Cost of Capital for Delivering Universal Service Obligations Estimates

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					16 June 2000

Final Report to
the Australian
Communications
Authority




                  Cost of Capital for Delivering
                  Universal Service Obligations
                  Estimates for 2000/01 to 2002/03
The Allen Consulting Group Pty Ltd
ACN 007 061 930



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Table of Contents



                    Chapter 1                                                                      1
                    Introduction                                                                   1
                      1.1 This Report                                                              1
                      1.2 The Weighted Average Cost of Capital                                     2
                      1.3 New Schemes to provide the Universal Service Obligation                  5
                      1.4 Previous Reports                                                         6
                      1.5 Forecasting the WACC for three years                                     7

                    Chapter 2                                                                      9
                    Parameters of the Capital Asset Pricing Model                                  9
                      2.1 Gearing Level                                                            9
                      2.2 Risk Free Rate                                                          11
                      2.3 Market Risk Premium                                                     12
                      2.4 Debt Premium                                                            13
                      2.5 Corporate Tax Rate                                                      14
                      2.6 Imputation Factor                                                       15
                      2.7 Beta                                                                    15

                    Chapter 3                                                                     16
                    Asset and Equity Betas                                                        16
                      3.1 Implications of calculating WACC on a forward looking basis for the Rest
                          of Australia                                                           16
                      3.2 Implications of calculating WACC on a forward looking basis for the
                          Extended Zones                                                          19
                      3.3 Implications of calculating WACC on a forward looking basis for the Pilot
                          Areas                                                                   20
                      3.4 Value of Beta                                                           21

                    Chapter 4                                                                     23
                    Levelisation                                                                  23

                    Chapter 5                                                                     25
                    Cost of Capital Estimates                                                     25
                      5.1 Cost of Capital for Universal Service Providers in the Extended zones and
                          Rest of Australia                                                        25
                      5.2 Cost of Capital for Universal Service Providers in the Pilot Areas      26
                      5.3 Recommended WACC Estimates for the years 2000/01 to 20002/03            27

                    Appendix A                                                                    28
                    Beta in Competitive and Monopoly Markets                                      28
                      A.1 Case 1                                                                  28
                      A.2 Case 2                                                                  29

                    Appendix B                                                                    30
Example of Tilted Annuity Approach to levelise WACC Estimates              30
  B.1 Worked Example showing the use of the Tilted Annuity Formula to levelise
      WACC Estimates                                                        30
COST OF CAPITAL FOR DELIVERING UNIVERSAL SERVICE OBLIGATIONS: 2000/01 TO 2002/3




                        Chapter 1
                        Introduction

                        The provision of standard telephone services in regional, remote and rural areas is an
                        important issue for the Commonwealth Government that wants to ensure universal
                        access for all Australians. Such services are essential to the social and economic
                        wellbeing of local communities outside the metropolitan areas, but the required
                        telecommunications infrastructure has traditionally been costly to install and maintain,
                        relative to the revenues that can be earned from customers in these areas.

                        The Government therefore imposes an obligation on a carrier (currently Telstra) to
                        provide standard telephone services in net cost areas — the universal service obligation
                        (USO). Part 2 of the Telecommunications (Consumer Protection & Service Standards)
                        Act 1999 allows for a universal service provider (USP) to be refunded for losses
                        incurred in providing services to declared net cost areas. These areas are defined as
                        areas that incur substantial losses as a result of circumstances beyond the control of the
                        service provider. Costs are shared among carriers in proportion to their ‘eligible
                        revenue’.

                        Recently the Commonwealth Government announced its intention to introduce a new
                        legislative framework for the USO. In the new framework, the net cost of universal
                        service provision (the NUSC) will be determined for up to three years, beginning with
                        2000/01 financial year. Under the new framework, three types of USO schemes will
                        operate in different ‘regions’ of Australia. One of the schemes may involve multiple
                        USPs. (The schemes are described in section 1.3.)

                        These new arrangements will significantly affect the NUSC, not least the cost of capital.
                        The provision of standard telephone services is a capital intensive activity and the costs
                        of providing the infrastructure normally are recouped over a number of years. This
                        implies that the opportunity cost to the USP of having its capital tied up in the required
                        infrastructure will be a key determinant of the calculated loss that is attributable to
                        servicing the net cost. This will be the case particularly where the USP will not have
                        exclusive access to customers in net cost areas.


                        1.1    This Report

                        The Allen Consulting Group (ACG) has been commissioned to provide advice on the
                        weighted average cost of capital for the purpose of calculating the net universal service
                        cost on a forward looking basis for the 2000/01, 2001/02 and 2002/03 years.

                        Consultations with Telstra, Cable & Wireless Optus, Vodafone and AAPT on the draft
                        report preceding this report were held on 8 and 9 June 2000. In addition, these carriers
                        provided submissions in response to the draft report.




                                                                                                                1
COST OF CAPITAL FOR DELIVERING UNIVERSAL SERVICE OBLIGATIONS: 2000/01 TO 2002/3



                        This chapter introduces the methodology for estimating the weighted average cost of
                        capital given the new USO schemes. Chapter 2 of this report will address the parameters
                        common to the weighted average cost of capital under all three schemes and chapter 3
                        will address the peculiar risk profile for providers under each scheme. Chapters 2 and 3
                        will note and respond to comments from the carriers. Chapter 4 will address the
                        approach to levelisation. Chapter 5 will present ACG’s estimates for the weighted
                        average cost of capital under the three USO schemes for the next three years.


                        1.2      The Weighted Average Cost of Capital

                        The methodology for estimating the cost of capital for the USO is based on the Capital
                        Asset Pricing Model (CAPM). This was the methodology used by the ACG in its advice
                        to the Australian Communications Authority (ACA) for the 1997/98 and 1998/99 to
                        1999/2000 assessments, consequently used by the ACA.

                        However, this report does not follow the approach of mechanically carrying forward the
                        previous analysis. Where appropriate, methodological changes have been made.

                        The term Weighted Average Cost of Capital (WACC) refers to the fact that firms use
                        both equity and debt finance to purchase assets and the cost of each will generally be
                        different. The cost of capital will be a weighted average of the cost of equity and debt,
                        with the weights equal to the proportions of equity and debt in the firm’s capital.

                        There is more than one way of calculating the WACC, depending essentially on whether
                        items related to tax payments are incorporated in the WACC or separately in the cash
                        flows of the firm in the question. The WACC will be calculated according to the formula
                                                                                   1
                        below in this report as it was in the previous two reports. This formula allows for the
                        payment of company taxes and the receipt of franking credits by equity investors.

