Utility Mergers and the Cost of Capital

Much work has been done on the impact of mergers and acquisitions on the shareholders of both acquiring and target firms (see Asquith et al. [1983], Bradley et al.[1988], Jarrell and Poulsen [1989], Jensen and Ruback [1983], and Travlos [1987]). Those studies generally indicate favorable stock price responses for target firms, and slight, to no, stock price response for acquiring firms. Recent interest has been focussed on utility mergers and impacts on share prices, with similar conclusions obtained (see Bartunek et al.[1993], Ray and Thompson [1990]). Bartunek et al found that acquirers experience wealth losses, while targets experience gains, and that the results are not as favorable as for either as compared with non-utility acquisitions. Ray and Thompson examined four electric utility mergers and found that three of them exhibited positive wealth gains for both acquirer and target shareholders. There are two significant differences in mergers between non-utility firms and mergers between utility firms. First, utility mergers are subjected to a much a higher level of regulatory scrutiny, at both the state and federal levels. Second, merger-induced efficiency gains and/or cost savings are generally passed on to customers rather than retained by shareholders (see Bartunek et al. [1993], Ray and Thompson [1990], Norris [1990], Studness [1989], and Studness [1996] for discussion of these two points). Because of this second point it is not surprising that utility shareholders do not gain as much as non-utility shareholders. Additionally, utility shareholders lose flexibility in terms of their portfolio allocations between the two pre-merger utility stocks, and have, in essence, forced portfolio allocations, based on the relative sizes of the two utility companies. This can result in an increase in the cost of equity, and cost of capital, of the merged utility, which in a regulated environment is ultimately flowed through to the customers (see Bonbright et al. [1988] and Morin [1994] for a discussion of cost of capital methods employed by regulators). Thus, in utility mergers, although there may be significant gains in operating efficiencies and cost savings inuring to the benefit of customers, consideration should be made of the offsetting increase in the cost of capital, which ratepayers ultimately pay for. This paper considers two different models for examining the theoretical increase in the merged utility’s cost of capital because of the loss in portfolio allocation flexibility. This is done from the perspective of a hypothetical investor with appropriate portfolio efficiency frontiers and risk-return indifference curves. In Section II, we consider a model (Model 1) where the portfolio consists of just two utility stocks. Section III examines a model (Model 2) where one of the utility stocks is not included in the pre-merger portfolio. In both models it is demonstrated that the utility merger will increase the merged utility’s cost of equity.