SECTION B7 FINANCIAL PROJECTIONS

Transcription

1 B7.1 THE FINANCING PLAN SECTION B7 FINANCIAL PROJECTIONS B7.1.1 Cost of Capital The Company subscribes to the NERA reports on Cost of Capital for PR09 (January 2009) and on The Evidence for a Small Company Premium on the Cost of Capital at PR09 (March 2009). Gearing level has been taken to be 60% debt/40% equity. In selecting the cost of capital to use in its modelling of the K requirement over the period the Company has used a value which it believes provides a good balance of the risks between the Company and customers. The value of 6.7% pre-tax represents a significant reduction from that which could be justified by the arguments put forward in the NERA paper. However, in using this value the Company is also proposing that some of the systematic risks facing the Company over the AMP5 period are capped by means of notified items. This conclusion has been arrived at following a series of risk modelling assessments carried out using different scenarios:- 1. The first scenario envisaged a cost of capital of 5.8% pre-tax. 2. The second scenario envisaged a cost of capital of 5.8% pre-tax but with a risk cap. 3. The third scenario envisaged a cost of capital of 6.7% pre-tax. 4. The final scenario envisaged a cost of capital of 6.7% pre-tax but with a risk cap. Each scenario was tested under the following conditions:- power costs were varied from those forecast in the Company s operating cost projections by the values produced in the Bergen Energi Report but using confidence limits of 90%. variations in turnover on an annual basis of between +2% and 5% of the forecast representing the two 90% confidence limits within a triangular distribution. variations in the capital cost of the one major project, Llwyn Onn Treatment Works replacement, of between 1% and +10% representing the two 90% confidence limits within a triangular distribution. a shock event equal to roughly 10% of turnover and with a probability of occurrence of once in 20 years. It should be noted that scenarios 1 and 2 included for a dividend cut of some 30% consistent with the cost of capital chosen. Dee Valley Water Section B 135

2 The results indicated that for scenario 1 the financial indicators produced were significantly outside the range indicated by Ofwat at PR04 for more than 10% of the iterations performed. Similarly, scenario 2 produced unacceptable ratios, as indeed did scenario 3, thus indicating that, even with a cost of capital which includes a small company premium, the value of 6.7% pre-tax is not sustainable. The alternative to scenario 3 would be to utilise a higher cost of capital until the financial indicators proved acceptable. However, in order to keep the proposed price increases to a minimum, the Company is proposing that a lower cost of capital than otherwise would be required, 6.7% pre-tax, is acceptable subject to the inclusion of risk capping mechanisms in the Final Determination. These risk capping mechanisms are those already available such as notified items and the shipwreck clause. The Company is proposing the following notified items be included in order to limit its risks during the AMP5 period:- on assumed power costs to constrain outturn within approximately ± 25% of estimated on numbers of meter optants on bad debts and cost of collecting debts on Traffic Management Act and lane rental on changes in taxation in relation to infrastructure renewals accounting due to FRED29 for costs arising from the introduction of competition. B7.1.2 Cost of debt The Company has assumed a base cost of debt of 3.8% to 4.2% (pre-tax) as per the NERA report. The small company premium has been taken as between 0.6% and 0.1%, based on the NERA report, giving a pre-tax cost of debt of 4.3% - 4.4%, with a net contribution of 2.6% to cost of capital at 60% gearing. The post-tax equivalent at 28% tax is 1.90%. B7.1.3 Cost of equity The base cost of equity has been taken to be 7.4% - 8.2% as per the NERA report. The range of small company premia has been taken to be between 2.8% and 2.1%, taking the premia for illiquidity and beta risk together. This gives a cost of equity of 10.2% % and a contribution to cost of capital, after 40% gearing, of 4.1%. The overall result is a (pre-tax vanilla) cost of capital of 6.70%, with an equivalent post tax figure of 5.97%. Dee Valley Water Section B 136

