Problems and Progress
Edited by Colin Robinson
Chapter 7: Cost of capital: some current issues
Julian Franks1 INTRODUCTION This chapter has three themes. First, how should regulators approach the issue of leverage? Can and should they intervene to limit a regulated ﬁrm’s leverage, for example, by restricting it if they can, or incentivising the company to do so, if they cannot, in order to maintain minimum credit ratings. If ﬁrms cannot maintain adequate credit ratings, is this a signal of excessive leverage or does it reﬂect an inadequate price cap and rate of return calculated by the regulator? Second, although the capital asset pricing model (CAPM) has become the favoured model for calculating the cost of capital by regulators, there is considerable doubt about its adequacy among ﬁnance scholars. The empirical evidence for the CAPM is far from ﬁrm and other models are widely used in empirical studies in the academic ﬁeld. The question is whether regulators should use these other models as a cross-check, at least on the CAPM. Third, given that the cost of capital of a company is a composite one that reﬂects a variety of risks within the company, should regulators recognise these diﬀerences in risk by applying diﬀerent costs of capital to separate parts of the business? This issue is particularly important when some parts of the business are regulated and others are not, or when the customers of the regulated businesses and the risks of the assets being used are diﬀerent. Finally, the issue of cost of capital is a very controversial one and...
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