Cost-of-capital competition: The art of leverage

Finance students have long studied theories on the weighted average cost of capital. In the most traditional of these, introducing debt leverage into a firm's capital structure initially reduced the borrower's over-all cost of capital. This was due to the deductibility of interest on debt versus the higher nontax-shielded cost of capital for new equity or retained earnings. This article examines whether independent power producers (IPP) have a financial advantage due to their increased leverage compared to conventional utilities. If any cost-of-capital advantage for IPPs does exist, it may be temporary. It is possible that as unforeseen problems emerge in this maturing industry, the business risk will be perceived as greater, and the cost of money and level of required equity will increase. The bottom line is that cost of capital is a function of current market perceptions of risk, is temporary and changeable, and hence should not be a basis for long-term legislative or regulatory decisions. A simple weighted average cost-of-capital comparison based on the debt/equity capital structure of a project and a utility does not produce an accurate or reasonable comparison and cannot be used to show that IPPs have an [open quotes]unfair advantage[close quotes] based on increasedmore » amount of lower-cost debt. It is clear that (1) simple weighted average cost-of-capital models don't work, (2) other variables are involved in the [open quotes]real[close quotes] cost-of-capital determination, making it more difficult to draw any obvious conclusion, and (3) acceptable debt leveraging varies with time and is subject to the demands of a changing market, which continuously affects relative capital costs. Thus, it is not easy to see that because of their increased balance-sheet leverage, IPPs have an unfair advantage over utilities in the competition to see who can produce power more efficiently.« less