The cost of capital is the rate of return that investors require to invest in a firm.
Elements of the cost of capital
Investment can be funded with equity capital and / or debt capital. Therefore the cost of capital is a weighted average of the returns on equity and on debt.
The weights represent the relative importance of equity and debt in the regulated firm’s capital structure.
The regulated firm and the cost of capital
Where a regulator sets prices (for businesses with market power), the regulator typically has to specify 'an allowed cost of capital or rate of return on capital'.
What happens if the cost of capital is set too high/too low?
If the cost of capital is set too high for a regulated firm then profits will be higher than required to ensure appropriate investment occurs and final prices to customers will be too high.
If the cost of capital is set too low investors in the regulated firm may be attracted to other investment opportunities and investment in the regulated firm can decline.
The QCA has reviewed its cost of capital methodology for regulated businesses.
As part of this review, the QCA released discussion papers covering various aspects of the cost of capital for public comment. The QCA has released decision papers on the cost of capital related to:
- market parameters – risk-free rate, market risk premium and gamma
- benchmark cost of debt estimation methodology
- trailing average cost of debt.