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⭐Cost of Capital for Mobile, Fixed Line and Broadcasting Price Controls Report for ComReg
Cost of Capital for Mobile, Fixed Line and Broadcasting Price Controls Report for ComReg
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Collin Norton
1 Error! No text of specified style in document. Cost of Capital for Mobile, Fixed Line and Broadcasting Price Controls Report for ComReg April2 Europe Economics is registered in England No Registered offices at Chancery House, Chancery Lane, London WC2A 1QU. Whilst every effort has been made to ensure the accuracy of the information/material contained in this report, Europe Economics assumes no responsibility for and gives no guarantees, undertakings or warranties concerning the accuracy, completeness or up to date nature of the information/analysis provided in the report and does not accept any liability whatsoever arising from any errors or omissions Europe Economics. All rights reserved. Except for the quotation of short passages for the purpose of criticism or review, no part may be used or reproduced without permission.3 Contents 1 Executive Summary Theoretical Approach Generic Parameters in the WACC-CAPM Approach Specific Parameters in the WACC-CAPM Approach Mobile WACC Fixed Line WACC Broadcasting WACC Introduction Theoretical Approach The Regulatory Cost of Capital The WACC-CAPM Approach Use of CAPM and Alternatives Other Issues regarding the WACC Generic Parameters in the WACC-CAPM Model Total Market Returns and the Economic Cycle Risk-Free Rate The Equity Risk Premium Taxation Conclusion on Generic Parameters Specific Parameters in the WACC-CAPM Model Gearing Equity Beta Debt Premium Aiming Up Mobile WACC Gearing Equity Beta Debt Premium BEREC Member Survey on MTR WACC Overall WACC for a Hypothetical Efficient Mobile Operator Fixed Line WACC Gearing Equity Beta Debt Premium Overall WACC for a Hypothetical Efficient Fixed Line Operator Broadcasting WACC... 744 8.1 The WACC in Market A and Market B The Viability of Commercial DTT Services Regulatory Approaches to Broadcasting Gearing Debt Premium Equity Beta Overall WACC for a Hypothetical Efficient Broadcaster... 845 Executive Summary 1 Executive Summary Europe Economics has estimated the cost of capital in three telecommunications markets on behalf of the Commission for Communications Regulation (ComReg). The WACCs that we estimate are for a hypothetical efficient operators in their respective markets. These markets are: The market for wholesale mobile call termination and the rate charged for that service (the mobile termination rate, or MTR ). This is the WACC for a hypothetical efficient mobile operator. Fixed-line telephony. This WACC is estimated with reference to an Irish fixed-line operator with an efficient capital structure, notwithstanding Eircom s recent Examinership and the company s distorted capital structure. This is the WACC for a hypothetical efficient fixed line operator. Access to digital terrestrial television (DTT) transmission assets ( Broadcasting Market A, in which 2rn, a wholly-owned subsidiary of RTÉ, operates) and the DTT multiplex ( Broadcasting Market B in which RTÉ operates). Although these are separate markets, we do not find strong arguments for assigning different WACC values between these two markets. We therefore estimate the WACC for a hypothetical efficient broadcaster, which is the appropriate cost of capital for each of these markets. We estimate forward-looking WACCs for these three markets covering a three to five year period from 2014/ Theoretical Approach Our approach uses the weighted average cost of capital-capital assets pricing model (WACC-CAPM) approach. This is in view of an assessment of the relative merits of using the WACC-CAPM approach over using the dividend growth model, residual income model, Fama-French three factor model, or the third moment CAPM approach. We estimate the WACC on a pre-tax nominal basis, consistent with ComReg s regulatory approach. 1.2 Generic Parameters in the WACC-CAPM Approach We view total market returns to be more stable than their component parts, which are the risk-free rate and the equity risk premium (ERP). Real total market returns have been relatively stable in Irish regulatory determinations compared with the risk-free rate and the ERP, and have decreased from around 8.5 per cent in the early 2000s to a post-crisis level of around 7 per cent. We argue that the Eurozone is a single capital market. Capital market conditions in Ireland continue to improve, and government borrowing costs in particular have come down markedly since their highs during the Irish sovereign debt crisis. Nevertheless, investors continue to demand a premium for Irish government debt relative to other Eurozone sovereigns. Given a single Eurozone capital market and the recent premium attached to Irish government debt, we argue that the German government bond is the appropriate asset to use in an assessment of an Irish and Eurozone risk-free rate. However, with low to negative real yields on government bonds, interpreting government bond yields as the risk-free rate in current conditions is problematic. In addition to regulatory precedent and current market data, we appeal to a relationship between economic growth and the risk-free rate to inform our estimate of the risk-free rate6 Executive Summary The real risk-free rate is converted into a nominal risk-free rate, as ComReg sets the WACC according to a nominal post-tax WACC. This is done using a forward-looking inflation estimate. Inflation forecasts, Ireland s current and historic experience with inflation, and the European Central Bank s view to keep inflation below, but close to, two per cent inform our analysis of the appropriate inflation rate. On the ERP, we appeal to the authoritative estimates of Dimson, Marsh, and Staunton (DMS). They estimate that the arithmetic