Public Utilities Reports

PUR Guide 2012 Fully Updated Version

Available NOW!
PUR Guide

This comprehensive self-study certification course is designed to teach the novice or pro everything they need to understand and succeed in every phase of the public utilities business.

Order Now

Measuring Return on Equity Correctly

Why current estimation models set allowed ROE too low.

Fortnightly Magazine - August 2005

some market-wide economic factor normally produce fluctuations in the market value of a company's assets of plus or minus (+/-) 2 percent. At 100 percent equity, these changes produce fluctuations of +/-2 percent of the market value of the company's equity, too. But at a 50-50 market-value, debt-equity ratio, the same asset-value fluctuations produce equity-value fluctuations of +/- 4 percent. At a 75-25 market-value debt-equity ratio, these fluctuations become +/- 8 percent of the market value of the company's equity. Figure 1 illustrates this point for debt-equity ratios of 0-100, 25-75, 50-50, and 75-25. Higher risk means a higher required rate of return, so the cost of equity goes up at an ever increasing rate as a company adds debt, which offsets the lower cost of debt. In short, there is no magic in financial leverage.

This result should be familiar to anyone who owns a home. When housing prices go up or down, the effect on the owner depends in part on how big the mortgage is. Figure 2 shows this effect for mortgages that are 0 percent, 20 percent, 50 percent, and 80 percent of the dwelling's initial purchase price. The figure assumes the purchase price of a home is $100,000, and that a year later housing prices in the area are expected to vary within a range of plus or minus 10 percent of today's price. The impact on the homeowner's net worth depends on the size of the mortgage. With no mortgage, a +/-10 percent change in the dwelling's price translates into a +/-10 percent change in the owner's equity. With a mortgage of 50 percent of purchase price, this range doubles to +/-20 percent. With a mortgage of 80 percent of purchase price, the +/-$10,000 in the home's value becomes +/-50 percent of the owner's initial $20,000 in equity.

Implications for Rate Regulation

Nearly half a century of financial research on the effects of capital structure on the value of the firm 7 and the resulting literature have explored the effects of risk, corporate taxes, personal taxes, financial distress, the signals companies send investors through the ways they raise capital, and possible divergences of interests between managers and shareholders. We believe it is fair to say that no single theory has emerged as "the answer" to how capital structure affects the value of a firm.

Empirical as well as theoretical research has been done. For most industries, modest amounts of debt appear to add some value to the firm. However, companies display a wide range of intra-industry capital structures, and the most profitable firms in an industry tend to use the least debt, a finding that holds internationally as well as in the United States. The most profitable firms are the ones that could make best use of the corporate tax shields that interest expense provides, 8 and presumably these firms tend to be the best managed (why else are they the most profitable?). The fact that these firms do not use more debt implies that the corporate tax advantage of debt must be offset by other