The effect of flotation costs and brokerage fees on the cost of common equity of public utilities

Flotation costs incurred to externally raise common equity cause utility investment funds to be less than the amount of investor contributions, thereby increasing their cost of common equity. Regulated utilities obtain compensation for flotation costs through an adjustment to their allowed rate of return on common equity. However, the proper method of flotation cost compensation is a subject of controversy. It has been argued in this publication, and in various regulatory arenas, that flotation cost adjustment methods for the discounted cash flow (DCF) model overestimate the cost of common equity if the stock price is not adjusted to reflect brokerage fees incurred by the investor. This paper presents a critical analysis of this argument as formalized by David S. Habr in an article published in the NRRI Quarterly Bulletin. This analysis demonstrates that Habr`s conclusions are incorrect and his model is inappropriate for determining a utility`s flotation cost adjustment. Adjusting a utility`s allowed return on equity to reflect the brokerage fees paid by investors will underestimate the utility`s true cost of common equity.