structure that is likely to make the firm more valuable. It is important that the definition of the weighted average cost of capital (WACC) is consistent with the net cash flows that are allowed as a return to capital. The most obvious examples are where an after-tax definition of cash flows is to be used that an after-tax definition, as distinct from a before-tax definition, of the cost of capital is used. However, obvious inconsistencies are not the most common source of error amongst practitioners, the more common errors are more subtle, insofar as there are a number of after-tax definitions of the WACC that could be used and therefore a variety of definitions of net cash flow. The most common error is to mix these definitions of the after-tax WACC with an inappropriate definition of the after-tax net cash flow. Moreover, there are some good arguments why the after-tax cash to compensate for the cost of capital should be used and therefore an after-tax definition of the WACC instead of a before-tax cost of capital. The effective tax rate is likely to vary between time periods because of depreciation, investment allowances and other factors that often cause the actual tax applicable to an investment to differ from the statutory tax rate. If a before-tax WACC is derived, this rate has to be some form of average rate for the investment’s life unless a separate WACC is to be estimated for each year. It is simpler and more accurate to add a component for tax in much the same way as operating costs for the period and then compensate the capital on an after-tax basis. Consolidated WACC The WACC derivation in (1) implicitly assumes we are dealing with a single-division or pure play entity. That is, it assumes the cost of equity Re can be derived for the entity as a whole. Where the Re cannot be observed directly for the consolidated entity, a consolidated WACC may be derived from an amalgam of the divisional WACCs. This can be achieved in a number of ways. Consolidated WACC = WACC1 * (Value1 / Total Value) +

WACC2 * (Value2 / Total Value) + . . . WACCn * (Valuen / Total Value)

where WACC1, WACC2, … and WACCn represents the WACC of division 1, 2, … and n respectively.

1.3 Definitions of the WACC and Net Cash Flows

As we have already indicated the cost of various components of the firm's capital structure, in broad terms debt and equity, weighted by their proportion to the firm's total assets is the firm’s weighted average cost of capital (WACC).

1.1.1 The “Vanilla” WACC The definition of the WACC that is appropriate for net cash flows after company tax and whose cash flows reflect the tax deductibility of interest is the simple or “Vanilla” WACC which was defined above as Equation (1) and in Appendix A under 4. This definition of WACC weights the required return to equity and debt by their respective value in the capital structure. In contrast to

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the more traditional after-tax definition of WACC found in most textbooks (and described below) it does not include any tax effect of interest deductibility which is incorporated into the net cash flows. The precise definition of after-tax net cash flows appropriate for the “Vanilla” WACC can be found in Appendix A but essentially it is the after tax income that accrues to shareholders plus the interest cost of the debt. Equivalently, it is earnings before interest and taxes (EBIT) less the effective amount of company tax that is paid. The effective company tax should not only include deductions for depreciation, investment allowances and the like, it should include any value in the franking credits because they can be deducted from personal tax liabilities they represent a withholding of personal tax at the company level. The absence of a tax parameter in the Vanilla WACC – taxes are taken account of in the definition of cash flows – makes the equation less prone to error than alternative equations which include some tax effects. The effective tax rate is likely to vary between time periods because of depreciation, investment allowances and other factors that often cause the actual tax applicable to an investment to differ from the statutory tax rate. If a WACC equation is used other than the “Vanilla” WACC it will have a tax parameter, moreover, this tax parameter will require a rate of tax that is some form of average rate for the investment’s life unless a separate WACC is to be estimated for each year. It is simpler and more accurate to add a component for tax in much the same way as operating costs are treated in the net cash flows for the period and then compensate the capital on an after-tax basis. Another advantage of the “Vanilla” WACC is that capital market rates are usually quoted on an after company tax basis. Therefore, the values for the equation’s parameters are more readily identified with market observations, easier to comprehend and less prone to any errors through adjustments. In summary, the reason for arguing that the "Vanilla" WACC is the most appropriate is that all the adjustments for taxes, imputation credits and the like occur in the net cash flows. This has the advantage of clearly identifying when taxes are paid (also, it clearly recognises the difference between economic depreciation and tax depreciation). In addition, this simple WACC or “Vanilla WACC” is much easier for lay people to understand because it bears a closer resemblance to observable market rates.

1.3.1 The Traditional After-Tax Definition of WACC The more traditional after-tax definition of WACC takes account of taxes in the WACC formula, i.e.

WACC = Re.V

S + Rd.

V

D.(1-T(1-γ )) … (2)

Where,

T is the corporate tax rate; γ is the value attributed to franking credits; and

other terms are as defined above.

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The effect or value of tax credits is taken into account through γ ≤ 1.0. Where tax credits are worthless (γ =0.0), the equation reverts to the standard textbook (USA) equation reflecting a

classical tax system. The equation and its associated net cash flows are defined as 2. in Appendix A. The net cash flows ignore the effect of gearing or interest deductibility from taxes, so that the cash flows are effectively EBIT less taxes where the taxes reflect any value of the franking credits. The equation was adopted because it reflected the Modigliani and Miller Proposition that gearing does not affect the value of the firm and the net cash flows are unaffected by gearing under this definition which made it easier to estimate net cash flows. However, the WACC equation is affected by gearing, moreover as we indicated above it requires a geometric mean estimate of taxes taking account of gearing and deductions for depreciation which are extremely difficult to measure accurately as a geometric mean. The equation and the associated estimate of net cash flows are likely to lead to less accurate valuations than the “Vanilla” equation and its associated net cash flows.

1.4 Taxes and Imputation Tax Credits

The amount of tax paid by a company reflects the tax assessable income and this is unlikely to coincide with the net cash flows, and the “effective” tax rate. Under an imputation tax system not all the tax collected from the company is really company tax. To the extent that part, or all, of the tax collected is redeemable against personal tax liabilities it represents personal tax. The company is collecting that proportion of the tax that is redeemable but it is tax that would otherwise be paid by the shareholder as personal tax. Therefore the “effective” tax rate for the company must take into account that amount of the tax paid by the company that is later redeemed by shareholders as a payment of personal tax. The issue is to assess what proportion of the tax collected from the company is not company tax but a pre-payment of personal tax. In the case of Australia Post, we understand that the imputation tax credits are unable to be utilized. Hence at an Australia Post level the value of them appears to be zero (γ =0.0). In

effect, Australia Post faces a classical tax system. The after-tax definitions of WACC defined in Appendix A when γ =0.0 cause the equations under 2. to be identical to those of a Classical Tax

System. However, the key consideration in the estimation of WACC (and treatment of franking credits) is the inherent risk of the opportunity cost of capital. This requires consideration at a broader level. In this context, the opportunity cost for investments in Australia Post is that of a normal, public commercial listed company. Hence franking credits should be valued. We consider a value of 50% to be appropriate (ie. γ =0.5). This reflects the approximate level of credits which are

accessible (paid by the average company) and the actual proportion which is utilised by investors. Section 4 describes how this may be applied.

1.5 Parameters of the WACC and their Estimation

It is usual to estimate the WACC by separately estimating each of the components of the WACC equation. An alternative method is to estimate the WACC as a whole by models such as the Capital Asset Pricing Model. The WACC for an entity should be the same whatever approach is used but there are subtle differences between the approaches which can lead to different values for the WACC, we will explain this in the next section, and in this section we will explain the more conventional estimation procedure.

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As the name implies, the WACC is an average cost of the capital, typically broken up into debt and equity, that is used to finance the assets or capital of the company. The respective amount of equity and debt are weighted by their respective proportions of the capital. These proportions should reflect current or market values and so when the respective weights are estimated S/V and D/V they should reflect the market value of equity (S) and debt (D) and their sum (V) will reflect the market value of the firm’s assets. The cost of the debt capital (Rd), following the above principle, should be the current cost or rate of return (yield) required on debt of the “quality” (risk class) issued by the company. Care must be taken to ensure all the costs of this debt are recognised, particularly in the case of hybrids or mezzanine finance where part of the cost of the debt is often an option on equity. Because the return or interest on the debt is set under the terms of the debt as a contractual rate, it is usually relatively straight forward to estimate Rd. The same is not true for equity cost (Re) The suppliers of equity capital are the residual claimants (after debtholders and government through their tax claims) on the assets and the revenues of the company. The consequence is that the equity cost is a non-contractual rate and it has to be estimated indirectly through models such as the Capital Asset Pricing Model (CAPM), the most popular method of estimating the cost of equity (Re) but by no means the only approach that could be used. The CAPM approach will be discussed more fully in the next and subsequent sections. The estimates of the above parameters of WACC are the same whichever definition of the WACC is used. The same is not true of the remaining parameters: tax (T) and the associated value of the tax credits (γ ). The estimate of these parameters differs depending on which definition (equation

1 or 2 above) of WACC is adopted. If the “Vanilla” WACC definition is adopted the approach is fairly straight forward. Insofar as the parameters T and γ do not appear in the WACC equation

the WACC is unaffected by their values. Instead, they are estimated as part of the net cash flows. The definitions for estimating the net cash flows are given in Appendix A. In contrast, if the WACC definition described by equation 2 is adopted, then rather than applying the actual tax and credits for each period, an estimate of the average rate for these parameters over the life of the assets or company must be made. Moreover, because the WACC is a compounding variable, these averages are not simple averages but a geometric average reflecting the effect of compounding rates. Inevitably, assumptions of constant rates are required or implied to be able to easily estimate the values – assumptions which may be at odds with reality.

