108 Corporate Finance
Southwestern Bell is a large manufacturer of telecom equipment. The company publishes a required
rate of return for each of its subsidiaries and for particular projects. WACC based on market value weights is
the most popular hurdle rate for capital investments. Sometimes the company uses a modified multistage
dividend discount model. The company uses pure play betas in some of its businesses where pure play firms
are available. The pure play beta is adjusted for leverage. The concept of divisional cost of capital is applied
wherever possible.
Vulcan Materials Company is an international producer of industrial materials, industrial chemicals, and
construction aggregates. The company reviews hurdle rates periodically—once in three years or whenever
there is a need for revision. Not much importance is given to hurdle rates. The company uses leverage-
adjusted beta to estimate cost of equity. Usage of pure play and average industry beta is also in vogue.
A DECISION CASE: AUSTRALIAN GAS
TRANSMISSION AUTHORITY
Utility services like gas transmission lines and electricity distribution are regulated in many countries. The
regulators in these countries have to fix the price per unit of output (e.g., electricity that the company can
charge) and hence the return on equity (assuming that expenses are constant or increase in a definite fashion).
The idea is to add a constant spread to the cost of equity to calculate the allowable return on equity and work
backwards to calculate price per unit. So these regulators are required to calculate cost of equity for the
utility in question. They examine betas of individual listed firms and industry beta in arriving at a proxy beta.
Australian regulators of gas transmission lines use the CAPM to calculate cost of equity. They calculate
beta using the following formula:
β =
ED
E
D
U t ⎟ βD
⎠⎞
⎜
⎝
⎛ +β 1(1 – – )The asset beta is relevered at a target D/V ratio of 0.6. They use a proxy beta of 0.7 to estimate the cost
of equity.
There are four listed Australian entities: AGL, Australian Pipeline Trust, Envestra, and United Energy.
ACG, AGL, and United Energy are multi-utilities, with strong profiles in both gas and electricity. The Australian
Pipeline Trust is the only member of this group whose principal business is gas transmission pipelines. The
Australian Pipeline Trust has the highest equity beta of the group, at above 1. Envestra has the lowest beta at
between 0.40 and 0.47, depending upon the choice of debt beta and levering formula. Further, four-year
stock market data is available for only two firms.
The following is the asset beta range for gas distribution companies and other related industry groups:
Industry Asset beta range
Gas distribution (listed companies) 0.46–0.47
Electricity generation (listed companies) 0.88–1.22
Electricity distribution (listed companies) 0.46
Gas distribution (regulatory decisions) 0.40–0.60
Electricity distribution (regulatory decisions) 0.35–0.50
The actual range of asset beta for Australian gas distributors is 0.09–0.47. However, for Envestra (asset
beta of 0.09) the equity beta was estimated using only 46 observations, and the company had a leverage ratio