1. Cash flows in the financial model Lecture 6a

2. Overview Elements of cash flow model Reminder on discounting and rate of return Application to two-period model The simplified regulatory model we use in the lab and coursework

3. Elements of cash flow model Operating expenditures –Maintenance, repairs, operation, customer transactions, central operations Capital expenditures Initial and closing regulatory asset base Future values discounted at cost of capital, avoiding accounting rates of return What is the reasoning behind this?

4. Discounting If we can borrow and lend at r% then £100 today is equivalent to £100 + r in a year’s time. If r= 5%, £100 next year is worth £100/(1.05) today i.e. 100/(1+r). This is the amount I would need to invest today to get £100 next year. If the £100 is not due for two years, it is worth £100/(1+r) 2 today Generally the present value of a sum S of money t years away is S/(1+r) t The rate of interest r is also known as the discount rate. Regulators use companies’ cost of capital as the discount rate

5. Multi-period Investment Criterion If I wish to maximise my wealth I will carry out all investments with a positive Net Present Value The accounting rate of return in any year may be higher or lower than the cost of capital NPV = Present value of future income streams less initial investment Investors in utilities need to know that their investment has a positive NPV Regulators use financial models to investigate NPV arising from price controls

6. NPV in price control period NPV = Present value of cash inflows in price control period plus present value of closing RAV minus RAV at start of period

7. Application to 1-year price control (simplified!) YearNPV 01 Profits6.5 Net investment5.0 Free cash flow 1.5 Asset Value+100+105.0 Total “cash” flow-100+106.5 Present value @6.5%-100+100.00 Initial RAV is “investment” Final RAV is part of “cash flow” Cash available for dividends Return in 6.5%, but most is re-invested

8. What proportion do companies keep? Example for a saving of £100 pa in year 1 Discount rate 6% 10% 1NPV over five years £421 £379 2NPV over 100 years £1,661 £999 3Ratio (1)/(2) 25.3%37.9% Let’s look at a slightly more complex financial model