Cost of equity and leverage under "fair" rate-of-return regulation

Abstract

A rate-of-return regime characterized by "fairness" satisfies two criteria: the total allowed return on the rate base is equal to the cost of capital, and the regulated firm should be able to raise capital without either gain or loss to existing equity holders. Assuming a monopoly firm with a single product, a single-period state-preference world, risk-free debt, corporate (but not personal) tax, and perfectly price inelastic demand; this paper shows that in such a regime the tariff of a regulated firm will have to be reset with leverage. This resetting arises because unlike in a Modigliani-Miller world where firm (and equity) value is enhanced by the leverage (because of interest tax shields), "fairness" implies that interest tax shield benefits accrue to consumers, after ensuring equity holders receive a return on equity commensurate with systematic risk. If demand is not perfectly inelastic, a change in tariff consequent upon change in leverage will also lead to a change in equilibrium output. With the assumption that there is a single driver of systematic risk (that of output), the cost of equity-leverage relationship obtained with perfectly inelastic demand is shown to still hold.