A tale of three deals - ADT, Westinghouse, KCPL - at Western Resources.
Sensing changes in the utility industry, Western Resources Inc. in 1994 began to examine what it was and what it...
Is Too! Is Not!
In the August 1995 Mailbag, Mr. Michael Yokell claims our May 15, 1995, article ("It Ain't in There: The Cost of Capital Does Not Compensate for Stranded-cost Risk") "is simply wrong" and "nonsensical on its face" because we fail to distinguish between the cost of capital before and after the stranded-cost issue arose.
In fact, it is Mr. Yokell who fails to distinguish between the cost of capital (by definition the average rate of return shareholders require over all possible outcomes) and whether the allowed rate of return granted by regulators affords investors an unbiased opportunity to earn the cost of capital. In our example, the 12.5 percent (which Mr. Yokell wrongly considers the cost of capital before stranded-cost risk arises) is in fact the average rate of return investors require after stranded-cost risk arises. The 20 percent (which Mr. Yokell wrongly considers the cost of capital after stranded-cost risk arises) is the allowed rate of return regulators must grant on the equity rate base if investors are to expect to earn 12.5 percent on average, given that there is a 1-in-4 chance they will earn 30 percent less than the allowed rate of return if costs are stranded:
(3/4 x 20%) + [1/4x(20%-30%)] = 15%-2.5% = 12.5%.
In an efficient capital market, the stock in our example will always be priced to yield an average rate of return of 12.5 percent (em that's the definition of cost of capital. However, the average rate of return investors can expect on the equity rate base will equal the 12.5-percent cost of equity only if regulators allow a rate of return on equity equal to 20 percent. If regulators have not allowed such a premium over the cost of equity, they have not compensated shareholders for stranded-cost risk.
Thus, contrary to Mr. Yokell's claim, our example is both internally consistent and fully compatible with the assumption of an efficient capital market.
A. Lawrence Kolbe
The Brattle Group/IRI
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