Cost of Capital

- Position Paper -
June 2001

Civil Aviation Authority

CAA House, 45-59 Kingsway, London WC2B 6TE

TABLE OF CONTENTS

Executive Summary...................................................................................................................5

Responses ..................................................................................................................................6

1. Introduction .......................................................................................................................7

2. Risk free rate .................................................................................................................... 12

3. Equity risk premium........................................................................................................ 14

4. Beta .................................................................................................................................. 16

5. Debt premium.................................................................................................................. 18

6. Gearing and tax................................................................................................................ 19

Effective versus statutory tax rates............................................................................................................... 19
Gearing ............................................................................................................................................................. 20

7. Summary: cost of capital estimates ................................................................................ 21

8. Specific airport factors .....................................................................................................22

9. Incremental costs estimates and the cost of capital........................................................23

10. Conclusion ...................................................................................................................24

11. Attachment 1 ................................................................................................................25

12. Attachment 2 ................................................................................................................26

Executive Summary
The cost of capital is a key regulatory parameter for capital intensive businesses such as airports.
While the price cap is to be set in terms of the Civil Aviation Authority’s (CAA) statutory duties for
the 2003-08 period the long term nature of airport investment problems and opportunities suggests
that a long term view be taken to the maximum extent appropriate. The CAA envisages that a
conventional approach be taken drawing on best regulatory practice and the latest Competition
Commission (CC) decisions in respect of generic parameters, up-dated to take account of the latest
data. Firm-specific parameters have to be estimated from available data with a degree of judgement
involved. Estimates for congested airports with major new projects in the pipeline may differ from
airports with capacity available. The paper lays out the initial CAA analysis and evidence as clearly as
possible to allow argument, analysis and empirical evidence to be submitted by interested parties.
Ultimately a judgement will have to be made by the CAA consistent with achieving its statutory
objectives.

The paper presents preliminary estimates of the real pre-tax cost of capital for the designated airports
of 6.1%-9.2%. The CAA is open to arguments and evidence on the assumptions that it has adopted
for these estimates.
Responses
This paper is intended as a note outlining the CAA’s current thinking on the cost of capital.
Comments are not explicitly requested, but those interested parties who wish to comment on the
issues raised in this paper should be sent in writing by 16 July 2001 to:

Susie Talbot
Economic Regulation Group
Civil Aviation Authority
CAA House
45-59 Kingsway
London
WC2B 6TE

Email: talbots@caaerg.co.uk
Fax: 020 7453 6244

All responses will be treated as public information unless otherwise specified. If a response is made
in confidence it should indicate that.
1. Introduction
1.1 The cost of capital reflects the opportunity cost of funds for investment in companies. If
their investments were expected to earn a return below their cost of capital, investors would
have superior alternatives for their funds. They could find other projects with the same
expected return but lower risk, projects with the same risk, but a higher expected return, or
projects with a higher risk and a higher expected return which still made a better opportunity
than airports. It may be worth noting that arguments are often made about risks affecting the
cost of capital that on closer analysis are project cash-flow risks and uncertainties. The
expected cost of capital is often a critical issue in the regulation of capital-intensive utilities via
RPI-X regulation where small changes in the cost of capital can have a major impact on the
price cap. This is the case for airports. The cost of capital is also very important and relevant
for incremental cost estimates.

1.2 The CAA is not envisaging a formal consultation on this document but would welcome
views, argument, analysis and evidence that would assist the CAA in coming to a final view
on this issue. The CAA is conscious that where airport capacity is under heavy pressure and
investment is the priority it will be important that the estimate used has a low risk of being
too low rather than being too high. This balancing of risk is consistent with maximising
regulatory certainty so as to provide a sound basis for long term investment in desired
capacity.

