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In: The journal of financial research: the journal of the Southern Finance Association and the Southwestern Finance Association, Volume 6, Issue 1, p. 25-31
ISSN: 1475-6803
In: The quarterly review of economics and finance, Volume 41, Issue 1, p. 33-47
ISSN: 1062-9769
In: The journal of hospitality financial management: publ. on behalf of the Association of Hospitality Financial Management Education, Volume 1, Issue 1, p. 15-24
ISSN: 2152-2790
In: The journal of business, Volume 68, Issue 2, p. 231
ISSN: 1537-5374
In: The journal of financial research: the journal of the Southern Finance Association and the Southwestern Finance Association, Volume 14, Issue 2, p. 167-179
ISSN: 1475-6803
AbstractTwo 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.