this document explains how the Weighted Average Cost of Capital (WACC) is calculated and how it impacts pricing. Pressure must be placed on government utilities to reduce the WACC's used in ther determination of required revenues and consumer pricing

1. If YES
Then understanding WACC is vitally
important
A’Ohlin Commercial Insights © 2013 Page 1
Do YOU want CHEAPER water & sewerage and electricity prices?

2. Weighted Average Cost of Capital
(WACC)
– Post GFC
a Revision Lower is Needed
A’Ohlin Commercial Insights
www.aohlininsights.com
3 December 2012
A’Ohlin Commercial Insights © 2013

3. • Broadly speaking, a company’s assets are financed by either debt or equity.
• WACC is the average of the costs of these sources of financing, each of which
is weighted by its respective use in the given situation.
• By taking a weighted average, we can see how much interest the company
has to pay for every dollar it finances.
• A firm's (or a project’s or a business unit’s) WACC is the overall required
return on the firm as a whole and, as such, it is often used internally by
company directors to determine the economic feasibility of expansionary
opportunities and mergers.
• It is the appropriate discount rate to use for cash flows with risk that is similar
to that of the overall firm.
Weighted Average Cost of Capital is the percentage cost (interest) or
return required to finance a company or project by debt and/or equity
A’Ohlin Commercial Insights © 2013 Page 3

4. Firm is interested in investing in a new shopping centre or commercial
development
 it should go ahead if the returns forecasted to be generated are at least equal
to the WACC
 if they are below the WACC, then the project is not expected to generate
enough return to compensate those providing the debt (usually the banks)
nor is it sufficient to compensate the owners (equity) for also risking their
money
WACC is used as a hurdle rate when making investment decisions
A’Ohlin Commercial Insights © 2013 Page 4

5. • Cost of equity
– no longer is an equity risk premium acceptable
– the risk free rate proxy, the 10 year government bond rate, has been at
consistently low levels with the RBA implying that this will continue
• Cost of debt
– wholesale funds are at record low levels
– banks are shifting their cost structure from wholesale funding market exposure to
the relatively more expensive self-funded deposit market
A’Ohlin Commercial Insights © 2013 Page 5
Cost of funding has undergone structural change and must be re-
assessed downwards

6. Cost of Debt (Rd)
• Interest rates have plummeted
• Cost of raising debt is at an all time low
Cost of Equity (Re)
• Risk Free Rate (Rf)
– 10 year government bond rates at an all time low
– Australia is one of a handful of countries retaining AAA credit status
• We can borrow money in international markets at cheaper rates because we are
considered to be “less risky” or “more credit worthy”
• Premium for investing in a “riskier asset”
– 6% Market Risk Premium has been Australia’s historical average to 2010
– since December 2010, the global market has materially changed with Australia
now being regarded as relatively safe, and thus driving down our Market Risk
Premium
A’Ohlin Commercial Insights © 2013 Page 6
Historical WACCs, particularly those used by the public sector, are
no longer applicable in today’s environment

7. Reserve Bank of Australia
Statement by Glenn Stevens, 6 November 2012
• Global growth is forecast to be a little below average for a time
• Risks to the outlook are still seen to be to the downside (largely due to situation in
Europe)
• Long term interest rates faced by highly rated sovereigns, including
Australia, remain at exceptionally low levels
• Capital markets remain open to corporations and well rated banks
• Australian banks have no difficulty accessing funding, including on an unsecured
basis
• Borrowing conditions for large corporations are similarly attractive
• Expected benefits of lower cash rates are starting to have an effect, namely:
– Stronger housing market
– Higher stock prices
A’Ohlin Commercial Insights © 2013 Page 7
The Reserve Bank of Australia advises that long term interest rates
remain at exceptionally low levels

8. A’Ohlin Commercial Insights © 2013 Page 8
The premium differential between debt and equity is reducing
a lower cash rate is reducing the premium differential between
asset classes, with the intention of attracting investors into the
property and stock markets – a covert attempt to stimulate the
economy. This in turn means the premium differential
between debt and equity is reducing, reflecting a structural
shift in the cost of funds to a lower base.
No longer is an equity risk premium of 5 to 6 per cent acceptable.
i.e. the belief that shares offer annual excess returns of 5 to 6 per
cent over government bonds is now being questioned, and may
have significant implications on the pricing determinations of
several government agencies (such as the Australian Energy
Regulator when determining acceptable gas and electricity
margins, and the Regulators of water utilities in setting water and
sewerage pricing margins).

