Comment on Regulation and the Term of the Risk Free Rate: Implications of Corporate Debt

Abstract

Lally (2007) concludes that regulators must estimate the risk‐free rate as the yield‐tomaturity on Government debt with a term‐tomaturity equal to the regulatory period, to ensure that the present value of expected cash flows equals the investment base. The analytics behind this conclusion assume that forward rates are an unbiased estimate of future spot rates, an assumption which is inconsistent with empirical evidence. This has an important economic implication. With the typical case being that the yield curve is upward‐sloping, adopting a short‐term risk‐free rate would result in equityholders being systematically undercompensated for the actual risk involved in a long‐lived project. If we adopt an alternative assumption that current rates are an unbiased estimate of future rates, the regulated rate of return is a function of the entire forward curve of interest rates and the accounting depreciation schedule. For long‐lived assets, benchmarking against the yield‐to‐maturity on long‐dated Government securities results in a far closer approximation of the appropriate return than the use of short‐term rates.

Citation

Hall, J. (2007), "Comment on Regulation and the Term of the Risk Free Rate: Implications of Corporate Debt", Accounting Research Journal, Vol. 20 No. 2, pp. 81-86. https://doi.org/10.1108/10309610780000692