The Irrelevance of Compounding Frequency in Determining a Utility's Cost of Equity

The relevance of the frequency of compounding in utility rate regulation is often misunderstood. Increasingly, analysts have advocated that the allowed return on equity capital should be the quarterly or continuously compounded equivalent of the market determined annual rate of return estimate emerging from a discounted cash flow (DCF) analysis. Of course, restating an annual rate of return in terms of its quarterly or continuously compounded equivalent creates a lower return measure. If this lower return were applied to an unchanged rate base, the resulting estimates of the utility's earnings and revenue requirements would also be lower. However, the use of a quarterly or continuously compounded rate will not alter the estimate of a utility's annual earnings requirement as long as it is implemented with a rate base construct that is consistent with quarterly or continuous compounding. That is, regardless of the frequency of compounding, the allowed rate of return and, hence, service rates must be set at levels that are expected to generate the quarterly dividends and growth in investment (share price) requ red by investors. Linke-Zumwalt [1] and Siegel [2] have explored the effect on capital cost estimation when recognition is given to the fact that firms commonly pay dividends quarterly but change the dividend amount only periodically. Both articles demonstrated that the market return estimate based on quarterly dividends is higher than