1.6 Risk and the Cost of Capital

At any point in time risk usually distinguishes the relative cost of capital for different investments. The cost of capital measures the degree of risk aversion for investors. In a pure fundamental corporate finance framework, the risk aversion is a pure time-value-of-money (opportunity cost of capital) concept represented simply by a risk premium over the risk free rate. The risk premium is usually determined with respect to the average return in a broad, market-based portfolio of securities. However, this does not capture specific risks to the project such as construction risk or demand risk. Specific risks may be handled in one of two ways:

- The first is the textbook approach with adjustment to cashflows for the probability weighted or “expected” value of cashflows after specific risks.

- The second is a market or short-hand approach using an all up risk premium all specific risks added to the cost of capital.

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Used appropriately, both the methods above result in an equivalent answer. Here is an example that illustrates our point:

Figure 1-1 Handling Risk – Adjustments to WACC and Probability Weighted Cashflows

Year

Assumptions 1 2 3Construction Cost -100Earnings 75 80Predicted Cashflow -100 75 80

AdjustmentsProbability of Cost Overrun 50%Cost Overrun -30Cashflow Adjustment -15Adjusted Cashflows -115 75 80

Valuation Approach: Market Based Risk Premium

WACC 10%Risk Premium for Construction Risk 8%Cost of Capital 18%

Cashflows -100 75 80Discount Factor 1.18 1.40 1.65 PV Predicted Cashflows (84.6) 53.7 48.4 Net Present Value of Project 17.5$

Valuation Approach: Cashflow Based Specific Risk Pr icingWACC 10%Risk Premium for Construction Risk 0%Cost of Capital 10%

Cashflows -100 75 80Adjustment for Construction Risk -15Discount Factor 1.10 1.21 1.33 PV Predicted Cashflows (104.5) 62.0 60.1 Net Present Value of Project 17.5$

The first approach using an additional risk premium is a commonly employed method as it is relatively simple to apply. The discount rate is adjusted by a single factor for all risks (market and diversifiable). The discount rate or risk premium is derived from examining the internal rate of return of investments of comparable risk. This method makes the significant assumption that projects are comparable. This is clearly not the case for unique assets – particularly many infrastructure projects. Hence this method provides only a shorthand account for project risks. It is in these circumstances that the "text book" approach of separately identifying the two broad classes of risk - the non-compensated diversifiable risk and the compensated non-diversifiable risk - comes into its own. Because it can quantify the risk and link the required return from one risk class to another and therefore one investment to another, the "text book" approach has greater universality.


The principle arising out of these observations is that we recommend when there is a readily available capitalisation rate from comparable investments use it because it is likely to incorporate compensation for all the relevant risk e.g. in valuing investment in residential real estate. However, when the investment is unique and no such "benchmarks” are available, typically, we will have to resort to models of risk compensation in order to derive an appropriate cost of capital or capitalisation rate e.g. the required or justifiable return for the provision of unique infrastructure assets. This is further discussed in Section 4.3.

1.7 CAPM and Risk

As mentioned above, risk can be segmented into two basic types: non-diversifiable and diversifiable risk. In the context of the CAPM and the “textbook” and regulator approach to pricing and valuation the non-diversifiable risk is taken account of in the discount rate through estimating the cost of capital in the context of CAPM whereas the diversifiable risk is taken into account in the estimate of the expected net cash flows. Non-diversifiable risk is also known as:

• systematic risk; • market risk; • covariance risk; and • beta (β) risk.

Because the β risk is non-diversifiable it commands a risk premium, known as the market risk premium (MRP), which is defined as [ E(Rm) – Rf ]. The MRP is the premium a market portfolio of assets or securities (Rm ) is expected to earn above the risk-free rate (Rf). The effect of non-diversifiable risk is captured through such models as the Capital Asset Pricing Model (CAPM):

( )[ ]MRPR

RRERR

jf

fmjfj

ββ

+=

−+=

(3) where: Rj is the expected return on asset (security) j or its required return or cost of capital; and βj is the non-diversifiable risk associated with asset j and because of the MRP this βj component of risk increases the discount rate or cost of capital in an NPV analysis. The CAPM is the standard approach to estimate the required return (Cost of Capital) of equity (Re) where unlike debt there is no contractual rate set for the return. The risk occurs as β in the above CAPM and this is non-diversifiable risk for which the capital market pays a market risk premium MRP. As we have mentioned, in the case of debt, we typically use the yield on debt to estimate the cost of debt (Rd). Such a yield includes both non-diversifiable risk and diversifiable risk. The latter is usually included when estimating a company’s WACC or asset cost of capital, although logically the diversifiable risk should not be included but for major companies it is so low the bias is judged to be not consequential. Diversifiable risk is also known as:

• non-systematic risk; • non-market risk; • non β risk;


• idiosyncratic risk; • residual risk; and • insurable risk.

Diversifiable risk can be diversified away because it is uncorrelated with other risks or variations in net cash flows and as such it does not command a premium in the sense that non-diversifiable risk commands a premium. However, this does not mean that it has no effect on values or that it can be ignored in a discounted cash flow analysis. It has become almost conventional to use the CAPM for estimating a required or expected return to equity. The CAPM is testimony to the adage that in finance and economics, in fact in all social sciences, “models that are to be used but never to be believed”. There are far more academic papers around showing the inadequacies of the CAPM as a means of estimating expected or required returns to equity capital than there are papers illustrating its value. The problem is finding a robust alternative to the CAPM. It just does not exist at the moment. The severest critics of the CAPM are the academics. However, from a practical point of view these critics take the assumptions underlying the derivation of the CAPM far too seriously. From practitioners point of view all the CAPM needs to provide is a means of deriving an expected return for the non-contractual financial obligations of the company. In this context, it is best looked at as a base rate of return which is widely recognised (the surrogate for the risk free rate e.g. a government bond rate) plus a risk premium which is provided by a readily identifiable risky benchmark (the market index) which is then scaled (the β) by some measure of the relative (to the index) risk of the asset or investment. The theoretical support for the use of β can be readily derived using the market model, an empirical surrogate of the CAPM, without many of the assumptions needed to derive the CAPM. This scaling of market risk by a β or relative co-variance risk gives rise to the notion of non-diversifiable or systematic risk which earns a premium in the capital markets because it has to be borne and cannot, by definition, be diversified. If we set the cost of capital on the basis of systematic or non diversifiable risk then, of course, that other component of risk that is diversifiable must be taken into account in the net cash flows as an actuarial estimated expected net cash flow i.e. the probability of the alternative states of nature that might occur by their outcomes. All of the parameters of the CAPM have been subject to a great deal of investigation and criticism in empirical investigations of the model. The problem has been to find an adequate substitute. The simplicity of the model and the strong theoretical backing to β as a relative risk measure is strong. Moreover, the ability to take such measures from one set of investments and apply them to other investments gives a robustness and practical value to the model that is not apparent in the results thrown up by "gross empirical studies". These are the studies that throw all the data into a computer and look for empirical relationships between returns and various “factors”. The use of neural networks is the most rampant expression of such an approach. Developing pricing models from parameters such as size, price to book and sundry other accounting variables has been of limited value to the practice of valuation because of a lack of strong theoretical support for the relationships. Yet there is no doubt that CAPM is a very limited model and really only supported by the relative returns of large companies in well developed stock markets. This clearly limits the use of the CAPM in circumstances where the cost of equity capital has to be estimated for companies or investments that are not traded under such conditions. The argument for using the model in the case of Australia Post, a large company but unlisted and government-owned, rests on the concept of the opportunity cost of capital.