mean ERP for Ireland is 4.6 per cent, based on 112 years of data. Recent regulatory precedent and the possibility for elevated equity risk premia in the event of a re-emergence of Eurozone financial turbulence suggests 4.6 per cent may be too low on a forward-looking basis, however. We consider the DMS evidence in light of these two factors. On taxation, we use the statutory 12.5 per cent Irish corporation tax rate, consistent with previous ComReg regulatory WACC determinations. The table below lays our our ranges and point estimates for each generic parameter. Table 1.1: Generic WACC parameters Low (%) High (%) Point (%) Real risk-free rate Inflation Nominal risk-free rate ERP Tax Rate 12.5% 12.5% 12.5% Source: Europe Economics 1.3 Specific Parameters in the WACC-CAPM Approach The specific parameters in the CAPM are gearing, beta and the debt premium. On gearing, we use a notional gearing informed by market evidence on operators actual gearing in each sector to determine a notional level that is consistent with achieving an investment-grade credit rating. This is consistent with ComReg s previous approach in regulatory WACC determinations. As we view the Eurozone capital market as a single capital market, we estimate Eurozone companies equity betas on a European equity index. Equity betas are converted into unlevered betas or asset betas using the gearing of actual companies. We arrive at our estimates of the appropriate equity betas by relevering our estimates of the appropriate unlevered betas at our notional gearing estimate. On the cost of debt, we argue against embedded debt adjustments, as they are inconsistent with the thought experiment of an efficient new entrant. We estimate the cost of debt via a bottom-up approach. This involves estimating the cost of debt by adding a debt premium to the risk-free rate estimate. We argue that there is a premium that would elevate the cost of debt for an efficient company operating in Ireland relative to an identical efficient company operating in certain core European countries. We argue that the adverse consequences of setting the cost of capital too low or worse than those of setting the cost of capital too high. For that reason, we aim up on our WACC estimates, adjusting parameters one standard deviation above our point estimate in each case. 1.4 Mobile WACC In assessing the Mobile WACC, we estimate each specific parameter with reference to regulatory precedent and market data on listed operators. Furthermore, we analyse data provided to us in a ComReg data request to operators to be covered under this price control. Finally, our estimates are informed by the results of a ComReg survey to the national regulatory authorities of EU Member States that make up - 2 -7 Executive Summary the Body of European Regulators of Electronic Communications. The table below contains our range and point estimates for the cost of capital parameters derived from this analysis. Aiming up on our central pretax WACC estimate of 8.2 per cent gives a WACC of 8.7 per cent. Table 1.2: Mobile WACC Low High Point Estimate Tax rate (%) Real risk-free rate (%) Inflation (%) Nominal risk-free rate (%) Equity risk premium (%) Gearing (%) Asset beta Equity Beta at notional gearing Nominal post-tax cost of equity (%) Nominal pre-tax cost of equity (%) Debt Premium (%) Nominal pre-tax cost of debt (%) Nominal Vanilla WACC (%) Nominal pre-tax WACC (%) Europe Economics calculations 1.5 Fixed Line WACC In our assessment of the fixed line cost of capital, we rely primarily on regulatory precedent and market evidence to inform our parameter estimates. We also consider Eircom s actual financial position. Eircom is currently very highly geared and, as a result, has a high cost of debt. Also, as the company is not listed and has a very distorted capital structure, it is difficult to estimate Eircom s cost of equity with any certainty. The table below contains our estimates of the fixed line cost of capital. Aiming up on our point estimate of a pre-tax nominal WACC of 8.0 per cent gives an aimed-up WACC of 8.5 per cent8 Executive Summary Table 1.3: Fixed Line WACC Low High Point Estimate Tax rate (%) Real risk-free rate (%) Inflation (%) Nominal risk-free rate (%) Equity risk premium (%) Gearing (%) Asset beta Equity Beta at notional gearing Nominal post-tax cost of equity (%) Nominal pre-tax cost of equity (%) Debt Premium (%) Nominal pre-tax cost of debt (%) Nominal Vanilla WACC (%) Nominal pre-tax WACC (%) Source: Europe Economics 1.6 Broadcasting WACC We estimate the WACC for Broadcasting Market A and Broadcasting Market B. We argue that the recent discussion about the lack of a commericially-viable DTT service in Ireland would not affect the cost of capital as such, since DTT will continue to be used as a public service distribution platform. Were DTT to cease to be the distribution platform for public service broadcasting, an appropriate way to address this would be to alter the depreciation of the regulated assets. The lack of any pure-play operators in the DTT broadcasting or DTT multiplexing market complicates the use of market evidence in the assessment of the broadcasting WACC. Furthermore, the fact that 2rn and RTÉ are public service statuory corporations makes assessing a regulatory WACC using their financial data difficult, since they do not operate with an aim to return capital to investors. This is in part the reason we assess the WACC for an Irish broadcaster with an efficient capital structure. Previous regulatory precedent suggests that towers and masts companies and integrated telecommunications companies are appropriate comparators for DTT broadcasters. Our parameter estimates are informed by regulatory precedent and market data on operators in these two sectors. The table below contains our range and point estimates for cost of capital parameters. Aiming up on our nominal pre-tax WACC estimate of 8.1 per