FIRM SUBJECT TO REGULATION WITH A LAG

has recently come to play an increasingly important role in the economic literature. One area where an intertemporal structure is especially important is in constructing a generalized model of firm valuation, financing and investment. The purpose of this paper is to construct such a model for a firm subject to regulation with a lag. This work constitutes an extension of an earlier paper [7] in which the impact of regulation which was continuously and instantaneously enforced was analyzed. The framework adopted is that of a dynamic set of continuous time activities. Modigliani and Miller's [17] definition of the value of stockholder wealth is assumed to hold at each moment in time. Investment opportunities are taken as exogenously determined. Given a criterion of maximizing the wealth of initial stockholders and given a generalized investment schedule, we derive optimal rates of capital accumulation, rates of earnings growth, and time paths of dividends and external equity sales. Differences in the optimum time path of these variables will be examined for the firm subject to a regulatory constraint that is enforced with a lag. The results for this firm will be compared to the unregulated firm and the regulated firm subject to continuous enforcement of the allowed rate of return. While some of the results in this paper are consistent with the Averich Johnson literature, important differences do exist. In addition, by starting with a financial model of the firm (as opposed to a production model) we have been able to analyze the impact of regulation on optimal capital budgeting criteria and financing patterns. The use of a financial model allows the derivation of optimum cut-off rates for new investment, allows the analysis of the impact of these cutoff rates on the division of profit opportunities between owners and customers, and finally permits an analysis of the impact of regulatory parameters on the market value of the firm. All of this is possible in financial models and could not be done in the production model used in the Averich Johnson literature.