                                                                 (1 − T )Re  E                  D
                                         Post–Tax WACC =                    * + (1 − T ) * Rd *
                                                               1 − T(1 − γ ) V                  V
                        where

                        Re is the required rate of return on equity, after company tax

                        Rd is the pre–tax average cost of debt

                        T is the corporate tax rate

                        γ is the value of franking credits or imputation factor

                        E is the market value of equity

                        D is the market value of debt

                        V=D+E is the market value debt plus equity

                        The pre–tax WACC is found by ‘grossing up’ the post–tax WACC by a factor of (1–T)
                                                                            Re        E       D
                                                  Pre–Tax WACC =                     * + Rd *
                                                                       1 − T (1 − γ ) V       V




                        1
                              The formula comes from R.R. Officer, “The Cost of Capital of a Company Under an Imputation Tax
                              System”, Accounting and Finance, 34, 1, May 1994.
                                                                                                                          2
COST OF CAPITAL FOR DELIVERING UNIVERSAL SERVICE OBLIGATIONS: 2000/01 TO 2002/3



                        An issue that arises is whether the corporate tax rate or an estimate of an effective tax
                        should be used in the above formula. Two factors, the difference between tax
                        depreciation rates and economic depreciation rates, and the company’s debt shield, lead
                        to the deferral of tax liabilities and hence in any year the ratio of tax paid to income (the
                        effective rate of tax) may differ from the statutory rate of tax. The effective tax rate will
                        differ over the relevant period due to the introduction of the business tax reforms. (This
                        issue is discussed in chapter 2.)


                        Estimation of the Return on Equity

                        There are many ways to estimate the return on equity required by investors, all of which
                        involve estimating the compensation that must be paid to investors for undertaking risky
                        investments. Generally speaking, the greater the risk, the greater the return required by
                        investors. The most important practical issues are which risks are compensated and by
                        how much.

                        The conceptual basis for the CAPM is that investors hold a diversified portfolio of
                        securities and that the risks associated with one investment are different than for the
                        market as a whole. A security’s risk can be decomposed into those unique to the
                        company in question (eg. it will lose sales to a competitor) and market risk (eg. it will
                        lose sales due to a recession, which will also affect its competitors). The key point is that
                        investors can eliminate company–specific risks by diversification (eg. by investing in
                        that company’s competitors) and so should not be rewarded for bearing this superfluous
                        risk. However, they cannot eliminate non–diversifiable risk (risk associated with
                        movements in the market as a whole) and so they should be rewarded for bearing this
                        risk. The extent of this reward depends on the extent to which the company’s returns are
                        correlated with the market as a whole. The larger this correlation, the greater the non–
                        diversifiable risk faced by the investor and so the larger will be the required return on
                        capital.


                        Specification of the CAPM

                        In the CAPM, the required equity return in a particular company is estimated as

                         R = R + β (R − R )
                            e       f         e   m     f



                        where       R    e
                                             is the required rate of return on equity, after company tax

                         R   f   is the ‘risk free’ rate of return;

                        β   e
                                 is the equity beta, defined as the covariance between the market return and the
                        return on the company’s equity, divided by the variance of the market return;

                         R −R
                            m        f   is the market risk premium.

                        Points to note about the CAPM are:

                        •        A distinction needs to be made between the “asset beta”, which refers to the
                                 riskiness of the returns to the asset per se, and the “equity beta” which refers to the
                                 riskiness of the returns to the equity holders. These are not the same because debt
                                 holders are assumed to be the first paid out of asset returns with the remaining
                                 income paid to equity holders. The greater the gearing, the greater the risk faced by
                                 equity holders, hence for a given asset beta, the equity beta will increase as the level
                                 of gearing increases.

                        •        Risk is synonymous with the variance of returns.

                                                                                                                        3
COST OF CAPITAL FOR DELIVERING UNIVERSAL SERVICE OBLIGATIONS: 2000/01 TO 2002/3



                        •   CAPM assumes that investors construct portfolios on the basis of expected return
                            and the variance of return only; ie. security returns are normally distributed, which
                            means they are symmetrically distributed around the expected return. CAPM does
                            not allow for skewed returns.

                        •   Only non–diversifiable risk affects the cost of capital. An asset whose returns are
                            characterised by zero non–diversifiable risk will have an equity beta of zero and
                            hence earn the risk–free rate of return on capital.


                        Equity Beta

                        The value of equity beta in the above formula depends critically on the leverage of the
                        firm in question ie. ratio of debt to total capital. This is because the equity holders in a
                        firm are the residual claimants of value, after the debt holders have been paid.
                        Consequently, the greater is the firm’s leverage, the greater the risk faced by equity
                        holders, and hence the larger their required return.

                        However, the risks associated with the cash flows associated with the firm’s assets per se
                        do not depend on whether those assets are financed by debt, equity, or some
                        combination of the two. The non-diversifiable risk associated with the firm’s assets (and
                        hence required return to those assets) is measured by the asset beta, and it is independent
                        of the firm’s capital structure. The equity beta, in turn, will depend on the asset beta and
                        the firm’s leverage.

                        Furthermore, while it may be convenient to assume that only equity holders face risk, ie.
                        debt holders face no risk, in practice that is not so. Debt holders do, in fact, face the
                        prospect that borrowers will default on their payments, and so charge a debt premium to
                        borrowers that reflects the risk of that event.

                        In the context of the CAPM, this risk is captured by the so-called debt beta, as follows.

                         Rd = R f + β d ( Rm − R f )
                        Analogously to the return on equity, the return on debt is equal to the risk free rate plus a
                        margin equal to the market risk premium multiplied by a parameter reflecting volatility,
                        the debt beta βd. Thus the debt beta is calculated as the debt premium (Rd-Rf) divided
                        by market risk premium (Rm-Rf).

                        The equity beta is then calculated as

                        β e = β a *(1+ D / E *(1− (1 − γ )* T))− β d * (1 −(1 − γ )*T) * D / E
                        This formula shows that the equity beta increases with increases in both the asset beta
                        and the ratio of debt to equity and decreases as the debt beta increases. In other words,
                        risk is shared between equity holders and debt holders and as the risk faced by debt
                        holders increases (represented by a higher debt beta) the risk faced by the equity holders
                        will diminish (represented by a lower equity beta).

