Meridian Water Utilities: Buyback, WACC and the Regulated Settlement
Meridian Water Utilities plc is a regulated UK water company with market capitalisation £2.4bn and debt of £1.6bn at both book and market value. Equity beta is 0.85, the risk-free rate 4.0%, the market risk premium 5.5%, and the pre-tax cost of debt 5.2% for its BBB rating. Tax is 25%. The regulator sets allowed revenue using a notional 55% gearing and a debt beta of zero, fixed for five years. Treasury proposes a £400m debt-financed share buyback, claiming it will cut WACC to 6.5% and return surplus equity. The CFO notes the allowed return is already locked, while the COO warns that the licence requires EBITDA/interest cover of at least 2.5× and that credit ratings below BBB raise the cost of the £1.2bn revolving facility. EBITDA is £720m and net debt £1.6bn. The board will vote next week.
1. Calculate Meridian's current WACC and the WACC immediately after a £400m debt-financed buyback. Is treasury's 6.5% claim credible?
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Current: E = £2.4bn, D = £1.6bn, V = £4.0bn. Ke = 4.0% + 0.85(5.5%) = 8.675%. Kd after tax = 5.2%(1 − 0.25) = 3.9%. WACC = 0.60(8.675%) + 0.40(3.9%) = 6.765%.
Unlever the equity beta using D/E = 1.6/2.4 = 0.667: βa = 0.85/[1 + 0.667(0.75)] = 0.85/1.50 = 0.5667. After a £400m buyback, debt is £2.0bn and equity £2.0bn, ignoring price effects. Relever: βe = 0.5667[1 + (2.0/2.0)(0.75)] = 0.9917. Ke = 4.0% + 0.9917(5.5%) = 9.454%. If the extra leverage costs the BBB rating, Kd might rise to, say, 5.8%, giving after-tax 4.35%. WACC = 0.50(9.454%) + 0.50(4.35%) = 6.90%.
WACC rises, not falls. The 6.5% claim is not credible: it ignores the relevering of equity risk and rating migration. A buyback changes financing mix, not asset risk. WACC can fall only if the tax shield from extra debt exceeds expected distress costs. Treasury appears to have held the equity beta constant, which is the error.
2. Advise the board on the buyback, considering the regulatory settlement and the licence covenant.
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Current interest = 5.2% × £1.6bn = £83.2m; EBITDA/interest = 720/83.2 = 8.65×. After £400m more debt at 5.8%, interest = 5.8% × £2.0bn = £116m; cover = 720/116 = 6.2×, still above the 2.5× licence floor. Net debt/EBITDA = 2.0/0.72 = 2.78×, so the balance sheet is tighter but not in breach.
The decisive point is regulatory. Allowed revenue is fixed for five years using notional 55% gearing, so the regulator does not reward extra actual leverage. Post-buyback gearing is 50%, still below notional, so there is no regulatory capital benefit; shareholders bear more financial risk for no extra allowed return. A downgrade below BBB would raise the cost of the £1.2bn facility and could trigger covenant discussions. The buyback also reduces the buffer needed for inflationary cost shocks and outcome-delivery penalties.
Recommendation: reject the full £400m buyback. If capital must be returned, use a smaller special dividend or tender, sized to keep gearing comfortably below notional and interest cover above, say, 5×. Retain the rest as headroom. The board should not approve a transaction whose main effect is a higher WACC.
3. Meridian is considering a £150m investment in an unregulated water-technology venture with an asset beta of 1.30. What discount rate should be used, and why not the group WACC?
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Use a project-specific WACC, not Meridian's 6.9% group rate. The venture's asset beta is 1.30, reflecting technology and unregulated cash flows, so its equity risk must be relevered at the financing chosen. At 50% debt: βe = 1.30[1 + 0.75] = 2.275; Ke = 4.0% + 2.275(5.5%) = 16.51%; Kd after tax, say 4.35%; WACC = 0.50(16.51%) + 0.50(4.35%) = 10.43%. At Meridian's current 40% debt: βe = 1.30[1 + (0.4/0.6)(0.75)] = 1.95; Ke = 14.73%; WACC = 0.60(14.73%) + 0.40(4.35%) = 10.58%.
Either way the hurdle is around 10.5%, roughly 3.6 percentage points above the group WACC. Discounting the venture at 6.9% would wrongly accept projects that do not compensate for their risk and would cross-subsidise them from the regulated business. Because the venture is unregulated and outside the licence, it should also be ring-fenced with non-recourse debt if possible, so failure does not impair the regulated entity. Use scenario analysis as well as the CAPM rate.