Diversification, double leverage, and the cost of capital

Public utility regulators choose between ‘double leverage’ and ‘independent company’ approaches to determine the cost of equity capital for electric utility holding companies that have diversified and telephone holding companies that have diversified and issued parent debt. Dissimilarities between these two approaches result in significant differences in cost of capital estimates, in allowed rates of return, and in prices of utility services. No valid support for the ‘double leverage’ approach is found after an analysis of descriptive examples and a general theoretical examination of the two approaches compared against established goals of rate of return regulation. The ‘independent company’ approach is shown to be universally correct. The authors suggest, therefore, that only the ‘independent company’ approach should be employed in rate of return cases of regulated public utilities whose parents own subsidiaries with unequal risk and/or whose parent has its own debt.