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Risk Sharing, the Cost of Equity and the Optimal Capital Structure of the Regulated Firm

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  • Clive J Stones
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    Abstract

    This paper considers the relationship between the regulator's pricing decision and the allocation of risk between consumers and shareholders. Consumers are willing to trade-off price variations against a lower expected price. Prices are higher in adverse economic conditions but shareholder returns are not necessarily lower. It might be optimal to insure shareholders against market risk to achieve a lower expected price. The socially optimal capital structure depends on consumers' and shareholders' attitudes to risk. There is only one very special set of conditions where the social optimum is 100% debt finance with the firm operating ona 'not-for-profit' basis.

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    File URL: http://www.york.ac.uk/media/economics/documents/discussionpapers/2005/0531.pdf
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    Paper provided by Department of Economics, University of York in its series Discussion Papers with number 05/31.

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    Handle: RePEc:yor:yorken:05/31

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    Keywords: Regulation; gearing; leverage; debt finance; equity finance.;

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    1. Dasgupta, Sudipto & Nanda, Vikram, 1993. "Bargaining and brinkmanship : Capital structure choice by regulated firms," International Journal of Industrial Organization, Elsevier, vol. 11(4), pages 475-497.
    2. Spiegel, Yossef, 1994. "The Capital Structure and Investment of Regulated Firms under Alternative Regulatory Regimes," Journal of Regulatory Economics, Springer, vol. 6(3), pages 297-319, September.
    3. Gianni De Fraja & Clive Stones, 2004. "Risk and Capital Structure in the Regulated Firm," Journal of Regulatory Economics, Springer, vol. 26(1), pages 69-84, 07.
    4. Yossef Spiegel & Daniel F. Spulber, 1997. "Capital Structure with Countervailing Incentives," RAND Journal of Economics, The RAND Corporation, vol. 28(1), pages 1-24, Spring.
    5. Cowan, Simon, 2004. "Optimal risk allocation for regulated monopolies and consumers," Journal of Public Economics, Elsevier, vol. 88(1-2), pages 285-303, January.
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