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The Rental Cost of Sunk and Regulated Capital

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  • John P. Small

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  • Henry Ergas

    ()

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    Abstract

    Standard approaches to estimating the cost of capital are vulnerable to two errors when applied to sunk assets subject to economic regulation. First, investors in sunk assets usually have a valuable ability to delay commitment which is therefore an opportunity cost of investment. Second, economic regulation alters the distribution of returns to capital, and may do so in a way that eliminates profit potential but leaves some risk of losses. This paper studies the impact of, and the interaction between, these effects. A fundamental connection is established between the value of the real option to delay investment, the risk of losses under regulation and the rate of economic depreciation. A practical benefit of this analysis is that existing empirical methods for estimating real options can now be used to estimate the size of the "investment incentive margin" that regulated firms should be allowed.

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    File URL: http://www.uvic.ca/socialsciences/economics/assets/docs/econometrics/ewp9908.pdf
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    Bibliographic Info

    Paper provided by Department of Economics, University of Victoria in its series Econometrics Working Papers with number 9908.

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    Length: 25 pages
    Date of creation: 24 Jun 1999
    Date of revision:
    Handle: RePEc:vic:vicewp:9908

    Note: ISSN 1485-6441
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    Keywords: cost of capital; depreciation; return to capital;

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    1. Pratt, John W & Zeckhauser, Richard J, 1996. "Willingness to Pay and the Distribution of Risk and Wealth," Journal of Political Economy, University of Chicago Press, vol. 104(4), pages 747-63, August.
    2. Andrew B. Abel & Avinash K. Dixit & Janice B. Eberly & Robert S. Pindyck, . "Options, the Value of Capital, and Investment," Rodney L. White Center for Financial Research Working Papers 15-95, Wharton School Rodney L. White Center for Financial Research.
    3. John P. Small, 1999. "The Timing and Scale of Investment Under Uncertainty," Econometrics Working Papers 9906, Department of Economics, University of Victoria.
    4. Pindyck, Robert, 1989. "Irreversibility, uncertainty, and investment," Policy Research Working Paper Series 294, The World Bank.
    5. McDonald, Robert & Siegel, Daniel, 1986. "The Value of Waiting to Invest," The Quarterly Journal of Economics, MIT Press, vol. 101(4), pages 707-27, November.
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