Valuation of non-regulated projects

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Valuation of non-regulated

projects

N.V. Nederlandse Gasunie

Groningen, April 2007 Rijksuniversiteit Groningen

Faculty of Management and Organization Supervisor RuG: Dr. J.H. von Eije

Gasunie: Dr.ir. B.M. Visser Author : Remôn te Morsche

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Rijksuniversiteit Groningen II

Valuation of non-regulated projects

N.V. Nederlandse Gasunie

Master thesis Technology Management (TBW program)

Discrete Technology

Cluster Financial Management

Rijksuniversiteit Groningen

First supervisor RuG: Dr. J.H. von Eije

Second supervisor RuG: Mr. drs. H.A. Ritsema

Supervisor Gasunie: Dr. ir. B.M. Visser

Author: R.H.A. te Morsche

Groningen, April 2007

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Rijksuniversiteit Groningen III

PREFACE

This thesis is written as a final report for my study Technology Management (TBW program) at the Rijksuniversiteit Groningen. In the final year of this study it is common to do an internship at a company and to write a thesis about the problem you investigated. This thesis is written at the financial department of N.V. Nederlandse Gasunie. I came in contact with Gasunie during a case at the career week of AIESEC, an event where students have the opportunity to meet several companies. The case was led by Wout de Groot, an employee of Gasunie. At the end of the case he gave me his business card. Several months later when I started to look for a company where I could do my internship I contacted Wout and he introduced me to Gasunie for which I would like to thank him.

The department where I did my research at Gasunie is FFE, which is the economic section of the corporate finance department. The manager of the department, Martien Visser was my supervisor during the process. I would like to thank Martien, because despite of his busy schedule he always made time to discuss the finance problems concerning my thesis and to answer my questions. I would also like to thank the other employees and students at the FFE department for their inputs, especially Kees Alberts who was my roommate during the first four months. Next to this I would like to thank Johan de Boer and Chris van Winsum of the Treasury department where I accomplished my later research. My first supervisor of the university is Henk von Eije, who I would like to thank for his inputs. He was immediately very enthusiastic about my subject and gave me ideas on how I could do my research. Next to this I would like to thank my second supervisor Henk Ritsema, who immediately accepted when Henk von Eije asked him to be second supervisor.

Also I would like to thank my parents who supported me during the whole process of my study, my sister Angelique and her husband Ted, who gave me some feedback concerning the content of the report. I would like to thank Joost Hooghiem, Dorenda Nicolaij, Tom Smeenk and Lieke van der Sande for their feedback on my thesis, their enthusiasm and their books. Also I would like to thank my friends for their enthusiasm and Frank Koopman for his creative insights.

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Rijksuniversiteit Groningen IV

MANAGEMENT SUMMARY

In the European Union N.V. Nederlandse Gasunie is one of the biggest transporters of gas. From the date of 1 July 2005 Gasunie became an independent provider of gas transport services in the Netherlands and Europe. In order to meet with the increasing demand for transport capacity Gasunie’s existing gas transmission system will need expansion. Many of the new projects are non-regulated. This means that there is possible competition and the tariffs are therefore free.

In chapter 2 the problem that led to this thesis is introduced. Before any of the new projects are undertaken Gasunie needs to review them financially to find out whether they are profitable. This led to the following research objective: “Developing a valuation model for non-regulated gas infrastructure projects of Gasunie, for (potential) third party contracts.” To reach the objective of this research the following main question is tried to be answered in this thesis: “What characteristics should a model for the valuation of non-regulated projects have, for (potential) long term sales contracts?” To answer the main question several sub-questions have been made that together – if answered – answer the main question. Finance literature and methods how to value projects under leverage are investigated, as well as credit ratings, unused capacity and real options.

The first sub-question: “What scientific theories can be used to value non-regulated projects?”, is discussed in chapter 3. The net present value approach that is thoroughly discussed in finance literature is used as the basis for many calculations. For the net present value approach a discount rate – also called cost of capital – is needed. To calculate this cost of capital several input variables have been determined. A risk free rate of 3.9 percent, a market equity risk premium of 5 percent and an unlevered beta with a range of 0.56- 0.60 seem adequate for Gasunie. Next to the weighted average cost of capital approach there are also other financial methods for dealing with leverage. The adjusted present value approach and the flow to equity approach are other possibilities. When dealing with uncertainty consensus seems to go into the direction that the discount rate reflects the risk that is systematic and cannot be diversified away. The cash flows are affected by the remaining part of the risk. Real options give an insight in the ability of companies to change course in response to changing circumstances.

The second sub-question is answered in chapter 4: “How should the valuation of a project be done when Gasunie uses leverage?” For Gasunie an unlevered cost of capital of 6.9 percent is calculated. The debt premium that is determined for Gasunie is in the range between 66 and 94 basis points. This leads to a cost of debt varying from 4.56 percent to 4.84 percent. The levered beta range that is determined for Gasunie is between 0.79 and 0.93. When you combine these numbers and the numbers

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Rijksuniversiteit Groningen V found in chapter 3 the weighted average cost of capital can be calculated. For Gasunie a WACC between 6.3 percent and 6.8 percent seems accurate. The weighted average cost of capital approach, the adjusted present value approach and the flow to equity approach seem at first glance to be quite different, but if applied correctly all three approaches provide the same value estimate. However under different circumstances one method might be easier to use than the other.

The third sub-question: “How can the credit rating of the contracting parties be taken into account in the valuation process?” is answered in chapter 5. The decision has been made to reduce the cash flows of the contracts depending on the credit rating of the party that signed a contract with Gasunie. In order to answer the question how this should be done, a table is used that depicts default percentages of different rated firms after different periods. To be of use for its goal this table is first interpolated and then prolonged by extrapolation. Now the question remains when which part of the table should be used. For firms with a credit rating between AAA and A no reduction of the cash flows will be done at all. The reason for this is that the reduction percentages for these firms in the table are so low that they will not have a significant influence on the calculation and would only lead to extra work. Cash flows of firms with a credit rating of BBB and lower will be reduced by this reduction table. When there is only one possible shipper the reduction percentages will be relatively high. These percentages can be found in table 5.3 in this thesis. The reason that these percentages are relatively high is that there is no alternative shipper to sell the capacity to when the contracting party goes bankrupt. When there are several potential shippers the default percentages first need to be reduced, because the capacity of shippers that have gone bankrupt can be resold again. This leads to a new adjusted table of reduction percentages that can be found in table 5.5 of this thesis. These percentages will be used to reduce the cash flows of firms with a BBB rating or lower when there are several potential shippers.

