utility companies, the external money market is reached primarily through the sale of stocks (equity financing), bonds, and short term borrowing (debt financing). Profit from the sale of electricity is used to pay stockholder dividends and to pay the debt plus interest (i. e., the cost of capital). The portion of total funds needed that are raised from these various sources differs among the utilities. Likewise dividends and interest rates paid may vary widely. However, Table 14-3 can be regarded as depicting typical assumptions for the utility industry. TABLE 14-3. INTEREST RATE The interpretation of Table 14-3 is as follows. Utilities raise approximately 55 percent of their external capital needs from the sale of bonds and by borrowing, for which they incur 8 percent annual market interest charges. However, in the face of an assumed 5 percent price escalation, the real interest amounts to only 3 percent because the utility enjoys the opportunity to pay their debt with money that each year is declining in value by 5 percent. Similar interpretations hold for stock financing, such that a weighted rate of return of approximately 4. 4 percent is a good approximation of the overall real rate of return for capital investment in the industry. (At 5 percent annual price inflation, this corresponds to a market interest rate of 9.4 percent.) For this evaluation, a 7. 5 percent real rate of discount (12. 5 percent market rate) has been used, even though for the regulated utility industry such a rate of return is most likely high. This discount rate has been purposely chosen for conservatism, to reflect economic risk, and to account for a certain amount of government involvement and the corresponding 10 percent real rate of discount often required by the Office of Management and Budget (OMB) for public investment projects.
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