DILUTION COSTS, UNDERINVESTMENT, AND UTILITY REGULATION UNDER ASYMMETRIC INFORMATION

This article addresses the problem faced by a regulated natural monopo list who must raise outside funds to finance socially desirable projec ts. We demonstrate that ''fair rate of return'' utility price regulati on will lead to underinvestment incentives in the presence of asymmetr ic information between the firm and the capital markets regarding the firm's assets and future costs. This problem is especially severe when financing choice is restricted to equity. Underinvestment can be eith er completely eliminated by adjusting the allowed rate of return above the fair rate or reduced by switching to debt finance.