                        CAPM should not be used mechanically to calculate the cost of capital. CAPM rests on
                        assumptions that may be only approximately true and sound judgment is required in its
                        application.




                                                                                                                    4
COST OF CAPITAL FOR DELIVERING UNIVERSAL SERVICE OBLIGATIONS: 2000/01 TO 2002/3



                        1.3         New Schemes to provide the Universal Service
                                    Obligation

                        The Commonwealth Government’s new legislative framework for the USO will
                        introduce three types of USO schemes will operate in mutually exclusive areas of
                        Australia. Broadly, these three schemes are:

                        •      pilot areas;

                        •      the extended zones; and

                        •      ‘rest of Australia’.


                        Scheme 1: Pilot Areas

                        The Government intends to establish two Pilot Areas within which any number of
                        approved carriers may compete to provide the standard telephone service — that is,
                        there will be ongoing contestability for these services in these areas. Any carrier can
                        enter provided it has pre-qualified as a USP with the ACA. Carriers may seek
                        qualification at any time.

                        ACG will treat these two Pilot Areas as the same for the purposes of estimating the
                        WACC. One pilot area will attract BARN (Building Australian Regional Networks)
                                          2
                        funding for USPs.

                        Both areas will be net cost areas overall, but they will include some profitable zones as
                        well as unprofitable zones. It is expected that each Pilot Area will include 10,000 to
                        15,000 net cost services.

                        All USPs will be required to offer a standard service to all households in the area. They
                        may also choose to offer services in addition to the standard telephone service.
                        However, in each zone, a Primary USP (PUSP) or ‘carrier of last resort’ will be
                        declared. PUSPs must remain prepared to provide a standard service to any customer in
                        the zone as well as providing payphones etc.

                        Initially, the PUSP for both areas will be Telstra. However should another carrier gain a
                        greater market share than Telstra or be prepared to be the PUSP, the Government may
                        declare another carrier the PUSP for that zone. In this situation, Telstra would be free to
                                                        3
                        remain in the area and compete.

                        All carriers (including the PUSP) will be paid a subsidy per service provided. The
                        subsidy will vary for zones considered more or less profitable. For example, the subsidy
                        per service connected in a provincial town is likely to be less than a subsidy per service
                        connected in a remote area and the subsidy level may be zero for some services in
                        operation. The PUSP will also be paid an additional premium payment in recognition of
                        requirement to maintain infrastructure capable of connecting customers within service
                        requirements.

                        The subsidy per service and the premium payment will be determined administratively
                        using an approach similar to that used to calculate the NUSC in the past. (It will be
                        funded from the USO Fund made up of contributions by all carriers and carriage service
                        providers in proportion to their eligible revenue.) The policy intention is to subsidise the
                        provision of the standard service in these Pilot Areas, but not to provide full
                        compensation to one USP for doing so.

                        2
                              Funding to support innovative market models for the delivery of regional communications services.
                        3
                              There will be no mandated requirement for Telstra to provide access for other USPs to its infrastructure.
                                                                                                                                          5
COST OF CAPITAL FOR DELIVERING UNIVERSAL SERVICE OBLIGATIONS: 2000/01 TO 2002/3



                        The ACA has advised ACG that it expects the Pilot Areas to be identified in June this
                        year, the subsidy and premium payment amounts to be determined by August 2000, the
                        interested carriers to pre-qualify by the end of this year and the first carriers (USPs) to
                        commence offering services in the Pilot Areas in the first quarter of 2001.


                        Scheme 2: Extended Zones

                        The ‘Extended Zones’ is the area which currently does not have access to untimed local
                                                                                        4
                        calls or to untimed local call rate access to internet services. This region incorporates
                                             5
                        111 extended zones. Extended Zones are call charging zones outside Telstra’s standard
                        local call charging zones. The region includes approximately 40,000 services in
                        operation in remote areas covering 80 per cent of Australia’s land mass.

                        The government is currently offering the right to untimed local calls into the Extended
                        Zones by tender to all carriers. The chosen carrier will become the sole USP in that
                        region.

                        This sole USP will be paid a subsidy plus a once-only $150 million grant to fund the
                        introduction of untimed local calls in the region. The subsidy will be based on forward
                        looking costs and revenue (based on Telstra’s past revenue for last year) and paid at the
                        end of the financial year. It will also be funded from the USO Fund made up of
                        contributions by all carriers and carriage service providers in proportion to their eligible
                        revenue.

                        Competition is possible under this scheme where a new entrant becomes sole USP.
                        Telstra may remain in the region (or any other carrier may enter the region) and provide
                        services in direct competition with the sole USP albeit without subsidy payments and
                        without universal service obligations. It is possible that Telstra could compete with the
                        sole USP successfully given the sunk nature of its infrastructure costs.


                        Scheme 3: Rest of Australia

                        The ‘Rest of Australia’ incorporates the remaining net cost zones in Australia —
                        approximately 400,000 net cost services within the urbanised areas. In this area, Telstra
                        will remain the sole USP under the same arrangements as exist currently.


                        1.4       Previous Reports

                        ACG has previously provided the Australian Communications Authority (ACA) with
                                                                                               6
                        estimates for the cost of capital of providing USO services for 1997/98 and 1998/99 to
                                   7
                        1999/2000 .




                        4
                              With the exception of the ‘inner extended zones’ within which are small communities with access to
                              untimed local calls within their own ‘inner’ zone only.
                        5
                              Each extended zone includes an outer extended zone and an inner extended zone. A ‘pastoral rate’ for
                              calls is currently available for calls between customers in the outer extended zone, from customers in an
                              inner zone to another customer in the same inner zone, from customers in an inner zone to customers in
                              its surrounding outer zone, and from customers in the extended zone to the designated ‘community
                              service town’ (which provides essential medical and other services to the extended zone).
                        6
                              ACG (1999a) Final Report to the Australian Communications Authority, Telstra’s Weighted Average
                              Cost of Capital: Application to the USO, 31 March.
                        7
                              ACG (1999b) Final Report to the Australian Communications Authority, Cost of Capital for Delivering
                              Universal Service Obligations, Estimates for 1998/99 and 1999/2000, December.
                                                                                                                                     6
COST OF CAPITAL FOR DELIVERING UNIVERSAL SERVICE OBLIGATIONS: 2000/01 TO 2002/3



                        The key issue in calculating the WACC previously was whether the equity beta value
                        should take account of the existence of the USO cost sharing arrangements. ACG’s view
                        was that the effect of USO Fund arrangements significantly decreased the risks
                        associated with providing USO services and that this decrease should be reflected in a
                        lower equity beta. ACG considered that the payments to Telstra from the USO Fund
                        greatly mitigated (if not eliminated) the non-diversifiable risks faced by Telstra in the
                        provision of the USO.
                               “The effect of the regime can be interpreted as providing the USO provider with
                               sufficient compensation that it would not choose to leave the industry (which is to
                                                                                                      8
                               supply USO services to net cost areas) if it had the freedom to do so.”

