On the Use of the CAPM in Public Utility Rate Cases: Comment Author(s): Richard W.

McEnally Reviewed work(s): Source: Financial Management, Vol. 7, No. 3 (Autumn, 1978), pp. 69-70 Published by: Wiley on behalf of the Financial Management Association International Stable URL: http://www.jstor.org/stable/3665015 . Accessed: 08/02/2013 07:25
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On Public

the

Use

of

the

CAPM
Cases:

in
Comment

Utility

Rate

Richard W. McEnally
Richard W. McEnally is Professor of Finance at the University of North Carolina at Chapel Hill.

In a recent article in Financial Management -

"On the Use of the CAPM in Public Utility Rate Cases" - Eugene Brighamand Roy Crum express reservationabout using the CAPM because, they risk claim,"anincreasein a company's systematic can beta coefficient"[2, p. 7]. actuallylowerits calculated I have no real quarrelwith their logical argument, whichin its essencedependson the stock of the company in questionexperiencing price declines during are periodswhengeneralmarketreturns abovethe expectation. However, the examples they adduce to show that the problemis "more than hypothetical" are anotherstory. Their first illustrationsrelate to some recent and well-known cases of financialdistress- W. T. Grant, FranklinNational, Penn Central,and the REITs. At the sametime thingsweregoingfrombadto worsefor these firms and their stock prices were collapsing, their measuredbetas actuallydeclined.To Brigham and Crum,this resultis clearlyincompatible with the whichaccompanied fallthe "risingrisk perceptions" ing stock prices. It seemsto me that the difficultyhereis a failureto distinguishbetween systematic(or nondiversifiable)

risk. Obviously and nonsystematic(or diversifiable) in of the probability loss frominvestment theseenterwas high. But it is extremelydifficultto argue prises was that the outcomeof suchan investment dependent in any seriousway upongeneralmarketor economywide developments.The survivalor non-survival of these firms largelyinvolvedproblemspeculiarto the individualfirm. Therefore,it boggles my mind (as Brighamand Crumput it) not at all that a portfolio managermight think he was reducinghis portfolio's
risk by making some judicious investment in these stocks - providing he had even an elementary un-

derstanding of portfolio diversificationprinciples. Whateverthe outlook for these stocks' returnsmay have been, they were not likely to have been highly
correlated with the returns of the general market.

Incidentally,none of these examplesaccordsvery well with Brigham Crum'shypothesized and sourceof

downward bias in betas. It is a matter of a moment to confirm that, for each of the examples they present, the stock price declines occurred contemporaneously with large declines in the standard market indexes - a condition which by their logic should have produced upward-biased betas.

1978 FinancialManagement Association

69

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70

1978 FINANCIALMANAGEMENT/AUTUMN

Brigham and Crum's second and more significant set of examples concerns the telephone and electric utilities. After reciting a veritable rate witnesses' catalogue of factors that purportedly increased the utilities' fundamental risks vis-a-vis the market in the years 1965-1975, they observe that their betas were essentially unchanged over this period. Now it would be easy enough to assert once again that the difficulty is confusion of diversifiable and nondiversifiable risk, and in fact I see few if any systematic risk factors in Brigham and Crum's list. However, I would like to suggest a somewhat different explanation. Those of us who were present in 1965 will recall that utility stocks then had something of a growth image that had largely disappeared by 1975. In an excellent demonstration, Boquist, Racette, and Schlarbaum [1] have shown that the beta of a common stock should be directly related to its duration in the sense that Macaulay defined it [3], and moreover that a stock's duration should vary directly with its anticipated growth rate. Applying this to the utilities, the declining growth rate expectations might well have reduced their durations, ceteris paribus, thereby having a dampening effect on their real (rather than measured) betas. We should also remind ourselves that a stable beta does not imply a constant level of absolute risk or required return. The stable betas of the utilities over the

years 1965-1975 simply mean that any changes in their systematic risk paced changes in the risk of the market. Casual observation suggests that the risk premium on common stocks in the aggregate rose over this period, an occurrence which would tend to raise the required return on any stock with a beta not equal to zero - including the utilities. In conclusion, let me observe that the position of apparent defenders of the faith is easily misunderstood. I share the doubts Brigham and Crum express about the proposition that only systematic risk is "relevant" and thus their ultimate concern about exclusive reliance on the CAPM in regulatory proceedings.

References
1. John A. Boquist, George A. Racette, and Gary G.

"Duration Risk Assessments Bonds and for Schlarbaum, and Common Stocks,"Journalof Finance (December 1975),pp. 1360-65. 2. EugeneF. Brigham and Roy L. Crum,"OnThe Use of The CAPM in Public Utility Rate Cases, Financial Management (Summer1977),pp. 7-15. 3. FrederickR. Macaulay, Some TheoreticalProblems Suggestedby The Movementsof InterestRates, Bond Yieldsand Stock Pricesin the UnitedStates since 1856, New York, National Bureau of Economic Research, 1938

ANNOUNCING

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The Journal of Financial Research is the official joint publication of the Southern Finance Association and the Southwestern Finance Association. Its editorial policy interprets "financial research" to include financial management, investments, financial institutions, capital market theory, and portfolio theory. However, certain boundaries concerning preferred subject matter have been established. Financial decision-making and policy-making are emphasized at the level of the individual unit of operation, as opposed to monetary economics or public policy. This limitation in scope is not intended to discourage using research results to infer market characteristics. As an example, the Journal shall focus upon the financial management of financial institutions in contrast to an analysis centering upon macro-financial variables. Moreover, contributions that purport to illustrate the application of a management science technique or quantitative tool must be more than remotely connected with finance to be publishable. The Journal will be published three times a year, with the first issue expected in November 1978. In addition to articles resulting from submissions to the editors, competitive papers will be refereed and selected from meetings of both the Southwestern Finance Association and the Southern Finance Association. Manuscripts and communications for the editors and business correspondence should be addressed to the Journal of Financial Research, College of Business Administration, P.O. Box 4320, Texas Tech University,
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