THE APPLICATION OF THE COST OF CAPITAL IN DETERMINING A FAIR RATE OF RETURN FOR PUBLIC UTILITIES: A NEW APPROACH TO COMPARATIVE EARNINGS AND FINANCIAL INTEGRITY STANDARDS

Generally, public utility economists argue that setting a utility's allowed rate of return equal to its cost of capital satisfies both the legal standard of equity and the economic criterion of efficiency. However, while financial economists tend to agree with this prescription, the finance literature provides no similar consensus on how the capital structure of a firm affects its cost of capital. Hence most advice for fair rate of return regulation seems nonauthoritative.;The present study attempts to make several contributions. First, it reviews the basis for advocating the cost of capital as an optimal allowed rate of return. Here the study clarifies previous analyses. Following this review, the present study develops a general firm valuation model that joins the issues confronting financial economists and offers a usefulness in public utility proceedings. The properties of the model are investigated by applying it in a simulation analysis of sixty-six investor-owned public utility firms. Results of this simulation indicate the existence of an optimal capital structure for public utility firms and hence a determinant cost of capital that can guide public utility regulation.