Video | Agriculture | Confidence | Economy | Energy | Employment | Finance | Media | Property | RBNZ | Science | SOEs | Tax | Technology | Telecoms | Tourism | Transport | Search

 


Explanatory Notes on Access Pricing Methodology

From: http://www.treasury.govt.nz/media/FNZC_note.pdf. Note you will need to view the PDF original to see the equation formatting correctly.


Page 1

Explanatory Notes on Access Pricing Methodology 1. Introduction

These explanatory notes are intended to assist the parties to apply the access pricing principles contained in Schedule 6 of the Heads of Agreement (HOA). They do not form part of the HOA and may need amendment in the future to reflect changes in economic value and cost of capital methodology in New Zealand.

The notes are intended to be an overview of the pricing principles, rather than a detailed guide to their practical application.

2. Over-riding Principle

The over-riding principle in setting access charges is stated in the HOA as: “The track access charges (“TAC”) payable by Opco will be set at levels that are expected to ensure that Opco is commercially viable.” This is stated as an expectation because:

- access charges are to be set on a forward-looking basis every three years and the actual results achieved by Opco may differ from the assumptions made in setting the charges. The access charge regime is not intended to guarantee that Opco is commercially viable;

- access charges will not be adjusted within a three-year period. Opco will bear the positive and negative impacts of over- or under-achieving relative to the assumptions used in setting the charges; and

- access charges will comprise a fixed and variable (GTK) component. If actual GTK’s differ from the levels assumed in setting the access charges, Opco’s actual financial performance will differ from its expected performance.

3. Primary Test

The primary test of whether Opco is expected to be commercially viable over the period in question is the level of its expected economic return over the period.

Access charges will be set so that Opco is expected to make an economic return of not less than zero over the period. Where the cap on Trackco’s economic return applies (see section 5 below), Opco’s expected economic return could exceed zero. In any event, access charges will not be set at levels that are expected to produce an economic loss for Opco.

This test is intended to be applied to each year of the three year forecast period, but factors such as the desirability of avoiding large variability in access charges from year to year may suggest that Opco’s expected economic gain/loss in particular years may differ from zero, provided the gain/loss over the entire three year period is expected to be zero.

4. Methodology

(i) Introduction

A firm makes an economic gain (or loss) if the returns it generates for its capital providers (i.e. the providers of the firm’s debt and equity capital) exceed (or fall short of) the expected level of returns required by the capital providers.

The expected level of returns required by capital providers is a function of:

- the amount of capital they have invested in the firm; and

- the cost of capital, as measured by the firm’s weighted average cost of capital (“WACC”).

A firm’s economic gain or loss can be measured using economic value reporting principles.

Economic value reporting principles are based on Stern Stewart’s economic value added (“EVA”) methodology. The general approach is to derive from accounting information (based on generally Page 2

accepted accounting practice) a measure of the total economic return available to debt and equity providers.

This measure of total economic return is net operating profit after tax (“NOPAT”) plus any revaluations of operating capital.

The total economic return is compared with the expected level of return required by capital providers. The required expected level of return is estimated as: average operating capital x WACC This is referred to as the “capital charge”. Hence, the economic return is estimated as: total economic return - capital charge.

If this is positive, an economic gain has been derived. If it is negative, an economic loss has resulted.

(ii) NOPAT

NOPAT excludes interest expense on debt and the interest expense implicit in lease rentals. Tax is calculated as the cash tax that would be payable on taxable income in the absence of a deduction for (explicit and implicit) interest expense. It reflects the benefit of any tax losses available.

NOPAT is after the deduction of depreciation but before the amortisation of any goodwill or other intangibles. The value of intangible assets should be subject to periodic review to ensure that it represents the economic value of the assets. Any change in the value of intangible assets would be added (or subtracted) from NOPAT to derive the total economic return.

Lease payments relating to capitalised leases are excluded from NOPAT, but depreciation on leased assets is expensed in deriving NOPAT.

For Opco, NOPAT will be calculated excluding any revenues and expenses not directly relating to Opco’s rail and ferry operations. For example, revenues and expenses relating to any property leases will be excluded (since leases are expected to earn a property-related return, rather than Opco’s WACC).