cent gives an aimed-up WACC of 8.7 per cent9 Executive Summary Table 1.4: WACC applicable to Broadcasting Market A and Broadcasting Market B Low High Point Estimate Tax rate (%) Real risk-free rate (%) Inflation (%) Nominal risk-free rate (%) Equity risk premium (%) Gearing (%) Asset beta Equity Beta at notional gearing Nominal post-tax cost of equity (%) Nominal pre-tax cost of equity (%) Debt Premium (%) Nominal pre-tax cost of debt (%) Nominal Vanilla WACC (%) Nominal pre-tax WACC (%) Source: Europe Economics - 5 -10 Introduction 2 Introduction Comreg has commissioned Europe Economics to produce recommendations on the appropriate costs of capital for the following price controls: Mobile termination rates (MTR), applied to the following mobile providers deemed to have significant market power: Hutchison 3G Ireland, Lycamobile Ireland, Eircom Group Mobile, Telefonica Ireland, Tesco Mobile Ireland and Vodafone Ireland. The appropriate WACC to be used in this price control is assessed for a hypothetical efficient mobile operator. This will be referred to as the Mobile cost of capital. Eircom s fixed-line telecommunications business. The WACC is estimated for an Irish fixed-line operator with an efficient capital structure. This will be referred to as the Fixed Line of cost capital. Broadcasting, applying to 2rn in Broadcasting Market A (transmission and distribution via towers and masts infrastructure) and to RTÉ in Broadcasting Market B (DTT multiplexing). 2rn is a fully owned subsidiary of RTÉ. The WACC is estimated for an Irish broadcaster with an efficient capital structure. Although these are separate markets, we do not find strong arguments for assigning different WACC values between these two markets. Thus, we estimate a WACC for an Irish broadcaster with an efficient capital structure, which is the appropriate cost of capital for each of these markets. This report gives our recommendations on costs of capital for each of the three controls. We proceed as follows: In section 3 we discuss our theoretical approach to determining the WACC. This covers the Weighted Average Cost of Capital-Capital Asset Pricing Model (WACC-CAPM) approach, which is overwhelmingly the preferred approach in European price controls. We discuss whether this approach remains appropriate and the applicability of possible alternative. In section 4 we give our recommendations on the generic parameters of the cost of capital. These are the risk-free rate, the equity risk premium and, in this case, the tax rate. In section 5 we discuss methodological issues in determining the specific parameters of the cost of capital, namely gearing, equity beta and the debt premium. In section 6 we present our recommendations on the appropriate cost of capital for the MTR determination. In section 7 we present our recommendations on the appropriate cost of capital for Eircom. In section 8 we present our recommendations on the appropriate cost of capital for broadcasting, consisting of a joint recommendation for Market A and Market B11 Theoretical Approach 3 Theoretical Approach 3.1 The Regulatory Cost of Capital Companies finance their operations through two sources of capital: debt and equity. Each comes at a cost: the cost of debt is the price paid for fixed-payment liabilities, such as bonds and loans, while the cost of equity represents the opportunity costs of employing contributed capital, such as public shares or private equity investment. Given that the level of return to investors is uncertain, companies must compensate investors for the risk that investing in them induces in the investor s portfolio. Firms operating in competitive markets earn exactly the rate of return required by the market to finance their assets. However, this is not generally the case for firms with significant market power. One of the purposes of a price control is therefore to set the rate of return at the cost of capital that would occur in a competitive market. 3.2 The WACC-CAPM Approach The WACC-CAPM (Weighted Average Cost of Capital Capital Asset Pricing Model) approach has been the standard conceptual framework within which the cost of capital has been examined in Irish regulatory determinations and has generally been favoured in other European jurisdictions (for example, the UK). The CAPM framework was developed in the 1960s, building on the portfolio analysis work of Harry Markowitz, as a way to estimate the value of assets. The key feature of CAPM is that, given its important assumptions concerning the efficiency of financial markets and that investors care only about the mean and variance of returns, investment returns can be expressed as: where r is the (expected) return on the asset, r f is the return that would be required for a perfectly riskfree asset, MRP is the market risk premium, that is to say the excess return over the risk-free rate that would be delivered by a notional perfectly diversified portfolio equivalent consisting of all assets ( the whole market ), and β A is a measure of the correlation between movements in the value of the asset of interest and in the value of assets as a whole. It is also called beta (or sometimes the asset beta ). Under the capital asset pricing model (CAPM) approach, the cost of capital is computed from (a) the average cost of debt for the various forms of debt held by the company, and (b) the cost of equity. This is the return that investors (shareholders and lenders of various types) require in order to invest in the company. The weighted average cost of capital (WACC) is calculated using the following formula: ( ) ( ) where r E is the cost of equity, r D is the cost of debt and E and D are the total values of equity and debt respectively used to determine the level of gearing in the company, and so giving the relative weights between the costs of equity and debt finance12 Theoretical Approach Within the context of the WACC-CAPM approach, CAPM is generally most useful in estimating the cost of equity. 