3 B7.1.4 Return on capital Over the AMP5 period, the post-tax return shown in line 18 of ICS Table B7.1 equates to an average cost of capital, calculated as a pre-tax cost of debt/post tax cost of equity basis, of 6.7%. The return is lower in 2010/11 and higher in later years because K has been slightly re-profiled to reduce the impact on customer bills in the first year. B7.1.5 Projected capital value The Company confirms that the opening value of the RCV used in the financial model at 31 March 2008 is m as provided by Ofwat. The RCV is calculated by the financial model, and increases sharply in 2011/12 and 2012/13 with the high capital expenditure, primarily related to the Llwyn Onn project. At the end of 2015, the RCV is approximately 0.6m lower than the opening year-end value. B7.1.6 Critical financial indicators and covenants and availability of finance The Company has reviewed the financial indicators calculated by the model and shown in ICS Table B7.1, Block G. It will be noted that, in 2011/12 and 2012/13, the adjusted cash interest cover in line 25 is below the minimum level of 2.0 times set by Ofwat at the last review. This is because of high capital expenditure in these two years. Cost of capital has been set at a level that will allow some leeway on the debt covenants in order to mitigate the effect of the low cash ratios in these two years. The Company has reviewed all the covenants on the Artesian loan. These are calculated at group level (i.e. including the non-appointed business). It is confirmed that this financing plan can be accommodated within the existing covenants. Due to the current banking crisis, all offers of additional finance are indicative only and the actual availability of finance has yet to be tested. This issue is covered in more detail in section B1.2. B7.1.7 Capital structure The Company is not proposing any radical change to its capital structure. This financing plan involves an increase in gearing of over 25% between 2007/08 and 2014/15. It is possible that a portion of the additional borrowings of approximately 6m as at the end of 2014/15 may be of a medium to long term nature. If this is the case, the Company will consider refinancing the borrowings on a longer-term basis, including the possibility of taking a further tranche of debt under the Artesian or a similar facility, whether on a fixed or index-linked basis. B7.1.8 Dividend policy This financing plan includes a real dividend increase of 2% per annum from 2008/09 to 2014/15. This compares with a real increase of 2.3% that was Dee Valley Water Section B 137

4 allowed in the 2004 Final Determination. (The dividend is consistent with the cost of capital assumptions). B7.1.9 Working capital assumptions The working capital assumptions are constant over the period 2007/08 to 2014/15. Measured debtor days are based on monthly management information and unmeasured debtor days are calculated as at 31 March. Creditor days and capex creditor days are based on standard terms. It should be noted that net cash flow from operating activities shows a decrease of 5.0m in 2008/09. This is due to an increase in working capital, specifically a reduction of approximately 5.0m in trade creditors. This represents the settlement of the sewerage creditor at 31 March 2008 in favour of Dwr Cymru and United Utilities, and therefore effectively reduces the non-core cash in the balance sheet as at 31 March The income from billing and collection of sewerage charges is a non-core item and does not form part of this financing plan. B Key assumptions The Company confirms that all key assumptions that have a material effect on the financial assumptions have been exposed and explained. B7.2 DEPRECIATION AND IRC Depreciation (ICS Table B7.3) CCD on existing assets has been calculated by the Company based on the asset inventory information in ICS Tables C3.1 and B7.13. The calculated data has been used to populate ICS Table B7.3 line 20. CCD on asset additions included in lines 22 to 24 of ICS Table B7.3 is based on the calculations made by the financial model as reported in FM report 2 lines 60 and 61. CCD on wip commissioned after 31/3/08 has not been included in ICS Table B7.3 lines 21 and 23 as the amounts involved are not likely to be significant. The majority of current work in progress is considered to be included in the valuations in ICS Table C3.1. There have been no material changes in allocation rules used to analyse expenditure by asset life category compared with those used to compile the information in the 2008 June Return. The allocation rules are consistent with the depreciation profiles set out in block F of ICS Table B7.3. The CCD profiles in ICS Table B7.3 lines 20 to 25 are presented in Figures B7.1 to B7.3. The profiles are affected by the significant variations in the MNI expenditure profile as discussed in the commentary on ICS Tables B7.10 and B7.11 below. Dee Valley Water Section B 138

5 The enhancement profile is affected by the assumption that there is no additional enhancement expenditure in the AMP6 period, leading to the flat profile after 2014/15. Figure B7.1Total CCD Base service provision per Table B7.3 lines 20 to 22 m /08 08/09 09/10 10/11 11/12 12/13 13/14 14/15 15/16 16/17 17/18 18/19 19/20 Figure B7.2 Total CCD Enhancement per Table B7.3 lines 23 to m /08 08/09 09/10 10/11 11/12 12/13 13/14 14/15 15/16 16/17 17/18 18/19 19/20 Figure B7.3 Total CCD per Table B7.3 line 25 m /08 08/09 09/10 10/11 11/12 12/13 13/14 14/15 15/16 16/17 17/18 18/19 19/20 Dee Valley Water Section B 139