Similarly, for Trackco, NOPAT will exclude revenues and expenses relating to property, subleases or other activities of Trackco not directly relating to the provision of rail infrastructure services.

(iii) Operating Capital

Operating capital is calculated as the depreciated book value of fixed assets, capitalised leases of operating assets and net working capital. Operating capital can also be derived from the amounts of debt and equity capital employed to finance that capital.

For both Opco and Trackco, assets will be valued at accounting book value rather than alternatives, such as optimised deprival value (“ODV”). The ODV of an asset is estimated as the lesser of its optimised depreciated replacement cost (“ODRC”) and economic value, where the latter is generally calculated using discounted cash flow (“DCF”) methodology. For rail assets in New Zealand, ODRCs are likely to exceed economic values, so ODV methodology would generally result in the adoption of DCF values. DCF values are unsuitable as a basis of setting the access charges, e.g. Trackco’s DCF value is likely to be negative, so could not be used for determining Trackco’s economic return.

Capitalised leases are valued at the present value of the expected lease payments discounted at the cost of debt inherent in the price and terms of the lease.

Works under construction become part of operating capital at the time they become operational.

Prior to that date, interest on capital expended is accrued at the WACC and added to the amount of the expenditure to ensure that Opco (or Trackco) earns its required return on the projects prior to completion. The capital cost plus accrued interest are depreciated over the economic life of the asset.

Page 3

Net working capital excludes interest-bearing assets (e.g. short-term deposits) or liabilities (e.g.

overdraft) because these are taken into account in the calculation of the cost of capital.

For Opco, operating capital excludes assets (including working capital) not directly relating to Opco’s rail or ferry operations. Similarly, for Trackco operating capital excludes assets (e.g.

property leases) not directly relating to the provision of rail infrastructure services.

Since Trackco is acquiring the rail network infrastructure for $1, the initial value of the infrastructure for this purpose is $1.

(iv) Capital charge

As noted in (i) above, the capital charge is based on average operating capital. This is calculated as the average of opening and closing capital, where any revaluations of operating capital over the period are excluded from closing operating capital. This exclusion is necessary because asset revaluations are included in the economic return.

(v) GAAP

Opco’s and Trackco’s NOPAT and operating capital will be based on generally accepted accounting practice in New Zealand (as defined in the Financial Transactions reporting Act 1993).

For both entities, the application of GAAP for this purpose needs to be consistent with its application for financial reporting, except where this would be in conflict with the pricing principles in the HOA.

(vi) WACC

The economic value reporting methodology requires an estimate of Opco’s and Trackco’s WACC.

A firm’s WACC is a weighted average of its estimated costs of debt and equity, where the weights are the proportions of debt and equity in the firm’s total capital.

The methodology generally accepted in New Zealand for estimating the cost of equity is the Brennan-Lally Capital Asset Pricing Model (“CAPM”). This was used by First NZ Capital to estimate the WACC for Opco and Trackco. The methodology and parameters are outlined in Appendix A.

Except for the impact of different proportions of debt and equity in their total capital, Opco and Trackco are to have the same WACC. In particular, they are to have the same asset beta. The rationale for this is that, under the access pricing principles adopted in the HOA, Trackco is exposed to the same economic cycles and other economy-wide fluctuations that affect Opco.

Trackco’s revenues (from access charges) depend on Opco’s performance. Trackco is analogous to an equity provider to Opco - it provides capital to Opco (in the form of the track infrastructure) and receives a return that has the same riskiness as the returns Opco provides to its equity investors.

(vii) Financial model

Financial models of Opco and Trackco are required to apply the methodology. These should be ten-year models. A longer period may be required to enable the long-term impacts of capital expenditure to be adequately reflected in the model.

The models should include explicit assumptions regarding key value drivers, such as price and volume assumptions for major revenue streams, projected changes in fixed and variable costs and the timing and projected costs and benefits of capital expenditure.

The HOA contains provision for access charges to be retrospectively adjusted if Opco knowingly provides materially inaccurate information for the purposes of a triennial review, or if the actual timing or quantum of Opco’s capital expenditure materially departs from what was assumed for the purposes of a triennial review.

(viii) Example

Details of the way in which First NZ Capital applied this methodology to Opco and Trackco for the year ending 30 June 2004 are shown in Appendix B.