1 However, the CAPM remains a theory of the prices of assets in general, not simply equity, and the cost of debt may still be usefully thought about in CAPM terms, as we discuss below Cost of Equity Within the context of the WACC-CAPM approach, CAPM is used to determine the cost of equity, r E, applying the following equation: r f is the return on a risk free asset, usually proxied by a measure of the rate on medium to long-term government bonds. β E is the correlation between the risk in company returns and those of the market as a whole, which can be estimated from primary market data. MRP is the market risk premium over the risk free rate, an economy-wide parameter. In practice what is estimated is the equity risk premium (ERP) which will be a reasonable proxy for the MRP provided the equity market is sufficiently diverse. Thus in the standard CAPM there are three determinants of the expected return on any asset: the return on a riskless asset; the market premium over that riskless rate that is earned by investors as a whole, reflecting systematic risk; and the particular company s exposure to systematic risk. Company specific risks do not enter the cost of capital, as they can, by definition, be diversified away by investors Cost of debt The cost of debt measures the combination of interest rates charged by banks to the company and the return paid by the company on corporate bonds or other debt instruments. Note that although it may also be expressed in CAPM terms, the cost of debt is usually conceived as being made up of a risk free component and a company-specific risk premium. Assuming reasonable efficiency in capital markets, the premium on debt from one source should be the same as that on debt from any other source involving the same risk. This principle should apply however complex the particular structure of finance adopted. Since payments on debt are generally fixed (in contrast to the variable returns on equity), risk in this context principally means the risk of non-payment. A key issue to note is that, since payments on debt are fixed but there is some risk of default, the observed return on debt is not necessarily identical to the expected return from holding the debt. For example, supposing that the whole value of a bond is lost on default, the expected return is: where, p d is the probability of default. However, the expected return in CAPM terms considers only systematic risk, i.e.: 1 Due to equity s role within companies capital structures, there is generally more divergence between observed and required equity returns than is the case for debt13 Theoretical Approach Hence, the relationship between the observed return on debt, debt beta and the probability of default can be expressed as follows: ( ) Provided that the probability of default is sufficiently low, the observed return will therefore be a reasonably close estimate of the required return. This provides the justification for thinking of the cost of debt in terms of the risk-free rate and a debt premium. However, these considerations should be borne in mind when interpreting observed returns for bonds with a higher probability of default Inflation and Taxation Depending on the precise form of regulation, the WACC may need to adjust for inflation and/or taxation. Taxation represents a cost to a regulated company, and it is a principle of economic regulation that such costs, when efficiently incurred, ought to be recovered by the company in question. Some regulators, such as Ofwat, give companies explicit tax allowances in their charges, effectively treating taxation as an operating expense. Other regulators give companies allowed returns on a pre-tax basis, effectively including an allowance for taxation in the return on capital. We note that this is similar to the case for inflation, with some regulators using a real WACC with an index-linked asset base, and others using a nominal WACC without asset base indexation. ComReg s practice has been to use a nominal pretax WACC: ( ) where g is the level of gearing, t is the tax rate, r D is the pre-tax cost of debt and r E is the post-tax cost of equity. For the controls in question, it is proposed that both taxation and inflation will be allowed for within the cost of capital, so we will estimate a nominal pre-tax WACC Summary on CAPM The WACC-CAPM approach involves two generic (i.e. market-wide) parameters: the risk-free rate and the equity risk premium, which sum together to form the total market return ; and a number of idiosyncratic (firm- or project- or industry-specific) parameters including: the equity beta; the debt beta; the gearing; and the debt premium. 3.3 Use of CAPM and Alternatives CAPM has been the dominant tool for the analysis of the cost of capital in regulation in Ireland (and, indeed, the UK). Given this dominance, and in view of the significant regulatory learning costs that would be associated with a change in methodology, we would need very good reasons to recommend using an alternative model to CAPM. We note that CAPM s use reflects significant advantages over other finance models. It has clear theoretical foundations, which allow for intuitive engagement by non-technical stakeholders. It is also well integrated with the rest of finance theory, for example the Modigliani-Miller theorem can be proved from the CAPM. Moreover, among possible models, none performs better empirically in explaining asset prices in the long run. Like any model, CAPM is not without criticisms. Some empirical studies from the 1970s to 1990s identified a small firm effect, with small firms found to have higher returns than predicted by CAPM, and/or a value - 9 -14 Theoretical Approach effect, with some firms with low book to market value ratios having higher expected returns than predicted by CAPM. The standard way of empirically estimating