6 Historic cost depreciation (ICS Table B7.7) The depreciation included in ICS Table B7.7 is based on the historic cost assets existing as at 31/3/08. It has not been adjusted for any work in progress, in line with the approach taken in ICS Table B7.3 (see above). The HCD and CCD profiles are compared in Figure B7.4. Whilst the profiles are broadly consistent, the CCD profile in 2010/11 to 2012/13 is affected by the revaluation of software (written off over 3 years), which has not been mirrored in the HCD register. Figure B7.4 CCD profile compared to HCD profile m /08 08/09 Non infrastructure asset lives (ICS Table B7.9) 09/10 10/11 11/12 12/13 13/14 14/15 15/16 16/17 17/18 18/19 19/20 HCD CCD Asset life assumptions are consistent with those used previously and are the same for both engineering and financial purposes. Operational asset lives were last reviewed in Comparison of current cost depreciation and maintenance noninfrastructure expenditure for the period 1997/98 to 2024/25 (ICS Tables B7.10 and B7.11) The data used to populate lines 19 to 21 is described in detail in the table commentaries in Section B7.4 below. Lines 1 to 4 are populated from the financial model calculations. As requested in the Ofwat response to Query FBP/005, the original figures which would have populated line 3 before the adjustments entered in lines 5 to 14 have been disclosed in Section B7.4 below. The adjustment entered in line 9 Other (1) represents the difference arising due to the fact that the asset life percentages used to calculate CCD in the financial model for the period 2004/05 to 2006/07 are based on the PR04 FD assumptions which varied significantly from the actual asset life percentages. The detailed calculations are described in Section B7.4 below. The effect of the difference in the assumptions to actual is that depreciation Dee Valley Water Section B 140

7 has been charged significantly more quickly in the financial model, hence the reduction of CCD in the years 2007/08 to 2010/11 by a total of 1.4m. This is the only adjustment which has been made to the difference calculated by the financial model. However, it is the Company s contention that for a small company such as Dee Valley Water, it is unlikely that a period of 28 years represents the long term. In the period 1997/98 to 2024/25, the Company has incurred major levels of expenditure on its two main treatment works. Expenditure at Boughton treatment works was incurred over the period 2005/06 to 2007/08. The value of this work has been taken into account in the 2008 MEAV valuation. On the basis of this valuation, 93% of the current net MEAV of 15.7m has a remaining useful life in excess of 15 years. This amounts to a depreciation change of 0.546m which will be ongoing after 2024/25. Expenditure at Llwyn Onn treatment works will be incurred over the period 2010/11 to 2012/13. In total the expenditure will amount to 16.3m. All of this expenditure is expected to have a life equal to or greater than 15 years, and will give rise to a depreciation charge of 0.667m which will be ongoing after 2024/25. Modern equivalent asset valuation (ICS Table B7.13) The opening position MEA of assets at 31/08/2008 per Table 25 JR08 is consistent with both the gross and net positions of Table 25 of the 2008 June Return. Detailed comments on the reasons for the adjustments made in ICS Table B7.13 are contained in Section C3.2. Infrastructure renewals charge (ICS Table B3.5) As described in the commentary to 2008 June Return Table 33, the Company calculates the Long Range Normative Charge (LRNC) based on its medium to long term view of the maintenance needs of infrastructure assets over a period of 15 years. During the AMP4 period the LRNC has been calculated as the average of the projected expenditure from 2005/06 to 2019/20, which at 2007/08 prices amounted to 2.13m per annum. For AMP5 the parameters have been set so that the financial model calculates the LRNC based on the 15 years from 2010/11 to 2024/25, at 2007/08 prices giving an annual charge of 1.846m per annum. The Company s policy is to write off any variances between forecast and actual expenditure in the AMP period in which they arise. Thus the accrual which is projected at 31 March 2010 of 1.488m relates only to the increasing levels of projected renewals expenditure. There will be no element of over or under spend included in this accrual which will require writing off during the AMP5 period. Dee Valley Water Section B 141

