Essay About John Hamilton And Discount Rate

Mobile Energy Inc.
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Case 8
Mobile Energy, Inc.
In reviewing the latest financial results of Mobile Energy, Inc., (MEl), John Hamilton, vice-president for
planning of MEl Industries, a subsidiary of MEl engaged in transportation services and real estate
development, realized just how important these nonregulated activities had become to the parent of Mobile
Electric Power, the utility serving the Mobile, Alabama, area. Although still accounting for less than 10
percent of the overall companys revenues, MEl Industries produced almost one-fifth of the holding
company s operating income in 1990. While justifiably proud of the contribution his fast-growing
operation made to the company in the last couple of years, he knew two recent investments were the
primary cause of this profitability. He was also aware that the volatile nature of the transit business would
make the return on future investments much less assured than these latest acquisitions which came with
reliable, term contracts. Given the largely operational basis for his companys investment decisions in the
past, Hamilton began to wonder whether the return expected on other current and future investments
properly compensated the firm for the risk it would be assuming. As he continued to think about the
implications, a number of questions popped into his head. He decided to give Kathryn Schultz, the
treasurer of MEl, a call and discuss some of these points over lunch the next day.
What Hamilton learned was that there was a formal, though unwritten, procedure for estimating a
risk-adjusted discount rate for use in the analysis of capital additions, and that this expected return, or
“hurdle” rate, for investments was based on the overall holding companys cost of capital. The debt, and
especially equity, components of this cost reflect risks associated with the operations and financing of the
firm. However, a single rate was used for all potential projects-whether regulated or not, or whether
having an apparent high- or low-degree of risk. While admitting that the risks associated with investments
by MEl Industries were indeed very different, Schultz noted the historic dominance of the regulated utility,
Mobile Electric Power, in the overall financial performance of MEl and that, until this year, the
contribution of nonregulated activities was fairly insignificant. After some further discussion, she agreed
with Hamilton that the whole issue merited a fresh look, and that she would set up a meeting next week
with all interested parties to kickoff a review of their current estimating procedures.
Existing Procedure
As a starting point for the discussion of this issue, Robert May, a senior financial analyst and assistant to
Kathryn Schultz, opened the meeting with a presentation of the companys current methodology. In large
part, the discount rate used in the analysis of capital additions at MEl is based on the utilityS “allowed”
rate of return on equity. The most recent determination of this rate was in January of 1990, when the
Alabama Public Service Commission granted Mobile Electric Power a rate increase designed to produce
a 13.5 percent return on equity. This allowed rate of return on equity is combined then with the after-tax
cost of new “AA”-rated utility bonds (the companys current rating) and new “AA”-rated preferred issues,
Sources: Data and information-based on various publications, including S&P Stock Reports.
58 Case 8
and weighted by its current capital structure (see EXHIBIT 1). The company reasoned that the rate of
return on equity reflected the average risk of regulated business activities of the firm, which until recently
accounted for over 90 percent of its income. An example of a recent calculation of this cost of capital,
and thus the required return on potential new investments, is:
Source Amount Rate Cost
Long-Term Debt $675 x 9.6%(1 – .34) $43
Preferred Stock 555 x 9.1% = 51
Common Equity 877 x 13.5% = 118
Total Capital $2,107 $212
Cost of Capital $212/$2,107 = 10.1 %
At this point Hamilton raised a major concern regarding the use of an accounting rate of return,
especially an “allowed” rate. In response, Schultz argued that investor (cash) returns were too unstable
because of the inherent volatility of the stock market. She also pointed out that this 13.5 percent rate was
consistent with the Commissions “allowed” returns of 13-14 percent for the company during the midto
late-1980s. Also, unlike many regulated utilities where the lags in the implementation ofregulated rates
alone result in actual returns 1-2 percent below those allowed, MEl historically has achieved returns
approximating those allowed because of especially effective management of rate requests. While this was
probably true, Hamilton attributed the companys success more to the strong growth in industrial demand