Weighted average cost of capital and Capital Asset Pricing Model

To calculate the cost of capital, the methodology currently used by PTC is based on the weighted average cost of capital (WACC), using the pre-tax variant of the WACC formula.

The formula for calculating pre-tax WACC results from the adjustment resulting from tax in the post-tax WACC formula:

The calculation of WACC depends essentially on: (i) the rate of return on equity, calculated using the Capital Asset Pricing Model (CAPM); and (ii) the rate of return on borrowed capital, as explained in the following formula:

Where:

Ke is the rate of cost of equity, calculated using the Capital Asset Pricing Model (CAPM) using the following formula:

Ke = Risk free interest rate + β x Risk premium

Where:

Risk-free interest rate is the rate that compensates investment in risk-free assets;

β: represents the covariance between the performance of a company's shares and that of the stock market as a whole, that is to say, it reflects the risk of the shares of the company relative to general market risk;

Risk Premium reflects the difference between the rate of return provided by the stock market and that provided by risk-free investments;

Kd is the cost of debt capital;

G is gearing, corresponding to the weight of debt capital as a proportion of total invested capital; and

ti  is the rate of income tax.

The main advantage of the pre-tax methodology compared to the post-tax approach stems from the fact that the first incorporates the cost of income tax, whereby this same cost is allocated to the products and services through the cost of capital. By contrast, the use of a post-tax method tends to impute income tax via common costs.

According to PwC’s report, international experience supports the use of the methodologies described above, which are shared by several operators in regulated industries in several countries (See Table 1), and are considered as common practice recommended by regulators.

According to the Principles of implementation and best practices (PIBs) concerning the methodology used for calculating the cost of capital, developed within the Independent Regulators Group (IRG) ¹, the WACC (PIB 1) is cited as a consensus methodology for calculating the rate of cost of capital and while CAPM (PIB 4), although containing some shortcomings, is cited as the most suitable method for calculating the cost of equity.

ICP-ANACOM compared CAPM with other ways of calculating the cost of equity capital, evaluating their advantages and disadvantages, as explained in PwC’s report ², concluding in favour of CAPM.

CAPM is the most widely used model ³, given that it presents a clearer theoretical basis and its implementation is simpler. The theory underlying this model is that of the efficient portfolio, holding that economic agents in a market will invest in an efficient portfolio, that is to say, they will invest in a portfolio that maximizes their expected results for a determined level of risk, taking into account each agent's degree of risk tolerance/aversion.

In light of the above, PTC should continue to use the WACC methodology for calculating the rate of cost of capital, using the pre-tax variant and the CAPM methodology for calculating the cost of equity.