8 The calculation of the renewals charge and balance sheet position from 2008/09 to 2010/11 will follow the pro-forma calculation below:- At 2007/08 prices m Balance at 31/3/08 (1.522) LRNC 08/09 (1.440) Renewals expenditure Write off prior year variances Balance at 31/3/09 (1.329) LRNC 09/10 (1.440) Renewals expenditure Write off prior year variances Balance at 31/3/10 (1.256) LRNC 10/11 (1.846) Renewals expenditure Balance at 31/3/11 (1.488) In calculating the projected balance sheet position in ICS Table B3.5 line 16, the expenditure for the AMP9 period (2025/06 to 2034/35) is assumed to be at the same level as AMP7, giving an annual charge of 2.081m for the AMP7 period. Commentary to ICS Table B3.5 indicates the level of renewals expenditure is expected to decline during the AMP10 period leading to a gradual write off of the accrual. B7.3 TAXATION B7.3.1 Capital expenditure allocations IRE expenditure All IRE expenditure has been included in line 7 of ICS Table B7.12. For the years up to and including 2009/10 the Company expect to receive relief based on the renewals charge. For 2007/08 the renewals charge included in line 17 is the charge calculated for statutory account reporting purposes. For 2008/09 and 2009/10 the charge is the expected long range normative charge (as calculated in Section B7.2 above, ICS Table B3.5) as adjusted for differences in expenditure compared to plan in the AMP4 period. For the AMP5 period the renewals charge will give rise to a balance sheet accrual, due to increasing projected levels of expenditure (as discussed in Section B7.2 above). The current advice received from the Company s tax advisors is that in these circumstances relief will only be available on actual IRE. Thus only the expenditure has been included in line 17, and the percentage of the charge has been shown in line 20. Dee Valley Water Section B 142

9 MNI expenditure MNI expenditure has been split between lines 2-5, 7 and 11 of ICS Table B7.12. As discussed in the commentary to Table 18a of 2008 June Return, the Company has carried out a significant programme of works at the Boughton treatment works, which has been included in the tax computations for the years ending 2006 to A review of the capital allowances relating to this project has now been completed by the Company s tax advisors. The review has resulted in a resubmission of the 2006/07 computation. The percentages included in ICS Table B7.12 for 2007/08 reflect the outcome of the Boughton review. This review has meant expenditure which was previously categorised under line 4 (long life assets) now being treated as part of line 3 (general pool) under the water industry entirety agreement. In addition, certain plant has been identified as eligible for enhanced capital allowances and thus been included in line 1 (100% first year allowances). The expenditure in the years 2010/11 to 2012/13 includes a major programme of work at the Llwyn Onn treatment works. The allowances available on the project have been based on the review of the Boughton project referred to above. For the purposes of ICS Table B7.12, a split of allowances has been based on the anticipated expenditure profile prepared for the Business Plan. The assumed percentage split relating to the Llwyn Onn project is as follows:- Enhanced capital allowances 1.7% General pool 87.7% (assumes entirety agreement applies) Industrial buildings 6.7% Revenue 3.9% (includes demolition costs) Other MNI expenditure has been allocated on the basis of the expenditure s allocated asset life. The results of the capital allowance review, in respect of both Boughton and Llwyn Onn, represent the considered view of the Company s tax advisors. It is important to note that the Boughton capital allowances have not yet been agreed by HMRC. If the figure agreed is materially different from that submitted, the effect on capital allowances for both projects could be significant and could represent a material risk to this Business Plan. Infrastructure enhancement The only expenditure included in this category is mainlaying for new development and growth. Grants and contributions available have been netted off this expenditure, the balance being included in the long life asset line. Dee Valley Water Section B 143

10 Non-infrastructure enhancement This expenditure has been allocated between the general pool and long life asset categories as dictated by its allocated asset life. Grants and contributions Grants and contributions taxable on receipt have been included in ICS Table B7.12 line 12. B7.3.2 Average asset lives These lines have not been populated as no expenditure has been included in lines 15 and 16. This is consistent with the approach taken in the 2008 June Return Table 18a and b. B7.3.3 Other deductions/adjustments Interest charge The interest charge entered in line 27 of ICS Table B7.12 for 2007/08 is the charge included in the 2007/08 tax computation. For the years 2008/09 onwards this line has been populated based on the output from the financial model report 7 line 12 (loan interest) and line 16 (indexation of index linked loans). It should be noted that the low charge in 2009/10 is due to the impact of negative inflation, creating a positive indexation adjustment of 0.928m. Profit or income not subject to tax In 2007/08, 0.230m represents the actuarial gain calculated under FRS17 and included as revenue. Such income has not been included in the financial model for 2008/09 onwards and therefore has not been deducted in line 30 of ICS Table B7.12. Pensions - difference between profit and loss charge and cash payments In 2007/08, 0.125m represents the difference between profit and loss charge, and the cash payments made on the defined benefit pension scheme. For 2008/09 onwards, the contributions have been included in operating costs and thus no difference arises. Disallowable expenditure The disallowable figure of 0.011m per annum on line 28 of ICS Table B7.12 represents operating costs disallowable for tax purposes, as included in the submitted computation for Dee Valley Water Section B 144

