Rate of return inequity

Journal Article · Fri Apr 15 04:00:00 EDT 1994 · Fortnightly; (United States)

OSTI ID:7199595

Cargill, T F; Wendel, J

Utility stock and bond prices will be increasingly sensitive to differences between allowed rates of return and market rates for comparable investments. Allowed rates of return on equity (ROE) are traditionally set at a level commensurate with the returns on alternative investments of comparable risk. This focus on financial market conditions is becoming increasingly important as deregulation and market innovations increase competition among alternate financial instruments. Accurate estimates of the market rate are essential if the utility is to compete for investment capital. The discounted cash flow (DCF) model provides one widely used approach for estimating the market-determined rate of return. Jurisdictions using the model prefer the annual version, which assumes that the utility pays only one annual dividend. This assumption, however, reduces the accuracy of the estimate for utilities that pay quarterly dividends. Indeed, using an annual model to approximate the DCF model for a firm that pays quarterly dividends consistently and significantly underestimates the market rate of return. Despite the importance of such understatement, only two states permit a quarterly version of the DCF model: Illinois and Nevada. This article highlights the effect of financial reform and deregulation on the process for determining the allowed ROE, explains the relevance of annual and quarterly dividends for the DCF model, and discusses in nontechnical terms two methods for adjusting the DCF model to account for quarterly dividend payments.

• OSTI ID: 7199595
• Journal Information: Fortnightly; (United States), Journal Name: Fortnightly; (United States) Vol. 132:8; ISSN FRTNE8
• Country of Publication: United States
• Language: English

Related Subjects

32 ENERGY CONSERVATION, CONSUMPTION, AND UTILIZATION
320603* -- Energy Conservation
Consumption
& Utilization-- Municipalities & Community Systems-- Public Utilities-- (1980-)
ACCOUNTING
FINANCING
MATHEMATICAL MODELS
PUBLIC UTILITIES