CAPM assumes that the equities market as a whole is perfectly diversified, whereas in theory under CAPM diversification takes place across all assets, including non-equity assets such as gold and real estate. Further, CAPM does not explicitly account for investor s preferences about the skewness of returns. In view of these considerations, we therefore examine alternative models of the cost of equity to determine whether there is a justification for shifting away from CAPM The Fama-French three factor model Fama and French (1992, 1996) 2,3 suggested a model for excess returns incorporating firm size and the ratio of book value to market value as explanatory factors in addition to beta. In this model, the empirical equation for the excess return on portfolio j, Z j r j r f, is given by: Where s j is the size of the firm effect, h j is the size of the ratio of book to market value effect, SMB is the difference between returns on portfolios of small and large stocks, and HML is the difference between returns on portfolios of high and low book-to-market ratios, Z m is the market portfolio and u j is the error term for portfolio j. For most regulated companies the effect of using Fama-French instead of CAPM is expected to be small. For an average firm, j will be close to 1 (as is the case in the CAPM) while s j and h j will be close to zero (since firms are identified in relative terms, the average must be zero). The main impact of the additional factors would therefore be for firms at extremes, or in cases where the effect is to change materially the estimate of. The Fama-French model has been popular in the past, but has also been subject to criticism on the grounds of a lack of clear theory as to why the additional factors included should deliver positive premia. Moreover, it has been argued that the fact of having identified that small firms and firms with high book to market ratios have had higher returns than implied by their systematic risk should itself cause asset prices to adjust to eliminate this anomaly. Smithers & Co (2006) found only very limited evidence for the existence of the value effect for utilities in the UK. 4 In recent UK regulatory determinations the Fama-French model has been used to advocate a small company premium to the cost of capital. The theory, evidence and substantial effect (in terms of there being any small company premium to the cost of capital) were rejected comprehensively by the UK Competition Commission in the Bristol Water case. 5 The Competition Commission stated that they do not consider that there is robust UK empirical evidence of small firms being more risky and hence having a higher cost of capital, 6 and that they consider that the arguments for a higher cost of equity due to small size in itself are weak. 7 The Fama-French model therefore lacks the clear theoretical foundations of the CAPM, while its empirical basis is less clear. We do not, therefore, believe it would be appropriate to use it in place of the CAPM. 2 Fama, Eugene F. and French, Kenneth R. (1992) The cross-section of expected stock returns The Journal of Finance, 47(2), p Fama, Eugene F. and French, Kenneth R. (1996) Multifactor explanations of asset pricing anomalies The Journal of Finance, 51(1), p Report on the cost of Capital, Smithers & Co (2006), provided to Ofgem. 5 See Appendix N of 6 Ibid. Appendix N paragraph Ibid. Appendix N paragraph15 Theoretical Approach Dividend Growth Model According to the dividend growth model, the rate of return required to sustain the value of a share is its current yield plus the expected rate of growth in yield. A simple DGM states that the current value of a stock can be expressed as: where P 0 is the current price of the stock, D 1 is the expected next period dividend, r is the required rate of return, and g is the expected constant long-term growth rate of earnings. Solving for r gives the following approximation of the cost of equity: ( ) This means that the cost of equity is the prospective dividend yield of a stock plus the constant long-term growth rate of dividends. Clearly, this version of the DGM makes the strong assumption that the dividend growth rate will be constant. A multi-stage DGM allows the dividend growth rate to vary between dividend periods (for example, short and long term). The DGM has strong theoretical foundations (since it is based on valuation of a share as the stream of future dividends expected by investors, discounted at the cost of equity) and was for many years the main working tool in US regulatory determinations. The challenge in applying it relates particularly to estimation of the future path of dividends expected by investors. Within a multi-stage DGM, analysts forecasts can be used for the next few years. Thereafter, there are various proxies that could be used for dividend growth, ranging from historic trends in dividends to the long-run sustainable growth rate of GDP or trend growth in regulated assets. However, these typically give different answers and therefore often result in wide ranges in estimates from the DGM. As the UK Competition Commission put it in the Bristol Water case: We regard the DGM evidence as consistent with a wide range of figures for the cost of equity. 