AN ANALYSIS OF REGULATED RATES OF RETURN FOR WHOLLY OWNED SUBSIDIARIES

John R. Ezzell, H. Christine Hsu, James A. Miles

Research output: Contribution to journalArticle

Abstract

Two methods are used by public utility regulators to set the allowed rate of return to a wholly owned subsidiary: the “independent firm” approach and the “double leverage” approach. Neither approach is consistent with any existing theory of firm valuation. The contribution of this paper is to derive from standard valuation theory a “divisional cost of capital” specification of the allowed rate of return to a wholly owned subsidiary. On the basis of this specification it is shown that the independent firm approach allows shareholders to capture the value created by the interest tax savings on parent debt. It is also reconfirmed that the double leverage approach induces cross‐subsidization since it allows each subsidiary to earn the same rate of return on equity regardless of the level of risk specific to the subsidiary.

Original languageEnglish (US)
Pages (from-to)167-179
Number of pages13
JournalJournal of Financial Research
Volume14
Issue number2
DOIs
StatePublished - Jan 1 1991

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All Science Journal Classification (ASJC) codes

  • Accounting
  • Finance

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