Paul Grout and Anna Zalewska*
*Limburg Institute of Financial Economics, University of Maastricht
Circularity arises in regulation if the value of a company's assets used to set prices is itself determined by future earning capacity. The view that it is not possible to determine values and prices in these circumstances has become well established in the literature. In this paper we formalise this precise circularity result. We then show that if there is a possibility of future review and the regulator makes symmetric errors in estimating the cost of capital (known to the company) then almost all valuations involve undervaluation of the assets of the privatised company.
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