X. Cost of Capital

The cost of capital for a public utility typically is expressed as an overall rate of return, calculated by adding the weighted costs of long-term debt, preferred stock, and common stock equity. Because San Gabriel has no preferred stock outstanding, its capital structure includes only the two factors of long-term debt and common equity. During the evidentiary hearings, San Gabriel and DRA achieved a stipulation as to the capital structure, cost of debt, return on equity (ROE) and overall rate of return for purposes of this GRC, agreeing on an ROE of 9.90%, and overall rate of return of 9.33% for TY 2006-2007 and 9.35% for TY 2007-2008. Neither the City nor the District joined the stipulation.

A. Capital Structure

DRA's expert witness proposed an imputed capital structure consisting of 40% long-term debt and 60% common equity, an equity ratio approximately half way between the average equity ratio of a group of small water utilities and San Gabriel's actual equity ratio. This was accepted by San Gabriel. The City's expert witness recommended an imputed capital structure consisting of 50% debt and 50% equity, based on a proxy group of water utilities which had a five year average debt/equity ratio of approximately 50/50. We have addressed this issue in the last two GRC decisions for San Gabriel, D.04-07-034 in the last Fontana Division case and D.05-07-044 in last year's Los Angeles County Division GRC. In both decisions, we adopted a hypothetical capital ratio of 60% common stock equity and 40% long-term debt. Having adopted a 60/40 ratio in 2004 and 2005, we are disinclined to depart from that ratio absent compelling evidence. We adopt the stipulation between San Gabriel and DRA.

B. Effective Cost of Long-Term Debt

The stipulation between the DRA and San Gabriel results in a cost of long-term debt for each year, 2006 through 2008, based on the amounts proposed by San Gabriel. The agreed upon long-term debt rates are: 8.44% for 2006, 8.49% for 2007, and 8.54% for 2008. The City's expert recommended using San Gabriel's historical issuance cost of debt, calculating overall interest costs of 8.33% to 8.36%. He adjusted downward the estimated issuance expenses on San Gabriel's planned debt issues. We are not convinced bond costs will be as low as the City's witness has estimated. We adopt San Gabriel and DRA's stipulated amounts.

C. Cost of Equity

Equity cost is a direct measure of the utility's after-tax ROE investment. Its determination is based on subjective measurement, and is not susceptible to direct measurement in the same way as capital structure and embedded long-term debt costs. The quantitative models commonly used as a starting point to estimate investors' expectations are the discounted cash flow (DCF) and risk premium (RP). Although the parties agree that the models are objective, the results are dependent on subjective inputs. For example, each party used different proxy groups, growth rates, and calculations of market returns. Detailed description of the DCF and RP models are contained in the record and are not repeated here.

San Gabriel's expert witness presented an analysis of its cost of equity financing developed from a range of estimated equity costs for a sample of water utilities and gas utilities. The range of estimated equity costs resulting from the water utilities sample was from 10.3% to 11.6%, while the overall range of estimated equity costs for San Gabriel was from 11.5% to 12.8%, supporting a recommended 12.0% ROE. San Gabriel's own recommendation was an ROE of 11.5%. DRA originally proposed an ROE of 9.0%, while the City proposed an ROE of 8.9%. San Gabriel and DRA agreed to jointly support an ROE of 9.9%. Consistent with a 9.9% ROE, San Gabriel and DRA also jointly proposed to set the overall rate of return for TY 2006-2007 at 9.33% and for TY 2007-2008 at 9.35%.

DRA's expert witness criticized the 11.5% ROE as unreasonably high due to the use of forecast interest rates above current long-term yields, and excessive risk premium estimates. The City's expert witness expressed similar objections. Both witnesses criticized the relevance of San Gabriel's consideration of a sample of natural gas utilities.

What stands out in a comparison of the testimony of the experts is the inevitable and pervasive use of judgment, which colors all results. We have recently reviewed ROE for San Gabriel in its recent rate cases and found reasonable in 2004, an ROE of 10.10% (D.04-07-034, p. 59); and again in 2005 an ROE of 10.10% (D.05-07-044, p. 33). In this case, San Gabriel and DRA have stipulated to an ROE of 9.90%, the City proposes 9.0%. Having recently considered this matter, we believe a 20-basis point reduction in ROE is more in line with current trends than the City's more drastic 120-basis point reduction. We adopt 9.90% as the reasonable ROE and the overall rates of return of 9.33 for TY 2006-2007 and 9.35% for TY 2007-2008 as stipulated by DRA and San Gabriel (Ex. 85).