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

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 themajor methods used to estimate the required rate of return. It is a thorough review and critiquethat 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 pointof departure is the cost of capital as a concept and the rationale for setting the allowed rate ofreturn equal to the cost of capital. On this basis a comprehensive set of evaluation criteria aredeveloped, including theoretical, practical, and empirical aspects. With the conceptual andmethodological framework established, the authors proceed to evaluate the five major estimationmethods: 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.The authors areaffiliated with Charles River Associates in Boston. Lawrence Kolbe is Vice President, James Read isSenior Research Associate, and George R. Hall is Vice President. A Charles River AssociatesStudy.

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