Estimation of Cost of Capital 109of 0.8328. Envestra has a highly unusual capital structure in the sense that other companies have a leverage
ratio in the range of 0.1736–0.2988.
The Allen Consulting group, the advisor to the regulator, examines betas of similar firms from the US,
Canada, the UK and Australia before coming up with an estimate of beta for Australian firms. ACG estimates
of beta for companies in the US, UK, Canada, and Australia are given here:
Tax term included in leveraging formula,
Equity beta estimates Debt beta = 0.15
for 60 percent debt to value Negative beta included Negative beta excluded
Australian companies 0.66 0.66
US companies 0.10 0.20
Canadian companies 0.02 0.26
UK companies 0.05 0.18
The consultants then varied the debt beta and recalculated the equity beta at the target D/V ratio:Tax term excludedEquity beta estimates with from levering formula Tax term included
60 percent D/V with Debt beta Debt beta
negative beta firms excluded Zero 0.15 Zero 0.15
Australian companies 0.69 0.66 0.68 0.66
US companies 0.25 0.19 0.26 0.20
US diversified pipelines 0.92 0.86 0.91 0.86
The regulatory authority sets beta value for a period of five years.
- Is the average Australian proxy beta a good proxy in estimating cost of equity? Why? Or, why not?
- Is it correct to include Envestra in the sample? Why or why not?
- Is it correct to derive proxy beta from other industry groups like electricity distribution?
- In general, when would asset beta be high?
- In general, when would the debt beta be positive? High?
- Should American, Canadian, and UK firms be examined before deriving a proxy beta? Why? Or, why not?
- Some American firms have negative beta. When would beta be negative?
- What is the impact of including for excluding firms with negative beta?
- Why is beta for US firms low compared to firms in Australia? What bias, if any, could have resulted in
a low value? - Should Australian firms be worried that the beta estimate will not be revisited for five years?
- Is the estimated beta (0.7) biased? Is it high or low?
IN CONCLUSION
The cost of capital is an important idea in finance theory. This chapter introduced several approaches for
estimation of cost of capital for both listed and unlisted firms. It is inappropriate to apply the weighted
average cost of capital as the hurdle rate for all the projects and divisions across the board. Cost of capital is