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FOR FCC RECORD ONLY
$//MO&O, Tele-Media of Western Connecticut, DA 96-96//$
$/76.922 Rates for Cable Programming Service Tiers/$
$/76.924 Cost Accounting and Cost Allocation Requirements/$
     Before the
                     FEDERAL COMMUNICATIONS COMMISSION
                          Washington, D.C. 20554
     DA 96-96
In the Matter of                 )
                )
Tele-Media Company    )
of Western Connecticut           )    (CUID No.CT0001 (Derby)
     )          CT0002 (Ansonia)
Cost of Service Showing to Support     )          CT0003 (Seymour)
Cable Programming Service Rate   )     CT0060 (Shelton)
                                 )     CT0061 (Naugatuck)
                                                              )          CT0062 (Oxford)
     )          CT0063 (Beacon Falls)
     )          CT0096 (Bethany)
     MEMORANDUM OPINION AND ORDER
Adopted:  January 26, 1996                    Released:  February 26, 1996
By the Chief, Cable Services Bureau:
I.  INTRODUCTION
     1.  Tele-Media Corporation ("Tele-Media") was incorporated in 1970.  Tele-Media
subsequently acquired its Western Connecticut system in 1990.  The Western Connecticut provides
11 channels on its cable programming services ("CPS") tier 1 and 15 channels on its CPS tier 2
system.  There are approximately 41,502 subscribers on the CPS tier 1 and approximately 21,982
subscribers on its CPS tier 2.
     2.  On November 8, 1993, Tele-Media filed a cost of service submission with the Federal
Communications Commission ("Commission") in response to complaints alleging that Tele-Media's
CPS rates in the communities in its Western Connecticut system are unreasonable.  Tele-Media
supplemented its filing on July 12, 1994 and August 16,1994.  On February 20, 1995, October 18,
1995, and December 8, 1995, in response to Commission staff's request for additional information,
Tele-Media submitted supplemental and amended data relating to its cost of service filing.
     3.  On December 1, 1993, the Attorney General of the State of Connecticut filed a Reply to
Tele-Media's cost of service filing.  The Attorney General states that Tele-Media is a monopoly and
rates of cable monopolists which do not pass the competitive benchmark test should be reviewed on
the same basis as are the rates of other monopolistic utility companies.  In opposing Tele-Media's
inclusion of intangibles for rate recognition, the Attorney General contends that a review of cable
rates under a cost of service analysis is the exception not the rule and, therefore, the process must
closely adhere to traditional ratemaking principles.  Otherwise, the Attorney General argues, the
exception would eliminate the rule as cable operators presented "imaginative" cost of service
showings as Tele-Media has done in this proceeding to justify their excessive rates and charges.
     4.  Tele-Media's cost of service filing seeks to establish that its monthly CPS rates of $6.60
and $9.00 for CPS tier 1 and CPS tier 2, respectively, for the period September 1, 1993 through May
14, 1994, is justified based on Tele-Media's cost of providing CPS.  Our review of the record
indicates that Tele-Media's monthly CPS rates in effect for the referenced time period are cost
justified under general cost of service principles and the Commission's rules.
     5.  Pursuant to the Commission's rules, cable operators are required to make showings on a
franchise-level basis.  The purpose of the rule is to assign costs (both investment and expenses) and
revenues accurately to the regulated services offered by the cable operator, so that the Commission
can ensure that rates charged for such services are just and reasonable.  Tele-Media has submitted a
single cost of service filing for its integrated cable system in Connecticut, which includes the
communities of Derby (CUID No. CT0001), Ansonia (CUID No. CT0002), Seymour (CUID No.
CT0003), Shelton (CUID No. CT0060), Naugatuck (CUID No. CT0061), Oxford (CUID No.