Clearly, Australia Post could be readily listed and its securities would be expected to behave in a manner similar to other companies’ securities of a comparable risk class. Therefore, the opportunity cost of the funds to the government reflects a listed Australia Post.

1.8 Leveraging and De-leveraging Formulae in the Co ntext of CAPM

We indicated above that the cost of capital and the WACC could be estimated as a whole in the context of CAPM. For example, if we estimated the company’s β as a whole we could apply the CAPM to estimate the company cost of capital which would be equivalent to the WACC. Similarly, the arithmetic of the CAPM and β’s allows us to break this total β into equity and debt β. The relationship enables us to correct for leveraging (gearing) effects on equity and debt returns in the context of CAPM. Adopting the Vanilla WACC definition (equation 1 above) and substituting for Re and Rd the CAPM (equation 3) for these returns, i.e. Re = Rf + βe(MRP) and Rd = Rf + βd(MRP), we get the equation:

βa = βe.VS + βd

VD … (4)

where, βa is the beta of the assets or the company as a whole, βe is the beta of equity, and βd is the beta of debt. The other variables have been previously defined. Alternatively, if we adopted the definition of WACC under equation 2. the deleveraging formula becomes:

βa = βe.VS + βd

VD (1-T(1-γ)) … (5).

It is our preference to reliever or delever using equation 4 above. This method is least prone to errors in estimation. Tax terms may then be applied, if appropriate, to the cost of equity derived from the beta estimate. Derivation of the cost of equity or βe is discussed in the next section.


2 Capital Asset Pricing Model (CAPM) Parameters

2.1 Risk Free Rate

There has been some debate about what is the appropriate risk free rate to use in the CAPM. The debate has not concerned the source of the surrogate “risk free” rate which is a Commonwealth Government Issued security. The debate, to the extent that it exists, concerns the duration or term of such a security together with the sampling method used for determining an estimate. The CAPM is a single period model of no fixed duration and various governments securities from government bills to long term government bonds have been used as a surrogate rate. In the context of CAPM theory there is no reason to pick one duration over another. However, ideally the duration of the CAPM should be the duration of the planning period for which the CAPM is to be used to estimate an expected or required return. This means that if the planning horizon is a long term investment then a long term government bond is the appropriate duration to use. Further, it has been conventional in Australia to use 10 year Commonwealth Bond Yields as the proxy of the risk free rate as it is a highly liquid security which provides a good reflection of the expected yield on a long term government security. The data bases that have been assembled typically use such a bond as the surrogate risk free rate and, therefore, measures of market risk premium and the like are more readily available where a 10 year Commonwealth bond rate has been used. The date at which the yield on a government bond should be taken as the surrogate for the risk free rate is the date closest to the date of the pricing decision since the yield is meant to reflect the risk free rate that could be expected going forward. Capital Partners consider the most recent yield on a government bond the best estimate of the future rate and this is the yield that should be used to estimate the risk-free rate (Rf) in the CAPM. The duration of the bond should ideally match the investment horizon. For long term investment decisions, we recommend the 10 year government bond rate.

2.2 Determination of the Equity Beta

The standard method for estimating equity betas is an ordinary least squares (OLS) regression of stock returns on market returns. Most commercial data sources use four or five years of monthly stock returns and monthly returns on a broad stock market index portfolio. The slope coefficient from a standard OLS regression of stock returns on market returns is then used as an estimate of the equity beta. As with any regression, the estimated coefficient is not a precise calculation, but simply an estimate. The standard statistical (and legitimate) interpretation of the estimated coefficient from any regression is that the true value of this parameter comes from a normal distribution with mean equal to the parameter estimate and standard deviation equal to the standard error of the estimate. That is, the regression approach does not compute the true beta, it merely narrows it down to within some probabilistic range.


The width and range of this distribution depends on how precisely the coefficient can be estimated. It is the standard error of the regression estimate that measures the precision with which it has been estimated. Typically equity beta estimates, computed by regressing stock returns on market returns, have large standard errors. This means that they are imprecisely estimated and single point estimates cannot be relied upon with any great confidence. Hence we recommend that an industry average asset beta be applied. Appendix B provides further discussion on the different approaches to handling imprecision in beta estimates and the historic regulatory position. Pure-Play or Single Division Beta Estimation Capital Partners approach is to:

1. Identity the industry segment a company operates in. 2. Estimate individual equity betas of comparable listed companies in the industry. Whilst

we have a preference for long term (5 year monthly) betas, this may often not be practical where operations change over time. Capital Partners use the average of the 3-year weekly and 5 year monthly betas to derive an estimate of individual equity betas.

3. Estimate the unlevered beta for the industry segment a. Unlever the equity beta for each comparable company using the leverage of

each company as per the formula described in 1.8. b. Calculate the average of the unlevered betas. This is used as the estimate of the

industry asset beta. This is sufficient to estimate industry WACC directly and is our preferred approach.

4. Where an equity beta is desired, as needed for the calculation of WACC in approaches other than the Vanilla WACC, the industry asset beta should be relevered using the firm’s market levels of debt and equity to derive the equity beta.

Consolidated or Multi-Divisional Beta It is difficult to estimate a consolidated beta (and thus consolidated WACC directly). This is because where an entity engages in multiple activities across different industries it is difficult to identity truly comparable companies. The alternative choices are:

- Use a single point estimate of the consolidated company’s equity beta and unlever this. This assumes the company is listed.

- Use a weighted average of appropriate asset beta estimates for different industries a company operates in.

It is our preference to use the second approach. The weights should ideally be related to the relative contribution or exposure to other industries. The weighted average asset beta may then be relevered at the relevant gearing level as per a pure play firm above.

The consolidated WACC of a business is best derived from the value-weighted average of comparable industry betas of a particular company or project will operate in.

2.3 Debt Betas and the Cost of Debt Capital in the WACC

The difference between the interest rate or yield on debt issued by the entity and the comparable yield on the commonwealth government issued security of the same term is called the debt margin. This margin will reflect the risk of the entity’s debt relative to the commonwealth debt’s security. As we have already indicated the risk of the security can be divided up into diversifiable and non-diversifiable risk both of which will reflect the default risk of the entity or borrower. Clearly, the risk of the entity’s debt will be a function of the amount of asset backing to t he debt or equivalently the degree of leverage or gearing that the entity has. The greater the debt to value or debt to equity ratio of the entity, other things being equal, the greater the risk and therefore the


greater the required return or debt margin. This effect is clearly shown in the deleveraging equations (4) and (5). Similarly, the cost of equity will increase as the proportion of debt in the capital structure increases but this does not imply the cost of capital for the entity’s assets changes. The change in proportion of equity to debt can offset the relative increase in equity and debt costs such that the WACC or asset cost of capital remains unchanged – this is an illustration of the Modigliani Miller (MM) Proposition that “a company’s value is invariant with changes in its capital structure”. As a practical proposition the so called MM hypothesis is valid within reasonable ranges of debt/equity for most entities. The consequences are that in setting a debt margin, we are implicitly setting a level of gearing. If the observed equity beta is used together with a debt beta to derive an asset beta the assumptions employed will imply a particular level of gearing. When estimating a WACC it is usual to estimate the cost of debt using the contractual interest rate on the debt as a measure of the required or expected return on such debt. To the extent that the WACC is used to discount expected net cash flows and the redemption yield on the debt is used as a measure of the cost of debt reflects both diversifiable and non-diversifiable risk will also cause an over estimate in the debt component of the cost of capital. The same problem occurs when we ascribe the full “debt margin” to the estimation of the beta of debt (βd). Where expected cash flows are used in the numerator of the NPV model, diversifiable risk is taken into account in the product of the probability of the various "states of nature" and the outcomes, in much the same way as an insurance premium reflects the actuarial expected outcomes. To include compensation for such risk in the WACC is to double count for this risk. Nonetheless, the usual practice is to ignore such double counting or overestimate in debts contribution to WACC on the grounds that for major issuers of debt, such as listed companies, it is small and insignificant. Capital Partners recommends Australia Post use a debt beta of 0.1 in calculating WACC. This is roughly equivalent to the expected yield on an investment grade security with strong ability to meet debt service. We recommend against the textbook practice of assuming debt beta of zero for simplicity as only the risk free asset meets this criteria.

2.4 The Market Risk Premium (MRP)

As one of the CAPM parameters the MRP is common to all asset or securities, it reflects the premium the beta or covariance risk of the asset or company must command. It is the premium for an average unit of risk (β = 1.0).

