SCEG OATT Formula Transmission Rate Filing.pdf - SCANA ...

20091231-0037 FERC PDF (Unofficia1) 12/29/2009
Direct Testimony of Michael J. Vilbert
Docket ERI 0·_-000
Page 7 of35
EXHIBIT
NO. SCE-13
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using current cost of capital methodologies are likely to be conservative. Section III first
describes the selection of the Proxy Group. It then describes the Commission's current
cost of capital estimation methodology based upon the DCF model and provides the
results of the FERC DCF model for the Full and Restricted Samples. The section
concludes with the recommended cost of equity for SCE&G's regulated transmission
assets in the southeastern United States.
7 II.
COST OF CAPITAL
THEORY
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A. THE COST OF CAPITAL AND RISK
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Please formally define the "Cost of Capital."
The cost of capital can be defined as the expected rate of return in capital markets on
alternative investments of equivalent risk. In other words, it is the rate of return investors
require based on the risk-return alternatives available in competitive capital markets. The
cost of capital is a type of opportunity cost: it represents the rate of return that investors
could expect to earn on alternative investments of comparable risk. "Expected" is used in
the statistical sense: the mean of the distribution of possible outcomes. The terms
"expect" and "expected" in this testimony, as in the definition of the cost of capital itself,
refer to the probability-weighted average over all possible outcomes.
The definition of the cost of capital recognizes a market tradeoff between risk and return
that is known as the "security market risk-return line," or "security market line" for short.
This line is depicted in Figure I. The higher the systematic risk, the higher is the cost of
capital. A version of Figure I applies for all investments. However, for different types
of securities, the location (i.e., the intercept and the slope) of the line may depend on
corporate and personal tax rates.