Revisiting equity management -- The art of wise compromise.

BACKGROUND

The rural electric program had its beginnings in Franklin Roosevelt's first term as President in the 1930s. It was simultaneously an effort to bring electricity to the rural areas and create jobs in the 48 states then building the electric lines, wiring houses and operating the newly created electric systems.

In most of the areas where the rural electrification program was established to provide electric service, the existing investor owned utility companies exhibited little interest in making the necessary investments to serve the rural areas on an area-coverage basis. In their opinion, there would never be sufficient demand for electric service to provide the rate of return they deemed necessary to justify the necessary investment.

In order for many projects to show feasibility, most Rural Electric Administration (REA) borrowers were established as non-profit cooperative corporations. In most cases enabling legislation had to be enacted in the various states to provide a framework under which these non-profit cooperative corporations could be created. As of December 31, 2000, most CFC and RUS (formerly REA) distribution borrowers are electric cooperatives with a relatively small group of public power districts (Nebraska) or public utility districts (Washington and Oregon).

Only with the combined advantages of long-term low interest REA loans for 100% of the project cost, exemption from federal income taxes because of their non-profit cooperative status, standardization of accounting, reporting, construction, etc. and a wealth of technical assistance from REA were the projects feasible.

Most, if not all REA borrowers were incorporated with an equity, which consisted only of a $5 per consumer "membership fee" which was consumed largely by the organizational expenses of the fledgling business.

THE NEED FOR MARGINS AND EQUITY

From the beginning, RUS recommended that its borrowers earn margins to build reserves against contingencies and to provide the rural electric cooperative members with some equity in the system which they "owned" but which was mortgaged to the Federal government. It was evident in both policy and mortgage documents that a 40% equity level was desirable.

A capital credit allocation and refunding plan evolved which provided the rationale for a nonprofit corporation charging rates for service in excess of the cost of providing service and "allocating" the "margins" back to the member owners in proportion to their patronage. Provision was made to refund or revolve these allocated credits back to the members when cooperative Boards of Directors deemed that the financial condition of the cooperative justified the capital credit refund.

Since that time, the composite equity of the rural electric distribution program has grown to 47% of total capitalization (Chart 1).

THE IMPORTANCE OF ADEQUATE EARNINGS RATIOS

During the 1970s, when the Federal government was faced with the situation that the growing capital requirements of the program far exceeded amounts they were willing to authorize, CFC was created by program leaders as a vehicle to attract capital in the private capital market. Today, with loans and guarantees outstanding to members of approximately $22 billion, CFC continues to meet these needs.

As a private lender, CFC plays a significant role in educating the financial community about the financial health of its rural electric cooperative members. In fact, in connection with its first Collateral Trust Bond issue, CFC made potential investors aware of the rural electric program's outstanding composite earnings track record. During the decade preceding the sale of these collateral trust bonds, the composite earnings ratio of all rural electric distribution systems was within the 3.23 to 3.73 range, with the trend being upward with time. These consistently strong ratio achievements have contributed to CFC's ability to earn bond ratings of AA by S&P and Aa by Moody's from its early years to today.

Since CFC's credit is a reflection of the credit-worthiness of its member-systems, its ability to sell long-term bonds at favorable interest rates is in large part a function of each member-distribution system maintaining adequate earnings ratios and equity levels.

NEXT STAGE IN THE LIFE CYCLE

The jump from meeting Federal government requirements to meeting Wall Street's requirements to attract additional sources of debt capital on the open market required consistent maintenance of acceptable terms such as coverage and equity.

As part of this effort, CFC and NRECA created the Capital Credits Study Committee in 1976. The Committee's charter was to study all aspects of the ideas, work, and methods from various individuals and groups in the rural electric program, and develop and promulgate concepts regarding margins, equity levels and, ultimately, revenue requirements.

Regulatory commissions accepted the premise that investor owned utilities must be allowed a rate of return sufficient to cover the interest on their outstanding long-term debt and to provide a reasonable return on the equity capital invested by the owners or stockholders. Soon cooperative leaders rapidly embraced the same philosophy.

EQUITY MANAGEMENT PLANNING

Mathematical models were developed, and later improved, that contained principal concepts indicating that there was an "optimum" equity level for every cooperative. This optimum level being a function of each system's blended cost of debt capital, its capital credit revolving cycle, it's rate of growth in total capitalization, and its TIER, Times Interest Earned, objective. The models were able to prove that if a system's actual equity level were either higher or lower than the optimum level, higher electric rates would be needed in order to provide sufficient revenues to satisfy all of the constraints operating to restrict the cooperatives freedom of action.