The fourth sub-question is answered in the last part of chapter 5: “How can the value of unused capacity be calculated?” To answer this question a reduction factor for the cash flows is introduced. This means that the risk of unused capacity is put in the cash flows and not in the cost of capital. All the potential cash flows for the capacity that has not been sold in the present are reduced with 25 percent. This means that for calculations of this capacity 75 percent is taken as certain and the rest is considered to have a value of 0.

The fifth and last sub-question is answered in chapter 6: “What forms of real options may exist for Gasunie that can raise the value of (potential) long term contracts?” The two most interesting option forms for Gasunie are the option to defer an investment and the option to expand. When a numerical example is made it can be shown that real options can ad value to a project. This extra value is of most

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Rijksuniversiteit Groningen VI importance when the project has a negative net present value and real options might exist that can make it interesting to invest.

Together the answers to the sub-questions provide a model for non-regulated gas infrastructure projects of Gasunie. For projects with a relatively high risk the higher beta in the beta-range and therefore higher cost of capital can be used. For projects with relatively low risk the lower beta in the beta-range can be used.

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Rijksuniversiteit Groningen 1

Preface... III Management Summary ...IV Table of contents... 1 Introduction... 3 1. N.V. Nederlandse Gasunie... 4 1.1. Company profile ... 4 1.2. Strategy ... 5 1.3. Regulation... 8 1.4. Summary... 8 2. Problem Definition ... 9 2.1. Problem introduction ... 9 2.2. Research objective ... 10 2.3. Research question ... 10 2.4. Sub-questions... 11 2.5. Research restrictions ... 11

2.6. Schematic overview of thesis ... 12

2.7. Research Methodology ... 13

2.8. Summary... 14

3. Valuation Framework... 15

3.1. NPV ... 15

3.2. Cost of Capital ... 16

3.3. Risk free rate... 17

3.3.1. Choice of duration... 18

3.3.2. Reference market ... 19

3.3.3. Current or average yields ... 20

3.4. Equity market risk premium ... 21

3.5. Beta ... 24

3.5.1. Length of the estimation period of the beta... 26

3.5.2. Return interval... 26

3.5.3. Comparable companies ... 26

3.6. Leverage ... 28

3.6.1. Weighted average cost of capital method ... 29

3.6.2. Adjusted present value approach ... 30

3.6.3. Flow to equity approach... 31

3.6.4. When should the WACC, the APV and the FTE approach be used?... 32

3.7. Risk ... 33

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3.8. Real Options ... 35

3.8.1. Types of real options... 36

3.8.2. Factors influencing real option value... 37

3.8.3. Forms of analysis ... 38

3.8.4. Decision tree example... 39

3.9. Summary and conclusions ... 42

4. Valuation under leverage ... 43

4.1. Unlevered cost of capital of Gasunie ... 43

4.2. Cost of debt and the capital structure... 44

4.3. Weighted average cost of capital ... 46

4.4. Adjusted present value approach ... 47

4.5. Flow to equity approach ... 50

4.6. Scenario analysis of the three methods for valuation under leverage... 50

5. The risks of default and of unused capacity... 53

5.1. Credit rating risk ... 53

5.2. Interpolated table of default percentages ... 54

5.3. Extrapolated table of default percentages ... 55

5.4. Reduction of cash flows when capacity is resold ... 58

5.5. Adjusted table of cash flow reduction percentages... 61

5.6. Situation when there is only one possible shipper ... 63

5.7. What percentages should be used to discount the cash flows? ... 64

5.8. Unused capacity... 66

6. Real Options ... 70

6.1. Possible options for Gasunie... 70

6.2. Numerical example of a decision tree... 72

Conclusions and Recommendations ... 77

Bibliography ... 80

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INTRODUCTION

At the moment the energy sector is in a turbulent period. The electricity sector is in the spotlights, because of possible split-ups of companies. In the Netherlands in the gas trading and infrastructure business this phase is already past. In 2005 Gasunie was split-up by the shareholders into a trading company and a gas distribution company. The trading company is now named Gasterra and the remaining part which is called N.V. Nederlandse Gasunie has developed into a gas infrastructure company. A subsidiary of Gasunie, Gas Transport Services B.V. (GTS) is now responsible for the operational part of the national gas transmission system.

N.V. Nederlandse Gasunie (often called “Gasunie”) where the research for this thesis is done is now situated in a fast changing environment and time phase. Many of the activities that originate from the past and still are the main part of the company are now regulated. To be a competitive player in the future Gasunie want to expand in businesses that are interesting for the time ahead. The goal of Gasunie is to make the Netherland the gas hub of northwest Europe and by that contribute to market integration and the future security of supply of the Netherlands. For a large part these new projects can be activities that are non-regulated at the moment. Before such an activity is started it has to be financially reviewed to find out whether it is going to be profitable in the future. Therefore the valuation of non-regulated projects is an item that is very important for Gasunie.

Finance literature already has developed several theories that can be used for the valuation of projects. The net present value method and the WACC theory are examples. However there are certain areas where literature has very little to say about. An example is how the risk concerning the credit rating of the party that signed a gas distribution contract with Gasunie can be integrated in a valuation model. Another example is how the value of free distribution capacity of Gasunie’s gas infrastructure network can be valuated. These and other questions will be answered in this thesis.

In chapter one a general company profile of N.V. Nederlandse Gasunie is presented. The main activities of the company and the strategy of the company are described. In chapter two the main problem that led to this thesis is introduced. In chapter three relevant theories for the subject are described and the input variables of the capital asset pricing model are determined. Chapter four shows how to value a project when Gasunie uses leverage. In chapter five is described how the credit rating risk of the parties that signed contracts with Gasunie can be integrated in a discounted cash flow model. Next to this the valuation of unused capacity is described. Chapter six deals with the question what real options may exist that can raise the value of non-regulated projects. After chapter six the conclusions of the preceding chapters are summarized and recommendations to Gasunie are given.

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1. N.V. NEDERLANDSE GASUNIE

In this chapter the activities and the profile of N.V. Nederlandse Gasunie are introduced. First in paragraph 1.1. a general description of the company is outlined. In paragraph 1.2. some more details about the strategy of Gasunie are described. After this several projects that Gasunie initiated recently are introduced.

