Cost of Equity Uncertainty and Rate of Return Regulation: Implications of New Developments in Financial Economics

Abstract

Estimation of a corporation's cost of equity is crucial for various financial analyses. One area in which it is necessary is in rate of return regulation. In order for the regulator to set an appropriate rate of return, the corporation's cost of equity must be estimated accurately. This article examines the two most common methods used to estimate the cost of equity: the discounted dividend model and the capital asset pricing model. Recent developments in financial economics make traditional applications of these methods suspect. These developments are the use of share repurchases, and a prospective equity risk premium much lower than historic values suggest. The uncertainty described here, in combination with previously known sources of uncertainty, suggest that increased scrutiny of cost of equity estimates is warranted. Also, the ongoing search for improved models of the cost of equity should continue.