A Re-Examination of the Foundations of Cost of Capital for Regulatory Purposes

Abstract

In regulatory proceedings, few issues are more hotly debated than the cost of capital. This article formalises the theoretical foundation of cost of capital estimation for regulatory purposes. Several common regulatory practices lack a solid foundation in the theory. For example, the common practice of estimating a single cost of capital for the regulated firm suffers from a circularity problem, especially in the context of a multi-year regulatory period. In addition, the relevant cost of debt cannot be estimated using the yield-to-maturity on a corporate bond. We suggest possible directions for reform of cost of capital practices in regulatory proceedings.