Page 4

5. Trackco’s Economic Return

Trackco’s expected economic return is to be capped at zero, i.e. Trackco is not expected to earn a return that exceeds its cost of capital. This provision is stated in the HOA as an expectation for similar reasons to those stated in section 2 above in relation to Opco. Because access charges are to be set on a forward-looking basis every three years, Trackco may make economic gains if its revenues exceed (or its operating or capital costs are less) than those assumed at the time of setting the charges.

If the cap applies, all further economic gains generated by the Opco/Trackco combination will accrue to Opco.

6. Trackco Capital Expenditure

Subject to the over-riding principle, access charges are to be adjusted to enable Trackco to make an economic return of zero on capital expenditure it undertakes for commercial purposes or to enable it to comply with legal and regulatory requirements. Access charges will not be adjusted for capital expenditure undertaken for other purposes, such as where there is no economic benefit to Opco.

While Opco is expected to make an economic gain of no more than zero, access charges will be constrained by the over-riding principle, irrespective of the level of capital expenditure undertaken by Trackco. Hence, the access charge adjustment relating to Trackco capital expenditure will be relevant only when Opco is expected to make an economic gain of greater than zero.

The increase in access charges attributable to a capital expenditure project would become payable (subject to the above qualifications) from the date on which the project is completed and becomes operational for Opco and Trackco.

7. Subsidies, Penalties and Incentives

It is envisaged that Opco may receive subsidies from Trackco or the Crown for the delivery of noncommercial services. To avoid the access pricing regime negating the effect of such subsidies, the economic return expected to be earned by Opco under the methodologies outlined above will be calculated before the effect of any such subsidies paid by Trackco or the Crown in respect of specified non-commercial services that are provided for in a contract between either party and Opco.

Both Opco and Trackco will be subject to performance incentives and penalties relating to their performance relative to service level agreements and key performance indicators. Again, to avoid the access pricing regime negating the effect of such penalties and incentives, they are to be excluded in applying the methodologies outlined above.

8. Transitional Provisions

During the first three years and nine months of the regime, the total amount of access charges payable by Opco are subject to the limits specified in the HOA. These are that the total access charge (excluding GST) payable by Opco will be:

- fixed at 9/12ths of $55 million in the nine months ending 30 June 2004;

- no more than $60 million in the year ending 30 June 2005;

- no more than $65 million in the year ending 30 June 2006; and

- no more than $70 million in the year ending 30 June 2007.

The actual level of access charges payable by Opco in the June years ending 2005, 2006 and 2007 may be less than these limits depending on the results of applying the methodology outlined above. Any refund due to Opco as a result of these limits will be paid retrospectively and progressively as soon as it becomes apparent that the limits will be applicable.

Page 5

Appendix A: Weighted Average Cost of Capital Estimation

This appendix outlines the methodology and parameter estimates employed by First NZ Capital to estimate Opco’s and Trackco’s weighted average cost of capital (“WACC”).

Methodology

The WACC for a company financed by a combination of debt and equity is conventionally defined as: e d k E D E T k E D D WACC * + + - * .

+ = ) 1 ( where: D and E = market values of debt and equity, respectively kd and ke = investors’ required return on debt and equity, respectively T = the corporate tax rate An application of the WACC therefore requires market value estimates of the company’s debt and equity, and estimates of its cost of debt and cost of equity. The cost of equity is typically estimated using models such as the Capital Asset Pricing Model (“CAPM”).

CAPM

To account for the effects of New Zealand’s dividend imputation regime on the cost of equity, First NZ Capital uses the Brennan-Lally version of the CAPM.

The Brennan-Lally model explicitly accounts for the differential taxation of asset returns. The basic intuition of the model is that if a particular asset provides a return in a form that is unfavourably taxed visà- vis other classes of asset returns, all other things (such as risk) being equal, it must offer a higher pretax return than those other classes to compensate for this.

Although the Brennan-Lally model accounts for differences in investor-level taxes on different types of asset returns, the model is applicable to post-corporate tax, but pre-investor tax cash flows.

