How does a lower WACC proposed by regulators as a pricing benchmark affect shareholders?

The weighted average cost of capital (WACC) allows managers to see how much interest the company has to pay. WACC is therefore a useful tool in decision making. In today’s blog I will be looking at how industry regulators propose lower WACC’s for companies in order for them to reduce their prices. Are these WACC’s achievable, if not, what are the implications for the shareholders?  

Practical Application

For a company to grow, cash generated by the business ventures must exceed the returns paid to investors. The WACC can therefore be used as a benchmark; it helps managers make investment decisions and can be used by regulators. The most common use is seen in capital investment decision making: only those projects with a higher return than the company’s WACC will be accepted by management, thus the lower the WACC, the greater the investment opportunities. The knock on effects can be seen with an increase in shareholder returns. 

If a lower WACC is such a positive thing, how can lower WACC proposed by regulators be a problem? Regulators can use WACC as a benchmark for companies pricing models. They can enforce certain rules to companies based on their proposed WACCs.  Examples of this can be seen in the broadband, electricity and water industry.

Ofcom

Ofcom wanted BT to reduce the price of its wholesale broadband products in order to improve internet access in rural areas.  The basis for their proposed cuts in price comes from their estimation on BT’s WACC. As a result, Ofcom proposed a lower WACC of 8.6%.  Analysts said this would in turn cut the price of the subsidiary’s wholesale products across the country. However if BT were to reduce their prices, group revenue could be cut by £150million and earnings could decline by 8%.

Ofgem

Ofgem has allowed electricity distribution network companies to invest £7.2bn in the distribution network. The companies are keen to invest heavily in their networks as the returns they are allowed to earn are based on the size of their assets. However, Ofgem is only permitting price rises of just 5.6% per year on average. The industry argued that this may not be enough to deliver the investment. The decision for this came from the assumed WACC of 4.7%. This is significantly below anyone had anticipated.  Ofgem argued that those companies who manage themselves efficiently could earn up to returns of 13%, while those mismanaged companies could see a 3% return.  Is it really down to the performance of management? Or is the WACC too low?

Ofwat

Ofwat’s final determination foresees average water bills to decline by 1% over the next five years. This is based on Ofwat’s forecasted WACC of 4.5%, lower than companies’ request of 5%.Water companies have argued that this decision favoured customers; they argued that they did not come close to matching any of the price rises they had asked for. Instead they told them to expect a price decrease.

What are the implications to shareholders?

 The above example show how regulators forecasts of WACC are used to enforce new pricing policies. Although a lower WACC is beneficial for companies, enforcing them may have serious implications if they are not achievable. Looking at BT, assuming a lower WACC can be achieved in order to lower prices can have a damaging effect on the company, thus hindering shareholder wealth maximisation. The regulators forecasts are forcing companies to become more efficient to meet their demands, however is this fair? Looking at Ofwat’s terms, it may be difficult for the water companies to meet these requirements due to the high levels of debt most of these companies have. Debt is now more expensive, thus they face rising costs. Is it therefore fair for Ofwat to foresee a decline in water bills?

However, you could argue that Ofgem’s actions could benefit shareholders. Although their proposed WACC is lower than the industry expected, they have argued that those companies who are well managed and efficient could deliver returns of up to 13% to its shareholders. Therefore, could enforcing lower WACC’s benefit shareholders? Does this force companies to become more efficient?

 

Conclusion

It can be argued that for investment purposes a lower WACC is beneficial for companies and can increase shareholder returns due the range of available investment opportunities.  However, is this case when regulators are using this as a benchmark for pricing policies?  The real answer is how realistic are these proposed WACCs? In the case of BT it could be argued that their WACC was too low to achieve and would cause problems which as a result would destroy shareholder wealth.  Regulators should take this into account when setting benchmarks. However, it is also a way to force companies to become more efficient. It is easy to lower the WACC by restructuring a company’s capital structure, thus proposing lower WACC’s aren’t necessarily a bad thing. In Ofgem’s case, they argued that it was down to the management of the company, and those run efficiently would be able to deliver up to 13% in returns.

To conclude, using WACC as a benchmark for pricing policies can have both positive and negative implications to shareholders. It should therefore be emphasised that the proposed WACC’s should be realistic, which would allow companies to meet these levels and improve efficiency which as a result would benefit shareholders.

References 

 Arnold, G (2013) Corporate Financial Management. 5th ed. Great Britain: Pearson.