1.3 There remains intense debate on how several of the key components of the cost of capital
should be estimated for regulatory purposes. The issue has been given considerable
prominence in recent regulatory decisions, particularly the CC’s decisions over the appeals by
two water companies. The CAA proposes to draw on what we consider to be regulatory best
practice in coming to a conclusion on the key issues affecting the generic elements of the cost
of capital (the risk free rate and the equity risk premium). Our focus will be the framework
provided by the capital asset pricing model (CAPM) applied on a weighted average cost of
capital basis (WACC)1. We are not proposing to use other techniques such as dividend
growth2 or arbitrage pricing models, although we have examined recent relevant literature3.
We would of course welcome any evidence based on these approaches that assists the CAA in
coming to a final view on the appropriate cost of capital in this review. This is not a precise
science and judgement will be needed in coming to a view on this issue as an integral part of
the final regulatory decision given the CAA’s statutory objectives.

1 See Attachment 1 for the conventional formula.

2 Attachment 2 provides an example of this methodology.
3 See, for example, “New Facts in Finance” John H. Cochrane June 1999 gsbwww.uchicago.edu/fac/finance/papers/
1.4 In this review the CAA will “model” the airport businesses with a view to forming the
appropriate price cap on a cash-flow basis. In this framework the cost of capital takes its
technically correct role (in the capital asset pricing model) as a discount rate (as opposed to a
target rate of return). Estimating the cost of capital requires estimates or judgements on the
following:

• the return demanded on risk-free assets;

• the equity risk premium;
• airport company betas;
• the debt premium;
• gearing;
• treatment of tax.
1.5 We first cover the two generic components of CAPM: the risk free rate and the equity risk
premium. The estimations are in real terms. The distinction between using a post-tax pre-
financing cost of capital, using a post-tax, post-financing cost–of-capital and pre-tax cost of
capital (and calculating a ‘tax wedge’ in the cost of capital) is largely one of presentation
provided they are handled consistently.

1.6 Table 1 shows an overview of approaches adopted in recent decisions of other regulators and
the Competition Commission on the components of the cost of capital.
Table 1: An overview of approaches adopted by other regulators and the MMC/CC

Institution Case Basis of Risk free rate, Equity risk Equity Debt premium, Approach to WACC,
estimation % premium, % Beta % gearing %
MMC BAA, 1996 Real pre-tax. 3.5-3.8. 4.0-5.0. 0.7-0.9. 0.3-0.8. Estimated, but 6.4-8.3.
not optimal.
(30%)
MMC Cellnet/ Nominal 6.5-6.8 3.5-5.0 1.27 0.7-1.0. (9.1%). 14.9-17.8.
Vodafone, 1998 pre- tax. (nominal); (4 year Planned level (nominal)
3.5-3.8 (real). average,
LBS)
Ofwat Water and Real post- 2.5-3.0. 3.0-4.0. 0.7-0.8. 1.5-2.0 Optimal (50%) 4.6-6.2.
sewerage charges, tax.
Nov. 1999
Ofgem PES review, Dec. Real pre-tax. 2.25-2.75. 3.25-3.75. 1.0. 1.85-1.7 (adj. Optimal (50%) 6.0-6.9.
1999. From 1.4 to
reflect LT
debt).
CC Sutton and East Real pre-tax 3.0 4.0 0.7 - 1.0 1.5 - 1.9 25% - 50% 7.3
Surrey Water
August 2000
ORR October 2000 Real pre-tax 3.0 4.0 1.1 - 1.3 1.5 - 1.75 50% 6.9 - 8.2
(based on CC (to reflect (assumed)
central values) impact of
gearing)
1.7 It can be seen that there has been some divergence between the latest CC decisions (Sutton
and East Surrey Water et al) and the more recent periodic review conclusions of Ofwat,
Ofgem and ORR in respect of the risk-free rate and the equity risk premium.
2. Risk free rate
2.1 This has been the source of controversy in the recent periodic reviews. The most recent CC
decisions used a (real) risk free rate range of 2.75%-3.25% with a mid-point of 3.0%4. This
followed previous MMC conclusions in relation to BAA (1996), Manchester Airport (1997)
and Northern Ireland Electricity (1997) and Cellnet-Vodafone (1999) where the real risk free
rate was assumed to be 3.5%-3.8%. Recent conclusions by Ofgem, Ofwat5 and ORR6 use a
risk free rate in the range 2.25%-3.0%. Ofgem’s paper on Transco (February 2001) is
suggesting a range with a slightly lower mid-point than this.