First NZ Capital uses the following version of the Brennan-Lally model: MRP T R T D k e J I f J D J e * ) 1 ( â + - + * = where: k e = expected pre-investor tax return on equity DJ = dividend yield TD J = weighted average over all investors of their tax rates on dividends Rf = pre-investor tax risk-free rate of interest

Page 6

TI J = weighted average over all investors of their tax rates on interest net of capital gains tax, divided by one minus the capital gains tax rate ß e = the equity beta MRP = market risk premium (“MRP”) applicable in the Brennan-Lally model

First NZ Capital Estimates

We outline below First NZ Capital’s estimates for the parameters used to calculated Opco’s and Trackco’s WACC for valuation purposes. Appendix B describes how First NZ Capital estimated Opco’s and Trackco’s WACC for the purpose of calculating Opco’s capital charge, to the extent there are any differences.

Market values of debt and equity

For valuation purposes, the market values of Opco’s debt and equity were calculated annually, on a rolling basis, based on the results of our discounted cash flow (“DCF”) analysis. Under the DCF approach, the enterprise value of a business is defined as the sum of the future free cash flows available to the owners of that business, discounted by that business’ WACC. The market value of debt was assumed to equal the book value of Opco’s debt. The market value of Opco’s equity was then estimated by subtracting Opco’s net debt from Opco’s enterprise value.

Taxation

The New Zealand corporate tax rate of 33% was used.

Cost of debt

Opco’s cost of debt was calculated on a rolling basis as the weighted average cost of Tranz Rail’s individual debt facilities. This ranged from 8.2% - 8.7% for the financial years ending 30 June 2004 to 30 June 2013.

Cost of equity

For the purpose of estimating the cost of equity, First NZ Capital used the following estimates for the market parameters: MRP = 7% TD J = -3.1% TI J = 19.8%

Risk-free interest rates

Annual risk-free interest rates for the ten years from 2004 to 2013 were estimated using projected forward rates sourced from a decomposition of the government bond yield curve as at 30 May 2003. The annual risk free interest rates ranged from 4.95% to 5.85% for the financial years ending 30 June 2004 to 30 June 2013.

Dividend yield

For the financial year ending 30 June 2004, we assumed that Opco pays no dividends. For the financial years after 2004, we assumed a dividend payout ratio of 10%, with the dividend yield calculated based on the implied market value of equity, as calculated above.

Page 7

Beta

An estimate of Tranz Rail’s equity beta (pre-Crown deal) was obtained from Barra. Tranz Rail’s asset beta was then calculated by de-gearing the equity beta by the ratio of Tranz Rail’s debt to equity, as calculated above. This estimate was used for the purposes of our stand-alone valuation of Tranz Rail.

Page 8

Appendix B: NOPAT and Capital Charge This appendix provides an explanation of how First NZ Capital calculated Opco’s and Trackco’s NOPAT, operating capital and WACC.

NOPAT

Opco’s NOPAT was calculated by treating the GATX lease as if it had been brought “on balance sheet”.

Accordingly, Opco’s NOPAT was calculated by making the following adjustments to Opco’s earnings before interest and tax (“EBIT”):

- increasing EBIT by the operating expense attributable to the GATX lease;

- decreasing EBIT by the notional depreciation charge on the assets related to the GATX lease; and

- recalculating Opco’s unlevered tax to reflect these adjustments.

The specific assumptions underlying the calculation of Opco’s and Trackco’s EBIT and unlevered tax were based First NZ Capital projections and public information set out in Tranz Rail’s 2002 annual report.

Forecasts for macroeconomic variables such as inflation and GDP growth were sourced from First NZ Capital Research.

Operating expenses attributable to the GATX lease and the appropriate depreciation charges were calculated based on financial information contained in Tranz Rail’s 2002 annual report.

Unlevered tax was calculated based on the EBIT forecasts, with adjustments to reflect the deductibility for tax purposes of certain capital expenditure items. The unlevered tax calculations reflected First NZ Capital’s understanding of Tranz Rail’s tax loss position.

Operating capital

Opco’s operating capital was calculated by summing the average book value of Opco’s fixed assets (excluding the network assets transferred to Trackco), the average outstanding balance of the GATX lease contract, the average balance of Tranz Rail’s investments (excluding ATN) and the average net working capital balance.