1.1. Company profile

In the European Union N.V. Nederlandse Gasunie is one of the biggest transporters of gas. From the date of 1 July 2005 Gasunie became an independent provider of gas transport services in the Netherlands and Europe. This is a continuation of the transport activities supplied by the former vertically integrated company that was separated into a trading and transport company. Gasunie is also the owner of one of the most extensive high-pressure gas transport networks in Europe. The network consists of almost 12,000 kilometers of pipelines. The total volume that is transported per year is approximately 100 billion cubic meters. Gasunie has a strong financial position. In 2005, the rating agencies Standard & Poor’s and Moody’s rated the company AA+ and Aaa. The state of the Netherlands has been the only shareholder since 1 July 2005. The head office is in Groningen. More than 1400 employees are distributed over around 20 locations throughout the Netherlands.

Gas Transport Services B.V. (GTS), the national gas transmission system operator is responsible for the management and development of the inland pipeline network. GTS is a 100% subsidiary of Gasunie but operates independently as required by the Gas Act. Through GTS, Gasunie supplies transport services to customers, particularly shippers, to industries connected to the network and other national and international network operators. Its activities aim to develop a well-functioning, efficient and transparent gas market, as well as creating value for the shareholder. Gasunie is contributing to the transition towards a sustainable energy supply, based on its knowledge and experience. Natural gas, as the cleanest of all the fossil fuels, occupies a crucial position, during this transitional phase. Apart from GTS Gasunie carries out its activities via two business units, Construction and Maintenance and Participation and Business Development. Through subsidiary Gasunie Engineering B.V. Gasunie is active in engineering, research and development (N.V. Nederlandse Gasunie, 2006).

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1.2. Strategy

The main strategy of Gasunie consists of three targets (N.V. Nederlandse Gasunie, 2006): • operational excellence;

• providing sufficient transmission capacity; • connecting to the gas sources of tomorrow.

Over the next few decades, security of supply will be an important issue in Europe and the Netherlands. The demand for gas is increasing while domestic output is declining. Dependency on countries such as Norway and Russia is becoming even greater. There are also considerable gas reserves in the Middle East and in Africa. Necessary new gas flows will involve extensive investment in the infrastructure. This will imply both investment in pipelines and installations as well as the construction of one or more LNG terminals and underground storage facilities.

Gasunie’s existing gas transmission system will require expansion, particularly in order to meet the increasing demand for transport capacity, both in the northwest route and on the northeast-southwest Netherlands route. Gasunie is investing in storage capacity in salt caverns and is investigating the possibilities for participation in the construction of an LNG terminal on the Maasvlakte and the expansion of the hub services. Gasunie wants to participate in international pipeline projects which are crucial for the supply of gas to the Netherlands. The company is looking to cooperate with neighbouring network operators. The central position, the quality and the size of Gasunie’s gas transport network, as well as the geological circumstances, offer an enviable starting point for making the Netherlands the “gas hub” of northwest Europe and by that contribute to market integration and the future security of supply of the Netherlands. Despite the increasing level of competition on the European gas market, Gasunie has the ambition and the assets to continue to occupy a strong position as gas transporter within Europe.

Initiated projects by Gasunie:

GWWL (Grijpskerk Workum Wieringermeer pipeline)

Because of the expansion of international gas trading and because of reduced gas reserves in the North Sea a shortage of gas originates in the west of the Netherlands. The construction of a pipeline with a length of 110 kilometers between Grijpskerk and Wieringermeer is necessary to guarantee the certainty of gas deliverance in the west of the Netherlands and to be able to deliver gas across borders as well.

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Figure 1.1: Main transmission system and connected facilities, at year-end 2005.

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Zuidwending

Gas storage in salt caverns near Zuidwending (eastern Groningen) is a joint venture with Nuon, facilitated by Akzo Nobel. Gas storage in salt caverns provides the potential to guarantee the integrity of the gas transport network. This provides also a contribution towards the proper functioning of the gas market, because part of the storage capacity will also be made available to sell to third parties. As an independent party, Gasunie will supply storage capacity to the market in a non-discriminatory and transparent manner.

BBL (Balgzand Bacton pipeline)

This is a pipeline which runs from the northwest of the Netherlands to the east of England and is almost finished. In the year 2004 the BBL Company V.O.F. was founded and most contracts with constructors were signed. In 2005 the construction was started. An important moment was august 2005, when official dispensation of European legislation by regulators in the United Kingdom and the Netherlands were granted. After this the investment decision was finalized. The project will probably be completed in the end of 2006.

Gate Terminal B.V.

Gas supply forecasts show that, within the foreseeable future, shortages of natural gas will arise in northwest Europe, including the Netherlands, due to increasing demand and decreasing domestic production. Additional gas will have to be supplied in order to meet these shortages. This can be done by imports of gas through pipelines as well as via supply of LNG by ships. Given the volume of the necessary extra imports, both supply options will be necessary in order to satisfy the anticipated demand for gas. Against this background, at the beginning of 2005 Gasunie and Vopak took the initiative for the development of an LNG terminal in the Netherlands. This initiative is currently aimed at the Maasvlakte.

Nord Stream

Nord stream, formerly known as NEGP (North European gas pipeline) is a possible future project in which Gasunie is participating. Nord Stream is a 1200 kilometre long off-shore natural gas pipeline stretching through the Baltic Sea from Vyborg in Russia, to Greifswald in Germany, which is to be built by Nord Stream AG. Nord Stream is scheduled to begin operation in 2010. Initially one pipeline will be built with a transport capacity of around 27.5 billion cubic metres of natural gas per year. In the second phase, a parallel pipeline will be laid to double the transport capacity to around 55 billion cubic metres a year. The second pipeline is planned to be ready in 2012. The total investment for the offshore pipeline is estimated to be at least 5 billion euros (www.nord-stream.ru/eng).