2.2 The reason for the difference is that the regulators have generally focused on current market
rates on index linked UK government stocks, which are currently lower than in recent years,
while the CC has focused more on longer term averages of index linked gilts.

2.3 It should be noted that the CC’s conclusions are based upon data on UK government index
linked gilts’ yields estimated by the Bank of England covering the period for which index
linked stocks have been available, 1982. It is not, therefore, a (very) long term average of the
type often used in estimating the risk-free rate7 and the equity risk premium (see below).
However, the return on index linked gilts since the mid-80s has been higher than ex post
returns on government bonds over the twentieth century as a whole. In the very long run,
the CC recognises, the risk free rate has been lower.8 Jenkinson (19999) calculates that the real
return on Treasury Bills from 1919-98 was 1.7% (average annual) to 2.1% (average 10 year
holding). CSFB in a recent publication10 estimated that the real average return since 1869 was
1.8%. The LBS Millennium Book11 estimates a lower return of 1.0% p.a. over the century.
This is consistent with US data. These are lower than the Ofwat/Ofgem estimates.

2.4 At the time of the water appeals the CC was aware that spot market rates were below longer
term averages and that the index gilt historic averages were above those estimated from very
long term time series. Arguably, therefore, the CC has set a conscious precedent and little has
changed subsequently. Ofwat, Ofgem and ORR have opted for a more forward looking basis
in their recent reviews. The CAA continues to be attracted to using historical data for the
purposes of the risk free rate given short term volatility and the long term investment focus
of the current review. The CAA is therefore minded to adopt the most recent published CC
decision for the purposes of this review. Given the historical data this seems to be the view
that minimises the prospect of too low a cost of capital and the risks that entails. This
represents a reduction from the last airport review where a range of 3.5% to 3.8% was used.

4 CC Sutton and East Surrey Water, August 2000, chapter 8, page 118, paragraph 8.16.
5 OFWAT 1999 Periodic Review: Final Determinations, page 130, table 27.
6 ORR October 2000 Periodic Review of Railtrack's access charges: Final determination, page 40, paragraph 5.6 (range of

2.75% - 3.25%).
7 In these studies the real risk free rate has been estimated as the ex post return on nominal government bonds. This has

been necessary because index-linked bonds have emerged relatively recently.

8 MMC Cellnet-Vodafone Appendix 6, paragraph 7.
9 Jenkinson, T.J. (1999) 'Real Interest Rates and the Cost of Capital' Oxford Review of Economic Policy, 15(2), 114-127.
10 CSFB 2001 Equity Gilt Study, April 2001, p.12.
11 Elroy Dimson, Paul Marsh and Mike Staunton, 'Millennium Book II : 101 years of Investment Returns' ABN

AMRO/London Business School, page 57, table 13.

The current CAA judgement on the risk free rate for the purpose of this review is that it falls
in the range of 2.75%-3.25% with a mid-point of 3%.
3. Equity risk premium
3.1 The difference between the CC and recent regulators’ analyses is less than for the risk free
rate. Both are on the low side of long-term time series estimates. In Cellnet-Vodafone the
MMC opted for an ERP of 3.5%-5.0%. The lower end of this range is below the upper
bound of the regulators’ ranges. In the water cases the CC used a central estimate of 4%,
0.25% below that for Cellnet-Vodafone. This was 50 basis points higher than Ofwat’s central
estimate and Ofgem (2001)12 suggests that even 3.5% is high.

