The Rental Cost of Sunk and Regulated Capital

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 pro...t potential but leaves some risk of losses. This paper studies the impact of, and the interaction between, these e¤ects. 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 bene...t 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 ...rms should be allowed. * The authors are grateful to Jerry Bowman and John Panzar, with whom some of the ideas in this paper were ...rst discussed. Small also thanks David Giles and the University of Victoria for their hospitality while this was being written. Address for Correspondence: John P. Small, Department of Economics, University of Auckland, Private Bag 92019, Auckland, New Zealand. email: [email protected]