COST OF CAPITAL AND FAIR RATE OF RETURN*

Abstract

THERE has been in the postwar period a widespread acceptance of the cost of capital technique for the determination of the rate of return to public utilities. However, there has also developed in this period a serious controversy which concerns the proper relationship between the cost of capital and the rate of return to be allowed to public utility companies in periods characterized by substantial changes in the of money. In Part I of this work the cost of capital approach to the rate of return has been analyzed and evaluated. Part II studied the issues in the current controversy. The cost of capital is the weighted percentage cost of the various components in the utility's capitalization. The historical or experienced cost of capital is the appropriate measure for the cost of debt and preferred stock capital. Computation of the current cost of debt and preferred stock capital is relevant only in those instances where the company applying for a rate change anticipates the issuance of debt and preferred stock securities in the relatively near future. A trend of recent earnings-price ratios is the most satisfactory measure of the cost of equity capital. In periods marked by rapid expansion, greater reliance may be placed on earnings-issue price ratios as indicative of the current cost of common stock capital. In the period 1946 through 1953 the rate of return allowed to public utility companies has been geared closely to the cost of capital. The cost-of-money approach, however, cannot account for realized inflation but merely to some extent for anticipated inflation. Only minor differences exist between the cost of capital to utilities in original cost states and the cost to companies in fair value or reproduction cost states. This method, therefore, results in economic expropriation or the reduction in real of the property of investors in original cost jurisdictions. Plans to prevent further economic confiscation are limited to consideration of the equity investors. Public utility commissions cannot change the nature of contractual obligations. Public utility rate control is viewed by the Supreme Court as a