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Cost of Common Equity, Allowed Fair Return, and Behavioral Finance

Cost of Common Equity, Allowed Fair Return, and Behavioral Finance. Professors J. Robert Malko and Austin Kwag Jon M Huntsman School of Business Utah State University Logan, Utah SURFA: Fortieth Financial Forum Georgetown University, Washington, DC April 10-11, 2008. OUTLINE.

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Cost of Common Equity, Allowed Fair Return, and Behavioral Finance

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  1. Cost of Common Equity, Allowed Fair Return, and Behavioral Finance Professors J. Robert Malko and Austin Kwag Jon M Huntsman School of Business Utah State University Logan, Utah SURFA: Fortieth Financial Forum Georgetown University, Washington, DC April 10-11, 2008

  2. OUTLINE • Three Approaches for Estimating or Determining the Allowed Return on Common Equity • Roger A. Morin’s Approach • J. Robert Malko’s Approach • Steven G. Kihm’s Approach

  3. OUTLINE • Behavioral Finance and the Allowed Return on Common Equity • Selected Major Insights • Selected Implications for ROE • Future Directions

  4. Three Approaches for Estimating or Determining the Allowed Return on Common Equity

  5. Roger Morin’s Approach • Cost of Capital = Required Rate of Return • Supply Side: Opportunity Cost • Demand Side: Stock Price • Allowed Rate of Return = The Cost of Capital • Apply Multiple Cost of Equity Methods and Judgment Roger Morin; New Regulatory Finance, Public Utilities Reports, 2006.

  6. Malko’s Approach • Apply Multiple Mathematical Cost of Equity Models to establish a Zone of Reasonableness • Need for a Regulatory Commission to apply its Judgment and consider Public Policy Objectives and Implications of its ROE Determination • Longer-Term Market Needs • Limited Incentives J. Robert Malko, et al., The Electricity Journal, June 2007, pp. 56-61.

  7. Kihm’s Approach • Energy Center of Wisconsin (608-238-4601) • Cost of Equity Models • Provide Minimum Return (8% or 9%) • Minimum Speed Limit • Substitute for Workable or Imperfect Competition Steven G Kihm, The Electricity Journal, December 2007, pp. 26-34.

  8. Kihm’s Approach • Need for a Regulatory Commission to use Judgment to make adjustments to determine a fair return on common equity Steven G Kihm, The Electricity Journal, December 2007, pp. 26-34.

  9. Behavioral Finance and the Allowed Return on Common Equity

  10. Selected Major Insights • Some financial phenomena can be better understood using models or methods in which financial agents are not fully rational • Selected Biases • Excessive optimism in Public Sector Projects • Estimating the Market Risk Premium • Gambler’s Fallacy

  11. Selected Implications for ROE • Multi-Factor Risk Premium Models (Economic Perspective) • Adjustments to Cost of Common Equity Models (Behavior Perspective)

  12. Future Directions

  13. Future Directions • Explicit Regulatory Objectives and Clear Adjustments to Determine ROE • Applying Multi-Factor RP Models • Insights from Behavioral Finance and Reasonable Adjustments

  14. Thank You Questions?

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