CT0062), and Beacon Falls (CUID No. CT0063).  The record indicates that these franchises are
served through the same cable system, the same rates are charged for cable services and associated
equipment in all seven areas, and the same channel line-ups are offered.  Therefore, we will, on our
own motion, waive the applicability of Section 76.924(e)(1) and permit the single filing.  The
characteristics peculiar to Tele-Media's filing distinguish it from filings where the applicability of
Section 76.924(e)(1) would be more appropriate and will not compromise our determination of cost-
based rates in this proceeding.
     6.  We emphasize that in this review process, pursuant to the Cable Television Consumer
Protection and Competition Act of 1992 (the "1992 Cable Act"), we are analyzing rates for a limited
past period to ensure that rates charged were not unreasonable, and if so, to determine the associated
refund liability.  In reviewing and evaluating this filing, we are applying general cost of service
principles with Commission rules and guidance that were available at the time these filings were
made.
II.  BACKGROUND
     7.  On May 3, 1993, the Commission released its Rate Order establishing rules to implement
the cable television rate regulation provisions of the 1992 Cable Act.  In the Rate Order, the
Commission determined that a benchmark and price cap approach should serve as the primary
method for regulating basic service and CPS rates.  The Commission also concluded that because the
benchmark methodology might not produce fully compensatory rates in all cases, it was appropriate
to permit operators, as an alternative, to justify rates based on costs, using individual cost of service
showings.  The cost of service approach was intended to be used only if an operator believed that
the maximum rate permitted under the benchmark formula would not enable the operator to recover
costs reasonably incurred in providing rate regulated cable services.  Under traditional cost of service
regulation, rates are set at a level to provide a company with recovery of its costs and a reasonable
opportunity to earn a fair return on its invested capital.
     8.  The Commission found, however, that the record before it at the time of the adoption of
the Rate Order did not provide sufficient information on which to develop detailed cost of service
rules for the cable industry.  Therefore, on July 16, 1993, the Commission issued a Notice of
Proposed Rulemaking which proposed requirements to govern cost of service showings submitted by
cable operators seeking to justify rates higher than those determined under the benchmark approach.
The Commission indicated in the Notice, as it did in the Rate Order, that general cost of service
principles would apply to cost of service filings submitted prior to the adoption of specific rules.
Tele-Media's cost of service filing under review in this proceeding was submitted during that pre-
adoption time period and covers only the period prior to May 14, 1994.  We are analyzing the rates
in effect for the period prior to May 15, 1994 under general cost of service principles, not under the
rules we adopted in February 1994.
III.  DISCUSSION
     9.  We have analyzed Tele-Media's cost of service submission consistent with our cost of
service approach discussed above.  If we found that a certain rate base or expense element was not
supported, was excessive, or was unrelated to providing regulated cable service, we have disallowed
that cost in whole or in part.  We have evaluated rate base and expense items to determine whether
Tele-Media should be permitted to recover those items in its rates.  In some cases, we have found
costs that are not allowable, and we have made appropriate adjustments.  We have also adjusted the
rate of return to be authorized during this period, as discussed below.  Even with our adjustments and
disallowances, however, we find that Tele-Media's monthly rates $6.60 for CPS tier 1 and $9.00 for
CPS tier 2 for the period under review have been justified.
     A.  Test Year
     10.  Determining a regulated company's cost of service involves the selection of an
appropriate test year.  The test year measures a company's operating experience during a twelve-
month period and is the basis for determining representative levels of revenues, expenses, and rate
base and capital structure.  The test year is one of the fundamental concepts upon which a
determination as to a company's revenue requirement and the reasonableness of its rates is based.  In
its cost of service submission Tele-Media selected a test year that consisted of data for the twelve
months of calendar year 1993.  We conclude that this test year appropriate for determining the
reasonableness of the CPS rates which Tele-Media charged during the period under consideration.
The test year is a time period sufficiently close to the period of time at issue in Tele-Media's cost of
service showing for which actual data is available and reasonably represents the Tele-Media's cost of
providing cable service.