8 The DGM therefore shares a strong theoretical basis with the CAPM, though in practice its estimates are less precise than those given by the CAPM. While it would be perfectly possible to pick one s point estimate of the cost of equity within the DGM range, this should be done on the basis of sound theoretical considerations which would include CAPM in any case. We do not therefore believe it would be appropriate to use the DGM in the place of the CAPM as the main basis for estimating the cost of capital Residual Income Model From an accounting perspective, the assets of a company are equal to the sum of the company s liabilities and equity attributable to shareholders. In any one year, the difference between a company s revenues and its expenses (including interest and taxes) is that company s net income. Any net income or residual income remaining after settling all in-year expenses accrues to equity holders. The book value of a company s equity is total assets less total liabilities. Book values of assets and liabilities can be measured in various ways, including historical cost, amortised cost, current cost, settlement value, present value, or fair value. Accounting valuations such as these stand in contrast to the market s valuation of a company s equity. The market s valuation of a company s equity is equal to price of a single share in the company multiplied by the number of shares outstanding. The market value of a company s equity would exceed its book value if investors expected strong future returns on equity relative to similar investment opportunities. Alternatively, the company could simply be overvalued. 8 Ibid., paragraph16 Theoretical Approach The total cost of employing equity in financing business operations is equal to the book value of a company s equity multiplied by that company s cost of capital. If equity shares are viewed as a claim on the future cash flows of a company, then the market value of a company s equity can be determined as the discounted cash flows accruing to equity investors over the company s lifetime. This is summarised as follows: where BE is the book value of equity, NI is net income, and K e is the cost of equity, all at time t. In other words, the market value of a company is equal to the current book value of equity and the present value of future residual income accruing to equity holders. The latter term is defined as the net income earned in the present period less the cost of employing last period s equity base in business operations, discounted using the cost of equity. This method of valuing a company s equity is known as the residual income model (RIM). Although it is conceptually similar to the DGM, in practical application it has the advantage of being less reliant upon analyst forecasts. In other words, whereas the DGM back-loads equity value (including terminal values that may be extremely difficult to predict), the RIM model is frontloaded, using information from that part of the equity value that is captured by its current book value. This reduces the extent to which RIM estimates rely on uncertain future parameters. However, it remains the case that the RIM relies on estimates of future parameters, namely future net income and future equity book values. While these can be proxied by using analysts forecasts and/or applying plausible future growth rates to current values, there remains uncertainty as to the appropriate choices of these inputs. Thus, although the RIM has significant advantages over the DGM, and retains its strong theoretical foundations, we do not believe in practice that it should replace the CAPM as the primary methodology of estimating the cost of capital Third moment CAPM The traditional CAPM assumes that investor s investment decisions are based only on the mean and standard deviation of a portfolio of assets. In the third moment CAPM, investors may have preferences over the distribution of returns that go beyond their mean and variance. The third moment of a distribution of returns is its skewness, which describes asymmetry about the mean in a random variable s probability distribution. The probability density functions in Figure 3.1 have the same mean ( ) and same variance, but the left distribution is positively skewed while the right one is negatively skewed. Figure 3.1: Distributions with the same mean and variance but differing skewness The standard Arrow-Pratt measure of risk aversion implies that higher moments of the distribution of returns would be of interest to investors, and in particular that they would dislike skewness. The assumption in CAPM that investors are indifferent to skewness is thus a simplification at variance with standard decision theory17 Theoretical Approach It is possible that some (risk-averse) investors might, for example, prefer distributions of returns with positive skewness (where downside risk is, in some sense, relatively more restricted) over those with negative skewness. As a result, distributions with systematic negative skew would have a higher cost of capital than predicted by standard CAPM, while distributions with systematic positive skew would have a lower cost of capital. Skewness is of clearest significance in a regulatory context under two circumstances: (a) when the entity is subject to material capacity constraints, in which case upside opportunity is curtailed by the price-cap and the capacity constraint (so creating negative skewness); (b) where technological or related innovative opportunities provide significant upside blockbuster opportunity especially with regard to upside risk to volume estimates (so creating positive skewness). Capacity constraints have generally been discussed in a regulatory context in cases where regulated businesses have been prevented from expanding, for example in the case of an airport at capacity. Moreover, given the relative maturity of the telecommunications markets analysed here, it is not clear that there is a good case for the existence of blockbuster opportunities that would generate the sort of upside risk that would generate positive skewness. In view of these considerations it appears the cost of capital would be adequately estimated using the standard model, so there appears no obvious reason to favour the use of a third moment CAPM Conclusion on Theoretical Approach We therefore retain the CAPM as the main tool for determining the cost of capital. CAPM has a number of advantages, including clear theoretical foundations, a history of regulatory precedent and superior performance to other models in explaining asset prices over the long-run. Although like any model it has received some criticisms, other available models such as the Fama-French model or the Dividend Growth Model, have their own drawbacks. Given that a move away from CAPM would represent a significant departure from regulatory precedent, we would require strongjustification to endorse such a move. In the absence of such justification to do so, and in view of CAPM s advantages, we therefore continue to use the CAPM as our theoretical framework for estimating an appropriate WACC for the markets under consideration. 