9. A’Ohlin Commercial Insights © 2013 Page 9
The equity (stock market) premium over the “risk free” Australian 10-
year government bonds over the past 30 years is actually very small.
Between 1982 and 2012:
Australian shares provided a compound annual (geometric) return of
12.3% (with annual volatility or risk of 17.7%)
Australian government bonds generated a compound annual return of
11.7% (with a volatility or risk of 8.6%)
This suggests an equity risk premium of only 0.6%.
Imputation credits may bump this up another percentage point.
However, 1.6% is still well below the previously accepted norm of 5 to 6
per cent.
(C Joye, The AFR, 3 Oct 2012)

10. A’Ohlin Commercial Insights © 2013 Page 10
A case is being made for the Australian equity market risk
premium (MRP) to be reduced by 2% down to 4%
The equity MRP is generally measured as the difference between a share
market holding period return and a Government bond yield to maturity.
While capital gains are implicitly captured in the share market return, for
some reason these are generally ignored in estimating the return on a
risk free asset.
This, together with a recalculation of government yields - which
incorporates the effects of capital gains/losses and the effects of
uncertain coupon rates –
…results in an equity MRP of 4%, rather than 6%.
(C Joye
& Professor Richard Heaney
Winthrop Professor Accounting and Finance, UWA Business School) 1
1. Heaney,R. & Kidd,S. A note: Calculating the Market Risk Premium: Does the risk free rate calculation matter?, draft copy, awaiting publication
C Joye, The AFR, 3 Oct 2012

11. Reserve Bank of Australia
Statement by Glenn Stevens, 6 November 2012 (continued)
• “Savers are facing increased incentives to look for assets with higher returns”
(Glenn Stevens)
• Recent outcomes on inflation were slightly higher than expected
• Needed to keep inflation low
– Contain pressure on labour costs in sectors other than those directly affected by
current strength in resources sector
– Improvement in productivity performance
A’Ohlin Commercial Insights © 2013 Page 11
The Reserve Bank of Australia is indicating that rates will remain
low
Governor Stevens is suggesting investors (such as self-funded retirees) should actively seek
alternatives to parking their money in relatively low yielding savings account (which in turn
puts added pressure on banks to lift deposit rates and thereby squeeze margins – see
comments below).
This is a “heads up” / indication that rates will remain low, if not lower, in coming months.

12. Australian Banks and Financial Institutions
The big four banks reported a combined annual profit of more than $25 billion
for the 2012 financial year [$25.2 billion in 2012 up from $24.2 billion in 2011]
• Record billion dollar profits despite the GFC and contracting global economies
– 6 Nov 2012 CBA makes $1.8bn in 3 months: CBA's unaudited cash earnings were
approximately $1.85 billion in the three months to September, up six per cent
from approximately $1.75 billion in the same period the previous year
– 5 Nov 2012 CBA was the standout with a bumper $7.1 billion profit while rival
National Australia Bank's $5.4 billion profit
– 24 Oct 2012 ANZ reports a top line 6 per cent increase in full-year cash profit to a
record $6.01 billion and a dividend hike
A’Ohlin Commercial Insights © 2013 Page 12
The Big Four Banks are making record BILLION dollar profits…

13. Australian Banks and Financial Institutions (continued)
How have they got there?
• Slashing more than 6,600 jobs over the past year (The AFR, Wed 7 Nov 2012)
• Accessing cheaper funds
– However, the banks continually bemoan “weaker interest margins because of
higher funding costs” (The AFR, Wed 7 Nov 2012) - this is false!
A’Ohlin Commercial Insights © 2013 Page 13
…by slashing jobs and accessing CHEAPER funding

