ELEC5212 Power System

Planning & Power Market

Module 3 Cost of Capital
Prof. Z. Y. Dong, Dr. Jin Ma

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Outlines

What is the cost of capital?

Investments
Net Present Value

Why is the cost of capital

important

Cost has direct impacts on the price and investments;

Under regulation, the regulator must determine (1) which
operating expenses are appropriate (2) whether customers are
paying prices that ensure sufficient long-run security of supply.
Based on these two considerations, the regulator could decide
whether the price is appropriate;
Under regulation, a utility is allowed to recover reasonable costs
incurred in the provision of service;
Under deregulation, generators are not guaranteed cost recovery,
but most transmitters and distributors remain regulated; So the
regulator must have a clear idea on the cost and how this cost
can be recovered so as to encourage investments;
However, one of the most difficult tasks of an electricity utility is
to determine its cost of capital.
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Cost of capital (I)

Financing the capital cost of new investment

can involves two sources:
Borrow funds from financial institutions, this is
called debt capital;

For debt capital, determining the appropriate cost of

capital is easy: the rate of interest charged by financial
institutions;

Provided by the owners or shareholders of the

firm or from profits earned by the firm, this is
called equity capital;

The rate of return is the rate that the owners of the

firm earn on their equity;

Cost of capital (II)

When a firm is a regulated electric utility, the

regulator must decide the appropriate rate of
return to charge customers to remunerate the
providers of equity capital. So the service can
be sustainable.

Capital market
For simplicity, we assume there is a single
market for financial capital;
Firms who want to borrow money enter this
market and announce how much they are
willing to borrow at each rate of interest.
Investors also enter this market and announce
how much they are willing to lend at each rate of
interest;

Market equilibrium

The equilibrium rental

(interest) rate and total
level of capital
demanded are
determined by the
intersection of demand
for financial capital by
firms and the supply of
financial capital by
investors.
If the interest rate is
low, supply would be
less and demands on
capital would be high.
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Demand behaviour

In a capital market, capital is a commodity;

If a firm purchases a unit capital, he must make sure
that the increase in his revenue that this unit capital
produces at least no less than the cost of that unit
capital; So it is worthwhile to attract the capital in;
If the increase of the revenue is higher than the cost
of capital that produces this increase of the revenue,
that firm will continue to demand capital inputs until
the revenue increase that the capital produces is just
equal to the price of the capital (that is its marginal
revenue product)
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Investor

Assume that individual investors attempt to

maximize their well-being; They are rational
investors;
We assume investors prefer certainty to
uncertainty;

Giving a choice between an uncertain outcome and an equivalent

certain outcome, most individuals would prefer the equivalent
certain outcome.
For example, consider the choice between (1) receiving 100$ with
probability one half and 0$ with probability one half and (2) 50$
with probability 1. Most individuals would choose the latter.

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So decisions of investors

Investors would be willing to invest less in

projects that are more risky.
Thus an electric utility decision maker has to
determine:
First, the risk class of each investment;
Second, the appropriate rate of return on
capital for the appropriate risk classes

It can be expected that for high risk project,

the investor would look for high rate of
return to protect them from the risk.
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Structure of rate of return(I)

The basic component of rate of return is riskfree interest rate;

Risk-free interest rate is also called (nominal)
rate of interest on the risk-free investment,
i.e., one investment that always pays a
known return to the lender; such as the
securities sold by the government; For a
stable government, this investment can be
seen as no risk;
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Risk-free interest rate (I)

There are two components to the risk-free

interest rate Rf:

One component compensates investors for inflation

rate i
The other component compensates investors
because they are unable to use the funds while the
capitals are being used by the borrower; This is
called real risk-free interest rate rf

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Risk-free interest rate (II)

(1+ Rf) = return/capital

If inflation is low (e.g. less than 5%) and the
real risk-free rate is low (e.g. less than 3%),
will be small, e.g.
, we often
approximate
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Structure of rate of return (II)

For all risky projects, investors will charge a risk

premium (RP) to compensate them for the unknown
rate of return

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An example of an interest rate

of return

The real (risky) interest rate r is 10%, which

is equivalently, for example, to a risk-free
rate rf=5% and a risk premium RP=5%;
If the rate of inflation is 10%, then the
nominal (risky) interest rate would be at least
20% with stable inflation.
If the rate of inflation is high, this item cannot
be neglected.
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Net Present Value (NPV)