     B.  Rate Base
     11.  Rate base represents the amount of used and useful investment the cable company
prudently makes in its facilities to provide service to its customers.  Under traditional cost of
service principles, it is necessary to determine the allowable rate base both to calculate the return
component of the revenue requirement and to compute the earned rate of return.  In analyzing Tele-
Media's filing, we have reviewed the components of the Tele-Media's rate base to determine the
investment upon which Tele-Media is entitled to earn a return.  For purposes of this review, we have
made adjustments to the rate base as discussed below.
     12.  Asset Valuation:  Tele-Media argues that the acquisition cost of its cable plant and
related equipment should be used to determine the value of its tangible assets for ratemaking
purposes.  Tele-Media asserts that the books and records of the original builder/owner of the cable
system and any subsequent owners are not available to Tele-Media and, therefore, it is impossible to
accurately recreate the value of the system based upon original cost.  Tele-Media also asserts that to
use an original cost methodology, in the case of an acquired system which has been bought and sold
over the years, could effectively render the cable system valueless as of the date of the acquisition
and prohibit the cable operator from ever earning a return on its investment.
     13.  Tele-Media also asserts that intangible assets that it proposes for inclusion in its rate base
for rate recognition are legitimate business assets that it acquired.  Tele-Media asserts that it
purchased this system in an arms-length transaction, in consideration of numerous factors including
the growth potential of the area.  Tele-Media states that to exclude any intangibles in excess of any
adjustments it has already made for intangibles would cause a substantial hardship to Tele-Media.
Tele-Media asserts that the rates that would result if only Commission-presumed intangibles were
allowed would not support the operation of its cable operations and would eventually force the
system out of business.
     14.  We continue to believe that original cost is a reliable and fair measure of the value of
tangible assets.  However, we recognize that when a cable system acquires another cable system, the
assets are valued in accordance with Accounting Principles Board Opinion No. 16 under the
"purchase" method.  The essential feature of the purchase method as it relates to acquired rate base
assets is that they are recorded on the acquiring company's books at the acquiring company's costs.
Thus, in many instances, companies may not have records concerning the original cost of their
acquired systems since in the unregulated environment in which the systems were acquired there was
no reason to record original cost data for newly-acquired assets.  We conclude that Tele-Media has
presented sufficient probative evidence to demonstrate that it does not have records of original cost
for its Western Connecticut system.  Therefore, we will not require Tele-Media to present original
cost data in this proceeding but, instead, will allow Tele-Media to use the acquisition cost of the
Western Connecticut system to determine the reasonableness of its rates in this proceeding.
     15.  However, as we recognized in the Notice, the use of any valuation method other than
original cost significantly increases the likelihood that the value of the rate base of an acquired
system includes amounts paid in excess of the original cost of the system which reflect an
expectation of monopoly profits in what was, at the time, an unregulated environment.  Therefore,
the Commission tentatively concluded that its goal for cost-based rates would be best achieved by the
exclusion of excess acquisition costs from the rate base.  However, we conclude that Tele-Media
has presented sufficient probative evidence to demonstrate that some intangible costs which it has
included in its cost of service filing do represent reasonable costs of providing service that should be
included in its rate base for determining the reasonableness of its rates.
     16.  In developing a methodology to exclude that portion of intangibles that represents
premiums paid for a system in expectation of monopoly profits, we recognize that the anticipated
cash flow from a system is one of the primary considerations for a potential purchaser.  The industry
typically defines cash flow, which can be readily derived from the financial statements of a company,
as the result of subtracting operating expenses, excluding depreciation and amortization, from
operating revenues.  We believe that it is possible to calculate with substantial confidence, through
the evaluation of Tele-Media's cash flow figures, the asset values of the components (both tangible
assets and intangible assets) of the acquired system for ratemaking adjustments.  We believe that this
methodology is consistent with general cost of service principles and the goal of ensuring that Tele-
Media subscribers pay reasonable rates.