3.2 The ERP has been the subject of enormous academic study. The ERP, which is forward
looking, cannot be directly measured or observed (unlike the risk free rate). The ERP has
typically been estimated using long run historical measures of the ex post real returns on
equities compared with those on bonds. These time series tend to suggest ERP for the UK in
the range 4.5%-6.5% (Millennium book, table 15 and 16). This depends on whether average
or geometric means are used and whether short term or long term bonds are used in the
calculation. (Estimates for the world’s largest capital market, the US, suggest an ERP roughly
100 basis points higher.) The CC in the Sutton decision included a calculation synthesising
the arithmetic mean – geometric mean debate to suggest numbers towards the top end of
their range as representing the best unbiased estimators13. Regulators and the CC have
advanced arguments that these estimates may be over-stated as the best indicator of the
forward-looking ERP because of the very high returns over the last two decades. Surveys of
current market expectations are also drawn on to suggest that some shaving of these estimates
is required.

3.3 It is also worth reiterating that the estimated risk free rate used as the basis for historic
estimates of the ERP was significantly below that assumed by the CC and other regulators
(see table 1 above). Consider a company with a beta of 1, a debt premium of 0.5%, and 50%
gearing. The real post tax WACC using long term averages for both the risk free rate (2%)
and the ERP (5.5%) would be 5.0%. Using the shorter term estimates of the risk free rate of
3.0%, and the CC’s ERP of 4.0%, would give a real post tax WACC of 5.25%, not dissimilar.

3.4 The CAA continues to be drawn towards the historical averages as the basis for estimating
the ERP. We have found it difficult to evaluate the forward-looking studies including the
dividend-growth studies. The recent Fama-French paper, summarised at attachment 2, based
on a dividend growth model suggests that the unconditional expected equity risk premium is
much lower than the realised number over the last fifty years, 7.4%. However Ang and
Bekart in a recent NBER working paper14 present evidence that dividend yields are unable to
predict stock returns. Bansal and Yaron15 suggest that concerns that historic estimates of the
premium of approximately 6.5% are too high, are addressed when the long term effects of
new information on expected earning growth rates are allowed for. Other regulators and the
CC will have studied these issues intensively. Accordingly, and given the observation that the

12 OFGEM Review of Transco's price control from 2002: Initial thoughts consultation document, February 2001,

paragraph 7.19, page 102

13 Op cit. p.280.
14 Working paper 8207 April 2001.
15 NBER working paper 8059 December 2000.
CC’s assumptions point to estimates of the generic parameters which are consistent (in
aggregate) with the long term historical data (even though the risk free rate and the ERP
estimates are different), at this stage the CAA is inclined to accept the CC’s conclusion in the
water cases that a reasonable range is 3.5% to 4.5% (Sutton, p. 121). This is 50 basis points
lower than the estimate used in the last airport review. We consider that the effect of this
reduction in this estimate is mitigated, to some extent at least, by the offsetting bias in the risk
free rate discussed above.
4. Beta
4.1 Under the Capital Asset Pricing Model the cost of equity is defined as the risk free rate plus
the equity risk premium multiplied by the beta. Beta can be characterised as a measure of the
non-diversifiable risk of the company or investment project.16

4.2 Where a company’s shares have a track record of being traded in a liquid stock market over
time, historical estimates of the company’s equity beta can be estimated using movements in
the company’s share price and dividend payments relative to the stock market. Such data is
available for BAA as a whole, including non-regulated activities. No such data is available for
MA which is owned by local authorities. The CAA will use BAA and other airport
companies’ betas but adjustment should be made to obtain appropriate comparable betas for
the regulated part of BAA and MA. We will also use betas estimated for companies which are
likely to have similar “beta”-risk characteristics as airports. The beta is likely to be affected by
the regulatory regime that is expected to prevail. For example a movement from a single to a
dual till will change the regulated companies beta.

4.3 The most recent London Business School Risk Management Survey gives BAA’s equity beta
as 0.79. This follows recent falls from a level above 1.0 in 1998 and 1999 which perhaps
reflected the windfall tax and uncertainty over the phase out of duty free. In the 1996 MMC
review into BAA, a beta of 0.9 was put forward by BAA. The MMC’s conclusion was to use
a range of 0.7-0.9 for the beta. A similar number was implicitly used for MA.