                               “In particular, … the operation of the USO fund is expected to significantly reduce the
                               non-diversifiable risk of providing USO services in net cost areas, and so to ignore the
                               effect of the fund would be to significantly err in the determination of the cost of capital
                                                                                                9
                               (in particular, to overstate the cost of capital significantly).”

                        ACA required ACG to estimate two WACCs for 1998/99 and 1999/00 — one WACC
                        that took account of the USO cost sharing arrangements, and one that did not.

                        ACG argued that the USO Fund was the mechanism through which the USO provider
                        would receive sufficient compensation to retain its assets in net cost areas in the
                        industry. As its operation had a significant effect on the projected net cash flows from
                        providing USO services in net cost areas, it had to be taken into account. The USO Fund
                        had the effect of transferring the (non–diversifiable) market risk associated with the sale
                        of USO services to net cost areas from the USP to the contributors to the USO Fund as
                        if they were the providers of the service. The operation of the Fund meant that the
                        particular identity of the USP did not affect the risks borne by the contributors to the
                        Fund. Hence there was no opportunity cost associated with being the USP per se.
                        However, a small amount of non-diversifiable risk may have remained, for example that
                        associated with non-payment by one or more carriers into the Fund.

                        ACG estimated that an asset beta of about 0.1 would be appropriate taking account of
                        the USO Fund arrangements. (When excluding the effect of the Fund, ACG estimated
                        the asset beta to be 0.6.)


                        1.5      Forecasting the WACC for three years

                        Previous estimates of WACCs for delivering USOs have been backward-looking. The
                        WACC estimates and all of their components were presented in nominal terms since the
                        inflation for the year in question was known. That is, the WACCs are set at a level that
                        will compensate the USP for the loss of spending power due to inflation, as well as the
                        real opportunity cost of holding those funds.

                        However, under the new USO schemes, ACG is required to provide forward-looking
                        estimates of the WACC. If a nominal cost of capital is set for three years in advance,
                        then the USP(s) will bear the risk that inflation will be higher or lower than that
                        implicitly forecast in today’s nominal interest rates, and hence they may not actually
                        receive their real cost of capital in those years. The WACC estimates for 2000/01,
                        2001/02 and 2002/03 could be adjusted for risk in a number of ways.

                        Cable & Wireless Optus (CWO) recommends that actual ex post revenues be used to
                        determine the NUSC applying to each year. In a concession to the Government’s

                        8
                              ACG (1999a) Page 11
                        9
                              ACG (1999a) Page 15
                                                                                                                              7
COST OF CAPITAL FOR DELIVERING UNIVERSAL SERVICE OBLIGATIONS: 2000/01 TO 2002/3



                        expressed desire for certainty in funding, CWO further suggests that actual revenues
                                                                                                  10
                        could be used to estimate the annual NUSC for all carriers except Telstra. Telstra notes
                        that for 2000/01 inflation risk is not a problem, and recommends an extension of the
                        approach used in this report where the average of the risk free rate is estimated for the
                                                                     11
                        first 20 trading days for each relevant year. Telstra also noted in discussions that the
                        NUSC estimated using a real measure of WACC does not send complete information to
                        new USO carriers of the true cost of providing USO services.

                        However, these approaches all require the NUSC estimate made this year for the period
                        2000 to 2003 to be revisited each year, at least in a limited way. This is contrary to the
                        request made by the government of the ACA.
                               The ACA is required to administratively determine subsidy levels for pilot areas prior to
                               the introduction of contestability. As such, there is no scope for adjusting the level of
                               subsidies when the actual level of inflation is known. At this stage, the ACA’s intention
                               is to use nominal WACC estimates to determine both subsidy and NUSC levels for
                               2000/01 to 2002/03.

                                                                            Communication from the ACA 14 June 2000

                        This report will present nominal pre-tax measure of WACC for 2000/01, 2001/02 and
                        2002/03.




                        10
                             Cable & Wireless Optus (2000a) Pilot Regions for USO Contestability, Response to the Department of
                             Communications, Information Technology and the Arts paper, p.7
                        11
                             Telstra (2000) Weighted Average Cost of Capital for USO Costing 2000/01 to 2002/03: Telstra’s
                             Response to ACG’s Report to the ACA, 7 June, p.3
                                                                                                                             8
COST OF CAPITAL FOR DELIVERING UNIVERSAL SERVICE OBLIGATIONS: 2000/01 TO 2002/3




                        Chapter 2
                        Parameters of the Capital Asset Pricing
                        Model

                        It is in the nature of the CAPM that most of its constituent parameters are unlikely to
                        have significantly changed since the ACG’s report of December 1999. However, we
                        have considered the most recent regulatory determinations of WACC since December
                        1999, including the:

                        •     ACCC’s draft report on The Assessment of Telstra’s Undertaking for the Domestic
                              PSTN Originating and Terminating Access Services dated April 2000; and

                        •     Office of the Regulator-General’s Draft Decision of the Victorian Port Price
                              Review dated May 2000 and 2001 Electricity Distribution Price Review Draft
                              Decision dated May 2000.

                        Forecasts of the WACC for 2000/01, 2001/02 and 2002/03 are presented in this chapter.
                        Each of the parameters making up the WACC is discussed in turn. Throughout this
                        chapter, we assume Telstra is the PUSP under the current USO scheme. This is
                        equivalent to the future arrangements in the Rest of Australia or Telstra winning the sole
                        USP role for the Extended Zones. Chapter 3 will address the CAPM parameters most
                        likely to differ under the three USO schemes.


                        2.1       Gearing Level

                        In 1999 ACG concurred with the ACCC that the forward-looking estimate of Telstra’s
                        gearing level was 10.1 per cent:
                                “in the absence of a rigorous study of the optimal capital structure for a firm like
                                Telstra, it is not unreasonable to regard Telstra’s target future gearing ratio as the best
                                                               12
                                estimate of such an optimum.”

