Abstract
AbstractIn regulatory proceedings, few issues are more hotly debated than the cost of capital. This article seeks to formalise the theoretical foundation of cost of capital estimation for regulatory purposes. We find that several common regulatory practices lack a solid foundation in the theory. For example, the common practice of estimating a single cost of capital for the regulated firm suffers from a circularity problem, in that the estimate of the cost of capital depends on the regulated revenue allowance which, in turn, depends on the cost of capital. This problem is especially severe in the context of a multi-year regulatory period. We also show that, in the context of a multi-year regulatory period the cost of capital cannot be expressed as a weighted average of the cost of equity and the cost of debt. In addition, the relevant cost of debt cannot normally be estimated using the yield-to-maturity on a corporate bond. We suggest possible directions for reform of cost of capital practices in regulatory proceedings.
Publisher
Springer Science and Business Media LLC
Subject
Economics and Econometrics
Reference25 articles.
1. Ahern, P. M., Hanley, F. J., & Michelfelder, R. A. (2011). New approach to estimating the cost of common equity capital for public utilities. Journal of Regulatory Economics, 40, 261–278.
2. Alexander, I., Estache, A., & Oliveri, A. (2000). A few things transport regulators should know about risk and the cost of capital. Utilities Policy, 9(1), 1–13.
3. Anderson, P. L. (2012). The economics of business valuation: Towards a value functional approach. Stanford University Press.
4. Breen, W. J., & Lerner, E. M. (1972). On the use of $$\beta $$ in regulatory proceedings, The Bell Journal of Economics and Management Science 612–621.
5. Brigham, E. F., & Crum, R. L. (1977). On the use of the CAPM in public utility rate cases, Financial Management 7–15.