The Cost of Capital: Estimating the Rate of Return for Public Utilities

The Cost of Capital: Estimating the Rate of Return for Public Utilities

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Overview

This book spells out the advantages and disadvantages of the major methods used to estimate the required rate of return. One of the most contentious questions in public utility regulation is what "fair" rate of return to allow investors. This book spells out the advantages and disadvantages of the major methods used to estimate the required rate of return. It is a thorough review and critique that will prove valuable to all members of the regulatory community - commissions and their staff, legal and management counsel, and intervenors - and to students of finance and regulation. The point of departure is the cost of capital as a concept and the rationale for setting the allowed rate of return equal to the cost of capital. On this basis a comprehensive set of evaluation criteria are developed, including theoretical, practical, and empirical aspects. With the conceptual and methodological framework established, the authors proceed to evaluate the five major estimation methods: comparable earnings, discounted cash flow, capital asset pricing model, risk positioning, and market-to-book ratio. In addition, they survey new methods of estimating the cost of capital, such as the Arbitrage Pricing Theory, that are likely to be used more frequently in the future. Several related topics are treated in appendices. The goal of the book is not to choose a single "best" method, but to provide a systematic assessment of the strengths of each.

Product Details

ISBN-13: 9780262612128
Publisher: MIT Press
Publication date: 08/31/2005
Series: MIT Press Series , #3
Pages: 196
Product dimensions: 5.90(w) x 9.00(h) x 0.50(d)

About the Author


Lawrence Kolbe is Vice President of Charles River Associates in Boston.


James Read is Senior Research Associate at Charles River Associates in Boston.


George R. Hall is Vice President of Charles River Associates in Boston.

Table of Contents

Preface
Acknowledgments
1 The Setting: Utility Regulation and Capital
Markets
1. Problems Facing Utility Regulation
2. The Ratemaking Process
3. Capital and Capital Markets in Ratemaking
4. Plan of the Book
2 The Cost of Capital: What It Is and Why It
Matters
1. The Concept of the Cost of Capital
2. Why the Allowed Rate of Return Should Equal the Cost of
Capital
3. Use of the MarkettoBook Ratio as a Guide for Regulators
3 The Five Major Methods: Definitions and
Conceptual Evaluation
1. Evaluative Criteria
2. Comparable Earnings
3. Discounted Cash Flow
4. Capital Asset Pricing Model
5. Risk Positioning
6. MarkettoBook Ratio
7. Conclusions from the Conceptual Evaluation
4 The Five Major Methods: Empirical Evaluation
and Overall Rankings
1. Empirical Evaluation
2. Summary of the Relative Merits of the Five Major Methods
5 A Look Ahead: New Approaches to CostofCapital
Estimation
1. The "Empirical" Capital Asset Pricing Model
2. Pogue's Approach for Industries without Traded Stocks
3. "Multifactor" Models
4. Conclusion
AppendiXes
A. The Effect of Debt on the Cost of Equity Capital
B. The MarkettoBook Ratio with "Vintaged" Equity Returns
C. Technical Notes on the Empirical Analysis
Notes
References and Additional Reading
IndeX

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