The MRP is the stock market’s price of risk relative to a risk-free rate of return such as the yield on 10-year Government bonds. The MRP is a real measure of risk as distinct from a nominal measure. The rationale for using historical data as a measure of the ex-ante MRP is that investors’ expectations will be framed on the basis of their past experience. Historically, the MRP tends to be mean reverting but there have been 10-year periods when the returns from equities have been below the yield of 10-year bonds.

A figure of 6% is commonly used in Australia and the US by regulators and academics, although some market participants use more recent data and subjective measures to justify using a lower MRP figure. When calculating ex-post MRP figures as a basis for determining the ex-ante MRP, the use of arithmetic average stock returns is favored over the geometric measure because arithmetic average returns are probably a closer proxy for what are expected by investors or how the expectations are framed by investors. The Australian historical MRP data has been reasonably consistent with that of the US, UK and New Zealand.


Figure 2-1 and Figure 2-2 demonstrate a justification for a MRP of 6%. The ten year moving average has a mean of about 6% although in any ten year period the average could be well below or above this average but this does not mean expectations will be framed on any one ten year period.

Figure 2-1: Ten Year MRP

-4 .00-2 .000.002.004.006.008.00

10.0012.0014.0016.00

Source: Officer

The Exponential Moving Series is also trending towards 6%, such a series places greater weight on more recent observations, the equation is defined as:

SMRP(t) = α.α.α.α.MRP(t) + (1-α).α).α).α). SMRP(t-1)

Figure 2-2: Simple Exponential Smoothing of the MRP , alpha=0.5

0

2

4

6

8

10

12

D e c ) 1 8 9 0 1 9 0 0 1 9 1 0 1 9 2 0 1 9 3 0 1 9 4 0 1 9 5 0 1 9 6 0 1 9 7 0 1 9 8 0 1 9 9 0

2.5 Security Market Line

The CAPM expresses risk and return on the Security Market Line which indicates the required return for any asset relative to the risk free asset and the market portfolio (or average equity investment). The SML is invariant to individual risk preferences.


The SML is depicted below. Note all assets are of greater risk than the risk free instrument. That is, there are no negative beta assets. At the low end of the spectrum are corporate bonds. The market portfolio or average equity has, by definition, a beta of 1.0. As the average market portfolio has debt, the average asset is of lower risk. As shown, when taking into account the average market gearing, the average unlevered equity (ie. the average asset) has a beta of 0.7.

Figure 2-3 Security Market Line

Source: Capital Partners for Illustrative Purposes Only With different levels of gearing, any single investment can be virtually anywhere on the SML. Hence it is more useful to compare where investments are on the SML at the asset (ungeared level). The beta for a particular investment will be derived by estimating the equity betas for all its comparable companies, and then delevering these equity betas to derive an asset beta. The average asset beta can then be used for the divisional WACC or regeared at an appropriate gearing for that division to derive a divisional equity beta.

Risk Free

Expected Return

Market Risk Premium

6.0%

Corporate Debt

Average Equity β = 1

Average Unlevered Equity

β = 0.7

Beta

Average company consolidated WACC


3 Estimation of WACC

This section outlines the basis of how we conclude on the consolidated WACC of Australia Post. Australia Post operates in a number of segments which span competitive to infrastructure-type services. These segments clearly are of differing risk and hence the typical estimation methods for examining pure-play companies are not valid for Australia Post. Further, it is impossible to directly observe the consolidated WACC for Australia Post. The consolidated WACC of Australia Post will be derived in a bottom-up approach by examining a range of comparable businesses to the ones Australia Post operates in. As a reasonableness test, this will be considered in light of the expected return behaviour for infrastructure assets.

3.1 Market and Fundamental Risk - Characteristics o f Infrastructure Assets

Risk will be determined by the fundamental nature of the asset. It is our experience that care needs to be taken in identifying the nature of infrastructure assets as some essential service assets are often incorrectly perceived to be of low risk. Incorrect specification results in substantial misallocation of resources. This is demonstrated below using the example of Horizon Energy – a major Victorian coal-fired power generator – where 90% of equity investment was lost. Power generation is an essential service often perceived as infrastructure but is in fact a commodity market subject to competitive forces with little pricing power – hence it is of high risk.

Figure 3-1: Misclassification of Risk

Source: Capital Partners for Illustrative Purposes Only As noted, the consolidated WACC will be built up from a review of different enterprises. Our sensibility check will be a determination of whether components represent the risk profile of a true infrastructure asset or are commercial in nature.

Probability Risk incorrectly identified and cash flows over-estimated

Actual cash flows lower than

forecast

Incorrect estimate of high cash

flow

Investment risk occurs when the value of an asset is incorrectly specified. A classic example was in the case of Horizon Energy (formerly 25% owners of Loy Yang Power Partnership). An excessive price was paid on acquisition. Risk was underestimated and cashflow was overestimated.

- Long term electricity prices were overestimated (median should be left of investment sunk cost)

- Volatility was greater as power generation is not true infrastructure. Investment -

Sunk Cost True Asset

Value


Infrastructure assets are essential services which normally exhibit monopoly or monopoly-like characteristics. They exhibit ability to control or influence prices over relatively identifiable demand. True infrastructure assets have little correlation with the market and hence are expected to have low asset betas. In Figure 3-2 below, those divisions which are expected to possess infrastructure like characteristics are expected to be within the green shaded area (ie. lower risk and return). The competitive business units are expected near the blue areas (ie. average market risk and return).

Figure 3-2 Security Market Line

Source: Capital Partners for Illustrative Purposes Only

3.2 WACC Estimation Process

As noted, the consolidated WACC will be built up from a number of comparable entities. We note that at some point, a subjective judgement needs to be made on where to disaggregate the behaviour of Australia Post. The WACC is estimated under four methods as below. All of these methods are before personal taxes.

1. Pre Corporate Tax: Suitable where tax is not calculable e.g. for internal divisional analysis.

Risk Free

Expected Return

Market Risk Premium

6.0%

Infrastructure βAsset between

0.2 & 0.5

Corporate Debt

Average Equity β = 1

Avg. Unlevered Equity β = 0.7

Beta


2. Post-Tax – Classical: An after-corporate tax WACC based on a classical tax system i.e. where no imputation credits are generated. Suitable for situations where franking credits are not paid or are attributed zero value.

3. Post-Tax – Imputation: An after-corporate tax WACC based on an imputation tax

system. Tax effects are incorporated in the discount rate.

4. Vanilla WACC: An after-corporate tax WACC that can be used under any tax system. All tax effects are accounted for in the cash flows.

The cash flows applicable to each WACC are shown in Table 4-1 in Section 4, along with the formulas for calculating each WACC. The average asset beta is sufficient to calculate WACC under the Vanilla-WACC approach. Vanilla WACC is the preferred method as it is least prone to error and explicitly recognises tax in the cashflows rather than the discount rate. However, for estimation of WACC using the alternative methods discussed, it is necessary to estimate the average equity beta. Equity beta is derived by relevering the average asset beta using CAPM parameters as discussed in Section 2. An optimal gearing of 70% equity/30% debt has been assumed. We note that each time levering or unlevering is conducted, there is additional risk of estimation error. A summary of key assumptions is below.

Table 3-1: Capital Partners’ Assumptions

Capital PartnersAssumption

Ten year Risk Free Rate (Rf) 5.56%Market Risk Premium (MRP) 6.00%Corporate Tax Rate (T) 30%Value Attrbuted to Franking Credits (γ) 0.5Debt Beta 0.1Gearing (D/V) 30%

3.3 Australia Post Overview

Australia Post’s main business segments are characterised by high volume, low margin transactions. Significant upfront investment is required and critical mass is essential to ensure the business operates effectively. Management and operating risk appear low relative to the average industrial company. However, as key functions are increasingly automated, there is less scope to vary costs with volume and operating leverage will increase. This profile is not dissimilar to many other key infrastructure assets. The key business segments we have considered in the determination of consolidated WACC are:

• Financial Services • Reserved Letter Services (“Letters”) • Property Development • Logistics

The key divisions and components of Australia Post’s risk are described below.


