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The Rental Cost of Sunk and Regulated Capital

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  • John P. Small
  • Henry Ergas

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.

Suggested Citation

  • John P. Small & Henry Ergas, 1999. "The Rental Cost of Sunk and Regulated Capital," Econometrics Working Papers 9908, Department of Economics, University of Victoria.
    • Handle: RePEc:vic:vicewp:9908
    Note: ISSN 1485-6441
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    File URL: https://www.uvic.ca/socialsciences/economics/_assets/docs/econometrics/ewp9908.pdf
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    References listed on IDEAS

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    1. Andrew B. Abel & Avinash K. Dixit & Janice B. Eberly & Robert S. Pindyck, "undated". "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.
    2. Pindyck, Robert S, 1991. "Irreversibility, Uncertainty, and Investment," Journal of Economic Literature, American Economic Association, vol. 29(3), pages 1110-1148, September.
    3. Avinash K. Dixit & Robert S. Pindyck, 1994. "Investment under Uncertainty," Economics Books, Princeton University Press, edition 1, number 5474.
    4. Robert McDonald & Daniel Siegel, 1986. "The Value of Waiting to Invest," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 101(4), pages 707-727.
    5. John P. Small, 1999. "The Timing and Scale of Investment Under Uncertainty," Econometrics Working Papers 9906, Department of Economics, University of Victoria.
    6. Andrew B. Abel & Avinash K. Dixit & Janice C. Eberly & Robert S. Pindyck, 1996. "Options, the Value of Capital, and Investment," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 111(3), pages 753-777.
    7. 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 747-763, August.
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    Cited by:

    1. repec:vuw:vuwscr:19098 is not listed on IDEAS
    2. de Braganca, Gabriel Fiuza & Rocha, Katia & Moreira, Rafael Henrique Rodrigues, 2008. "Real Options and the Regulation of Brazilian Fixed-Line Telephone Operators: The Mark-up on the Cost of Capital," Working Paper Series 3997, Victoria University of Wellington, The New Zealand Institute for the Study of Competition and Regulation.
    3. de Braganca, Gabriel Fiuza & Rocha, Katia & Moreira, Rafael Henrique Rodrigues, 2008. "Real Options and the Regulation of Brazilian Fixed-Line Telephone Operators: The Mark-up on the Cost of Capital," Working Paper Series 19098, Victoria University of Wellington, The New Zealand Institute for the Study of Competition and Regulation.
    4. Franklin, Sergio Luis & Diallo, Madiagne, 2013. "Real options and cost-based access pricing: Model and methodology," Telecommunications Policy, Elsevier, vol. 37(4), pages 321-333.

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    More about this item

    Keywords

    cost of capital; depreciation; return to capital;
    All these keywords.

    JEL classification:

    • D21 - Microeconomics - - Production and Organizations - - - Firm Behavior: Theory
    • D92 - Microeconomics - - Micro-Based Behavioral Economics - - - Intertemporal Firm Choice, Investment, Capacity, and Financing

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