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1.3. Regulation

Regulation is a subject that has a great impact on the current activities of Gasunie. This means that Gasunie is for a certain part restrained by the rules of the Dutch energy sector regulator, the NMa/DTe. Basically all activities that Gasunie is in are regulated. However it is possible for Gasunie to ask an exemption for activities where there is possible (international) competition. This means that the original transport activities in the Netherlands are to a large extent regulated. Gasunie has to allow several third parties to use its transport network. Next to this the tariffs that Gasunie asks for its services are restrained. For many new activities however Gasunie has the possibility to ask an exemption for a certain period of time of the regulator. This is because otherwise these activities would not be interesting to invest in, because of the high risk that is involved and the limited income that would exist in case of regulation. These are mostly activities where there are several possible parties that can act as possible competitors to Gasunie. These exemptions are often not for an unlimited time frame but for a certain period of time (for example 10 to 15 years). After this period it depends on the regulation that exists at that moment in the future how the regulation will be implemented hereafter.

1.4. Summary

In the European Union N.V. Nederlandse Gasunie is one of the biggest transporters of gas. From the date of 1 July 2005 Gasunie became an independent provider of gas transport services in the Netherlands and Europe. The main strategy of Gasunie consists of three targets: operational excellence, providing sufficient transmission capacity and connecting to the gas sources of tomorrow. At the moment Gasunie is initiating several new projects. Examples of new projects are: GWWL, Zuidwending, BBL, Gate Terminal B.V and Nord Stream. Regulation is a subject that has a great impact on the current activities of Gasunie which means that Gasunie is for a certain part restrained by the rules of the Dutch energy sector regulator.

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2. PROBLEM DEFINITION

In paragraph 2.1. the problem that led to this thesis is introduced. The next paragraph introduces the objective of this research. After this the research questions, the sub questions and the research restrictions are described. In paragraph 2.6. a schematic overview of the thesis is depicted which shows the different factors that influence the value of a project. Paragraph 2.7. describes the research methodology that is used for this thesis.

2.1. Problem introduction

In order to meet with the increasing demand for transport capacity Gasunie’s existing gas transmission system will need expansion. This will imply both investment in pipelines and installations as well as the construction of one or more LNG terminals and underground storage facilities. The projects that will be discussed in this thesis will be projects that are non-regulated. Examples of projects that are (partially) non-regulated are BBL, Nord Stream, Gate Terminal and Zuidwending. For regulated activities turnover is fixed by the NMa/DTe (Dutch energy sector regulator) and these activities are therefore less interesting to valuate.

Before any of these projects are undertaken Gasunie needs to review them financially to find out whether they are profitable. If a project turns out to have a negative net present value it needs to be rejected, because otherwise value is being destructed. To make long term investments it is important to have an insight in future cash flows. Long term contracts can be a certainty for future income. Once a pipeline is put into the ground it is economically not very wise to reverse this decision, because it is cheaper to leave it underground than to pull it up. The cost of putting pipelines into the ground can considered to be sunk. Operating costs are very low in comparison to investment costs. Good insight in the valuation of the gas transmission system can also be of help in negotiations with banks when Gasunie wants to expand and needs to borrow money. When certain parts of the system are sold a good valuation of the present system can be valuable as well. It might be the case that with a new valuation system the value of the gas transmission system turns out to be higher than with the current calculation method. This way Gasunie has a stronger position in case of future sales, future investments and negotiation with banks. A lower theoretical value will weaken their position. More insight in the valuation of non-regulated activities might also raise the understanding of regulated activities. A better understanding of a valuation model will strengthen the position of Gasunie in negotiations with the DTe.

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2.2. Research objective

The research objective of this thesis is the following:

Developing a valuation model for non-regulated gas infrastructure projects of Gasunie, for (potential) third party contracts.

For a valuation model it is interesting to find out what kind of finance theories exist for valuation purposes. These theories might already answer a certain part of the questions that Gasunie is dealing with. Next to this scientific theories might be interesting to use to find out what kind of influence the amount of leverage Gasunie uses has on the value of projects. Also numerical examples can be used to give an extra insight on the influence of leverage.

A specific problem that financial management of Gasunie faces and does not know how to deal with is how it should incorporate specific risks of shippers in a discounted cash flow model. Some shippers have a very high credit rating and seem very reliable, others have a lower credit rating and seem riskier. Next to this financial management of Gasunie is wondering how it should value capacity of pipelines that is free at the moment but might be sold in the future. Should the value of this potential capacity be reflected in a higher cost of capital or in reduced cash flows? Financial management of Gasunie is also wondering what kind of real options may exist that can raise the value of (potential) long term contracts. These questions together led to the research question and sub-questions that are described in paragraph 2.3. and 2.4.

2.3. Research question

To achieve the objective of this thesis, this research tries to answer the following question:

What characteristics should a model for the valuation of non-regulated projects have, for (potential) long term sales contracts?

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2.4. Sub-questions

Several sub-questions have been made that together will try to answer the main research question. The following sub-questions will be answered in this thesis:

What scientific theories can be used to value non-regulated projects?

This question will be answered in chapter 3. Several scientific theories will be discussed in this chapter.

How should the valuation of a project be done when Gasunie uses leverage?

In chapter 3 several theories are introduced that can be used when dealing with leverage. In chapter 4 these theories are used to show how to value a project when Gasunie uses leverage.

How can the credit rating of the contracting parties be taken into account in the valuation process?

In the first part of chapter 5 this question will be answered. For this purpose a table will be designed that can be used to reduce cash flows.

How can the value of unused capacity be calculated?

This question will be answered in the last part of chapter 5. First is discussed why the risk of unsold capacity should be reflected in lower cash flows. Then a reduction factor will be introduced to bring down the value of the possible cash flows of the unused capacity.

What forms of real options may exist for Gasunie that can raise the value of (potential) long term contracts?

In chapter 6 is discussed what forms of options might exist for Gasunie to raise the value of projects.

2.5. Research restrictions

The following research restrictions will be used for this thesis: • Critical business data of Gasunie has to be kept a secret.

• The contracts that are valuated in this thesis will be long term contracts. • Competitors are not taken into account for valuation purposes.

• Possible profits that Gasunie may make in the very far future are not taken into account for valuation and are therefore considered to be zero.

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Rijksuniversiteit Groningen 12 • The scope of this research is limited to non-regulated projects.

2.6. Schematic overview of thesis

To get a better insight in the different subjects that will be described in this thesis an overview of the different subjects is given in figure 2.1. The different factors that are of influence on the valuation model are shown in the middle of figure 2.1. These factors will be more thoroughly described in the chapters shown between the brackets behind the different factors.