Table 3-2 Components of Australia Post’s Risk

Division Type of Risk

Description

Financial Services

Retailing Transactional

Financial Services is a mix of retailing and infrastructure services. Key comparables are retailers and transactional services such as stock exchanges. The Financial Services division provides processing facilities for financial payments and retail services. Financial Services does not incorporate banking services such as deposit taking and lending. The nature of the business is twofold:

1. One side is a processing facility characterised by high volume transactions of low value;

2. The second part of the business is retail sales.

Reserved Letter Services (“Letters”)

Partial monopoly Distribution

Letters is an infrastructure asset with some demand risk which should primarily be recognised in cashflow forecasts. However, Letters does not possess a monopoly where mail is not delivered to individual households. This division still operates under a protected environment where local “Reserved Letter” services apply for addressed mail under 250g. However, even without this protection, addressed mail can be considered a natural monopoly in the sense that a large, single supplier of the service is the most optimal outcome. Letters provides an essential service where the expense of replicating letter boxes, post offices, sorting and the postal distribution network is an inherent barrier.

Property Development

Property market

The Property Development division is responsible for preparing post offices for sale and lease back. Post’s Property Development division is a small component of the overall business and earns little external revenue and hence bears little relevance to the consolidated WACC.

Logistics Transport and Distribution

Logistics is responsible for delivery of packages and parcels which do not fall under the services provided by Letters. Larger parcels are often delivered by third-party contractors and smaller ones by postal staff. Logistics also provide warehousing and distribution services on a commercial basis to larger customers such as Coles On-line.


3.4 Australia Post Consolidated Group WACC - Applic ation

Whilst detailed valuation methodology is beyond the scope of this report, it is necessary to consider the context in which WACC may be employed. In our view, the consolidated WACC for Australia Post is not truly applicable in a valuation context. It is unlikely that any individual investment project Australia Post undertakes will replicate this profile. The consolidated WACC may be used to estimate the value of Australia Post as a whole from consolidated ungeared cashflows. However, there is a high risk of estimation error should the consolidated WACC be applied in this manner. We recommend against this method of valuation except as a short-hand valuation only. Using the consolidated WACC for valuing the whole entity implicitly assumes the consolidated WACC is equally applicable to all future cashflows. This is beyond the scope of this report but we consider this unlikely given the changing nature of Australia Post’s business. Figure 3-3 below provides an example of the estimation error over time when a business takes on different types of projects. Assuming a business of three projects with different risk profiles, the initial estimation of consolidated WACC will prove to be conservative. This is because the higher risk project is expected to earn a higher return and hence the higher risk division’s relevance will increase over time. In the example below, all else equal, the consolidated WACC will increase from 10.8% to 11.3%. Therefore, use of a static consolidated WACC of 10.8% may overestimate value.

Figure 3-3 Consolidated WACC Example of Estimation Error Over Tme

25%

Market riskWACC = 13%

Moderate riskWACC = 10%

Infrastructure riskWACC = 7%

25%

50%

17%

23%

60%

Year 1 Value = $100Consolidated WACC = 10.8%

Year 10 Value = $284Consolidated WACC = 11.3%

Source: Capital Partners for illustrative purposes only.


The consolidated WACC is expected to increase over time to reflect the relatively higher expected return and faster growth of more risky projects. The consolidated WACC therefore requires ongoing review. An additional danger arises where the Consolidated WACC is applied as a single hurdle rate for all projects within Australia Post. This will result in the following:

- Potential rejection of low risk, positive NPV projects; - Potential acceptance of high risk negative NPV projects; and - An increase in the average risk of the firm.

Note this will be the case where any single company-wide hurdle rate is applied in a firm with projects of varying risk. Take for example the case of Telstra. Telephony lines are inherently low risk businesses. If the expected return for a telephony line were used to assess the merits of acquiring a software development company such as Solution 6, which is of higher risk, this would lead to poor investment decision making. This is demonstrated in Figure 3-4 where projects above the upward sloping Required Return are value accretive and projects below are value destroying. As shown, a flat hurdle rate results in sub-optimal investment decisions.

Figure 3-4 Investment Risk from Consolidated WACC a s a Hurdle Rate

Source: Capital Partners for illustrative purposes only. The consolidated WACC is mostly useful for assessing the overall position of Australia Post in a risk return context – providing investors with the ability to decide if, as a whole, it meets their own risk preferences. In the example shown, the risk of the example firm is between that of an infrastructure asset and a competitive asset.

Risk

Required Return

Hurdle Rate - Original

Consolidated WACC

Required Return Accept higher risk value destroying

projects Reject potentially valuable low risk

projects

Market risk Moderate

Infrastructure risk

Consolidated WACC Market Infrastructure

risk


3.5 Result

The consolidated WACC for Australia Post has been calculated under four different methods as below. Capital Partners preferred method is to use the Vanilla WACC.

Table 3-3: Australia Post Consolidated WACC






4 Application of WACC

This section defines how cashflows should be constructed under each of the WACC methods. The construction of WACC is relatively straightforward when compared to the estimation of cashflow. The critical issue is confusion over accounting identities and actual cashflows to owners of the business. It is cashflows that determine the value of an investment rather than profits. In the estimation of cashflows, confusion usually occurs in the treatment of different stakeholder claims (debt service, equity and net taxes), changes to working capital, capital expenditure, and determination of the “most likely case” or mean estimate of future cashflows. As discussed in Section 1.6, adjustments are required for idiosyncratic risk or Specific Risk Pricing. This is discussed briefly below in Section 4.3. Appropriate construction of expected cashflows requires significantly more detailed explanation than is within the scope. However, the cashflow treatment and derivation from accounting values is relatively formulaic and is shown below in Section 4.2. Note that it is implicitly assumed that future projects are of similar nature and risk as Australia Post is as a whole. In other words, the cost of capital depends on the nature of an individual project rather than the source of capital.

4.1 Application - Treatment of Cashflows

The calculation of cash flows depends on the WACC formula used. The appropriate cash flows for each WACC are presented in Table 4-1 (continued on the next page), along with the formulae for calculating the WACC.

Table 4-1: WACC Formulas and Cash Flows

Pre Corporate Tax WACC

Cash Flows

Net cash flows to equity + net cash flows to debt + tax payments. (Approximately EBITDA)

Debt Tax Shield

Cash Flow s to Gov't

Cash Flow s to Debt

Cash Flow s to Equity

WACC

V

Dr

V

S

T

rWACC d

e ..)1(1(

+−−

=γ


Post Corporate Tax WACC – Classical Tax System

Cash Flows

Net cash flows to equity + net cash flows to debt (Approximately EBITDA – Tax)


Cash Flow s to Debt


Debt Tax Shield

WACC

)1(.. TV

Dr

V

SrWACC de −+=

Post Corporate Tax WACC – Imputation Tax System – T ax Effects in Discount Rate

Cash Flows

Net cash flows to equity (excluding value of franking credits) + net cash flows to debt


Cash Flow s to Debt


Debt Tax Shield

WACC

)1(.))1(1(

)1(.. T

V

Dr

T

T

V

SrWACC de −+

−−−=

γ

Post Corporate Tax “Vanilla” WACC – Imputation wit h Tax Effects in Cash Flows

Cash Flows

Net cash flows to equity (including value of franking credits) + net cash flows to debt

Cash Flow s to Debt


Value of Franking Credits


Debt Tax Shield

WACC

V

Dr

V

SrWACC de .. +=

Capital Partners valuations incorporate the Vanilla WACC in a DCF framework, which requires an estimate of asset cash flows, net of tax and franking credits.


This structure enables Capital Partners to take a reported operational performance measure (EBITDA) and convert the result into a format that is a suitable for a WACC-based DCF model (Un-geared Post Tax Post Franking Cash Flow). Table 4-2 shows the calculation of cash flows to be used with the Vanilla WACC using Australia Post data from the 2004 Annual Report.

Table 4-2: Calculation of Net Cash Flow for use wit h Vanilla WACC

2004Profit From Ordinary Activities Before Tax 521.1Add: Borrowing Costs Expense 32.1Add: Depreciation and Amortisation 204.1EBITDA 757.3

Less: Purchase of PP&E (197.9)Less: Purchase of Intangibles (12.0)

Add: Decrease in Debtors 12.7Less: Decrease in Creditors (70.4)Less: Increase in Inventory (8.3)

Less: Income Tax Paid (179.4)Add: Value Attributed to Franking Credits 89.7

Ungeared Free Cash Flow 391.7

4.2 Tax and Imputation Credits

The optimal manner in which tax and imputation credits are treated is also critical in the determination of the best WACC estimation method. It is our preference to avoid confusing a cashflow term (taxes and imputation credits) with a risk measure. Capital Partners preferred approach is to build taxation, including imputation, into the cash flows rather than in the discount rate. This is an additional reason for preference for the Vanilla WACC as recently adopted by the ACCC. The Vanilla WACC leads to a valuation result that is post-corporate tax, but pre-personal tax where: • There is no need for a corporate tax term (Tc) in the discount rate, because the effects of tax

and franking credits are included in the cash flows • There is no need for a personal tax term (Tp) in the discount rate – the valuation is invariant to

this. Australia has what is known as a full imputation taxation system. This was adopted in Australia in 1987. This removed the impact of double-taxing of dividends, at both the company and the personal level. Tax at the corporate level effectively became personal witholding tax for shareholders who were Australian residents. However, not all of the franking credits are available or utilised. Analysis undertaken by Officer and Hathaway reveals that the value of franking credits can vary according to the type of company. In the case of Australia Post, our two key considerations are the likely franking credits available and an estimate of the proportion of shareholders who are able to take advantage of credits – in the context of Australia Post as a normal commercial entity.