James Goodwin, formerly with the REA, is credited with some of the first work in Equity Management for rural electric cooperatives. Goodwin developed a formula, that was later modified, that produced a percentage return on equity (Re) that is still used today in Equity Management planning.

The modified Goodwin formula is as follows:

Re=[(1 + g).sup.n + 1] - [(1+ g).sup.n]/[(1+g).sup.n] - 1 X "100"

Where Re=Rate of Return on Equity (as a percentage)

g=Rate of Growth in Total Capitalization

n=Period of Capital Credit Rotation (in years)

The formula produces the rate of return on equity (Re) to be earned each year on the total equity as of December, 31 of the prior year in order to hold equity at its present level.

See Table 1 for values of Re for varying growth rates and varying periods of patronage capital rotation.

Using the Return on Equity chart to demonstrate, a system growing at 6% per year in total capitalization and revolving capital credits on a 20 year cycle would require an Re of 8.72% to maintain its present equity position. If a lower Re were earned, the percentage equity would fall. If a higher Re were earned, the percentage equity would increase. If a longer revolving cycle were used, a lower Re would be adequate. If a shorter cycle were used, a higher Re would be necessary. If there were no capital credit refunds (with a cycle of infinity years represented in the chart as "1000"), the Re would be the system's rate of growth in that year.

The second component of total capitalization is debt capital, or long-term debt. Technically, the blended cost of a system's long-term debt would be calculated by multiplying the outstanding balance on each long-term note by the interest rare on that note, summing the interest amounts together, summing the note balances together, and dividing the total interest by the total of the outstanding note balances. For convenience, an approximation of the blended interest could be determined by dividing the total interest paid (on long-term debt) by the average of the total debt outstanding for the last full year and prior year (See Table 2).

It is important to be aware that the rate of change in the cost of debt can be influenced by many factors including:

* how fast new higher cost debt is requisitioned

* a system's rate of growth in plant

* the amount of internally generated funds invested in plant

* the amount refunded in capital credits each year

* how fast the older, low interest loans are amortized

The primary purpose of running a financially sound business in a financially sound manner is to ensure the availability of credit that will provide capital funds whenever debt capital is needed. While many factors enter into the ratings of credit risk and debt quality, the most commonly noted factor is interest coverage or TIER. By combining the criteria for patronage capital (as related to return on equity) with reasonable coverage criteria on interest charges (at what may be deemed a desirable capital structure) a valid indicator of the cooperative's financial health can be produced at minimal costs.

PUTTING THE PIECES TOGETHER

Now, lets look at the total rates of return for a system having a 6% rate of growth (in TC), rotating capital credits on a 20 year cycle, and having a blended interest cost of 6% at various equity positions (Table 3).

When the constant equity return prevailed, there was insufficient interest coverage at the lower equity position and excess coverage at the higher equity position.

Next, let's look at the same system, with the same rates, with our constant criteria now being interest coverage, or TIER, of 3.0 (Table 4).

With a constant TIER goal, there is excessive return on equity at the lower equity positions and insufficient return on equity at the higher equity positions. It is obviously not prudent to operate at either extreme.

The following graph (Chart 2) provides a visual analysis of alternative approaches. Operating at 100% debt at 6% interest would be the cheapest alternative for the cooperative. Operating at 100% equity with a 20-year capital credit revolving cycle that results in an 8.72% return requirement would be the most expensive alternative. The diagonal line connecting the two denotes the blended cost alternatives of the debt and equity components to the cooperative.

As a practical matter, however, virtually every cooperative operates using a mixture of debt and equity. Mortgage provisions of RUS and CFC set TIER at minimum levels of 1.25 to 1.50 to ensure debt and interest payment coverage. These targets are not expected to provide the necessary margins to operate the business, maintain equity, and retire capital credits on a consistent cycle. Most cooperatives will find they need to operate at a TIER level of between 2.0 and 3.0 to generate sufficient margins TIER, equity would fall to 54% from the previous 57%. It is easy to see how the increases in debt and equity costs cause changes in TIER requirements. (See Chart 5)

THE ART OF WISE COMPROMISE

Equity management concepts and models continue to remain a critical tool in developing and implementing equity management policies that are consistent with sound business practice and planning. Modeling enables a cooperative to test and set objectives at a level to support the optimum mix of debt and equity in order to minimize the cooperative s rate of return requirements and to meet its debt coverage obligations. In addition, it enables the cooperative to adhere to the cooperative principle of retiring capital credits back to its members as tangible evidence of ownership.

