Rate‐of‐Return Regulation and Utility Capital Structure Decisions

Abstract

A CORPORATION'S capital structure is a means for partitioning its return stream among different classes of securityholders and across different states of nature. The primary thrust of capital structure theory has been to determine whether and how this partitioning affects the total value of the firm.1 For a firm subject to rate-of-return regulation, however, the capital structure decision may take on an additional dimension. Under such regulation, the firm's output price is set by an outside agency so as to yield a fair return to providers of capital, and, if effective, this process reduces monopoly profits. But if the regulator's price-setting rule depends on the firm's capital structure in some predictable way, the firm may be able to influence price and hence reap additional profits by judiciously choosing its financing mix. The purpose of this paper is to analyze possible effects of a regulated firm's capital structure and to illustrate regulators' attempts to combat them. The determinants of a regulated firm's capital structure have been touched upon in previous papers (Gordon [8], Elton and Gruber [5], Gordon and McCallum [9], Jaffe and Mandelker [11], Meyer [14] and Sherman [24], for example), but that issue has not been their primary concern. The present paper differs from those mentioned above by focusing its attention more directly on the capital structure decision. This issue is of interest in its own right in view of the important position occupied by regulated firms' securities in the capital market, but the approach taken here also serves to highlight and extend some common threads in the previous papers. In particular the results of these papers emerge as straightforward applications of the price-influence principle, and differences among them can be attributed to differing perceptions of the regulator's pricesetting behavior. Section I of the paper discusses the price-influence principle in general terms and describes the circumstances under which it will alter a regulated firm's financing choice. Section II presents three illustrations of how the general principle might work in practice, depending on the price-setting behavior of the regulatory agency. Section III discusses regulators' attempts to thwart the priceinfluence effect, and conclusions are drawn in Section IV.