The cost of capital for regulated firms

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					The cost of capital for regulated firms

Alternative asset pricing models

Tim Giles, Vice President at Charles River Associates, London (TGiles@crai.co.uk).


Abstract

The cost of capital represents the opportunity cost that an investor incurs as a result of
investing capital in a firm or
project. In the context of regulation, regulated prices typically include an element that is
intended to compensate
investors for this cost. Underestimation of the cost of capital by regulators risks
underinvestment and slow exit from
essential industries. The evidence presented here, based on a Fama-French (1993) multi-factor
model, suggests that the
use of the single-factor Capital Asset Pricing Model (CAPM) by regulators may be creating a
substantial bias against
many firm, including those in the telecoms sector. Mis-estimation using the single-factor
CAPM may be substantial (from
+100% to ‑50%). Further research into multi-factor Consumption-CAPM models (C-
CAPM) in general and the
Fama-French (1993) model in particular is required to confirm any bias. However, the
evidence to date - particularly in
the mobile telecoms sector - substantially undermines the case for continuing to rely on the
single-factor CAPM.