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On the CAPM Approach to the Estimation of A Public Utilityâs Cost of Equity Capital ROBERT LITZENBERGER, KRISHNA RAMASWAMY and HOWARD SOSIN* I. Introduction IN RECENT YEARS the Capital Asset Pricing Model (CAPM) has been used in several public utility rate cases to measure the cost of equity capital. In actual application, the cost of equity capital is frequently estimated as the annualized 90 day Treasury Bl rate plus a risk premium. The risk premium is obtained as the il product of the average annual excess rate of return on a value weighted index of NYSE stocks (where the average is taken over a long period of time) and an estimate of the utilityâs NYSE beta. Underlying this procedure is the assumption that risk premiums are strictly proportional to NYSE betas. However, this assumption is inconsistent with the academic empirical literature on CAPM. This literature supports a (non-proportional) linear relationship between risk premiums and NYSE betas with a positive intercept. Other empirical studies suggest that, in addition to betas, risk premiums are influenced by dividend yields and systematic skewness. Evidence presented in this literature is consistent with the predictions of CAPM models that account for margin restrictions on
The Journal of Finance – Wiley
Published: May 1, 1980
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