14. Australian Banks and Financial Institutions (continued)
What’s behind the cry of “higher funding cots”?
• Funding costs have 2 components: cost of debt + cost of equity
– Cost of debt = interbank swap rate + lending/default risk premium
– Cost of equity = risk free rate (typically the 10 year bond rate) + market risk
premium (typically taken as the average yield on traded stocks), adjusted by a risk
factor specific for that business or project
• Debt is typically cheaper than Equity (and has a tax shield effect, preserving
profits)
A’Ohlin Commercial Insights © 2013 Page 14
But the banks are crying poor

15. Australian Banks and Financial Institutions (continued)
Issues driving higher funding costs:
• Mr Jason Yetton, head of retail and business banking at Westpac (the AFR
Wed 7 Nov 2012), said funding costs are increasing for a number of reasons
with the primary one being that the price of deposits is high
• Due to market volatility, banks are seeking more and more to self-fund loan
asset portfolios through deposits (relatively more expensive than wholesale
debt funding)
– Increased competition for deposit funding is driving up deposit rates for banks
– This together with lower cash rates
=> driving up banks’ cost of deposits
=> drives up cost of bank loans to customers
=> increases cost of debt for those businesses/people wanting to
borrow money from the banks
A’Ohlin Commercial Insights © 2013 Page 15
Increased competition for deposit funding is driving up deposit
rates for banks which also drives up the cost of bank loans

16. Australian Banks and Financial Institutions (continued)
Issues driving higher funding costs (continued):
A’Ohlin Commercial Insights © 2013 Page 16
The RBA’s “Bank funding” chart shows the increasing proportion of
domestic deposits since 2008 and the reduction in debt
note:
Deposits are also a form of
debt funding. As previously
noted, deposit funding is
generally relatively more
expensive than wholesale
debt funding.

17. Australian Banks and Financial Institutions (continued)
Issues driving higher funding costs (continued):
• The banks are doing whatever they can to maximise shareholder profits, and
• The problem in Australia is that they are doing this in a non-competitive
environment
A’Ohlin Commercial Insights © 2013 Page 17
Australian banks are doing whatever they can to maximise profits
in a non-competitive environment

18. Australian Banks and Financial Institutions (continued)
Issues supporting lower funding costs:
• Global bond rates are at record low levels => lower cost of equity
• Australia is one a only a few remaining AAA sovereign risk countries which means
it can borrow money relatively cheaply => lower cost of debt and equity
• Source of bank funds borrowed on international wholesale markets has fallen =>
lower of cost debt (Mr Jason Yetton head of retail and business banking, Westpac)
• Long term interest rates faced by highly rated sovereigns, including Australia,
remain at exceptionally low levels (RBA November 2012)
• Australian banks have no difficulty accessing funding, including on an unsecured
basis (RBA November 2012)
• Borrowing conditions for large corporations are similarly attractive (RBA
November 2012)
A’Ohlin Commercial Insights © 2013 Page 18
Borrowing conditions for Australian banks are very attractive with
record lows in cost of debt and equity

19. Australian Banks and Financial Institutions (continued)
Issues supporting lower funding costs (continued):
A’Ohlin Commercial Insights © 2013 Page 19
Bank spreads have FALLEN since January 2012…
source: The Australian Financial Review, Friday 11 January 2013

20. Australian Banks and Financial Institutions (continued)
Issues supporting lower funding costs (continued):
• CBA raised $US2 billion of three-year money through on Wednesday night (9
January 2013) at a cost substantially less than it paid a year ago;
• CBA will pay investors 44 basis points above the benchmark treasury rate
• In March last year (2012) CBA paid 140 basis points above the benchmark
treasury rate to issue five-year covered bonds to US investors.
• That’s a savings of nearly 100 basis points; a fall of 68.57%
– Yes, it is true that five-year bonds should be more expensive than three-year
bonds, however the size of the difference (nearly 100 basis points) highlights how
far wholesale funding costs have fallen on international markets in the past 12
months.
A’Ohlin Commercial Insights © 2013 Page 20
… and banks are able to raise substantially cheaper debt