3.4 Other Issues regarding the WACC Relevant time period A key issue in determining what return is appropriate is the start date and the time period over which the price control applies. In the case of the present controls, our understanding is that they will last 3-5 years from 2014/15, implying a mid-point between 2015 and Hypothetical efficient operator The reason for imposing price regulation is that the absence of competition gives firms the power to raise prices about those that would prevail in a competitive market. The relevant point of comparison is therefore with the competitive price, and the relevant WACC in this case is not necessarily that of the incumbent firm. Rather, the relevant WACC is that of a hypothetical efficient company. Our WACC estimates are therefore for hypothetical efficient mobile, fixed line and broadcasting operators. There may be pragmatic reasons, such as financeability considerations, for departing from a regulatory WACC estimated on such a basis, but such departures would require sufficient justification18 Theoretical Approach CAPEX incentive mechanisms If set at an appropriate level, the WACC should enable regulated firms to offer returns sufficient to finance their investment projects. However, there may be times when the regulator wishes to incentivise investment in certain projects in particular. CAPEX incentive mechanisms can be used by the regulator to encourage firms to pursue these projects. In general, the need for CAPEX incentives can arise in two ways. First, the regulator and the firm can agree ex-ante to a particular project whose risk profile is higher than the average risk profile of the firm s other projects. The firm undertakes the project and the regulator allows a higher WACC to compensate the firm and its investors for bearing the additional risk. ComReg might wish to consider such a mechanism only in circumstances in which it was clear that a particular project was both desirable and sufficiently riskier than the average project undertaken by the regulated company to require a higher return. Alternatively, the regulator can incentivise a firm to undertake a project it believes is in the public interest, regardless of the riskiness of the project. The difference between this situation and the first is that the risk of the project can be the same or lower than the average project risk for the company. To consider such an incentive, ComReg would need to be satisfied both that there was a sufficient public interest justification for the project to be desirable and that the regulated company would not otherwise engage in the project, even though its risk level was not necessarily higher than the average project for the company Trigger mechanisms The purpose of a trigger mechanism is to adjust the cost of capital when market conditions change to such an extent that the actual cost of capital differs significantly from the realised cost of capital when firms raise funds in the market. The concept of a trigger mechanism is, to some degree, already factored into the concept of periodic price control reviews. Indeed, the reason price controls are updated at all is to incorporate changes in the expected future outlook into allowed returns on investment. One effect of this periodic review, however, is to introduce regulatory uncertainty into the market. Regulatory uncertainty arises when investors are unsure of the expected rate of return on their investments due to uncertainty in regulatory outcomes. The more frequently the regulatory cost of capital is reviewed, the greater the scope for regulatory uncertainty. Introducing a trigger mechanism, then, can increase regulatory uncertainty. On the other hand, not updating the cost of capital when market conditions change drastically also comes with risks. If, for instance, the cost of capital rises sharply during the course of the price control due to a deep recession or a drying up of liquidity in capital markets, firms may not be willing to invest unless the cost of capital is adjusted upward to reflect new market conditions. The present controls are envisaged to hold for a period of three to five years. We do not envisage that trigger mechanisms would be required for these controls, since we believe that their duration is of such a length, and there is already sufficient flexibility within the process, to respond to significant changes in market conditions without increasing regulatory uncertainty19 Generic Parameters in the WACC-CAPM Model 4 Generic Parameters in the WACC- CAPM Model This section deals with the WACC parameters that will be common across all three price controls. The key generic parameters are the risk-free rate,, and the equity risk premium. Together the risk-free rate and the equity risk premium represent the total market return. To assess these parameters we consider a range of evidence, including previous regulatory precedent, estimates from market data, and authoritative third-party sources. The other key generic parameter is taxation. In theory the tax rate could be specific, since companies may differ in the effective tax rate that they pay. However, our recommendation is to use the statutory tax rate, so for our purposes taxation is a generic parameter. We explain our reasons for this below. 