In this vein, we are mindful of the fact that both Telstra and Commonwealth Bank were unable to transfer all franking credits on privatisation. However, sufficient amounts or warranties were made available such that all retained earnings in the period immediately following privatisation were virtually guaranteed to be fully franked. Hence we consider it appropriate to apply a level of franking similar to that of other comparable commercial enterprises (as discussed in 1.4). For Australia Post we recommend a level of 50%.

4.3 Allowances for Specific Risk

The value of an investment is a function of the cashflows generated and the risks associated with those cashflows. The forecast cashflows represent the expectation of the most likely case. These cashflows are then discounted to allow for systematic risk in the investment. However, as discussed, in Section 1.6 it is necessary to consider idiosyncratic or specific risks which are not captured in our estimation of beta. The forecast cash flows are adjusted to allow for specific risks relevant to the investment in order to determine the expected or probability-weighted cash flows. Examples of specific risks include, but are not limited to:

• Technology involvement; • Project scale; • Construction cost overruns; • Management inexperience; • Liquidity; and • Macroeconomic conditions.

The normal practice is to incorporate a risk premium in the discount rate for these specific risks. Capital Partners recommends against this practice as it confuses cashflow forecasting risk against the inherent risk of the asset. Furthermore, a risk premium inappropriately penalises all future cashflows for a specific event. For example, to value a development that faces the possibility of a cost over-run during construction, we would first estimate the probability of a cost over-run and the approximate impact on cash flows. If we estimate that there is a 10% chance of a delay that will cost an additional $5m, then the expected cost of delays is $0.5m. This is included in the cash flow forecasts. Accounting for specific risk in this way is simpler and more transparent than attempting to adjust the discount rate of the project. Capital Partners recommend that specific risks are expressly priced and included in the cash flow

forecasts rather than allowed for by adjusting the cost of capital.

Value = (Forecast “Base Case” Cashflows @ Discount Rate) - Value of Specific Risks.


4.4 Signals for Update of WACC

There are two factors that can be expected to change the WACC of Australia Post:

• Change in interest rates; and • Change in the risk profile of the business.

Interest Rates: An increase in interest rates increases the cost of capital for every asset in the economy due to the increase in the risk free rate. The 10-year bond rate varies continuously so it is prudent to review the WACC on a regular basis e.g. quarterly, or before each investment decision. An appropriate signal to reconsider the WACC is an announcement of a change in the short term target cash rate by the Reserve Bank of Australia Such announcements generally also signal a change in long term rates. Business Risk: A change in the business risk of Australia Post would bring about a change in the asset beta, thus affecting the WACC. Business risk could be altered by establishment of a new line of business or a change in the weightings of the existing divisions due to a change in their size relative to each other. Other Causes for Review of WACC: It would also be appropriate to review the WACC if new evidence emerges in the form of new listed comparables which could facilitate a more accurate estimation of the asset beta.


5 Conclusion and Summary

The key consideration for Australia Post is the opportunity cost of alternative and equivalent uses of funds for owners and investors in Australia Post. Despite government ownership, we consider that the opportunity cost of capital for Australia Post is that of a normal (listed) commercial enterprise. Capital Partners has estimated the consolidated WACC of Australia Post using the CAPM under four different methodologies. These are shown below.

Table 5-1: Consolidated WACC





Capital Partners recommends use of the Vanilla WACC. This method provides the purest representation of the inherent business risk of the enterprise. Tax and imputation impacts are not related to the risk of the enterprise but are cashflow impacts. The Vanilla WACC requires project assessment using post-tax, post-franking cashflows with only time-value-of-money consideration in the discount rate. We consider this method least prone to estimation error. This method is consistent with the ACCC’s most recent approach on WACC for other regulated assets. We recommend this be done at an assumed value of franking credits of 50% per dollar of tax. We suggest caution in the application and interpretation of the consolidated WACC. The consolidated WACC provides a measure of the relative risk of the enterprise and is most useful as a point of reference to gauge the performance of Australia Post as a whole. In our view, Australia Post is of moderately higher risk than the average infrastructure asset but of significantly lower risk than the average listed security. The consolidated WACC is a static number reflecting the current business mix of Australia Post. Over time, organic growth is expected to see riskier divisions contribute a larger share of value. Hence the consolidated WACC is likely to change over time. This makes the consolidated WACC less reliable as a valuation tool. It should only be used to provide a broad approximate valuation of the enterprise. When valuing specific projects, those projects should be of similar risk to that of the entire enterprise. We note the CAPM based risk measures above do not incorporate a premium for non-systematic or specific risk events for Australia Post. These will require specific review on a case basis. This is beyond the scope of this report. However, we broadly recommend that specific risks are not incorporated as a premium to WACC but are considered as an adjustment to forecast cashflows.


6 Appendix A – Definitions of WACC

There are a variety of WACC that could be used and the most commonly used formulae for the WACC and the appropriate definition of net cash flows, given the WACC, are given below. The proof of these definitions can be found in Officer, R.R. [1994], “The Cost of Capital of a Company Under an Imputation Tax System”. Accounting and Finance, Vol. 34, No. 1, pp. 1-17.

6.1 Definitions

X0 represents operating net cash flows, i.e. the net cash flows that are distributed to shareholders, debt holders and the government through taxation i.e.

X X X Xo e d g==== ++++ ++++

Xe is the net cash flows that are attributable to shareholders Xd is the net cash flows that are attributable to debt holders Xg is the net cash flows that are attributable to government through taxation T is the effective tax rate γ is the value of imputation tax credits as a proportion of the tax credits paid re is the required return to equity holders rd is the required return to debt holders S is the value of shares or equity D is the value of debt V = S + D is the value of the assets of the company

6.2 Before tax Cost of Capital

Definition of cash flows: X X X X

e d g0= + +

Cost of capital:

rr

TSV

rDV

ed0 1 1

=− −

+( ( )

. .γ


6.3 After tax Cost of Capital

1. Definition of cash flows:

X T

01( )−

Cost of capital:

r rSV

TT

rDV

Ti e d

= −− −

+ −. .( )

( ( ) ). ( )

11 1

1γ

2. Definition of cash flows: X T

01 1( ( ) )− − γ

Cost of capital:

r rSV

r TDVi i e d

= + − −. ( ( ) ) .1 1 γ

3. Definition of cash flows: X T T X X

d0 01( ) . ( )− + −γ

Cost of capital:

r rSV

rDV

Ti i i e d

= + −. . . ( )1

4. Definition of cash flows:

X X X T X Xg d0 0 0

1− = − − −' ( ) ( )γ

Cost of capital (the "Vanilla" WACC):

r rSV

rDVi v e d

= +. .

Is there a best WACC? It is our preference to adopt the definition for the WACC as in equation 4 above. The appropriate definition of cash flows, reordering the equation above is:

x x x T(x x T(x xog o o d o d− = − − + −' ) )γ

where: xo = economic operating profit (≡ earnings before interest and taxes) T(xo-xd) = company tax with interest xd as a tax deduction γ.T(xo-xd) = the value of franking credits added back because these are really a witholding of personal taxes at the company level.