4.4 The CAA considers that, in principle, some other regulated companies are partial
comparators: Transco, National Grid and Railtrack. There are differences however. The
airports have large commercial income which is only indirectly regulated, via the single till,
and which is arguably subject to greater competition than the core regulated business. Some
airports are also, arguably, subject to greater competition. The other utilities main attraction
as comparators is that their beta may reflect an element of regulatory risk and that their
profits are strongly influenced by price controls.

4.5 Ofgem records equity betas of 0.7 for Railtrack, 0.62 for National Grid and 0.75 for British
Gas measured over the five year period ending January 2001 (p.106). Ofgem estimates that
Transco, as part of BG group has an equity beta in the range of 0.45-0.74.

4.6 The Office of the Rail Regulator has recently published conclusions on Railtrack’s assumed
equity beta, which use a range of 1.1-1.3 reflecting the projected increased level of operational
gearing.

16 Some confusion may arise between non-diversifiable risk and the expected return on assets. In a competitive market
technology risk could certainty affect the expected return on a project, without having any impact on its beta. If
technology risk were to increase, for example, then the expected return on the project might fall. Thus the project may
no longer pass the cost of capital hurdle. But the cost of capital itself should not change (as long as the technology risk is
indeed diversifiable). In a regulated industry the impact on the expected return is likely to be softened since the regulator
is likely to allow a return on appropriate capital expenditure, even where its ex post value is less than anticipated. Of
course, the impact of regulatory risk might be greater where there is significant technology risk.
4.7 Given a continuation of current regulatory policy (a regulatory asset base approach with a
single till), the above information and roughly similar levels of gearing, the CAA currently see
little reason to change the range for the BAA equity beta used in the last review. The
comparison with other utilities is ambiguous, and the CAA would need additional argument
to justify changing from the current setting. We are open to arguments that given the
proposed development plan of each airport the beta could change reflecting the unique
characteristics of the new projects compared to the existing business. If the regulatory policy
changed then the beta would have to be adjusted accordingly. Moving from the current
single till should reduce the commercial risk of the regulated business. Retail businesses tend
to have higher betas suggesting that the regulated airport beta would fall. Moving to more
incentive based regulatory regimes such as output pricing, default price caps, could increase
the beta.

4.8 Thus the CAA is minded to use a beta in the range of 0.7 to 0.9 for both BAA and MA under
the assumption of the continuation of existing regulatory policies. As alternative regulatory
options are developed, the analysis of packages or combinations of these options will need to
include the effect on “beta-risk”.

4.9 We would expect that beta varies with company gearing since as gearing increases volatility in
net earnings increases. As discussed below, the CAA proposed to use actual or projected
gearing as the basis for its estimates. If gearing is projected to rise, the equity beta may also
rise.
5. Debt premium
5.1 Financial markets demand a premium on corporate debt over equivalent gilts to allow for the
greater risk of default on corporate debt. This premium will vary depending on perceived risk
with gearing being a major factor. According to OXERA the current premium on BAA debt
is 1.40%-1.45%. This is higher than the range used by the MMC for BAA’s regulated
business in 1996 which was 0.3%-0.8%. At the last review MA advised the MMC that their
premium was 0.8%17. Excluding the higher risk non-regulated business should lower the
current premium. However we note that recent regulatory decisions have used estimates in
the 1.5%-2% range. For example, the CC in the Sutton case used a premium of 1.5% with
gearing of 25%, rising to 1.9% with a gearing of 50%. We note, however, that Sutton is a
much smaller company than BAA. We also note that OXERA calculates that BAA’s
economic gearing is around 23%.

5.2 It has been argued that the debt premium should incorporate an adjustment for inflation risk.
The debt premium is by definition a premium over the risk free rate. The risk free rate has
been estimated using yields on index linked bonds, which are largely insulated from inflation
risk (timings of adjustments may leave some residual inflation risk). However, the debt
premium has been estimated using comparisons on yields on corporate debt with nominal gilts.
If the risk of inflation differing from expectations is not diversifiable, nominal gilt yields may
be subject to a degree of systematic risk. The standard method of measuring the cost of debt
would not allow for this. There are the usual problems of measurement of market
expectations of inflation here. The CAA also note that there may be other explanations for
any premium on nominal gilts over index linked gilts, such as differential tax treatment. CAA
believes this is relevant to the assessment of the pre-tax cost of capital ‘tax wedge’, but is not
inclined to allow an inflation premium on the debt premium.