     17.  The methodology that we are using in this proceeding, pursuant to which 34% of the
purchase price of a system is presumed to be attributable to the expectation of monopoly profits in an
unregulated environment, presents the best balancing of the concerns discussed in the Notice.  For
explanatory purposes, assume a cable operator with an expectation of monopoly profits buys a system
for $1,000, based on a system valuation of ten times cash flow.  This means that the operator
anticipates an annual cash flow of $100 and annual revenues of $200 based on an assumption of a
2:1 ratio between revenues and cash flow.  According to the Commission's benchmark survey, 17%
of annual revenues reflects a system's monopoly revenues.  Thus, in our example, $34 of the $200
would be deemed to reflect the operator's monopoly revenues.  Therefore, because expenses should
remain the same before and after rate regulation and since it is assumed that monopoly revenues
would flow straight to cash flow, $34, or 34% of the operator's $100 annual cash flow would be
comprised of monopoly revenues.  Under this methodology the 34% adjustment must be applied to
the entire purchase price, both tangible assets and intangible assets, because cable operators derive
revenues, including monopoly revenues, from the employment of  both categories of assets.  Thus,
had there been effective competition, the system would be expected to generate only $66 in annual
cash flow.  If, as we have assumed in the example, the acquisition price is ten times cash flow, then
it can be concluded that the system would have been purchased for $660 in a competitive
environment, not the $1,000 paid based on its monopoly status.  Therefore, $340 of the actual
purchase price, or 34% is attributable to monopoly expectations.  Applying this methodology to Tele-
Media's rate base in this proceeding results in a disallowance of $33,900,160.
     C.  Operating Expenses
     18.  Cable operators may recover in rates their reasonable operating expenses normally
associated with providing rate regulated cable services.  Operating expenses incurred by the cable
operator could be expected to include plant specific costs (e.g., maintenance), plant non-specific costs
(e.g., programming expense, engineering and testing), customer operations (e.g., marketing, billing
and collection), and corporate operations (e.g., legal, planning, accounting and finance).  Our review
of Tele-Media's expenses under general cost of service principles and Commission rules results in the
adjustments discussed below.
     19.  Allocations:  The Commission's rules in effect at the time of  Tele-Media's filing
required that cable operators generally aggregate expenses and revenues at either the franchise,
system, regional, or company level in a manner consistent with the practices of the operator as of
April 3, 1993.  The Commission also established cost allocation requirements.  Costs aggregated at
a higher level are to be allocated to the franchise level proportional to the number of subscribers in
the franchise area, and the costs are to be allocated between tiers proportional to the number of
channels on each tier.  Tele-Media allocated operating expenses and rate base costs based on a
weighted average of channels and subscribers per tier to determine a weighted average channel count
per tier.   Tele-Media has not presented sufficient probative evidence in this proceeding to support
the use of its allocation  method for costs between tiers.  Therefore, in our review and analysis of
Tele-Media's rates in effect for the period under review we have reallocated these operating expenses
on the basis of the channel factor allocator.
     20.  Revenue and Income Adjustments:  Under general cost of service principles, the expenses
incurred by a company are offset against the revenues it receives.  Therefore, advertising revenues
received by Tele-Media from QVC and Home Shopping Network should be offset against its
operating expenses and assigned to the tier from which those revenues were derived.  This results in
a total reduction to the revenue requirement on the two CPS tiers of $295,000.
     D. Rate of Return
     21.  A regulated entity is entitled to the opportunity to earn a fair return on investment.
That return should be sufficient to ensure confidence in the financial integrity of the enterprise, but
should be balanced against our interest in protecting a company's subscribers from paying excessive
rates. In the Rate Order, the Commission stated that it would make a case-by-case determination of
reasonableness for submissions made before specific cost rules were adopted.  In order to make a
determination of a reasonable rate of return for an operator, the Commission stated that it would
evaluate the operator's capital structure, cost of debt, and cost of equity, among other factors.
