Business Decision Making and Its Financial Effects

When an operator considers two or more courses of action, he generally bases his choice on the cash flows that the different options offer.¹ These cash flows occur over time and cash flow that is farther into the future is less important than cash flow that is nearer to the present. To quantify these relative differences, operators discount future cash flows to present values by dividing each year t’s cash flow by (1 + r)^t, where r is the discount rate.² r represents both the time value of money and the project risk. In other words, r represents what the operator needs to pay both debt holders and shareholders to obtain capital for this project. In general, the greater the risk in a project, the higher will be the discount factor that the operator would apply to the projected cash flows. The net of the present value of the cash inflow and the present value of the cash outflow is called the NPV of the project. Unless there is a barrier to raising capital³ or to obtaining some necessary input, an operator generally is willing to implement any project that has a positive NPV.⁴ Once a project is chosen and implementation begins, the project has financial effects on the operator and the operator records these effects in its financial statements.⁵ There are three basic financial statements that are of interest in regulation. The first is the cash flow statement, which records all of the cash inflows and outflows that result from the normal operations and projects that the operator undertakes. Cash flows are of interest to regulators in part because some regulators use projected cash flows to establish X-factors for price cap regulation.⁶ that relies on projected cash flows to establish X-factors is called U.K.-style price cap regulation.⁷ Revenue and operating expenses related to projects and normal operations are recorded on the income statement, along with interest, taxes, and depreciation expenses. Operating expenses are costs incurred for inputs that are used up within a year’s time. Assets (plant, other property and investments, current assets, and deferred debts) and liabilities (stock, long-term debt, non-current liabilities, current and accrued liabilities, and deferred credits) are recorded on the balance sheet. The income statement and balance sheet are of particular interest in rate of return regulation, but are important for other forms of regulation as well. This is described further in Price Level Regulation.

Footnotes

1. See Financial Analysis in the reference section.
2. Where NPV0 is Net Present Value today for cash flows received in 1 year, 2 years, etc
3. Usually there are barriers to raising capital in a developing country.
4. Some regulators also use NPV analysis in regulating overall price levels. Price Regulation in Price Level Regulation notes these financial analysis techniques.
5. See Identifying Informational Requirements.
6. For convenience, the authors refer only to price cap regulation, but these statements also apply to revenue cap regulation, which is described in the chapter on incentive regulation.
7. See Price Regulation in Price Level Regulation for information on price cap regulation and the financial modeling that U.K.-style price cap regulation entails.