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On the CAPM Approach to the Estimation of A Public Utility's Cost of Equity Capital

On the CAPM Approach to the Estimation of A Public Utility's Cost of Equity Capital On the CAPM Approach to the Estimation of A Public Utility’s 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 utility’s 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 http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png The Journal of Finance Wiley

On the CAPM Approach to the Estimation of A Public Utility's Cost of Equity Capital

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References (40)

Publisher
Wiley
Copyright
1980 The American Finance Association
ISSN
0022-1082
eISSN
1540-6261
DOI
10.1111/j.1540-6261.1980.tb02166.x
Publisher site
See Article on Publisher Site

Abstract

On the CAPM Approach to the Estimation of A Public Utility’s 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 utility’s 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

Journal

The Journal of FinanceWiley

Published: May 1, 1980

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