Computing the long-run incremental cost of capital intensive goods

Abstract

This paper develops the financial framework underlying the calculation of the appropriate discount rate for evaluating capital intensive projects and a methodology for determining fixed charge rates using the weighted average cost of capital. This allows for the decomposition of the fixed charge rate into specific fixed expenses such as depreciation, interest, equity returns, and income and property taxes. Because most energy models use constant dollar costs, accounting for inflation is very important. It is shown that inflation initially has a small impact on required capitalization rates. However, inflation causes economically efficient prices, ie prices based on marginal costs, to produce insufficient revenues to meet the revenue requirement.