The capital structure of a firm under rate of return regulation: durability and the yield curve

Abstract

I present a generalized dynamic model of firm behavior under rate of return regulation. The modeled firm has access to multiple types of capital which are substitutes (imperfect or perfect) in production. These capital inputs are differentiated based on durability and heterogeneous marginal effects on the firm’s total cost of capital. This approach is kept general but is motivated by the stylized shape of the bond yield curve, wherein high-durability (longer lived) assets command a higher required return on investment (higher bond yield). The results indicate that a regulated firm (relative to an unregulated firm) will over or under-invest in specific assets depending on their durability and the size of the assets’ marginal effects on the cost of capital relative to the regulated rate of return. Two specific sources of distortion in the capital structure are identified. The “yield curve” effect pushes the firm further (relative to the unconstrained case) towards assets with a low marginal contribution to the cost of capital, thus reducing the firm’s average cost of capital. The “duration” effect pushes the firm towards longer lived assets as a means to inflate the steady state capital stock. This is similar to (yet distinct from) the classic Averch and Johnson (Am Econ Rev 52(5):1052–1069, 1962) result.