This definition of net cash flows is also closer to what most would consider net of taxes cash to providers of capital insofar as it includes the effect of the tax shield afforded by debt. The WACC is a simple weighted average cost of debt and equity i.e.

r rSV

rDVi v e d

= +. .

is less prone to error and confusion relative to other equations or formulae. Also the values are more readily identified with observations of capital market rates and therefore easier to comprehend. Further, the absence of a tax parameter in the WACC-- taxes are taken account of in the definition of cash flows -- makes the effect of taxes less prone to error. As I have mentioned conventional WACC with tax included in the formula require an estimate of some sort of average tax rate for the entire life of the asset or the period of analysis. Such estimates are difficult to determine with any accuracy. The “Vanilla” WACC is also more accurate for finite life investments than alternative formulations because of the tax effect and cross product effects of taxation and depreciation. Finally, taxes can be accurately identified when they occur in the net cash flows. Their effect is not ignored, although who has to bear the taxes or changes in taxes is still a problem the Regulator has to solve. In summary, the reason for arguing that equation 4 is the most appropriate is that all the adjustments for taxes, imputation credits and the like occur in the net cash flows. This has the advantage of being able to clearly identify when these taxes are paid (also, it clearly recognises the difference between economic depreciation and tax depreciation). In addition, this simple WACC or “Vanilla WACC” is much easier for lay people to understand and bears a closer resemblance to market rates which they can observe.


7 Appendix B – Imprecision In Equity Beta and Regul atory Approach

The imprecision in beta estimates has been noted by Australian regulators. The imprecision of equity beta estimates has also long been recognised in the academic literature and in practice. For example, the Centre for Research in Finance (CRIF) at the Australian Graduate School of Management computes OLS betas as well as Scholes-Williams betas. The Scholes-Williams procedure provides a statistical correction for non-trading. This correction is designed to account for the fact that a particular stock may trade more or less frequently than the average stock in the index. The AGSM-CRIF Explanatory Notes explain that, “OLS can only be used when the data used satisfies the assumptions which underlie the regression analysis. One assumption, which is of potential importance in the Australian environment, is that the company and index rates of return should be measured contemporaneously; that is, over exactly the same time intervals. Since we are using monthly data, this is equivalent to assuming that all stocks have a trade (establishing the current price) right at the end of each month. While this might be the state of affairs for BHP, it is not so for many of the companies listed by the ASX. In fact, some listed companies exhibit infrequent trading to the point where they do not trade even at regular monthly intervals.” In fact, the problem is more severe than this – many of the stocks that are included in the index also trade infrequently. Therefore, even if we are trying to estimate the beta of a stock that is large and liquid and trades continuously, there is still a mismatch with the trading frequency of the index. The index likely contains stock prices from its smaller constituents. The CRIF Explanatory Notes also recognise this: “This thin trading phenomenon may introduce biases into the OLS estimates. A number of statistical methods exist for estimating beta in the presence of the thin trading phenomena. The CRIF betas are computed using a version of the method first suggested by Scholes and Williams (1977), this technique adjusts for thin trading inherent in both the stock and the market index”. However, we cannot simply rely on these Scholes-Williams betas for at least three reasons: They tend to be estimated with even less precision than standard OLS betas (i.e., they are designed to correct for non-trading bias, not statistical imprecision); the Scholes-Williams technique is only one of many statistical adjustments to OLS betas that have been proposed (see below); and the Scholes-Williams technique often produces extreme results, at least relative to standard OLS betas, but there is no consistent relationship between the two. For example, in the recent CRIF report (March, 2004), the Scholes-Williams beta is no different from the OLS beta for Envestra, 30% higher for Alinta, and 8 times as large for AGL. Another reputable data source, Bloomberg, provides a different statistical adjustment. Blume adjusted betas, as provided by the Bloomberg service as follows:

1. 0.33 raw 0.67 adjusted ×+×= ee ββ Three substantial pieces of work that document other variations in the way that betas are estimated in the Australian context are the ACG’s report for the ACCC (2002), the NERA (2002) response to this report and the research monograph by Brailsford, Faff and Oliver (1997). These sources document more than 20 alternative statistical approaches that have been proposed to estimate equity betas. Clearly, there is no single consensus approach for estimating equity betas. The very existence of so many alternative approaches is evidence that none is satisfactory, accurate, or robust. In this


context it is worth looking at some of the regulatory issues surrounding WACC and the estimates of equity β’s. By construction, the equity beta of the average Australian firm is 1.0. This is equivalent to noting that the average Australian firm is expected to require a return on equity that matches that of the market portfolio. Thus, an equity beta of 1.0 is, by construction, the starting point or null hypothesis when estimating the beta for a particular firm. Only when there is sufficient evidence to depart from this null hypothesis should a different value be used. Indeed, in the financial economics literature it is quite standard to construct “market adjusted returns” by assuming that all firms have an equity beta of 1.0. Brown and Warner (1980) demonstrate that, in many settings, assuming the equity beta of all firms is 1.0 produces more consistent and reliable results than if betas are statistically estimated for each firm. Conceptually, a particular firm may have a beta different from 1.0 if the business in which it operates has low systematic risk or if it has different gearing than the average firm. However, these effects are difficult to quantify precisely such that a maintained assumption that equity beta equals 1.0 is often superior. This is particularly true in cases where the two effects work in opposite directions. For example, regulated energy distribution firms are likely to have lower than average systematic risk but much higher than average (assumed) gearing. To the extent that these effects are difficult to quantify and tend to cancel each other, substantial evidence should be required before departing from an equity beta of 1.0. The issue has recently been addressed in some detail by the Productivity Commission (PC), the Supreme Court of Western Australia and the Australian Competition Tribunal. For example, the Productivity Commission’s Review of the National Access Regime recognises that the effects of too little infrastructure investment are far more severe than those associated with too much (or too early) investment. The PC states (p. xxii) that “Given that precision is not possible, access arrangements should encourage regulators to lean more towards facilitating investment than short term consumption of services when setting terms and conditions” and that “given the asymmetry in the costs of under- and over-compensation of facility owners, together with the informational uncertainties facing regulators, there is a strong in principle case to ‘err’ on the side of investors”. The PC goes on to quote from a submission to the review by NECG, which stated that “In using their discretion, regulators effectively face a choice between (i) erring on the side of lower access prices and seeking to ensure they remove any potential for monopoly rents and the consequent allocative inefficiencies from the system; or (ii) allowing higher access prices so as to ensure that sufficient incentives for efficient investment are retained, with the consequent productive and dynamic efficiencies such investment engenders. There are strong economic reasons in many regulated industries to place particular emphasis on ensuring the incentives are maintained for efficient investment and for continued productivity increases. The dynamic and productive efficiency costs associated with distorted incentives and with slower growth in productivity are almost always likely to outweigh any allocative efficiency losses associated with above-cost pricing. (sub. 39, p. 16)” The PC Review highlighted the need to modify implementation of the regime and made 33 recommendations to improve its operation. In particular it identified as a “threshold issue, the need for the application of the regime to give proper regard to investment issues” and “the need to provide appropriate incentives for investment.” This view is supported by the Commonwealth Government, which has resolved to amend the Trade Practices Act in this regard. In particular, the access regime will be modified to include a clear objects clause: “The objective of this part is to promote the economically efficient operation and use of, and investment in, essential infrastructure services thereby promoting effective competition in upstream and downstream markets…”


In addition, a set of pricing principles will be included that requires “that regulated access prices should: (i) be set so as to generate expected revenue for a regulated service or services that is at least sufficient to meet the efficient costs of providing access to the regulated service or services; and (ii) include a return on investment commensurate with the regulatory and commercial risks involved…” We believe that these views are consistent with the notion that a higher standard of evidence should be required to adopt an equity beta estimate below 1.0 than is required to adopt an estimate above 1.0.


8 Appendix C - Comparable Listed Post Offices

The Netherlands: TPG The Netherlands post office was partially privatised and listed on the Amsterdam Stock Exchange in 1994 – the first postal system in the world to be listed. TPG also owns global express parcel delivery and supply chain management businesses TNT Express and TNT Logistics. The Dutch mail market is expected to be deregulated by 2007. The Dutch government owns 19% of TPG. Germany: Deutsche Post Deutsche Post was privatised and listed in 2000. In 2002, it acquired global express parcel delivery business DHL. Deutsche Post also operates a logistics business and Postbank, a retail bank that operates from post retail outlets. The German government owns 63% of Deutsche Post. Singapore: SingPost SingPost was a division of Singapore Telecommunications (SingTel) until it was spun off in an IPO in 2003. SingTel has exclusive rights over basic mail in Singapore until 2007 and also operates a global express parcel business and a logistics business. It has also entered a JV with GE money to provide personal loans. SingPost is 31% owned by SingTel, which is 65% owned by the Singapore government. Australia

Post TPG Deutsche

Post SingPost

Local Letters Monopoly � � � �

Local Express Parcels � � � �

Global Express Parcels � �

Logistics � � � �

Transactions Processing � � �

Personal Banking �


9 Appendix D - Comparable Company Descriptions

Market

CapDescription A$m

Listed Postal Services

TPGNational postal service in the Netherlands, international postal services, global express parcel delivery, freight and logistics.

