Target Leverage and Cost of Capital in the Electricity Sector: Implications for Valuation and Public Policy

Abstract

This paper examines the factors that influence the target capital structure of electricity firms and proposes a protocol for estimating and applying target leverage in the sector. The target capital structure is crucial to the weighted average cost of capital (WACC), which impacts firm valuation, capital budgeting, and regulatory policies, thereby balancing investor returns with consumer tariffs. While prior energy finance literature has focused on the cost of equity, capital structure has often been overlooked. I aim to address this gap by introducing a protocol for estimating target leverage, relevant for calculating regulatory WACC and firm-level valuations. Although my focus is on the Brazilian electricity market, the methodology can be applied internationally. I find that electricity firms tend to align their leverage with a target level, and I discuss the implications of my protocol for regulatory WACC and corporate valuation.

JEL Classification: G31, Capital Budgeting; Fixed Investment and Inventory Studies; Capacity; G32, Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill; G38, Corporate Finance and Governance: Government Policy and Regulation