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Financial News

Fortnightly Magazine - March 1 1997

that rate. The value of the recovered stranded investment is thus equal to its book value of 100.

The market value of the utility's earnings under competition is 150: 12 capitalized at 8 percent. This brings the total ending shareholder wealth to 250, a decline of 50 from the original wealth of 300. Thus, full, stranded-cost recovery does not preserve shareholder wealth in this case.

Investing the Recovered Funds

Full preservation of shareholder wealth involves two factors in addition to recovery of stranded investment: 1) investment that replaces the stranded equity, and 2) the stock market's valuation of the impact of stranded investment.

First, reinvestment stands largely independent of the amount of stranded equity that is recovered. However, reinvestment does remain subject to normal capital budgeting constraints, which would ordinarily require company management to reject a particular investment unless its return exceeds the cost of equity. Only investments with a return above the cost of equity will enhance shareholder wealth. The supply of such investments does not depend on the ability to recover past investment.

Second, shareholder wealth is determined in financial markets. The stock market's valuation of a utility is the ultimate arbiter of the impact of stranded investment on shareholder wealth. Thus, it is possible that investor perceptions or apprehensions about the threat of stranded investment might affect shareholder wealth (em even if no portion of utility investment ever actually becomes stranded.

In this sense, shareholder wealth has already shrunk; it has been discounted by the threat of stranded investment. Rightly or wrongly, investors expect that some impairment of earnings is unavoidable for some utilities. This expectation is already reflected in depressed price-earnings ratios and market-to-book ratios (stock price divided by book value) for those utilities that carry the heaviest exposure to stranded investment.

Finding a High-Enough Return

The investment principle for fully preserving shareholder wealth remains simple enough. Corporations must recover the equity portion of stranded investment and reinvest that amount at a rate of return that matches the risk-adjusted return that would have been earned in the absence of exposure to stranded investment. With equity returns for utilities now hovering at between 12 percent and 14 percent, preservation of shareholder wealth will require reinvestment of recovered stranded equity at comparable rates of return.

This range of earnings exceeds the returns currently offered by investment-grade financial instruments, which implies that reinvesting recovered funds at financial market returns will not preserve shareholder wealth. As the example illustrates, when a utility's market-to-book ratio already stands above 1.0, the recovery of stranded investment by itself only sets the stage for preserving shareholder wealth. Unless the utility exhibits a separate ability to invest at a return above the financial market return, the value of recovered equity will not exceed its book value, and shareholder wealth will decline.

The difficulty will arise in finding good investment opportunities. Returning recovered funds to shareholders is akin to investing at a financial market return, and will not preserve shareholder wealth. Acquiring other companies, unfortunately, is not very promising either. On the one hand, the acquisition of a