5.3 Our starting point will be the range used in the last review, allowing the regulated companies
to make cases that their risk has changed. We will need to ensure that only the risks of the
regulated firms are considered and that risks associated with diversification are excluded. At
various stages BAA has indicated to us that its investment programme may cause gearing and
risk to rise significantly. MA no doubt will also wish to make submissions on this point also.

17 MMC report on Manchester Airport July 1997, page 69, paragraph 4.38.
6. Gearing and tax
6.1 The cost of tax is closely associated with the cost of capital:

• corporation tax is a charge on corporate profits which, for a price regulated company, are
largely determined by the regulatory assessment of the cost of capital;
• timing differences between the liability to tax and the recognition of accounting profits are
generally associated with capital transactions;
• the liability to corporation tax is significantly influenced by the capital structure of the
company, notably by the mix of debt and equity;
• the tax position of shareholders is, in principle, influential in determining the cost of equity
and debt with firms being price takers in respect of capital in competitive international
capital markets.
6.2 In practice, taxation can be considered an integral part of the overall cost of capital: the scale
of operating profits required to sustain the ability of the company to finance new investment.
There are, conventionally, two ways of measuring the cost of capital:

• as the weighted average of the cost of debt and the cost of equity, treating corporate tax as
a tax shelter benefiting debt (the post-tax approach, used by Ofwat);
• as the weighted average of the cost of debt and the cost of equity “grossed up” by the
corporate tax rate (the pre-tax approach, used by other regulators and the CC).
6.3 The post-tax approach is used by Ofwat to assess the cost of capital for water and sewerage
companies so that the effects of different tax and investment circumstances can be taken
explicitly into account. The pre-tax approach is used by other regulators such as ORR and
Ofgem, generally applying a relatively simple adjustment to the cost of capital: “grossing up”
the post-tax cost of equity by the corporation tax rate. Provided the two approaches are
handled appropriately there should be no difference between them18.

Effective versus statutory tax rates

6.4 Because of timing differences between the tax and statutory accounting rules effective and
statutory tax rates can differ. The effect of inflation on the real value of capital allowances
does reduce the impact of this deferral in present value terms. On the other hand, the
existence of inflation means that airports will receive tax relief not just for the real cost of
debt imputed in the CAPM model, but also on the inflation element of nominal interest
payments. This is a real tax benefit. The combined effect of accelerated capital allowances
and the tax treatment of interest would reduce the effective tax rate for airports over the
investment cycle, reducing the size of the tax-wedge necessary to ensure that the pre-tax cost
of capital covers the cost of debt, normal equity returns and the cost of tax. Our financial

18“Analysis of the Proposed Introduction of a New Method of Estimating the Costs of Tax & Capital” LECG, 18 April
2000.
 modelling will aim to project the actual stream of tax payments along with other cash
disbursements, pre-financing, so this issue will be addressed in this way.

6.5 In the last regulatory decision on airports the MMC and CAA used the statutory corporation
tax rate in the cost of capital calculations. In the water cases the CC used the effective tax
rate calculated from their financial modelling. The CAA is reluctant to change existing
regulatory practice for airports without careful analysis and modelling supporting such a
change. It would seem that such a move requires a careful assessment by the regulator of
optimal versus actual gearing including the tax liability management policy of the regulated
firm. This would seem to be more intrusive than is desirable given the CAA statutory duties.
Thus the CAA would propose to use statutory corporation tax rates in the cost of capital
calculation.