4.1 Total Market Returns and the Economic Cycle Total market returns expressed in CAPM terms represent the sum of the risk-free rate and the market risk premium. Total market returns are generally considered to be more stable than their individual components. During economic downturns, the risk-free rate tends to be depressed, while equity risk premia are elevated. Conversely, when the economic outlook is more positive, risk premia are generally lower and the risk-free rate higher. Of course, total returns will generally be lower during downturns, reflecting lower expected returns on risk-bearing investments in a weak economy and a lower risk-free rate. But the key issue is that variations in overall returns will be significantly lower than variations in the risk-free rate and equity risk premium. It is therefore useful to consider the risk-free rate and the equity risk premium within the context of the total return and the economic outlook Precedent The period leading to and following the financial crisis was especially turbulent for Ireland. Fluctuations in financial markets, large swings in Irish macroeconomic variables, and the bifurcation of Europe into a core and periphery have all complicated the estimation of the cost of capital. Current macroeconomic data and forecasts indicate that Ireland is likely to emerge from economic hardship and return to more normal economic performance over the next three to five years. Regulatory precedent on the risk-free rate and the ERP are especially useful in this situation. Precedent over the course of booms and busts offer a picture of how regulatory cost of capital parameters change as20 Generic Parameters in the WACC-CAPM Model macroeconomic conditions change. As economic conditions in Ireland are expected to normalise 9, precrisis precedents give some idea of what total market returns might be in the future. 10 Table 4.1 contains past regulatory precedent for the risk-free rate and ERP in Ireland since The real risk-free rate has varied between 2.0 and 3.0, while the ERP has ranged from 5.0 to 6.0. Total market returns have, in general, been falling since the early part of the 2000s. The highest total market returns figure is 8.6 per cent, used in and 2005, each time in the context of aviation regulation. Table 4.1: Total market returns in Irish regulatory determinations, Regulator Subject Year Real riskfree rate Implied nominal risk-free rate ERP Real total market return CER ESB PG CAR Aer Rianta CAR Irish Aviation Authority CER Bord Gáis Éireann ComReg Eircom 2003 n/a CAR Dublin Airport Authority CER ESB PG ComReg Eircom 2008 n/a CAR Dublin Airport Authority n/a CER EirGrid and ESB n/a CAR Irish Aviation Authority n/a CER EirGrid and ESB n/a Source: Various regulatory determinations. Figure 4.1 reinforces this point. Total market returns as the sum of the risk-free rate and the equity risk premium have remained relatively constant though slightly lower during the recession, when total market returns would be expected to be lower given a weak economic environment. 9 For example, the Central Bank of Ireland forecasts that GDP growth in 2014 will be 2 per cent, which would represent a steady increase in the GDP growth rate. See: n%20q4% pdf. At the time of writing, Bloomberg consensus forecasts for GDP growth stand at 2.2 per cent. Similarly and from the same two sources, HICP inflation is forecasted to rise from 0.6 per cent in 2013 to 0.7 per cent in 2014 and 1.3 per cent in We interpret the forecasted increase in the GDP growth rate and inflation to be indicators of normalisation of economic conditions, moving out of recession and deflation to growth and moderate inflation. 10 We are not asserting and do not believe that pre-crisis, and in particular , represent normal economic conditions. We analyse pre-crisis regulatory precedent only as a guide to how parameters may behave outside of the crisis, rather than relying exclusively on more recent, in-crisis data21 CER 2000 CAR 2001 CAR 2002 CER 2003 CAR 2005 CER 2005 CAR 2009 CER 2010 CAR 2011 CER 2014 Generic Parameters in the WACC-CAPM Model Figure 4.1: Total market returns in Irish regulatory determinations, Risk-free rate ERP Source: Various regulatory determinations. 4.2 Risk-Free Rate This section outlines our assessment of the appropriate risk-free rate in Ireland. We begin with a discussion of conceptual features of a risk-free rate in general and the Irish risk-free rate in particular. We then use this discussion as our point of departure for determining the Irish risk-free rate empirically Nominal versus Real Risk-Free Rates Since our estimate is for a pre-tax nominal WACC, we estimate the appropriate nominal risk-free rate. What matters for investors is the real return on their investments, but to achieve this within a regulatory WACC there will need to be some allowance for inflation either within the WACC itself or within the value of the asset base. In this case, since the asset base is not adjusted for inflation, compensation for inflation occurs through the WACC, which must be expressed in nominal terms. Our approach to estimating the appropriate nominal risk-free is to estimate separately the real risk-free rate and inflation. In principle nominal risk-free rates could be estimated directly from yields on nominal gilts. However, it is useful to decompose the nominal risk-free rate into the real rate and inflation, which are related as follows: where i is the nominal interest rate, r is the real interest rate, and π is the rate of inflation. Since the nominal risk-free rate could change either due to changes in the real risk-free rate or due to changes in inflation, it is useful to consider these components separately. As we will see, there are also difficulties in interpreting the relationship between sovereign bond yields and risk-free rates, which also make it useful to consider the real risk-free rate separately from inflation View more
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