Net Present Value maximization is the

most widely accepted method of project
evaluation in modern finance;
The most important concept around NPV
maximization is: time value of money,
i.e., that money in hand today has a
different value than the same amount one
year ago or one year from now.
So when we talk about money to be
invested, we should discount all of them
from future into the present.
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Discounting to Present (I)

To focus on the most important idea, we

neglect the transaction costs, i.e., the rental
rate on financial capital (money) is the same
for the borrower and the lender.
For example, if the real (risk) interest rate is
10% per year, the firm pays 10% per year to
the investor; There are no extra cost.
Actually, this is an assumption of a perfect
capital market.
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Discounting to Present (II)

So
Or we rewrite it into:
is denoted as the discounting factor

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Discounting to Present (III)

For year t
Here we use compounding: the return earned from a
previous period will be put into investment to earn the
return in the next period.

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Discounting to Present (IV)

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Discounting to Present (V)

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Discounting to Present (VI)

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Discounting to Present (VII)

If we discount by breaking the periods into subperiods, for example, into months.
Under monthly discounting, the annual rate of 10%
is divided by 12, or, 0.833% per month.
If we compound monthly, the annual rate would be:

The effective annual rate is 10.47%, a little higher than

10% annual rate;
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Discounting to Present (VIII)

If we discount by breaking the periods into days.
Under daily discounting, the annual rate of 10% is
divided by 365, or, 0.0274% per day.
If we compound daily, the annual rate would be:

The effective annual rate is 10.515%, even higher than

compounding monthly;
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Discounting to Present (IV)

Now we discount by breaking the periods into even
smaller time intervals.
We separate one year into m periods, the annual
rate of 10% is divided by m and when
, we
actually compound continuously
That is the limit that we can have for an effective annual rate;

It should be noted in this case monthly compounding approaches continuous

compounding and daily compounding is almost indistinguishable from continuous
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compounding.

Investment (I)

Now consider we investment yearly. For simplicity, we

assume we invest uniformly each year.
We discount our investments into the present value:

If we invest until year T, we can add all the terms together and get:

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Investment (II)

Question: If we make an investment PV in the present,

what amount must be collected each year to recover our
investment?
Since

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Investment (III)

Example: we make an investment of 1000$ today, if

r=10% and we want to recover our investment in 30 years
(say, the life cycle of this product that we invest in) , use

106.08$ must be collected each year for 30 years. That

means our average annual profit cannot be less than $106.08;
If it is less than this value under reasonable cause, the
regulator should consider compensation if necessary to
encourage the investments in this product.
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Investment (IV)

If T goes to the infinity, the equivalent payment that we

have to collect at every period in the foreseeable future
becomes
Since
In this case, r=10% and the present investment is $1000;
the annual payment would be $100. It gives a very close
estimate to the annual payment for long recovery periods
(e.g., 30 years) but with much simpler calculation.

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Net Present Value (I)

In our last module, we discussed the fact that firms

maximize their profits in each period;
But firms, particular those owning physical capital
with long productive lives, such as electricity
generation capacity, must make decision based on
future profits.
So we have to extend our behavioural assumption
from single-period profit maximization to multi-period
profit maximization.
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Net Present Value (II)

Considering profits (net cash flow) in two future

periods, Since

and we discount the future profits into the present value

of future revenues TR minus (net of) future costs TC.

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Net Present Value (III)

Since TC includes the variable cost (VC) and the fixed

cost (FC), this approach assumes that costs including
FC are incurred in each future period.
In most cases, some costs, such as capital costs,
must be spent in the current period so revenues can
be received in the future.
If the fixed cost is incurred in the first period and
variable costs are spent in the future periods, then.

in each future period, discounted at the relevant cost of capital r, to the

present.

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Net Present Value (IV)

Obviously, we may earn profit in some years, such as

PRt>0 or we may lose money in some years, such as
PRt<0; However, if NPV > 0, we earn profits in
average. A positive NPV implies positive discounted
profit to the present.

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Net Present Value (V)

Net Present Value Rule: The investors invest in

projects (e.g., power plants) with positive NPV
because all projects with positive NPV imply positive
discounted profits.
The investors will

first rank possible projects by NPV;

then begin by investing in the project with the highest
NPV;
This is often referred to as maximizing Net Present Value
principle in multi-periods framework.
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Summary

In this module, we learned methods to

evaluate cost of capital, which is very
important at the planning stage;
When we evaluate the cost of capital, we should keep the time
value of money in mind;
We have learned one most important method on investment
evaluations, i.e., net present value method.

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Thank you!

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