Investment and Rate of Return for the Regulated Firm

The subject of this paper is a public utility's optimal dynamic response to the rate of return allowed by a regulatory commission. The problem is formulated in terms of the firm's capital-budgeting policy, and a dynamic analysis is made using modern control theory. This permits the utility's financial policies to be related directly to (a) the way the capital market values the utility and (b) the restriction on earnings imposed by rate-of-return regulation. The solution to the resulting nonlinear control problem provides a quantitative basis for analyzing the impact that small changes in the rate of return have on market valuation and the firm's investment policy. The results furnish one measure of what is commonly called "capital attraction capability," or the firm's ability to attract investment capital in a competitive capital market, and display the relation between that capability and the allowed rate of return.