To assess whether the rate of return the operator is able to receive is sufficient to attract investor capital, the regulator must determine operator’s cost of capital.1 Generally the cost of capital is estimated as the weighted average cost of capital (WACC), which is a weighted average of the operator’s cost of debt and cost of equity. Unless the regulator believes that the operator has an inefficient capital structure, the weighting for debt (respectively, equity) is the amount of the operator’s debt (respectively, equity) divided by the operator’s total invested regulatory capital. Capital structure refers to the proportions of debt and equity that the operator uses to finance her operations.
The calculation of WACC requires market data. If these data are unavailable, close comparators may be used. The capital asset pricing model (CAPM) is the most common model for estimating the cost of equity. Cost of equity is adjusted to reflect the operator’s income tax rate. An adjustment for foreign currency risk may be needed if the operator obtains investment that is denominated in a foreign currency.
- See Earnings Measurement.