                        However, the new regulatory situation is significantly different to what has prevailed in
                        the past, as USO costing is no longer Telstra-specific. Telstra might not be the sole USP
                        in the Extended Zones and will possibly be just one of several USPs in the Pilot Areas.
                        There is no reason to presume that Telstra’s target gearing ratio should be applied to all
                        potential USPs; rather, a benchmark gearing ratio should be employed in the calculation
                        of the WACC.
                                                                                          13
                        Furthermore, even with regards to Telstra, the ACCC has recently adopted a new
                        approach. The ACCC has reconsidered the gearing level estimates using the valuation of
                        the regulatory asset base as the relevant basis. It has observed that the PSTN regulatory
                        asset base is a relatively stable asset and therefore, in the first instance, considered
                        Telstra’s current book gearing level of 43.1 per cent as a fair approximation. It then
                        compared this level against estimates of an efficient operator’s target, or benchmark,
                        gearing level and adopted an estimate of 40 per cent. The ACCC notes that this is a
                        departure from the approach that is usually appropriate under the CAPM model,



                        12
                              ACCC (1999) Assessment of Telstra’s Undertaking for PSTN Originating and Terminating Access: Cost
                              of Capital (Revised), June, Page 4
                        13
                              ACCC (2000) Draft Report on the Assessment of Telstra’s Undertaking for the Domestic PSTN
                              Originating and Terminating Access Services, April.
                                                                                                                              9
COST OF CAPITAL FOR DELIVERING UNIVERSAL SERVICE OBLIGATIONS: 2000/01 TO 2002/3



                                       however the Commission considers its new approach is appropriate for a regulatory
                                       model.

                                       Telstra has suggested a target gearing of 15 per cent (higher than the previous estimate
                                       of 10.1 per cent) as being consistent with the higher premium now applicable to the
                                                                                                      14
                                       company’s debt and reflecting its long term debt profile. In discussion, Telstra
                                       suggested an actual market gearing of between 7 to 23 per cent (actual gearing for US
                                       telecommunications companies providing standard telephone services provided by
                                       Bloomberg’s) would be more appropriate. Telstra describes the estimate of 40 per cent
                                       as a book value based gearing which is inferior to a market-value approach. Telstra also
                                       notes that this change in approach from previous ACCC PSTN decisions has been made
                                       in a draft report that may be revised.

                                       However, as noted above, in the current context what is important is an industry-wide
                                       benchmark. There now exists a large body of regulatory cases from which some
                                       guidance may be drawn on this issue. Table 1 below, adapted from the Office of the
                                       Regulator-General, Victoria (ORG) recent draft decision into electricity distribution
                                       prices shows that regulated Australian utilities have benchmark gearing levels of 60 per
                                       cent (and risk margins of up to 1.2 per cent).

Table 1
COST OF DEBT AND FINANCIAL STRUCTURE ASSUMED BY AUSTRALIAN REGULATORS

                                                               Assumed margin
                                                               over the risk free         Assumed
                 Regulatory decision                            rate structure             gearing
                                                                 (debt/assets)
 ORG Final Decision on Victorian Gas Distribution                    1.2%                    60%
 (October 1998)
 ACCC Final Decision on Victorian Gas                                1.2%                    60%
 Transmission (October 1998)
 IPART Great Southern Network Final Decision                         1.2%                    60%
 (March 1999)
 IPART Albury Gas Company Final Decision                           0.9 – 1.1%                60%
 (December 1999)
 IPART NSW Electricity Distribution Final Decision                 0.8 - 1.0%                60%
 (December 1999)
 ACCC TransGrid Final Decision (January 2000)                        1.0%                    60%
 ORG Draft Decision on Electricity Distribution Price                1.2%                    60%
 Review (May 2000)

Source: ORG 2000, 2001 Electricity Distribution Price Review: Draft Decision, May p.172


                                       The relevant issue is what is the optimal (WACC minimising) level of gearing. Since
                                       debt finance is tax deductible for the company, but equity finance is not, the WACC will
                                       tend to decrease as gearing increases, up to the point where the increases in the debt
                                       premium (caused by increased probability of bankruptcy) outweigh the effects of tax
                                                     15
                                       deductibility. There is no simple answer to the question of what is the optimal gearing
                                       ratio for a USP, but it should be larger than the 10 to 15 per cent suggested by Telstra,
                                       given the tax advantages of debt. Caution should be exercised however before adopting




                                       14
                                            Telstra (2000) p.5-6
                                       15
                                            The existence of an optimal capital structure is discussed in chapters 17 and 19 of Morin, R (1994)
                                            Regulatory Finance: Utilities’ Cost of Capital, Public Utilities Reports, Inc.
                                                                                                                                            10
COST OF CAPITAL FOR DELIVERING UNIVERSAL SERVICE OBLIGATIONS: 2000/01 TO 2002/3



                        gearing benchmarks (of 60 per cent) that have applied to electricity and gas companies,
                                                                                                          16
                        since they might not be comparable in all relevant respects to telecommunications.

                        In all the circumstances, a gearing level of 40 per cent for the telecommunications USO
                        would appear reasonable.

                        In estimating the USO WACC for 2000/01, 2001/02 and 2002/03, a gearing level of
                        40 per cent should be used.


                        2.2       Risk Free Rate

                        Typically, the risk free rate is estimated by the rate of return on Commonwealth
                        Government bonds. However, as noted in previous ACG reports, carriers have raised the
                        question of the most appropriate maturity of the bonds, arguing that the risk free rate
                        should be based on the relevant regulatory period.

                        The ACCC in its Draft Statement of Principles for the Regulation of Transmission
                        Revenues, has adopted the five-year Government bond rate as it corresponds to the
                        National Electricity Code regulatory period, and recently adopted a (hypothetical) 2 year
                        bond rate in its Draft Assessment of Telstra’s Undertaking for the Domestic PSTN
                        Originating and Terminating Access Service.

                        However, as ACG has noted previously, while the telecommunications USO cost is
                        calculated on a year–by–year basis, calculation of the NUSC is not equivalent to an
                        annual pricing review. This is particularly given the policy underlying the new USO
                        schemes that payments are no longer intended to fully compensate the USP (as discussed
                        in chapter 3).

                        ACG has recommended, and ACA adopted, the 10 year Commonwealth bond rate as the
                        risk free rate for estimating the WACC for the supply of USO services in the past. For
                        this assessment the risk free rate is forecast of 10 year bond yields. The best market
                        estimate of future rates is the most recent prevailing rate. However, as one day’s rate can
                        be subject to short term variability it is regulatory practice to adopt an average of the
                        rates over a short period to smooth these variations. Consistent with the approach
                                                                           17
                        adopted by the Office of the Regulator-General ACG has used an average of 10 year
                        bond yields for 20 days.