21. What does this mean?
• Overall, wholesale funding costs have come down, however:
a. the actual cost to each bank will depend on its individual funding mix
b. historically held debt, such as five-year money (i.e. entered into 5 year’s ago)
may still be cheaper than money sourced today, despite the recent fall in
spreads; if the money was sourced one year ago, today’s money will most
probably be cheaper
• Cost of funding has undergone structural change and must be re-assessed
– Cost of equity
• no longer is an equity risk premium acceptable
• the risk free rate proxy of the 10 year government bond rate has been at consistently
low levels with the RBA implying that this will continue
– Cost of debt
• wholesale funds are at record low levels
• banks are shifting their cost base from exposure to the wholesale funding market to
the relatively more expensive self-funded deposit market
A’Ohlin Commercial Insights © 2013 Page 21
Cost of funding has undergone structural change and must be re-
assessed

22. What does this mean to the WACC?
WACC = weighted cost of debt + weighted cost of equity
• Applying the change in AFMA Interest Rate Swaps from data/report publication dates to the
current date, will give an indication of the current cost of debt (i.e. as at 3 December 2012)
EXAMPLE:
• Tasmania’s Economic Regulator published a cost of debt for water pricing in March 2012 of
7.02%.
• In March 2012 the 3 year Interest Rate Swap was 4.280
• By December 2012 the 3 year Interest Rate Swap was 3.085
• CHANGE of -27.92%
• An argument could then be presented that the cost of debt appropriate for the Tasmanian
Water Utilities should be revised down by 27.92% to 5.06%.
• Further supporting this - as presented earlier - the wholesale cost of bank funding in
Australia has fallen.
A case is made a LOWER cost of debt.
A’Ohlin Commercial Insights © 2013 Page 22
A case is made to LOWER the cost of debt (Rd)

23. What does this mean to the WACC’s cost of equity (Re)?
Re = cost of equity
RF = risk free rate (the 10 year government bond rate is often used as a proxy)
Be = beta of equity ie. a measure indicating how risky that particular organisation is
relative to the Australian market place (stock market), a Beta of 1 would mean the
organisation is considered to have a risk profile the same as the Australian share
market
(RM – RF) = equity Market Risk Premium i.e. the premium investors demand for taking on
perceived additional risk by trading in the Australian equity markets (stock
market), rather than investing in the relatively “risk free” option of government
bonds
• As presented earlier
– a case can be made for a Market Risk Premium of 4% (as opposed to the traditionally used 6%)
– the risk free rate – 10 year government bond rate – has now also fallen
A case is made a LOWER cost of equity.
A’Ohlin Commercial Insights © 2013 Page 23
A case is made to LOWER the cost of equity (Re)

24. WACC = weighted cost of debt + weighted cost of equity
• Lower cost of Debt (Rd)
• Lower Cost of Equity (Re)
A case is made for a LOWER Weighted Average Cost of Capital (WACC)
• LOWER investment hurdles
• LOWER revenue streams are required from investments to cover the funding
costs (both debt and equity)
And this means,
LOWER PRICES FOR CONSUMERS
(particularly in government utilities such as electricity and water & sewerage)
A’Ohlin Commercial Insights © 2013 Page 24
A case is made to LOWER the WACC and supports the case to
reduce prices to consumers of government utilities: cheaper prices

25. If YES
Then understanding WACC is vitally
important
A’Ohlin Commercial Insights © 2013 Page 25
Do YOU want CHEAPER water & sewerage and electricity prices?

26. To refresh your understanding of WACC fundamentals visit
“WACC 101 – an introduction” at
http://www.slideshare.net/AOhlinInsights/weights-average-
cost-of-capital-wacc-101
A’Ohlin Commercial Insights
www.aohlininsights.com
A’Ohlin Commercial Insights © 2013

27. Weighted Average Cost of Capital
(WACC)
– Post GFC
a Revision Lower is Needed
A’Ohlin Commercial Insights
www.aohlininsights.com
3 December 2012
A’Ohlin Commercial Insights © 2013