On the Use of the CAPM in Public Utility Rate Cases: Comment

Abstract

* In a recent issue of Financial Management, Professors Eugene Brigham and Roy Crum called for caution when using the Capital Asset Pricing Model (CAPM) to estimate the cost of equity capital of a regulated utility [2]. While it is hard tp question the wisdom of caution in using any method of cost of capital estimation, it is unfair to single out the CAPM method as a biased mechanism for estimating a utility's fair rate of return. This note shows that, had Brigham and Crum (B-C) heeded their own caveat and cautiously reviewed the basics of the CAPM, they could not have made such a strong indictment of this model. A thorough analysis of beta and other indispensable aspects of the CAPM framework provides the analyst or regulator with proper signals that make it possible to detect changes in a stock's fundamental risk and the accompanying changes in the cost of equity capital. Any method that attempts to account rigorously for risk and return can be misleading if the analyst is not aware of potential biases. CAPM estimates are no exception. Although recent studies by Vasicek [8] and Klemkosky and Martin [4] show that expected bias in