The first factor that is of great importance for the valuation model is the cost of capital. The cost of capital is used for the discounting of future cash flows to calculate a present value. A higher cost of capital leads to a lower value estimate of projects, a lower cost of capital leads to a higher value estimate. The fundamentals for the unlevered cost of capital are determined in chapter 3. In chapter 4 the unlevered cost of capital is calculated and the influence of leverage on the cost of capital is introduced. In chapter 5 the risk of default of shippers and the risk of unused capacity is described. To make the list complete in chapter 6 is described what forms of real options may exist to raise the value of projects. When all these different questions have been answered, the answers together form a complete valuation model for non-regulated projects.

Figure 2.1: Overview of thesis

Valuation model Cost of capital (3, 4) Leverage (4) Risk of default (5) Unused capacity (5) Real options (6)

Complete valuation model for non-regulated projects

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2.7. Research Methodology

The methodology of this research will consist of different parts:

• Finance books do already provide theories about the valuation of projects. These theories are first gone through and the relevant literature for this thesis is summarized. Also the input variables of the capital asset pricing model (CAPM) will be thoroughly analysed.

• One of the corners stones to valuate a project, the weighted average cost of capital (WACC) is also calculated and is used in several parts of this research. Next to the WACC approach there are also other methods when dealing with leverage. These methods will also be investigated. • Contracting parties have different credit ratings. A company with a higher rating is less likely

to go bankrupt than a company with a lower rating. Therefore the chances of not being able to pay for the contracted capacity is lower for a higher rated firm than for a lower rated one. Whether and how this should be integrated in a discounted cash flow model has to be investigated.

• Research has to be done to answer the question how unused capacity can be integrated in a discounted cash flow model. Unused capacity is capacity that is available but not used. It is possible that this capacity is free in a pipeline at the present time and therefore this pipeline is operating under 100%. Another possibility is that at the moment all capacity is sold but after the contract period capacity becomes available again.

• Real options may exist that raise the value of a project. This might also be possible when calculating the value of long term contracts of Gasunie.

To investigate the different parts of the methodology several things can be done. A very important part will be the research of literature. Several different methods of valuation can be found there. Some parts might be more suitable for Gasunie to use than others. Literature might also clarify certain aspects about for example credit ratings, real options and unused capacity. Next to literature, interviews with experts on the subject will be held. This can be persons within the financial department of Gasunie but also people outside this department. Also experts of universities and external advisors / consultants might be an important source. Benchmarking is another aspect that can be of help to develop a valuation model for non-regulated projects. Practices of other companies can give new insights on how to do things at Gasunie.

All these factors together can be integrated to form a (combined) optimal discounted cash flow model. When this model is converted to Excel, data can be put in the system and valuation can be done.

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2.8. Summary

In order to meet with the increasing demand for transport capacity Gasunie’s existing gas transmission system will need expansion. Before any activities are undertaken Gasunie needs to review them financially to find out whether they are profitable. The research objective of this thesis is: “Developing a valuation model for non-regulated gas infrastructure projects of Gasunie, for (potential) third party contracts.” The methodology of this research will consist of different parts. Finance literature and methods how to value projects under leverage are investigated. Questions about credit ratings, unused capacity and real options are part of this research. Opinions of experts and benchmarking can also be inputs.

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3. VALUATION FRAMEWORK

To develop a valuation model for non-regulated gas transmission projects of Gasunie, some approaches to financial modeling are needed. In this chapter several scientific theories are being discussed to answer the first sub-question what scientific theories can be used to value non-regulated projects. The basis for the valuation of the non-regulated Gasunie activities is the net present value approach (NPV). This method will be discussed in paragraph 3.1. Then the capital asset pricing model (CAPM) is introduced in paragraph 3.2 which is a fundamental method to calculate the cost of capital for equity. The inputs of the CAPM are discussed and the values that can be used for Gasunie are calculated as well. These values can be used for calculations in later chapters, but other values are also optional. In paragraph 3.6. several theories are discussed about the influence of leverage on the value of the firm. In paragraph 3.7. is described what financial authors have to say about dealing with uncertainty. Finally in paragraph 3.8 an introduction is given about the use of real options, which is further discussed in chapter 6.

3.1. NPV

“To be consistent with the goal of shareholder wealth maximization, the value placed on a prospective investment project must satisfy three criteria (Shapiro, 2005:13):

• it must focus on cash and only cash;

• it must account for the time value of money; • it must account for risk.”

“The only value that is consistent with these criteria is the project’s net present value, the present value of the project’s future cash flows minus the cost of the project. Investments with positive NPVs add to shareholder wealth, those with negative NPVs reduce shareholder wealth. Companies therefore, should invest in positive NPV projects and reject negative NPV projects. This is the net present value investment decision rule. The NPV rule is implemented as follows: Calculate the present value of the expected net cash flows generated by the investment using an appropriate discount rate, and subtract from this present value the initial net cash outlay for the project. If the resulting NPV is positive, accept the project; if it is negative reject it. If two projects are mutually exclusive, accept the one with the higher net present value. In other words, if an investment is worth more than it costs accept it, if it costs more than it is worth, reject it. By taking into account all relevant cash flows, only cash flows, and the time value of money, NPV evaluates projects in the same way that investors do. Therefore, it is consistent with the objective of shareholder wealth maximization” (Shapiro, 2005:14).

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Rijksuniversiteit Groningen 16 Net present value = - Initial cash investment + Present value of future cash flows

n n 2 2 1 0

r)

(1

CF

...

r)

(1

CF

r)

(1

CF

I

-NPV

+

=

∑

=

+

=

n 1 t n t 0

r)

(1

CF

I

-NPV

(3.1) where

I0 is the investment in year 0

CFt is the cash flow in year t

r is the cost of capital

Nominal or real cash flows

“A nominal cash flow refers to the actual dollars to be received (or paid out). A real cash flow refers to the cash flow’s actual purchasing power” (Ross, Westerfield & Jaffe., 2005:191). Financial practitioners stress the need to maintain consistency between cash flows and discount rates. That is, nominal cash flows must be discounted at the nominal rate; real cash flows must be discounted at the real rate. As long as one is consistent, either approach is correct. In order to minimize computational error, it is generally advisable in practice to choose the approach that is easiest. (Financial management of Gasunie uses nominal cash flows, so they correct for inflation. Therefore discounting should also be done using a nominal rate).