11 Chargeable gains No chargeable gains are projected during the period. HMRC agreements As discussed in the analysis of MNI expenditure, the investigation into capital allowances at Boughton has now been completed. The 2006/07 computation has been resubmitted based on this report, and the 2007/08 computation has now submitted. The opening positions included in lines 21 to 25 of ICS Table B7.12 are based on the 2007/08 computation. B7.3.4 Deferred tax lines The deferred tax provision on lines 31 and 32 of ICS Table B7.12 is consistent with the undiscounted value included in the 2007/08 Regulatory Accounts. B7.4 TABLE COMMENTARIES Table B3.5 Water service base capital maintenance expenditure infrastructure (this commentary is repeated in Section B3.9) Line 14 - Infrastructure renewals charge The renewals charge has been calculated based on the following expenditure levels:- m m AMP5 2010/ / / / / AMP * AMP * Total expenditure 15 years Divided by 15 Renewals charge AMP Line 15 - Closing balance sheet accrual or prepayment The closing accrual has been calculated based on the proforma calculation in Section B7.2 above. Dee Valley Water Section B 145

12 Table B7.3 Depreciation on fixed asset additions Line 8 - Infrastructure enhancement expenditure The variance between the 2007/08 and JR08 Table 32 line 17 is due to the omission of costs in relation to connection charges as required by the guidelines. Line 9 - Non-infrastructure enhancement expenditure The variance between the 2007/08 and the JR08 Table 32 line 17 is due to the omission of costs in relation to connection charges as required by the guidelines. Table B7.4 Depreciation on fixed asset additions (enhancements) The zero entries within this table are correct. Table B7.10 Comparison of CCD and MNI expenditure for the period 1997/98 to 2009/10 Line 1 - MNI expenditure (excl. future efficiency) The line definition states that 1997/98 to 2006/07 should be inflated to 2007/08 prices. This is confirmed by Clarification FBP/001 that states that RPI should be used. However, within the text for ICS Tables B7.10 and B7.11 it states that 1997/98 to 2007/08 should be the actual level of expenditure reported in the June Return. The Company has used RPI to inflate historical expenditure to the 2007/08 report year. Line 19 to 21 - Breakdown of total gross CCD charge Line 19 to 21 have been populated based on the Company s current cost asset register as at 31 March 2008 after taking into account the impact of the MEAV revaluation. The split between lines has been based on the assumptions used to populate JR08 Table 33. As requested by Ofwat in their response to Query FBP/005, the original figures which would have populated line 3 before the adjustments in lines 5 and 14 are listed below:- (Note: the years affected commence in 2005/06.) Year CCD before adjustment Year CCD before adjustment m m 05/ / / / / / Dee Valley Water Section B 146

13 08/ / / / / / / / / / / / / / The adjustment made in line 9 relates to the difference between the asset life percentages used by the financial model which were those assumed by FD PR04 for years 2004/05 to 2006/07 and the actual life percentages. The differences are summarised below. The impact is that the financial model charges CCD significantly earlier than will actually by the case. Year Life Ofwat % Actual % 2004/05 VS S M ML L /06 VS S M ML L Year Life Ofwat % Actual % 2006/07 VS S M ML L Table B MEAV revaluation reconciliation Movements in column 2 are due to abandonment of assets at Newhall raw water reservoir (Dams & Impounding Reservoirs), Legacy and Overleigh towers (Water Towers) and Berwyn source pumping station (Source PStns). The movement in column 3 is due to the fact that only M&E assets were included in the valuation of Oerog at the last review (Treatment Works). Movements in column 6 are the balance of movements where the opening/closing blocks indicate a reduction in the value of that group of assets. Movements in column 7 are the balance of movements where the opening/closing blocks indicate an increase in the value of that group of assets. Dee Valley Water Section B 147

14 Movements in column 8 are due to:- the impact of changes to residual useful life of some assets the impact of changes to land values the impact of movement of assets between groups, ie Pendinas holding tank ( 108.2k/ 54k) moved from Dams & Impounding Reservoirs to W3 Treatment works, Berwyn PStn ( 162k/ 133k) moved from Source PStns to Booster PStns, aqueduct type assets have moved from Dams & Impounding Reservoirs to Raw Water Aqueducts ( 1656k) and Penycae (reservoir) house has moved from Dams & Impounding Reservoirs to Other (line 23). NB At final audit some minor errors were detected in Table B7.13. It was decided not to change the table at such a late stage. Dee Valley Water Section B 148