The value of Opco’s fixed assets, investments and net working capital were calculated from the same financial forecasts and assumptions underlying the EBIT calculations. The average outstanding balance of the GATX lease contract was based on information contained in Tranz Rail’s 2002 annual report.

Trackco’s operating capital was calculated in a similar way. It was assumed that the value of the network immediately following its sale to Trackco is $1. Trackco’s operating capital gradually increases with further capital expenditure. The capital expenditure assumptions were based on First NZ Capital forecasts.

Cost of Capital

Opco’s WACC for calculating the capital charge was calculated in a manner consistent with the principles outlined in Appendix A, with the following adjustments:

- the book value of equity was used to calculate Opco’s cost of equity;

- the book value of debt was adjusted to take into account the capitalised value of the GATX lease, based on information contained in Tranz Rail’s 2002 annual report;

- the cost of debt included the interest cost of the GATX lease, treating the lease as if it is on balance sheet. The assumed cost of debt associated with the GATX lease was based on First NZ Capital estimates; and

- the risk free rate was equal to the three year government bond rate for the relevant three year accessing charging period.

In calculating the appropriate asset beta for Opco, we examined the asset betas of a sample of companies comparable to Tranz Rail, together with the market implied asset beta for Tranz Rail itself.

The comparable companies consisted of a number of US Class 1 Railway Operators and domestic transport companies.

To estimate the asset beta of each sample company we obtained equity beta estimates for each company from Barra, together with the respective market capitalisation and debt levels. Asset betas were then estimated for each company by delevering the equity betas according to the specific gearing level of the company in question. The resulting asset betas were further adjusted to take into account differences in average gearing levels between countries to enhance the accuracy of the estimate.

Based on the sample of asset betas this provided, we estimated an asset beta of 0.45 for Opco.

Trackco’s WACC was calculated in the same way as Opco’s, adjusted for the difference in Trackco’s gearing, dividend payout ratio and the availability of tax losses.

Example calculations

The following pages outline First NZ Capital’s calculations for Opco’s and Trackco’s NOPAT, operating capital, WACC and capital charge for the financial year ending 30 June 2004.


Page 10

All NZ$M (unless otherwise stated) FY2004 Information source

Calculation of Opco's NOPAT

Revenue 609.2 FNZC forecasts
Operating Expenses (472.0) FNZC forecasts
Access Charge (55.0) Capped based on TrackCo EVA (zero economic gain/loss)
EBITDA 82.2
Depreciation (31.9) FNZC forecasts
Goodwill Amortisation 0.0 FNZC forecasts
Financing Cost Amortisation (1.2) FNZC forecasts
EBIT 49.1
add back GATX Charge 20.3 Tranz Rail annual report/FNZC forecasts
less GATX Depreciation (6.1) Tranz Rail annual report/FNZC forecasts
Unlevered Tax 0.0 Utilises tax losses (based on FNZC forecasts)
Opco's NOPAT 63.4

Calculation of Opco's Operating Capital

Average Fixed Assets
Land & Buildings 30.9 Tranz Rail annual report/FNZC forecasts
Capitalised Finance Assets 83.0 Tranz Rail annual report/FNZC forecasts
Plant, Equipment and Vehicles 227.4 Tranz Rail annual report/FNZC forecasts
Total Average Fixed Assets 341.3
Average GATX Balance 54.8 Tranz Rail annual report/FNZC forecasts
Average Investments 5.0 Tranz Rail annual report/FNZC forecasts
Average Working Capital
Accounts Receivable 73.0 FNZC forecasts
Prepayments 6.9 FNZC forecasts
Inventory 19.4 FNZC forecasts
Accounts Payable (79.1) FNZC forecasts
Average Net Working Capital 20.2
Opco's Operating Capital 421.3

All NZ$M (unless otherwise stated) FY2004 Information source

Calculation of Opco's WACC
Risk Free Rate 4.9% Government Bond forecasts
Cost of Debt 8.4% FNZC forecasts
Tax Rate 33.0%
Market Risk Premium 7.0%
T(i) 19.8% First NZ Capital Research
T(j) -3.2% First NZ Capital Research
Book Equity 173 FNZC forecasts
Net Debt (inc. GATX) 177 FNZC forecasts
Net Debt/Book Equity Value 102%
Net Debt/Book Capitalisation 51%
Asset Beta 0.45 Barra estimate
Equity Beta 0.91
Prospective Net Dividend Yield 1.1% FNZC forecasts
Post-tax Cost of Debt 8.4% Because utilising tax losses, cost of debt is pre-tax
Post-tax Cost of Equity 10.3%
WACC 9.3%