An electric cooperative, like any other business, functions in a dynamic environment. Change is constant and the cooperative doesn't always have control over that change. The needs of a cooperative's membership, along with the strategic goals of the cooperative, must be continually re-evaluated and balanced. Each cooperative's Board and staff have an obligation to move the cooperative in the direction that best positions the organization for the future. While the future can't be precisely predicted for each electric cooperative, we do know that the stronger the organization is financially, the more likely they are to meet the promise of service to their membership.

CFC has recently re-introduced an Equity Management modeling package. The package includes four of the most common capital credit retirement alternatives. The software is currently available on CFC's web site at www.nrucfc.org (through the Extranet). CFC regional vice presidents and staff ate also available to conduct in-depth Equity Management presentations to cooperative Boards and staff.

Claudia Phillips is the Director of Programs and Planning Analysis within the Corporate Relations Department of CFC. The Programs and Planning group is responsible for development and maintenance of financial and statistical models, including the Key Ratio Trend Analysis, Merger/Consolidation modeling, COMPASS Financial Forecast, and Performance Benchmarking. Claudia joined CFC in 1977, and has held the positions of Statistician, Mortgage Compliance Specialist, and Program Analyst prior to becoming Director of Programs and Planning Analysis in 1998. Claudia holds a BS in Business Administration from George Mason University, Fairfax, VA.

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TABLE 1

RETURN ON EQUITY %

                     Period Of Revolving Capital Credits - Year
Annual
Rate of
Growth       10      15          16         17         18        19

 0.00      10.00    6.67        6.25       5.88       5.56      5.26
 1.00      10.56    7.21        6.79       6.43       6.10      5.81
 2.00      11.13    7.78        7.37       7.00       6.67      6.38
 3.00      11.71    8.38        7.96       7.60       7.27      6.98
 4.00      12.33    8.99        8.58       8.22       7.90      7.61
 5.00      12.95    9.63        9.23       8.87       8.55      8.27
 6.00      13.59    10.29       9.90       9.54       9.24      8.96
 7.00      14.24    10.98       10.59      10.24      9.94      9.68
 8.00      14.90    11.68       11.30      10.96      10.67     10.41
 9.00      15.58    12.41       12.03      11.70      11.42     11.17
10.00      16.27    13.15       12.78      12.47      12.19     11.95
11.00      16.98    13.91       13.55      13.25      12.98     12.76
12.00      17.70    14.68       14.34      14.05      13.79     13.58
13.00      18.43    15.47       15.14      14.86      14.62     14.41
14.00      19.17    16.28       15.96      15.69      15.46     15.27
15.00      19.93    17.10       16.79      16.54      16.32     16.13
16.00      20.69    17.94       17.64      17.40      17.19     17.01
17.00      21.47    18.78       18.50      18.27      18.07     17.91
18.00      22.25    19.64       19.37      19.15      18.96     18.81
19.00      23.05    20.51       20.25      20.04      19.87     19.72
20.00      23.85    21.39       21.14      20.94      20.78     20.65

          Period Of
          Revolving
           Capital
          Credits -
             Year
Annual               No.
Rate of             Cycle
Growth     20       1000

 0.00     5.00      0.00
 1.00     5.54      1.00
 2.00     6.12      2.00
 3.00     6.72      3.00
 4.00     7.36      4.00
 5.00     8.02      5.00
 6.00     8.72      6.00
 7.00     9.44      7.00
 8.00     10.19     8.00
 9.00     10.95     9.00
10.00     11.75     10.00
11.00     12.56     11.00
12.00     13.39     12.00
13.00     14.24     13.00
14.00     15.10     14.00
15.00     15.98     15.00
16.00     16.87     16.00
17.00     17.77     17.00
18.00     18.68     18.00
19.00     19.60     19.00
20.00     20.54     20.00

TABLE 2

Interest Principal $470,000/(7,500,000 + $8,166,666)/2 = 6.0% Cost of Debt

TABLE 3

Equity Position        20%    40%    60%    80%

Equity @ 8.72%         1.74   3.49   5.23   6.98
Debt @ 6.00%           4.80   3.60   2.40   1.20
Total Rate of Return   6.54%  7.09%  7.63%  8.18%
TIER = Re + Interest/  1.36   1.97   3.18   6.82
 Interest
TABLE 4

Equity Position        20%     40%     60%    80%

Equity Re Required     9.60    7.20    4.80   2.40
Interest               4.80    3.60    2.40   1.20
Total Rate of Return   14.40%  10.80%  7.20%  3.60%
TIER = Re + Interest/  3.0     3.0     3.0    3.0
 Interest