3.2. Cost of Capital

“The discount rate used in calculating an investment’s NPV, also called the cost of capital or the required return, is the minimum acceptable rate of return on projects of similar risk. It is determined by the required return in the market for investments of comparable risk. As a corollary, investments undertaken by the same company that have different risks will have different required returns” (Shapiro, 2005:14). “One way to estimate the cost of capital for a project is to take the nominal riskless interest rate and add to it a risk premium.” “This can be done with the aid of modern capital market theory. This theory posits an equilibrium relationship between an asset’s required return and its associated risk, which can be represented by the capital asset pricing model (CAPM) or the arbitrage

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Rijksuniversiteit Groningen 17 pricing theory (APT). According to both models, intelligent, risk-averse investors will seek to diversify their risks. Consequently, the only risk that will be rewarded with a risk premium will be the asset’s systematic or unavoidable risk.” “The CAPM asserts that the risk premium for any asset, including a corporate project, equals the asset’s beta multiplied by the market risk premium” (Shapiro, 2005:145).

Asset risk premium (%) = Asset Beta x Market risk premium =

β

*

(r

m

-

r

f

)

Cost of capital =

r

f

+

β

*

(r

m

-

r

f

)

(3.2)

where

ß

is the asset beta coefficient

r

m is therequired return on the market portfolio

r

f

is therisk free interest rate

Figure 3.1: Security market line

The security market line (SML) is the graphical depiction of the capital asset pricing model (CAPM), which is shown in the preceding figure.

3.3. Risk free rate

“Hypothetically, the risk-free rate is the return on a security or portfolio of securities that has no default risk and is completely uncorrelated with returns on anything else in the economy. In theory, the best estimate of the risk-free rate would be the return on a zero-beta portfolio, constructed of long

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Rijksuniversiteit Groningen 18 and short positions in equities in a way that produces the minimum variance zero-beta portfolio. Because of the cost and complexity of constructing minimum variance zero-beta portfolios, they are not practical for estimating the risk-free rate” (Copeland Koller & Murrin, 2000:215). An alternative is to use government securities. There are three important choices that have to be made to find the risk-free rate using government securities. The duration is one aspect of concern; another is the question which reference market to use. Next to this you have to decide whether to use the current yield or to use averages. When you decide to use averages, you need also to decide what period to use to calculate the average.

3.3.1. Choice of duration

“We have three reasonable alternatives that use government securities: the rate for Treasury bills, the rate for year Treasury bonds, and the rate for 30-years Treasury bonds. We recommend using a 10-year Treasury-bond rate for several reasons” (Copeland et al., 2000:215):

• “It is a long-term rate that usually comes close to matching the duration of the cash flow of the company being valued. Since the current Treasury-bill rate is a short-term rate, it does not match duration properly. If we were to use short term rates, the appropriate choice would be the short-term rates that are expected to apply in each future period, not today’s short-term interest rate. The 10 year rate can be approached by a geometric weighted average estimate of the expected short-term Treasury-bill rates.

• The 10 year rate approximates the duration of the stock market index portfolio, for example the S&P 500 and its use is therefore consistent with the betas and market risk premiums estimated relative to these market portfolios.

• The 10 year rate is less susceptible to two problems involved in using a longer term rate, such as the 30 year Treasury bond rate. Its price is less sensitive to unexpected changes in inflation and so has a smaller beta than the 30 year rate. Also, the liquidity premium built into 10 year rates may be slightly lower than that of 30 year bonds. These are technical details, with a minor impact in normal circumstances. But they do argue for using a 10 year bond rate.”

Koller et al. (2005:302) state the following: “Ideally, each cash flow should be discounted using a government bond with a similar maturity. For instance, a cash flow generated 10 years from today should be discounted by a cost of capital derived from a 10-year zero coupon government bond.” “In practice, few people discount each cash flow using a matched maturity. For simplicity, most choose a single yield to maturity from one government bond that best matches the entire cash flow stream being valued. For U.S.-based corporate valuation, the most common proxy is the 10-year government bond.”

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Rijksuniversiteit Groningen 19 “If you are valuing a company or long term project, do not use a short term Treasury bill to determine the risk free rate” (Koller et al. (2005:303).

Damodaran (1999:65) writes: “Thus, the risk-free rate is the rate on a zero coupon government bond matching the time horizon of the cash flow being analyzed. Theoretically, this translates into using different risk-free rates for each cash flow on an investment—the one-year zero coupon rate for the cash flow in year one, the two-year zero coupon rate for the cash flow in year two and so on. Practically speaking, if there is substantial uncertainty about expected cash flows, the present value effect of using time-varying risk-free rates as opposed to using an average risk-free rate is generally so small that it is not worth the trouble. Using a long-term government rate (even on a coupon bond) as the risk-free rate on all of the cash flows in a long-term analysis will yield a close approximation of the true value. For short-term analysis, it is entirely appropriate to use a short-term security rate as the risk-free rate.”

It looks like the writers cited above agree on the fact that for long-term projects, long-term government bonds should be chosen. For non-regulated activities of Gasunie a 10 year maturity seems appropriate.

3.3.2. Reference market

In “Valuation”, Koller et al. (2005:302) write: “For U.S.-based corporate valuation, the most common proxy is the 10-year government bond (longer-dated bonds such as the 30-year Treasury might match the cash flow stream better, but their illiquidity can cause stale prices and yield premiums). When valuing European companies, we prefer the 10-year German Eurobond. German bonds have higher liquidity and lower credit risk than bonds of other European countries. (In most cases, the differences across European bonds are insignificant).”

Damodaran (2006:101) writes: “There are about 8 countries that issue 10-year Euro denominated bonds. We used the German Euro bond rate as the risk-free rate, not because Deutsche Bank was a German company, but because the German Euro bond rate was the lowest of the government bond rates. The Greek and Spanish 10-year Euro bond rates were about 0.20% higher, reflecting the perception of default risk in those countries. We would continue to use the German Euro bond rate to value Greek and Spanish companies in Euros.”

Taking the views of the writers above in consideration, the choice of a German bond, when valuing non-regulated European projects of Gasunie, seems appropriate.

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3.3.3. Current or average yields

Anderson Management International (AMI) states the following: “If capital markets were perfectly efficient, current yields would reflect all expectations of future earnings and the appropriate measure of the risk free rate would clearly be the current yield. In practice, capital markets are not perfectly efficient. However, at any point in time, current yields will still reflect the best available information on future yields. Although risk free rates can be affected by institutional factors and be volatile in the short run. AMI therefore considers it appropriate to calculate a risk free rate based on recent bond market yields. It is however recommended that this yield be calculated as a 6-month average of the latest yields, minimizing any short-fluctuations in rates while capturing the most up to date information and expectations.”