Opco's Capital Charge 39.3
Economic Gain 24.1

All NZ$M (unless otherwise stated) FY2004 Information source

Calculation of Trackco's NOPAT

Operating Revenue 14.5 FNZC forecasts
Access Charge 55.0 Capped based on TrackCo EVA
Operating Expenses (59.5) FNZC forecasts
EBITDA 10.0
Depreciation (1.5) FNZC forecasts
Goodwill Amortisation 0.0 FNZC forecasts
EBIT 8.6
less lease rental revenue (3.3)
Adjusted EBIT 5.3
Unlevered Tax 0.0 Adjusted for tax deductible capital expenditure
NOPAT 5.3

Calculation of Trackco's Operating Capital

Average Fixed Assets
Infrastructure Assets 12.4 Excludes land costs
Total Average Fixed Assets 12.4
Average Investments 0.0
Average Working Capital
Accounts Receivable 6.9 Only working capital relating to access fee
Inventory 0.9 Only working capital relating to access fee
Accounts Payable (4.5) Only working capital relating to access fee
Average Net Working Capital 3.3
Operating Capital 15.7

Calculation of Trackco's WACC

Risk Free Rate 4.9% Government Bond forecasts
Cost of Debt 8.4% FNZC forecasts
Tax Rate 33.0%
Market Risk Premium 7.0% First NZ Capital Research
T(i) 19.8% First NZ Capital Research
T(j) -3.2% First NZ Capital Research
Book Equity 0
Net Debt 0
Net Debt/Book Equity Value 0%
Net Debt/Book Capitalisation 0%
Asset Beta 0.45 Barra estimate
Equity Beta 0.45
Prospective Net Dividend Yield 0.0% No dividends assumed
Post-tax Cost of Debt 5.6%
Post-tax Cost of Equity 7.1%
WACC 7.1%

Capital Charge 1.1
Economic Gain 4.1 Economic gain in FY2004 given $55m fixed access charge


© Scoop Media

 
 
 
 
 
Business Headlines | Sci-Tech Headlines

 

Nurofen Promotion: Reckitt Benckiser To Plead Guilty To Misleading Ads

Reckitt Benckiser (New Zealand) intends to plead guilty to charges of misleading consumers over the way it promoted a range of Nurofen products, the Commerce Commission says. More>>

ALSO:

Half A Billion Accounts: Yahoo Confirms Huge Data Breach

The account information may have included names, email addresses, telephone numbers, dates of birth, hashed passwords (the vast majority with bcrypt) and, in some cases, encrypted or unencrypted security questions and answers. More>>

Rural Branches: Westpac To Close 19 Branches, ANZ Looks At 7

Westpac confirms it will close nineteen branches across the country; ANZ closes its Ngaruawahia branch and is consulting on plans to close six more branches; The bank workers union says many of its members are nervous about their futures and asking ... More>>

Interest Rates: RBNZ's Wheeler Keeps OCR At 2%

Reserve Bank governor Graeme Wheeler kept the official cash rate at 2 percent and said more easing will be needed to get inflation back within the target band. More>>

ALSO:

Half Full: Fonterra Raises Forecast Payout As Global Supply Shrinks

Fonterra Cooperative Group, the dairy processor which will announce annual earnings tomorrow, hiked its forecast payout to farmers by 50 cents per kilogram of milk solids as global supply continues to decline, helping prop up dairy prices. More>>

ALSO:

Results:

Meat Trade: Silver Fern Farms Gets Green Light For Shanghai Maling Deal

The government has given the green light for China's Shanghai Maling Aquarius to acquire half of Silver Fern Farms, New Zealand's biggest meat company, with ministers satisfied it will deliver "substantial and identifiable benefit". More>>

ALSO:

Get More From Scoop

 
 
 
 
 
 
 
 
 
Business
Search Scoop  
 
 
Powered by Vodafone
NZ independent news