17,235

Deutsche PostGerman national postal service, international postal services, global express parcel delivery, freight and logistics, electronic transactions, personal banking.

33,533

Singapore PostSingapore national postal service, international postal services, logistics, electronic transactions.

1,334

Express Parcel Delivery

FedEx CorpWorldwide express parcel delivery, transportation, freight, supply chain management, ecommerce.

41,026

United Parcel Service Package and document delivery, logistics, supply chain management 110,959

Blue Dart ExpressThe Indian agent for FedEx, offers a package and document courier service and delivery within India and worldwide.

243

Australian Infrastructure

Australian Infrastructure FundInvestment in unlisted transport infrastructure assets, primarily airports and railways.

698

Hills Motorway Ownership and operation of the M2 Motorway in Sydney. 1,952 Transurban Group Ownership and operation of tollroads in Melbourne in Sydney. 4,003

MIGOwnership and operation of tollroads, primarily in Canada, the UK and Australia.

7,750

EnvestraNatural gas distribution and ownership of transmission pipelines in South Australia, Queensland and the Northern Territory.

854

Australian Logistics

CTI LogisticsCourier services, warehousing, logistics, container freight forwarding, container packing and unpacking. 16

K & S Corporation Transportation, warehousing, fuel distribution, freight forwarding. 213

Toll HoldingsExpress rail, land and sea freight transport, logistics, warehousing and distribution, port operations, recycling. 4,306

Wridgways Australia Furniture removal, storage, import and export services. 32

International Logistics

D. Logistics A.G.Supply and warehousing services for airports, manufacturers, chemical companies and hospitals. 127

WincantonLogistical services, fleet management services, design and procurement of warehouse storage systems. 771

TDG Distribution, storage, supply chain management 447 Theil Logistics Global logistics and business services 900 Hub Group Container freight transportation and logistics 707


Market

Cap

Description A$m

Stock ExchangesAustralian Stock Exchange Australia's primary stock exchange and derivatives market 2,267 Honk Kong Exchange Hong Kong stock exchange 3,613 Euronext Exchange A pan-European stock exchange 5,585 London Stock Exchange The UK's primary stock exchange 3,446

Transactions ProcessingBaycorp Advantage Supply of credit reference information 700 Paychex Inc. Payroll and human resources services 16,382 Deluxe Corporation Electronic transactions and paper payments 2,466 Equifax Inc Transaction processing, direct marketing 5,298 Coinstar Inc. Self-service coin counting machines 762 iPayment Inc. Electronic transaction processing 889

RetailWoolworths Food, liquor, discount and specialty retailing 15,621 Coles Myer Food, liquor, apparel and discount retailing 11,674 Foodland Associated Food retailing, wholesaling and distribution 2,757 Brazin Specialty retailing 287 Miller's Retail Discount retailer 247 Colorado Group Specialty clothing retailer 490

Property DevelopmentWestfield Holdings Development and management of shopping centres 8,831 Peet & Co Residential property development 493 Australand Residential and commercial property development and ownership 1,567 FKP Property Group Residential and commercial property development and mangement 685 Port Bouvard Residential property development 81

Comparable Companies Omitted from Analysis due to I nsufficient Data

Company IndustrySalmat Direct marketing and deliveryBill Express Transactions processingGeodis S.A. Global shipping and postal services, parcel and express deliveryPeet & Co Property developmentJust Group RetailOsaka Securities Exchange Transactions processing (stock exchange)Nasdaq Stock Exchange Transactions processing (stock exchange)Singapore Stock Exchange Transactions processing (stock exchange)New Zealand Stock Exchange Transactions processing (stock exchange)Newcastle Stock Exchange Transactions processing (stock exchange)


Financial Services Devision - Comparable Companies Traditional financial services businesses (such as Banking and Insurance) do not provide an accurate comparison as these incorporate financial market risk. Financial Services is an amalgam of general retailing and transactional service industries. A number of listed retail companies are available for comparison to the retail element. For the transactional element, analogies may be drawn to stock exchange services and other data processing businesses where high volumes of relatively similar transactions are processed at a set rate. Capital Partners has assumed the risk is divided evenly between the two services.


10 Appendix E - Comparison to ACCC Methodology

The ACCC’s methodology in the most recent Letters pricing determination in October 2002 is slightly at odds with Capital Partners preferred Vanilla WACC approach. However, more recent pricing decisions by the ACCC relating to other industries have incorporated the Vanilla WACC and the 10-year bond yield, which are consistent with Capital Partners’ methodology.

10.1 Relationship of Post with the ACCC

Under the Australian Postal Corporation Act (1989), carriage of addressed letters weighing less than 250 grams is reserved for Australia Post. The Reserved Letter service is considered a notified service under Section 95X of the Trade Practices Act (1974). Post is required to notify the ACCC of any proposed price increase of the Reserved Letter service. The ACCC has the authority to object to proposed increases. The decision on whether to object to a proposed price increase is based on the ACCC’s calculation of an appropriate after-tax return on capital. The ACCC performs this role only for the Reserved Letters business and has no direct involvement with the other divisions of Post.

10.2 ACCC Determination of Efficient Pricing

The ACCC has two objectives in reviewing the prices of the Reserved Letters business: • To allow Post to earn an efficient rate of return on the capital invested in the Reserved

Letters business; and • To prevent Post from exploiting its monopoly position by increasing prices above an

economically efficient level. To determine whether proposed prices will lead to an efficient rate of return, the ACCC estimates the efficient costs of the division and its cost of capital. The following formula is applied in order to estimate the revenue the division would require in order to earn an efficient return on capital (the formula was obtained from the ACCC Australia Post Price Notification Decision October 2002). This revenue figure is divided by forecast volume to obtain an estimate of the efficient price level.

RR = O&M + D + ROC + T Where RR = required revenue

O&M = operating and maintenance expenditure D = depreciation or return of capital ROC = return on capital = WACC * WDV WACC = weighted average cost of capital (post-tax); WDV = written down (depreciated) average value of the asset base T = corporate tax, less benefit of dividend imputation


10.3 ACCC Calculation of WACC

The revenue and price calculation described above requires an estimate of the after-tax WACC of the Reserved Letters business. In its most recent Letters pricing determination in October 2002, the ACCC applied the WACC determined by Professor Kevin Davis. Professor Davis estimated Post’s WACC by applying the following equation, which has been referred to throughout this report as the “Post Tax – Imputation” WACC:

)1(.))1(1(

)1(.. T

V

Dr

T

T

V

SrWACC de −+

−−−=

γ … (6)

All terms are as defined in Appendix C and in the report.

Table 10-1: ACCC Assumptions from October 2002 Lett ers Decision

ACCC Assumption Rationale

S/V 70% Consistent with Post assumption

D/V 30% Consistent with Post assumption

T 30% Australian corporate tax rate

γ 0.5 Consistent with previous decisions

Rf 40-day average of 5-year Commonwealth bond rates

Term corresponds with length of regulatory period

Debt margin 0.3% Based on AAA credit rating

ße 0.55 Consistent with international listed delivery companies and regulated businesses in Australia.

MRP 6% Consistent with previous decisions

10.4 Recent ACCC Decisions from Other Industries

The ACCC has made pricing determinations for other industries more recently than the last review of Letters pricing in October 2002. The methodology used by the ACCC in its most recent pricing determinations is different from the methodology applied to Letters in 2002 and consistent with Capital Partners’ “Vanilla” WACC approach. In the Background Paper “Statement of principles for regulation of the electricity transmission revenues” dated 8 December 2004, the ACCC details its approach to calculating WACC. The process described is the Vanilla WACC detailed above in Section 1.4.1. The generic assumptions made by the ACCC in its December 2004 Background Paper on the Electricity Transmission Industry are as shown below.


Table 10-2: ACCC Assumptions from December 2004 Ele ctricity Transmission Background Paper

ACCC Assumption Rationale

T 30% Australian corporate tax rate

γ 0.5 Consistent with previous decisions

Rf 5 to 40-day average of 10-year Commonwealth bond rates

10 year rate consistent with original calculation of the MRP

MRP 6% Consistent with previous decisions and historical measures


Contact Details Capital Partners Pty Ltd ABN 88 077 750 004 AFS Licence No. 246803 Sydney Level 8, Aurora Place 88 Phillip Street SYDNEY NSW 2000 Australia Ph +61 2 8274-5900 [email protected] www.cp2.com

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