In different reports NERA (National Economic Research Associates) states:

“The latest data should be the market best estimate. While some regulators have used an average yield for a number of months there seems to be no rationale for doing so in what is a market with high liquidity unless there are specific technical factors which indicate that there may be temporary mis-pricing.”

“For this study NERA recommends that the risk free rate should be calculated as a 3-month average of recent bond price yields. This method captures the most recent information and views on inflation, while minimizing the distortion that can be caused by any one day’s deviation in the rate.”

“Because of the recent high level of volatility, we recommend that the estimate for the risk-free rate is based on the 1-year arithmetic average of daily yields on German government bonds with maturity dates close to July 2004.”

Taking the several views in consideration, there does not seem to be one right period to choose when looking at the yields. When volatility is low the current yield can be chosen. However when volatility is higher it is better to choose an average period of 6 months for example. To rule out too much influence of volatility, for non-regulated European projects of Gasunie a period of 6 months (daily) average seems appropriate.

The valuation of the risk-free rate for non-regulated European projects of Gasunie will be based on the following:

• a bond with a 10 year maturity; • German government bond; • 6 months (daily) average.

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Rijksuniversiteit Groningen 21 When 15 November 2006 is used as an ending date this leads to a risk-free rate of 3.9 percent (see appendix I for calculations).

3.4. Equity market risk premium

According to Damodaran (1999:68): “The most common approach to estimating the risk premium used in financial asset pricing models is to base it on historical data1. In the arbitrage pricing model and multifactor models, the raw data on which the premiums are based is historical data on asset prices over very long time periods. In the CAPM, the premium is usually defined as the difference between average returns on stocks and average returns on risk-free securities over an extended period of history.”

Time period

An important question that needs to be answered is what period you should choose when you want to calculate the historical premium. Koller et al. (2005:304) write the following: “If the market risk premium is stable, a longer history will reduce estimation error. Alternatively, if the premium changes and estimation error is small, a shorter period is better. To determine the appropriate historical period, we consider any trends in the market risk premium compared with the noise associated with short-term estimates.” “Over the last 100 years, no statistically significant trend is observable. Based on regression results, the average excess return has fallen by 3.3 basis points a year, but this result is well below its standard error. In addition, premiums calculated over sub periods, even as long as 10 years, are extremely noisy. For instance, U.S. stocks outperformed bonds by 18 percent in the 1950s but offered no premium in the 1970s. Given the lack of any discernible trend and the significant volatility of shorter periods, you should use the longest time series possible” (Koller et al., 2005:305). Damodaran (2006:97) adds: “Note that to get reasonable standard errors, we need very long time periods of historical returns. Conversely, the standard errors from ten-year and twenty-year estimates are likely to be almost as large or larger than the actual risk premium estimated. This cost of using shorter time periods seems, in our view, to overwhelm any advantages associated with getting a more updated premium.”

Arithmetic or geometric averages

In coming up with the average returns over past periods, a final measurement question arises: Should arithmetic or geometric averages be used to compute the risk premium? The arithmetic mean is the

1

Other approaches are survey premiums and implied equity premiums, but these approaches will not be further discussed in this thesis.

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Rijksuniversiteit Groningen 22 average of the annual returns for the period under consideration, whereas the geometric mean is the compounded annual return over the same period.

Arithmetic mean: (3.3)

Geometric mean: (3.4)

The contrast between the two measures can be illustrated with a simple example containing two years of returns:

Year Price Return 0 50

1 100 100%

2 60 -40%

Source: Damodaran, (1999)

The arithmetic average return over the two years is 30%, while the geometric average is only 9.54%. Damodaran (1999:70) chooses geometric average premiums: “Since the arithmetic averages tend to overstate the premiums especially in markets like the United States, which have a survivorship bias, leading to higher premiums. The geometric mean generally yields lower premium estimates than does the arithmetic mean.” Koller et al. (2005:305) use an arithmetic average of longer-dated intervals (such as five years), next to this they adjust the result for econometric issues, such as survivorship bias. In “Valuation” they state that: “To determine a security’s expected return for one period, the best unbiased predictor is the arithmetic average of many one-period returns. A one-period risk premium, however, cannot value a company with many years of cash flow. Instead, long-dated cash flows must be discounted using a compounded rate of return. But when compounded, the arithmetic average will be biased upward (too high). Overall can be said that academics and practioners remain divided on what mean to choose.

Choice of market

Shapiro (2005:146) states the following: “The market risk premium, also known as the equity risk premium, is ordinarily assumed to equal the average historical difference between the return on the stock market and the average return on long-term Treasury bonds. The return on the market is usually taken to be the return on a well-diversified portfolio of stocks, such as the New York Stock Exchange (NYSE) index or Standard & Poor’s 500 index (the S&P 500).”

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Rijksuniversiteit Groningen 23 There are European equity markets that may be mature such as the German DAX index, but they tend to be dominated by a few large companies, and are not representative of a well-diversified portfolio. In the Netherlands there is the Amsterdam Exchange Index, which is a capitalization-weighted average index of the 25 leading Dutch stocks traded on the Amsterdam Stock Exchange. A problem with the use of this index, which also applies to other economies where equity markets represent a small proportion of the overall economy, is that a selection of 25 stocks is unlikely to be representative of the true investment opportunity set for the whole economy. Therefore European indices are not as useful as for example the Standard & Poor’s 500 index.

Premium (arithmetic)

Shapiro (2005:147) writes: “Drawing on the data compiled by Ibbotsen Associates (2003), over the 77-year period from 1926 through 2002, the difference in returns between the S&P 500 and long-term U.S. Treasury bonds was 7.0%. This figure is one measure of the market risk premium relative to long-term Treasury bonds. However, a number of researchers and practitioners argue that the historical equity risk premium does not measure the forward-looking equity risk premium, that is, the risk premium that equity investors expect to realize on stocks bought today. One argument against the use of the historical equity risk premium is that it does not allow for changes in investors’ perceptions of the relative risks of holding stocks versus bonds. Over time, the volatility of stocks has fallen whereas the volatility of bonds has risen. As such, one would expect the equity risk premium demanded by investors to have declined over time. Similarly, the liquidity of stocks has increased over time relative to that of bonds, a result that one would expect to have reduced the equity risk premium as well. For these and other reasons, many academics, consultants and Wall Street practitioners use a forward-looking equity risk premium that is below its historical average. Typically, those who reject the use of the historical equity risk premium of 7% use an expected equity risk premium in the order of 4 to 6%.”