                        In response to the draft report, Vodafone noted that the 20 day average was too short,
                        and that further, the period used coincided with a particularly volatile time in financial
                                 18
                        markets. As noted, the use of a 20 day average is generally accepted practice (most
                        recently used by the ORG) designed to avoid such short term variability. However, in
                        this case the period used has had an impact on the rate.

                        The data used to estimate the risk free rate in the draft report was for the period 26 April
                        to 23 May 2000. In this report, the data used is for the period 15 May to 9 June 2000.
                        The change in period has resulted in the rate changing from 6.50 to 6.33 per cent.

                        For 2000/01, 2001/02 and 2002/03, the forecast risk free rate is 6.33 per cent.


                        16
                              Although , interestingly, energy utilities appear to have the same degree of non-diversifiable risk. In its
                              2001 Electricity Distribution Price Review Draft Decision, the ORG has assigned an asset beta of 0.5 to
                              the distribution companies, the same value assigned to Telstra’s PSTN by the ACCC.
                        17
                              Office of the Regulator-General, Victoria (2000) Draft Decision of the Victorian Port Price Review, May
                              2000 and 2001 Electricity Distribution Price Review Draft Decision, dated May 2000
                        18
                              Vodafone Australia (2000) Cost of Capital for Delivering Universal Service Obligations: Estimates for
                              2000/01 to 2002/03 Vodafone Submission, 6 June, p.5
                                                                                                                                     11
COST OF CAPITAL FOR DELIVERING UNIVERSAL SERVICE OBLIGATIONS: 2000/01 TO 2002/3



                        2.3       Market Risk Premium

                        The market risk premium (MRP) represents the excess over the risk free rate of return
                        required by equity investors to invest in a diversified Australian equity portfolio.

                        Previous ACG reports noted that the consensus of recent professional opinion in
                        Australia appeared to be that the market risk premium is 6.0 per cent. However it was
                        noted that a respectable body of opinion argues that the equity risk premium around the
                        world has fallen.

                        OFTEL, the telecommunications regulator in the United Kingdom, recently used a
                                                                   19
                        market equity risk premium of 5 per cent. Likewise, OFGEM, the energy regulator for
                        the United Kingdom, and OFWAT, their water and sewerage services regulator, used
                                                                       20
                        rates between 3 and 4 per cent late last year. IPART used a premium of between 5 and
                                                                    21
                        6 per cent in a number of recent decisions.

                        The ACCC used a figure of 5.5 per cent in its September 1999 Draft Decision on the
                        Access Arrangement by AGL Pipelines (NSW) Pty Ltd for the Central West Pipeline,
                        where it said:
                                “The Commission accepts that there is considerable evidence from recent studies of
                                financial markets that the market risk premium has reduced in recent years. The
                                Commission considers the evidence sufficient to lower the bottom end of the probable
                                range of the market risk premium giving a probable range of 3.5-7.5 per cent. This is a
                                particularly large range, reflecting the uncertainty (experienced both in Australia and
                                overseas) associated with estimating the market risk premium. The Commission favours
                                the lower numbers suggested by recent empirical evidence but acknowledges that such
                                figures are not universally accepted by financial markets at present. Accordingly, the
                                                                                                                  22
                                Commission has used 5.5 per cent in its calculations of the WACC for the CWP.”

                        However, the ACCC has since used 6.0 per cent as the MRP estimate in its Final
                        Decision on Transgrid in January this year.

                        While the MRP appears to be falling, ACG considers CWO’s previously recommended
                        MRP of 3.0 to 3.5 per cent is not justified. The very aggressive estimates from the
                        United States of a zero MRP (cited favourably by CWO) appear to be based entirely on
                        an assumption that the stock market in that country will continue its surge of recent
                        years. An assumption that must be questioned in the light of recent stock price falls
                        throughout the world.

                        Estimates of the MRP, particularly given recent developments in stockmarkets, must be
                        made with a certain degree of circumspection. Professional opinion remains divided
                        about whether the recent corrections in stockmarkets are just the first step towards a
                        major correction — implying a higher MRP or merely a temporary lull in a fundamental
                        restructuring of equity returns, driven the communications revolution and the new
                        economy — implying a lower MRP.




                        19
                              OFTEL (1998) Submission to the Monopolies and Mergers Commission inquiry into the prices of calls
                              to mobile phones, May 1998 found at http://www.oftel.gov.uk/pricing
                        20
                              OFGEM (1999) Electricity Distribution Final Proposals, December and OFWAT (1999) Water and
                              Sewerage Services Final Determination, November.
                        21
                              IPART (1999) Great Southern Network Final Decision, March, IPART (1999) Albury Gas Company
                              Final Decision, December and IPART (1999) NSW Electricity Distribution Final Decision, December.
                        22
                              ACCC (1999b) Draft Decision on the Access Arrangement by AGL Pipelines (NSW) Pty Ltd for the
                              Central West Pipeline, 10 September, Page 38.
                                                                                                                            12
COST OF CAPITAL FOR DELIVERING UNIVERSAL SERVICE OBLIGATIONS: 2000/01 TO 2002/3


                                                                                                                           23
                        Telstra advocates the use of ex post historical estimates of around 6 to 6.5 per cent.
                        However, ex ante estimates are conceptually more accurate. ACG notes the deliberations
                        of the ORG in its recent assessment of cost of capital for electricity distribution. The
                        ORG has estimated the forward-looking (ex ante) equity premium using the Dividend
                        Growth Model.
                                … in the period since October 1991,the ex ante estimate of the equity premium has
                                been very stable at approximately 5 per cent (averaging 4.8 per cent). This estimate of
                                the equity premium is consistent with the treatment of franking credits adopted in this
                                Draft Decision and a ‘gamma ’assumption of 0.5. However, the use of the dividend
                                growth model is based upon a number of simplifying assumptions that might not accord
                                with the expectations of investors on average. Accordingly, the Office does not consider
                                it appropriate to place undue weight upon the outcomes of such a model. Rather, it
                                should be used as additional guidance when selecting the equity premium within the
                                                  24
                                reasonable range.