6.6 Convention to date seems to have allowed for full or near-full adjustment of the cost of
capital by the tax benefit given by the deductibility of interest payments at the corporate level.
It can be argued that the relevant tax rates that are “incorporated” in the pricing of capital
assets in competitive capital markets must also take account of personal tax rates. This is
particularly the case where the corporation tax can be regarded as a withholding tax19. While
the top marginal personal tax rate is higher than corporate tax rates in the UK and the US, the
concessions20 in respect of the tax treatment of capital gains may mean the relevant effective
personal tax rate is lower than the corporate rate any way. Plausible estimates of the relevant
effective tax rates imply that the true tax shelter given by the deductibility of debt at the
corporate level may be much smaller or non-existent. For the purpose of calculating a cost of
capital our initial range will be from allowing a full tax shield to allowing no tax shield.

Gearing

6.7 Gearing can affect both the post tax and pre-tax WACC. The simple arithmetic of the
WACC approach implies that as gearing rises the post-tax WACC falls because of the subsidy
provided by the tax deductibility of interest payments but not dividend payments. This leads
to the idea that there is an optimum gearing at the point where the extra benefits from
increased debt are offset by a mixture of rising debt premium costs and bankruptcy risks.
Our reading of the literature does not suggest that there are adequate normative models
available to allow regulators to take a view on optimal (as against actual) gearing within the
conventional range. Accordingly the CAA is minded to use actual or projected gearing as an
input into calculating the cost of capital. The summary below uses a range of 0.2 to 0.3 for
illustrative purposes.

19 See for example “Finance Theory & Corporate Policy” 3rd Edition, T.E. Copeland & J.F Weston 1992 p.541 and

“Taxation & Corporate Financial Policy” Alan J. Auerbach NBER working paper 8203 April 2001
20 From the perspective of a comprehensive income tax.
7. Summary: cost of capital estimates
7.1 Taking the estimates and assumptions specified above, the CAA has estimated a range for the
cost of capital. The low case and high case are set out in Table 2 below.

Table 2: Estimates of the real cost of capital

Current Estimates Last Review

low high low high

Asset Beta 0.60 0.77 0.58 0.75

Gearing 0.30 0.20 0.30 0.30

Risk free rate 2.75% 3.25% 3.50% 3.80%

Equity risk premium 3.50% 4.50% 4.00% 5.00%
Equity beta 0.70 0.90 0.70 0.90
Post tax cost of equity 5.20% 7.30% 6.30% 8.30%
Dividend tax credit 0.80 0.80
Pre-tax cost of equity 5.04% 6.64%

Risk free rate 2.75% 3.25% 3.50% 3.80%

Debt premium 0.30% 0.80% 0.30% 0.80%
Cost of debt 3.05% 4.05% 3.80% 4.60%

Post tax WACCa 4.28% 6.65%b 5.55%c 7.19%c

Pre tax WACCa 6.12% 9.15% 6.41%c 8.32%c

Corporation tax rate 30.00% 30.00% 33.00% 33.00%

0.00%

a See attachment 1 for formula

b This reflects the assumption of no tax shelter from financing
c These numbers are not strictly comparable to the current estimates. See MMC's methodology, (MMC report BAA plc,

June 1996 p.81, paragraph 4.32)

