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Measuring Return on Equity Correctly

Why current estimation models set allowed ROE too low.

Fortnightly Magazine - August 2005

of equity at the different capital structures. Failure to take these differences into account is likely to lead to allowed rates of return on equity that are materially below the costs of equity that utility shareholders actually require.


  1. Recall that the CAPM estimates the cost of capital as the sum of (1) the risk-free interest rate plus (2) the product of the stock’s beta and the market risk premium. If the long-term risk-free rate is set at 5 percent, the market risk premium at 6.5 percent, and the beta at 0.6, the result is 8.9 percent. (Recall also that beta measures the sensitivity of the stock’s returns to the market’s returns, and that the average beta is 1.0, indicating an average-risk stock.)
  2. For example, a 5 percent value for the long-term risk-free rate, a market risk premium 
    of 5.5 percent, and a beta of 0.5 produce a CAPM cost-of-equity estimate of 7.8 percent. Use of a short-term interest rate, although uncommon in rate regulation, currently would produce even lower estimates for the cost of equity.
  3. Recall that the basic DCF method estimates the cost of equity as the sum of (1) the forecasted dividend yield plus (2) the growth rate.
  4. See, for example, Fischer Black, Michael C. Jensen and Myron Scholes, “The Capital Asset Pricing Model: Some Empirical Tests,” in M. Jensen (ed.) Studies in the Theory of Capital Markets, New York: Praeger (1972) 79-121; Eugene F. Fama and James D. MacBeth, “Risk, Returns and Equilibrium: Empirical Tests,” Journal of Political Economy 81 (1973), 607-636; and Robert H. Litzenberger, Krishna Ramaswamy and Howard Sosin, “On the CAPM Approach to Estimation of 
    a Public Utility’s Cost of Equity Capital,” The Journal of Finance 35 (1980) 369-387.
  5. Countries such as Australia, the United Kingdom, and New Zealand have implemented rate regulation much more recently than Canada or the United States. Their procedures, developed with the advantage of access to modern financial research, focus primarily on the overall market cost of capital rather than the separate costs of debt and equity. This approach avoids the problems raised in this article.
  6. At excessive debt levels, debt starts to bear risks ordinarily borne by equity. We ignore this possibility for now, but recognize it in the next section.
  7. The modern literature begins with Modigliani and Miller, “The Cost of Capital, Corporation Finance and the Theory of Investment,” American Economic Review, 
    48: 261-297 June 1958). Hundreds of papers have explored the theoretical and empirical aspects of the issue since that time.
  8. One advantage of debt is that it reduces corporate taxes on operating income, an advantage offset to a degree by the higher personal taxes on interest versus capital gains (and currently, dividends).
  9. See, for example, Brealey and Myers,  Principles of Corporate Finance , New York: McGraw-Hill/Irwin, 7th ed. (2003), Chapter 19. The after-tax weighted-average cost of capital is applied to the all-equity cash flows generated by the firm or project.
  10. The decline in firm or project value at high debt ratios is due to a combination of increases in the weighted-average cost of capital and other costs. In