                        ACG considers that the ORG’s findings indicate the reasonableness of the MRP estimate
                        of 5.5 per cent. This is despite the ORG deciding to adopt an estimate of 6.0 per cent.
                                For the purposes of this Draft Decision the Office has taken a conservative approach
                                and has used the figure of 6 per cent. It has done so notwithstanding the plausible
                                arguments that exist which suggest that the market risk premium has fallen below its
                                long-term historical average, and the market-based information provided by the
                                dividend growth model. This is at the upper end of that used in recent regulatory
                                decisions and consistent with the range of historical estimates. It is about 1 per cent
                                above the ex ante estimate of the equity premium over recent period (using the approach
                                                                  25
                                described in this Draft Decision.

                        ACG remains of the view that an estimate of 5.5 per cent for the MRP represents a
                        prudent assessment of current ex ante required return on a portfolio of share investments
                        relative to the return on government bonds.

                        In estimating the USO WACC for 2000/01, 2001/02 and 2002/03, a market risk
                        premium of 5.5 per cent should be used.


                        2.4       Debt Premium

                        The debt premium over the risk free rate reflects debt risk specific to the firm in
                        question. In ACG’s estimate of the USO WACC for 1998/99 and 1999/00, ACG used a
                        debt premium of 0.8 per cent for Telstra. Telstra provided the estimate based on market
                        information for the company as a whole.

                        We note that the ACCC in its recent draft report has stated that “in the Commission’s
                                                                                                         26
                        view, the debt premium on the PSTN should be lower than for Telstra as a whole”. The
                        Commission therefore adopted an estimate at the mid-point of the range of the observed
                        debt premium on Telstra’s bonds for the preceding year.

                        Telstra has recently provided estimates of its debt premium based on updates of the
                        same information provided for past assessments. The observed debt premium has risen
                        to 1.2 per cent. This increase appears to reflect the recent downgrade in ratings of
                        Telstra’s debt by Moody’s and Standard and Poor’s due to Telstra’s acceptance of
                                                                27
                        additional debt for e-based investments.


                        23
                              Telstra (2000) p.8
                        24
                              ORG (2000) 2001 Electricity Distribution Price Review Draft Decision, May, p. 158
                        25
                              op.cit
                        26
                              ACCC (2000) p. 95
                        27
                              Telstra (2000) p.9
                                                                                                                           13
COST OF CAPITAL FOR DELIVERING UNIVERSAL SERVICE OBLIGATIONS: 2000/01 TO 2002/3



                        Like the gearing ratio, the debt premium for calculating the USO WACC should not be
                        Telstra-specific. However, as shown in Table 1, 1.2 per cent appears to be the debt
                        premium that applies generally to regulated Australian businesses, so applying this
                        figure for the telecommunications USO is not unreasonable.

                        In estimating the USO WACC for 2000/01, 2001/02 and 2002/03, a debt premium of
                        1.2 per cent should be used


                        2.5       Corporate Tax Rate

                        As mentioned in chapter 1, an issue that arises when using the CAPM is whether to use
                        the corporate tax rate or an estimate of the effective tax rate. In past ACG reports,
                        largely due to the difficulty of estimating an effective tax rate and the divergent views of
                        carriers, the statutory corporate tax rate was used.

                        Telstra noted the difficulty in calculating the effective tax rate.
                                “Telstra has not been able in the short time available to calculate a rigorous estimate of
                                the effective rate. This is partly due to data unavailability at the USO level and partly
                                due to complications that arise when net cashflows are negative. This difficulty suggests
                                that investors are unlikely to be able to identify, in advance, an appropriate effective tax
                                rate to use in future years. Investors will therefore tend to rely on the statutory tax rate
                                                                                 28
                                to gross up their estimates of required return.”

                        However the Government’s recent taxation reforms, specifically the abolition of
                        accelerated depreciation, have essentially nullified this issue, for it is accelerated
                        depreciation that largely determines the difference between the statutory and effective
                        rates. Thus, from 2000/01 onwards, the statutory and effective corporate tax rates should
                        be quite similar. (But they will still exhibit some divergence, because under the tax laws
                        depreciation can only be claimed as a tax expense based on historical cost. The presence
                        of inflation will erode the real value of these deductions.)

                        Telstra’s submission to the ACA in 1999 addressed the business tax reforms.
                                “Telstra does not believe that this prospective change to the corporate tax rate should be
                                adopted in consideration of the USOs WACC for 1998-99 and 1999-00… Telstra
                                believes that the forward-looking focus of investors suggests that they may quickly
                                adopt the new statutory tax rate in their investment evaluations. Moreover, Telstra
                                believes that they will generally adopt the 30% tax rate and abstract through the short-
                                term application of the 34% rate.
                                … in a forward-looking sense accelerated depreciation has been removed and since that
                                was the major factor behind divergence in the statutory and effective rates, these tax
                                                     29
                                rates will converge.”

                        The estimation of an effective corporate tax rate is very difficult, and it is not surprising
                        that emerging regulatory practice eschews this approach altogether, in favour of an
                        approach that calculates the actual amount of tax paid. However, in the USO context,
                        even this would be difficult since it would entail estimates of tax paid by a fictional
                        entity on the basis of avoidable revenues and costs and a notional (best practice) set of
                        assets. It should be noted that the ACCC has recently attempted this, estimating an
                        effective tax rate of 20 per cent for PSTN as a whole using a cash flow model. AAPT
                                                             30
                        suggests ACG follow this approach.




                        28
                              Telstra (1999a) Page 6
                        29
                              op cit.
                        30
                              AAPT Telecommunications (2000) WACC for Delivering the USO, 7 June, p.2
                                                                                                                               14
COST OF CAPITAL FOR DELIVERING UNIVERSAL SERVICE OBLIGATIONS: 2000/01 TO 2002/3



                        However, the ACCC exercise assumed the current taxation system for 1999/2000 and
                        2000/01. An equivalent exercise of the three future years relevant to this report would
                        require significant asset information for possible USPs and detailed foresight as to the
                        application of the new taxation laws. This should be considered in the light of
                        expectations that the business tax reforms will result in a lower differential between the
                        statutory tax rates and the effective tax rates than existed previously.

                        There does not appear to be a feasible alternative—certainly in the time available to
                        prepare this report—to using the future statutory corporate tax rates.

                        In estimating the USO WACC, the statutory corporate tax rate used should be:
                                           2000/01     34.0 per cent
                                           2001/02     30.0 per cent
                                           2002/03     30.0 per cent

                        2.6      Imputation Factor

                        The WACC estimate needs to reflect the returns to private shareholders from franked
                        dividends. In past analyses, ACG has estimated the imputation factor, γ, to be 0.5 with
                        this value reflecting

                        •      the extent to which companies can pay franked dividends; and

                        •      the value of franked dividends in the hands of the investors.