8. Specific airport factors
8.1 We consider that the above analysis applies in full to Heathrow and Gatwick airports given
the excess demand they face. In the last review the MMC adjusted MA’s cost of capital
upwards from BAA’s by 25 basis points. The CAA accepted that adjustment in its decision.
The main arguments related to MA facing greater competitive risks than BAA’s airports. It is
not clear which parameter the MMC adjusted in making this overall adjustment. Even
though the MMC considered the issue, no off-setting adjustment was made reflecting MA’s
government ownership status because of the then limitations on MA’s borrowing freedom.
These have since been removed. The CAA is not attracted to the concept of an ad hoc
lowering of MA’s cost of capital because of its public sector status unless the debt premium
justifies it. This is because resources used in public sector entities also have opportunity costs
in terms of forgone private sector consumption and investment. However we accept that the
competitive and developmental positions of Stansted airport as well as MA could be different
from the others. Thus the CAA would consider argument and evidence that the cost of
capital is, or will be, higher at MA and Stansted (via debt premia and/or equity betas) given
their competitive and developmental position.
9. Incremental costs estimates and the cost of capital
9.1 The cost of capital is a key parameter in the calculation of the incremental costs of airports.
The CAA has emphasised the importance of these calculations for this review. We consider
that the cost of capital estimates using the above parameters should be ones used for
incremental cost calculations supplemented by sensitivity analysis. The one parameter that we
would envisage could be varied would be the beta, if after careful analysis, it was considered
that the beta for a specific project differed significantly from the estimated regulated business
beta. We are open to argument, analysis and evidence on this point.
10. Conclusion
10.1 The cost of capital is a key parameter for this review. Given the importance of getting the
best possible investment incentives for desired airport development, particularly in the South-
east, we judge that in setting this parameter it is critically important not to set it too low. The
adverse consequences of it being set too high are, in comparison, lower. The CAA is
adopting a pragmatic approach to this issue drawing as much as possible of best practice
followed by other regulators and the CC in terms of approach, analysis and data. This note
lays out our proposed approach and current data sources as transparently as possible. We
welcome analysis and evidence that will assist us in coming to an overall view that is most
likely to contribute to achieving our statutory objectives.
11. Attachment 1

Weighted Average Cost of Capital

The Weighted Average Cost of Capital (WACC) is the common way in which the cost of capital is
expressed and has two main components. They are debt and equity and their relative weighting in
overall financing together with tax. The conventional post-tax formula is as follows:

WACC = g .(rf + ρ )(1 − t ) + (1 − g )(rf + ( ERP) β ) {

where g = gearing
rf = risk-free rate
p = debt premium
t = corporate tax rate
ERP = equity risk premium
β = beta

The pre-tax equivalent is

WACC = g .(rf + ρ ) + ((1 − g )(rf + ( ERP) β ) /(1 − t )) |

The Miller21 adjustment for personal tax is that the conventional tax shelter on debt (1-t) in { above
is replaced by:-

(1 − t )(1 − te)
}
(1 − td )

where

te = personal tax on equity returns

td = personal tax on interest receipts

21 Originally developed by Miller, M. H. "Debt and Taxes" (1977) Journal of Finance, May, 261-275 and summarised in

Copeland, E. Thomas and Weston, J. Fred, Financial Theory and Corporate Policy, third edition,
p. 451-454.
12. Attachment 2
Dividend Growth Model: Fama and French

An alternative forward-looking methodology to the use of historical averages is the Dividend Growth
Model (DGM) as used by Fama and French (2001)22. The methodology is based on the principle that
investors are concerned with expected cash flows and their present value. The future stream of cash
flow from equity is expected dividend payments. This methodology is particularly suited to airports
as they are steady growth companies and lack wide variability in earnings (consequently, low
variability in dividend payout ratio).

In determining the equity premium, the risk free rate is subtracted from the average annual dividend
yield (during the estimation period), plus the average annual growth rate of dividends. Using this
method, Fama and French (2001) identified a divergence in the equity risk premium of 4.9% between
the estimate from the average return and dividend growth model for the period 1950-2000. It was still
argued that the DGM is a more accurate estimate than estimating using realised returns for producing
an ex ante expected value. This conclusion is based on three results:

• the DGM is statistically superior to the estimate from realised return and has more than
twice the precision;
• there is a decline in the DGM estimate from 4.2% (1872-1949) to 2.6% (1950-2000), this
correspond to the decline in the volatility of returns;
• the estimate of expected stock return using DGM is less than the income return on
investment while estimate of the realised return shows the opposite. Hence the DGM is
consistent with the view investment is on average profitable.

Thus their analysis suggests that the unconditional expected equity premium of the last fifty years is
probably far below the realised premium. The primary difficulty of this method is the determination
of the expected dividend yield and the expected annual growth rate of dividend, as they are primarily
based on projected accounting data.

22Eugene F Fama and Kenneth R French, 2001, The Equity Premium, The Center for Research in Security Prices - working
paper No. 522, April, University of Chicago Graduate School of Business forthcoming in The Journal of Finance.