     22.  In the Notice, released several weeks before the submission date of Tele-Media's cost of
service filing, the Commission discussed its analysis of rate of return generally, and tentatively
concluded that an after tax, overall rate of return in the range of 10% to 14% would reflect a
reasonable balancing of subscriber and cable interests.  The Commission reached its tentative
conclusion based on a summary analysis of the cost of equity and the capital structure of regulated
cable services.  The Commission examined the risk premium between the yield on public "Aa"
rated bonds and the estimated cost of equity for the Standard & Poor's 400 companies (S&P 400).
The Commission specifically found that:
     [i]f we use the S&P 400, or a subgroup of S&P 400 companies, as the primary
     surrogate for determining an appropriate cost of equity of regulated cable service, we
     tentatively conclude that the cost of equity will be in the range of 12-17%.  This, in
     turn, assuming a debt/equity ratio of 50%, would lead to a rate of return for regulated
     cable service of between approximately 10 to 12.4%. Given market changes in the cost
     of debt and equity, we tentatively conclude that a rate of return somewhere in the
     range of 10% to 14%, after taxes, would reflect a reasonable balancing of subscriber
     and cable operator interests and that we would select a final rate of return within this
     range to achieve our balancing of goals for cost-based rates for cable services.
Thus, as a general approach for the evaluation of refund liability from cost of service submissions
filed before the effective date of the interim cost of service rules, we find it appropriate and
reasonable to use the range established in the Notice for our analysis.
     23.  The Rate Order postulated a case by case determination of reasonableness regarding the
rate of return.  Tele-Media's cost of service submission claims an allowable pre-tax rate of return of
15.27%.  While Tele-Media contends that the overall rate of return which it proposes in this
proceeding is necessary to meet its capital obligations," it does not assert any particulars of capital
structure, cost of equity, or cost of debt that would justify a pre-tax rate of return of 15.27% in this
proceeding.  Therefore, Tele-Media has not sustained its burden of proving that a 15.27% rate of
return is reasonable.  In the Cost Order, which was issued shortly after Tele-Media had filed its cost
of service showing, the Commission adopted a presumptive unitary rate of return of 11.25% for
regulated cable operations.  Under the circumstances, we have no reason to believe that an 11.25%
rate of return would be unreasonable in this context.  The period of time for which the 11.25% rate
of return was calculated is sufficiently close to the period of time at issue in Tele-Media's cost of
service showing and we believe that the methodology used in arriving at a presumptive rate of
return of 11.25% is reasonable, and would be reasonable in this context as well.  Moreover, no one
has suggested that the appropriate rate of return should be any lower than 11.25%.  Even if we
found that Tele-Media was only allowed to earn a rate of return of 11.25% during the test year
rather than the 15.27% (which is higher than the after-tax 11.25%) claimed by Tele-Media, we
would find that its CPS rates are reasonable, and no refund is due.
IV.  CONCLUSION
     24.  Based on our review of Tele-Media's cost of service filing and supplemental
information, applying general cost of service principles and applicable cost allocation rules, we find
that, as discussed above, Tele-Media has justified the monthly CPS rate of $6.60 and $9.00 for CPS
tier 1 and CPS tier 2, respectively, which it charged for the period September 1,1993, through May
14, 1994.
     25.  Accordingly, IT IS ORDERED, pursuant to  0.321 of the Commission's rules, 47
C.F.R.  0.321, that the monthly CPS rates of $6.60 and $9.00 for CPS tier 1 and CPS tier 2,
respectively, charged by Tele-Media with respect to the above-referenced communities, for the
period September 1, 1993, through May 14, 1994, IS JUSTIFIED, and that no refund liability for
the CPS  tiers will be imposed.
     26.  IT IS FURTHER ORDERED that, pursuant to Section 0.321 of the Commission's rules,
47 C.F.R. Section 0.321, that the complaints against the monthly CPS rates of $6.60 and $9.00 for
CPS tier 1 and CPS tier 2, respectively, charged by Tele-Media Corporation with respect to the
above-referenced CUID numbers, for the period September 1, 1993, through May 14, 1994, ARE
DENIED.
                         FEDERAL COMMUNICATIONS COMMISSION
                         Meredith J. Jones
                         Chief, Cable Services Bureau