Koller et al. (2005:312) write:” Although many in the finance profession disagree about how to measure the market risk premium, we believe 4.5 to 5.5 percent is an appropriate range. Historical estimates found in most textbooks (and locked in the mind of many), which often report numbers near 8 percent, are too high for valuation purposes because they compare the market risk premium versus short-term bonds, use only 75 years of data, and are biased by the historical strength of the U.S. market.”

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3.5. Beta

“The risk of any asset to an investor is the risk added on by that asset to the investor’s overall portfolio. In the CAPM world, where all investors hold the market portfolio, the risk of an individual asset to an investor will be the risk that this asset adds on to the market portfolio” (Damodaran, 1999:46). Intuitively, assets that move more with the market portfolio will tend to be riskier than assets that move less, since the movements that are unrelated to the market portfolio will be eliminated when an asset is added on to the portfolio. Statistically, this added risk is measured by the covariance of the asset with the market portfolio.

)

r

(

)

r

(r

Cov

m 2 m , s

σ

β

s

=

(3.5) where

Cov (r

s ,

r

m

)

is the covariance between the return on asset “s” and the return on the market

portfolio

)

r

(

m 2

σ

is the variance of the market The formula for covariance can be written algebraically as

Cov (r

s

,r

m

) =

Expected value of

[(r

s

– r

s

) x ((r

m

– r

m

)]

(3.6)

where

r

sand

r

m are the expected returns, and

r

sand

r

mare the actual returns.

)

r

(

m 2

σ

=

Expected value of

[(

r

m

– r

m

)

2

]

(3.7)

Since the covariance of the market portfolio with itself is its variance, the beta of the market portfolio, and by extension, the average asset in it, is 1. Assets that are riskier than average will have betas that exceed 1 and assets that are safer than average will have betas that are lower than 1. The riskless asset will have a beta of zero.

“While there is no formula for selecting the right beta, there is a very simple guideline. If one believes that the operations of the firm are similar to the operations of the rest of the industry, one should use the industry beta simply to reduce estimation error. However if an executive believes that the

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Rijksuniversiteit Groningen 25 operations of the firm are fundamentally different from those in the rest of the industry, the firm’s beta should be used.” (Ross et al., 2005:326). When market information of the company is not available one should use the industry beta as well. For Gasunie, which is an unquoted company, beta cannot be directly estimated, so comparable companies have to be used as an alternative.

“Simply using the median of an industry’s raw betas, however, overlooks an important factor: leverage. A company’s beta is a function of not only its operating risk, but also the financial risk it takes. Shareholders of a company with more debt face greater risks and this increase is reflected in beta. Therefore, to compare companies with similar operating risks, we must first strip out the effect of leverage. Only then can we compare beta across industry. To undo the effect of leverage (and its tax shield), we rely on the theories of Franco Modigliani and Merton Miller (M&M)” (Koller et al., 2005:318). “As with any portfolio, the beta of this portfolio is a weighted average of the betas of the individual items in the portfolio” (Ross et al., 2005:329).

equity debt asset

β

*

Equity

Debt

Equity

*

Equity

Debt

+

=

(3.8)

If you make the commonplace assumption that the beta of debt is zero, you get:

equity asset

β

*

Equity

Debt

Equity

+

=

(3.9)

Rearranging this equation, you get:

)

Equity

Debt

(1

*

+

=

asset equity

β

(3.10)

For a leveraged firm the following addition can be made2:

)

Equity

Debt

*

)

T

-(1

(1

*

+

c

=

asset equity

β

(3.11)

To estimate an industry-adjusted company beta, you can use a four step process. First you should regress each company’s stock return against the index to determine a raw beta. Next, you should

2

Formula (3.11) should only be used for firms with a fixed debt level. Miles and Ezzell (1985:1) show that when the firm acts to maintain a constant market value leverage ratio, the marginal value of debt financing is much lower than the corporate tax rate. Therefore when a firm has a target debt level formula (3.10) should be used. Appendex IIb shows what kind of influence this can have on the beta of Gasunie.

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Rijksuniversiteit Groningen 26 unlever each beta. In step three, determine the industry unlevered beta by calculating the median. In appendix II a weighted average is used of the companies is used. In the final step, relever the industry unlevered beta to each company’s target debt-to-equity ratio (using current market values as proxies) (Koller et al., 2005).

Several questions need to be answered before an equity beta for Gasunie can be estimated. The estimation period has to be chosen and the frequency of measurement. Next to this, since Gasunie’s equity beta is not observed, there is the question which comparable companies should be used as proxies for its equity beta. (For this thesis Bloomberg is used for financial information).

3.5.1. Length of the estimation period of the beta

Most estimation services use five years of data for measuring beta, while Bloomberg uses two years of data. The trade-off is the following: A longer estimation period provides more data, but the firm itself might have changed in its risk characteristics over the time period. In subsequent tests of optimal measurement periods, researchers confirmed five years as appropriate (Alexander & Chervany, 1980). However the betas used in this thesis are derived from Bloomberg so two years of data is used.

3.5.2. Return interval

Returns on stocks are available on an annual, monthly, weekly, daily, and even on an intra-day basis. Using daily or intra-day returns will increase the number of observations in the analysis, but it exposes the estimation process to a significant bias in beta estimates related to nontrading. For instance, the betas estimated for small firms, which are more likely to suffer from nontrading, are biased downward when daily returns are used. Using weekly or monthly returns can reduce the nontrading bias significantly. The calculated betas by Bloomberg for different companies are used for this thesis. Since Bloomberg uses weekly data for its beta calculations this will also be the return interval used for this research.

3.5.3. Comparable companies

Since Gasunie is not listed on the stock exchange, other companies have to be used as comparable companies to calculate the beta. The best comparable companies would be the ones that are gas transmission companies. There are actually very little companies listed on the stock exchange that are for the largest part gas transmission companies. Most companies also have activities like production or trading of gas and others have activities that are for example oil related. Then there are companies whose risk profile might be quite similar to Gasunie but are not in the Gas business. Companies of this