Howard E. Thompson

An Analysis of Some Aspects of Regulatory Risk and the Required Rate of Return for Public Utilities

This paper uses a modification of the continuous time asset pricing model of Cox, Ingersoll, and Ross to analyze the effect of regulatory risk on the cost of capital. Analysis shows that random errors in setting the allowed rate of return can either increase or decrease the cost of capital depending on other regulatory parameters. However, the analysis suggests that regulatory risk is not material.

Insurance Exposure and Investment Risks: An Analysis Using Chance-Constrained Programming

By exposing itself to greater risks on the invested funds, the company can also increase its expected returns. Because there are risks involved with both the insurance and investment operations, a major problem for a company is to determine just how the two types of risks are to be balanced. This paper formulates the premium-volume/investment-mix problem for nonlife-insurance companies as a chance-constrained programming problem. A number of numerical examples of the model were run to assess the effects of investment risks, insurance risks, and the willingness of the company to tolerate risks. The paper derives the conclusion that risks in both investment possibilities and insurance portfolios are compensated for, to a large extent, by varying the growth rate of premiums, in addition to shifts in portfolio makeup. The two problems-growth and portfolio selection-cannot and should not be separated. The paper shows that the traditional rules of thumb-e.g., if the premium-surplus ratio is high, the common-stock portion of the investment portfolio should be low-are somewhat ambiguous and not borne out by the numerical examples.

REVISITING “DIVIDEND YIELD PLUS GROWTH” AND ITS APPLICATION

ABSTRACT In this paper we extend Thompsons [17] work using time series models within the discounted cash flow framework to estimate the cost of equity capita] for a firm. In particular we do the following: First, we prove the existence and uniqueness of a solution for the cost of equity capital. Secondly, we verify that the cost of equity function is continuously differentiable and derive the formula for its reliability. Formulas for both the cost and its reliability are in terms of infinite sums or infinite dimension matrices. Thirdly, we derive estimators of the cost of equity capital and its reliability which are in terms of finite sums and easy to calculate. We show that these estimated converge to the cost of equity capital and its reliability. Finally, our procedure for estimation applies to a wide variety of time series models that may be used to forecast dividends.

“Fifty in five”: The prospects for merger in the electric utility industry

By analyzing four case studies of merger attempts between electric utilities, we conclude that there are not strong incentives for a wave of combinations in the industry. Potential synergy gains do not provide a strong motivation since they are likely already being captured through joint ventures and coordination agreements. Those that still exist would most likely be distributed to rate payers by regulatory decisions. Managerial incentives of the bidder are countered by the desire of target management to remain independent. Potential gains to the financial community from a wave of mergers are large, but the regulatory process provides a dampening of this otherwise strong incentive.

Growth and Risk

Fewings [5] and Myers and Turnbull [13] have arrived at diametrically conflicting conclusions regarding the effect of growth on risk as measured by beta, the relative systematic risk in the Sharpe-Lintner-Mossin (SLM) capital asset pricing model. Fewings states his result in an unequivocal way: “…systematic capitalization risk of common stocks is undoubtedly a positive function of the rate of growth of expected corporate earnings†([5, p. 53]) Myers and Turnbull, on the other hand, state their result in a more conditional form, making the result depend on the nature of market expectations revisions but conclude that “increasing the growth rate decreases B …†([13], P. 327).

The impact of jump risks on nominal interest rates and foreign exchange rates

This article investigates the relationship between the nominal interest rate and inflation and also the forward exchange rate under a general specification of the underlying processes govering the foreign exchange rate. There are three distinct risks that affect the relation between the real rate of interest and the nominal rate namely, consumption risk, diffusion risk, and the existence of jump risks of inflation. Jump risks lower the nominal interest rate because of jump hedging of a nominal bond. The forward exchange rate depends on the expected depreciation of the domestic currency as well as these three risks. As the domestic jump risks increase, the domestic nominal interest rate decreases and the forward exchange rate decreases.

The Economic Life of an Investment and the Appropriate Discount Rate

Recently, the appropriateness of the weighted average cost of capital for making decisions on capital structure and the selection of projects has been seriously questioned. Arditti [1] showed that when project lives were finite, the weighted average cost of capital was not appropriate for valuing the firm. Beranek [2] demonstrates that when the objective is shareholder wealth maximization, the appropriate discount rate for capital budgeting decisions for finite lived projects n > 1 is not the traditional weighted average cost of capital.

Valuing Debt in a Complex Capital Structure

This article extends previous bond valuation models to account for more realistic assumptions regarding financial distress. Realized value of an individual bond under severe financial distress will reflect the expected outcome of credit-event negotiations and the relative priority listing of the security. We explicitly represent the probability rate of credit-event occurrence as a function of firm value relative to the fixed overall debt obligations of the firm. Risk premiums generated under reasonable parameter value choices fall within the range of observed bond risk premiums. Our model also provides an explanation as to why observed bond risk premia are positive after adjustment for default.

Comparison of alternative models for estimating the cost of equity capital for electric utilities

Abstract In this article five models used to estimate the cost of equity capital for electric utilities are systematically compared. We show the impact of model specification, data definitions, and estimation techniques on the estimates. Our search for the “best” model is based on reasonableness of estimates and the Pesaran-Deaton test for non-nested hypotheses. Conclusions emerging from the study are the following: 1) all models explain approximately the same proportion of the variation; 2) recognition of natural nonlinearities in the models does not lead to improvement; 3) no model can consistently reject the other models.

A Financial Model of Investment, With an Application to the Paper Industry

The purpose of this study was to develop a model of investment behaviour in manufacturing industiries to discriminate the effect and that of the cost of capital. Starting from the neoclasical framework this model relaxed the assumption of contrast cost of capital and improved the description of effect of taxes. It also replaced the traditional partial adjustments process by an improved model of expecttations. The model was tested on the paper industry, It explained well investment,capacity,and prices from 1964–83,and less well the financing of investments.Simualtions using the model showed that demand shifts were the most important determinants of investment in the paper industry.