Step 2: Calculate the appropriate cost of capital

  • The third and final core component of the revenue requirement is calculating the cost of capital, or the allowed rate of return. This is expressed as a percentage and essentially represents the amount of return that investors will receive on their investment, the rate base.

  • Setting the allowed rate of return requires balancing two equally important objectives:
    • incentivizing continued investment in the power sector; and
    • ensuring that customers pay just and reasonable rates.

  • Thus, the challenge in specifying the allowed rate of return is anticipating the return investors require for contributing capital to the utility. Paying less than this required return puts the utility at risk of being unable to attract capital. Paying more than this required return imposes a charge on customers with no corresponding benefit.

  • The predominant method for setting the allowed rate of return is to use the utility’s weighted average cost of capital (“WACC”). The WACC is often based on deemed values for the capital structure and the cost of debt and equity. Although in theory the amount of debt in the capital structure should make no difference to the WACC, as more debt means greater risk to debt holders who thus would charge more to lend to the company, in practice debt is normally less expensive than equity. Typically, utilities can be deemed to have as much as 60% debt in their capital structure, given the generally stable revenue streams they garner. While the WACC is based on an assumed capital structure, the company is free to have more or less debt based on what it feels is optimal. However, rates to customers do not change if the company chooses a different capital structure.
WACC = [ D x RD ] + [ ( 1 - D ) x RE ]
the ratio of debt to assets
the post-tax cost of debt
the cost of equity
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