Determination of Cost of Capital (Debt and Equity), Including With Scarce or Unreliable Cost Information

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  1. Estimating the cost of capital with limited or unreliable information
  2. Cost of Debt
  3. Cost of Equity
  4. Role of Taxes
  5. Weighted Average Cost of Capital, including the choice of weightings
  6. Foreign Currency Risk

Core References

A Back-of-the-Envelope Approach to Assess the Cost of Capital for Network Regulators
The World Bank, December 1997.
Alexander, I., and A. Estache

Provides a description of how to estimate cost of capital in a developing country context.

Infrastructure Concessions, Information Flows, and Regulatory Risk
Note no. 203 in Public Policy for the Private Sector. Washington, D.C.: World Bank Group, December 1999.
Burns, P., and A. Estache

Holds that regulators need to compute the weighted average cost of total capital (debt plus equity) to ensure a return to investors and sustain the asset base. Describes how to identify the cost of debt. Examines techniques for estimating the cost of equity with market data. Finds that in developing countries, however, concessionaires are often unlisted, so market data are not available, or the concessionaires may be part of a larger conglomerate, so market data will cover not only the regulated activity but others as well. Examines using comparators to solve these problems. Also discusses using benchmark ratios based on international best practice.

Gas Control Inquiry: Final Report
New Zealand, 2004.
Commerce Commission of New Zealand

Explains components of the weighted average cost of capital and how to estimate them. Provides cases using gas companies in New Zealand.

The Cost of Capital and Access Arrangements
in Infrastructure Regulation and Market Reform: Principles and Practice, edited by Margaret Arblaster and Mark Jamison. Canberra, Australia: ACCC and PURC, 1998, pp. 161-184.
Davis, Kevin, and John C. Handley

Analyzes cost of capital methodologies. Considers the importance of access arrangements, alternatives to the Capital Asset Pricing Model, factors affecting the derivation of beta risk and the feasibility of international benchmarks, determination of beta risk for an operator with markets with different levels of competition, the impact of price cap regulation, the treatment of depreciation in the cost of capital, the relationship between beta risk, pricing principles and asset valuation methodologies, and the treatment of stranded assets.

European Regulators’ WACC Decisions Risk Undermining Investment Decisions
NERA, February 2015.
Grayburn, James and Haug, Tomas

Examines how the Capital Asset Pricing Model gives inaccurate estimates of the cost of capital when the elements of the model are estimated from different time periods. The analysis shows that, because the risk premium is higher when risk free rates are lower, estimating the former when the risk free rates are higher understates the cost of capital when the estimated risk premium is applied after the risk free rate has declined.

The Cost of Capital: Intermediate Theory
Cambridge UK: Cambridge University Press, 2005.
Armitage, Seth

Describes issues regarding how to measure the cost of capital.

Regulation and the Cost of Capital
in Crew, M. and D. Parker, eds., International Handbook on Economic Regulation, Northhampton, MA: Elgar, 2008.
Jenkinson, Tim

Discusses difficulties in estimating risk and the appropriate equity cost of capital. Examines the trend towards high levels of debt in utility capital structures. Discusses whether capital structure should be regulated. Finally, examines issue of “financeability” – whether the projected revenues, profits and cash flows are such as to enable the company to maintain a strong credit rating.

Estimating the Market Risk Premium in Regulatory Decisions
Australian Competition and Consumer Commission. 2013.
Gibbard, Peter

Provides a survey of the debate about estimates of the market risk premium based upon historical averages of excess returns and estimates that are conditional on current information.

A Study into Certain Aspects of the Cost of Capital for Regulated Utilities in the U.K.
Smithers & Co Ltd, London, U.K. February 13, 2003.
Wright, Stephen, Robin Mason, and David Miles

Examines key areas of the cost of capital, including the common components of the cost of equity, a comparison of asset pricing models for regulation, practical issues in estimation of asset pricing parameters for utilities, the case for consistency in setting the cost of capital, and regulatory risk.

Sectoral References

ELECTRICITY

The Rate of Return for Electricity Distribution
IPART Discussion Paper, Sydney, Australia, November 1998.
Independent Pricing and Regulatory Tribunal of New South Wales

Describes processes for estimating the cost of capital. Explains with cost of capital is important. Covers weighted average cost of capital, effective tax rate, cost of equity, cost of debt, and inflation.

WATER

Testing for Financeability: An Assessment
2006.
OXERA

Examines rationale for Ofwat’s financeability adjustments in the 2004 periodic review and the potential for alternative approaches.

The Capital Structure of Water Companies
October 11, 2002.
OXERA

Examines appropriate capital structure for water companies in the U.K. Considers effects of capital structure on the cost of capital, whether an operator should be expected to choose an optimal capital structure from the regulator’s perspective, and appropriate regulatory responses to capital structure issues.

Other References

Regulatory Structure and Risk and Infrastructure Firms: An International Comparison
Policy Research Working Paper No 1698, The World Bank, 1996.
Alexander, I., Mayer, C. and Weeds, H.

Provides an econometric analysis of how forms of regulation affect cost of capital.

Understanding Risk & Return
2001 Marshal Lectures, University of Cambridge, 2001.
Campbell, John Y.

Explains why simple models have difficulty explaining some puzzles in asset pricing.

Corporate Ratings Criteria
2003.
Standard & Poor’s

Describes Standard & Poor’s criteria for rating corporations, including industrials and utilities. Considers country risk, sovereign risk, cyclicality, regulation, and loan covenants.

Key Words

Cost of Capital, Equity, Debt, Taxes, WACC, CAPM, Risk

 

Case Studies

Jamaica Public Service Company Limited Tariff Review for Period 2009-2014
September 2009
Office of Utilities Regulation (OUR)

The Cost of Capital Estimation for Fixed Telecommunications Services: A Final Report for OFTA
August 2000.
National Economics Research Associates (NERA)

BGE’s Cost of Capital: A Final Report for the Commission for Energy Regulation
August 2003.
NERA

Final Determinations. Future Water and Sewerage Charges 2000-05: Periodic Review 1999
November 1999.
OFWAT

A Study into Certain Aspects of the Cost of Capital for Regulated Utilities in the U.K.
Smithers & Co Ltd, London, U.K. February 13, 2003.
Wright, Stephen, Robin Mason, and David Miles