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AN ANALYSIS OF REGULATED RATES OF RETURN FOR WHOLLY OWNED SUBSIDIARIES
Author(s) -
Ezzell John R.,
Hsu H. Christine,
Miles James A.
Publication year - 1991
Publication title -
journal of financial research
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.319
H-Index - 49
eISSN - 1475-6803
pISSN - 0270-2592
DOI - 10.1111/j.1475-6803.1991.tb00654.x
Subject(s) - subsidiary , valuation (finance) , shareholder , rate of return , economics , business , capital structure , leverage (statistics) , debt , equity (law) , finance , microeconomics , monetary economics , financial economics , multinational corporation , corporate governance , mathematics , statistics , political science , law
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.