Enrique Arzac

Flotation Cost Allowance in Rate of Return Regulation: A Note

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Abstract:
The cost of external equity capital is higher than the investor-required rate of return because of flotation costs (underwriting expenses and underpricing). Recognizing this, regulatory agencies have generally included an allowance for flotation costs in the authorized cost of capital. The adjustment for flotation costs can have a significant effect on the firm and its consumers. For example, a change of 0.5 percent in the required return on equity of the entire Bell System would change its before-tax annual revenue requirements by about $400 million.1 In spite of its significance, flotation cost adjustments are usually made in an ad hoc fashion. In this paper we derive a flotation cost adjustment formula which is consistent with accepted principles of share valuation and the available empirical evidence on the nature of flotation costs. Our formula yields the adjustment to the utility's allowed return on equity which maintains unimpaired the value of the dividend stream corresponding to pre-issue stockholders. It depends on easily estimable parameters characterizing the financial policy of the utility and the magnitude of flotation costs. We also show the relationship between the results of this paper and Gordon's approach to valuation. Gordon seems to be the only author who previously considered the problem of equity valuation under continuous equity financing and flotation costs, but he did not derive a flotation cost adjustment formula.

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