                        In its submission, CWO has claimed that the value of franking credits to be unrelated to
                        pay out ratios, on the grounds that firms could then affect their cost of capital by the
                        dividend policy (minimising it by 100 per cent of profits as dividends). CWO claims this
                        to be inconsistent with observed behaviour by firms. CWO proposes that the value of γ
                        lies between 0.8 and 1.0, based on the assumption that investors (especially following
                                                                                                  31
                        the business tax reforms) can now take full advantage of franking credits.

                        Clarity on this issue has recently been provided by the Victorian Office of the Regulator
                        General in its 2001 Electricity Distribution Price Review Draft Decision. According to
                        the ORG, the value of franking credits in Australia has been estimated at 0.5 based on
                        two different methodologies, aggregate taxation statistics and an empirical estimation of
                        the drop-off in the share price of firms at the point at which the dividend is paid. This is
                        market-based evidence that is not reliant on any assumptions about pay out ratios.

                        In its previous reports ACG recommended that an imputation factor of 0.5 be used. This
                        is the value generally used by Australian regulators. There would appear to be no
                        compelling reason to depart from this value.

                        In estimating the USO WACC for 2000/01, 2001/02 and 2002/03, an imputation
                        factor (gamma) of 50 per cent should be used.


                        2.7      Beta

                        Beta in the CAPM reflects the non-diversifiable risk faced by equity investors. The
                        appropriate value of beta is discussed in the following chapter.




                        31
                              Cable & Wireless Optus (2000b) Response to the Australian Competition and Consumer Commission’s
                              A draft assessment of Telstra’s Undertaking, April, p.6
                                                                                                                          15
COST OF CAPITAL FOR DELIVERING UNIVERSAL SERVICE OBLIGATIONS: 2000/01 TO 2002/3




                        Chapter 3
                        Asset and Equity Betas

                        In previously assessing the cost of capital for the Universal Service Obligation, ACG
                        concluded that because the USP (Telstra) was compensated ex post for losses actually
                        incurred, the net cost of USO provision, including payment from the USO Fund, was
                        effectively zero. On this basis, the non-diversifiable risk and hence beta in the CAPM
                        was also effectively zero. To account for the small probability that Telstra would not
                        receive its full entitlement because other carriers might default on their payments into
                        the Fund, beta was set at 0.1.

                        The new arrangements (described in chapter 1) announced by the Government could
                        potentially have profound impacts on the risk of USO provision, including the non-
                        diversifiable risk. The new arrangements are different in two important respects:

                        •      the cost of the USO will now be calculated on a forward looking basis; and

                        •      provision of the USO will be contestable in certain areas:

                                –       in the Extended Zones with a payment of up to $150 million to the
                                    successful tenderer for the purpose of upgrading infrastructure; and
                                –        in the Pilot Areas with the possibility of multiple carriers, and where
                                    Telstra will be given a premium payment as compensation for being designated
                                    the PUSP.

                        The implications of each of the above for beta risk is discussed below.


                        3.1         Implications of calculating WACC on a forward
                                    looking basis for the Rest of Australia

                        In the Rest of Australia, Telstra will continue as the sole USP. Under the old
                        arrangements (as set out in section 57 of the Telecommunications (Consumer Protection
                        & Service Standards Act 1999)) the Net Universal Service Cost (NUSC) is defined as

                        NUSC = avoidable costs less revenue foregone in serving cost net cost areas.

                        That is, in this formulation, the net cost of universal service provision is the incremental
                        cost caused by providing USO provision less the incremental revenue gained as a result
                        of that provision. In algebraic terms

                         NUSC = ∆C − ∆R
                        where ∆C is the incremental cost incurred by the sole USP including the cost of the
                        USO, and ∆R is the incremental revenues earned by the provision of USO services.

                        Since, under the old arrangements, the payment to the USP from the USO Fund was in
                        fact the NUSC, it follows that the net cost of universal service provision, inclusive of
                                                           32
                        payment from the Fund, was zero. In terms of the CAPM, this implies essentially zero
                        covariance with the market return, and the value of beta was zero (or very close to zero).




                        32
                              This does not mean that the cash return to the universal service provider was zero, since cost in this
                              calculation included a normal (competitive) return to capital.
                                                                                                                                16
COST OF CAPITAL FOR DELIVERING UNIVERSAL SERVICE OBLIGATIONS: 2000/01 TO 2002/3



                        (It should be noted that Telstra expressed concern that the current WACC estimates
                        assumed USO cashflows should be taken into account when there has been no explicit
                        government policy statement that this should be the case. The ACA has undertaken to
                                               33
                        investigate this issue. )

                        However, under the new arrangements, it is ACG’s understanding that the forward
                        looking estimates of the NUSC for the years 2000/01 to 20002/03 will be based on
                        benchmark, not actual, incremental revenues, where the benchmark will be (or will be
                                                                                            34
                        closely related to) Telstra’s incremental USO revenues for 1999/00.

                        This means that, under the new arrangements, payments from the Fund need not be fully
                        compensatory. To see this, let ∆Z be the incremental benchmark revenue from earned
                        from USO provision.

                        Payment from the Fund is then

                         Payment = ∆C − ∆Z

                        However, actual net revenues (before payment from the Fund payment) are

                        net _ revenue_ before _ fund _ payment = ∆R − ∆C

                        This means that net losses, after the payment from the Fund, are

                         Net _revenue _ after _ fund _ payment = ∆R − ∆Z

                        which will not (in general) be equal to zero. This means that the beta associated with the
                        provision of USO services will also not generally be zero.

                        It is useful to compare beta for USO services in the absence of the Fund with the beta
                        inclusive of the (now not fully compensatory) Fund. Without the Fund, beta is given by
                        the expression

                                     Cov( ∆R − ∆ C,M)
                        β
                             N
                                 =
                                          var(M)
                        where Cov denotes covariance, Var denotes variance and M denotes the return to the
                        market portfolio.

                        With payments from the Fund, beta is given by

                                     Cov(∆R − ∆ Z, M)
                        β
                             F
                                 =
                                         var(M)
                        Let X = ∆R – ∆Z i.e. X is the difference between actual incremental revenues from USO
                        provision and benchmark incremental revenues.

                        From the properties of covariances, it follows that

                        Cov(X, M) = ρ(X,M)σ (X)σ (M)

                        where ρ(X,M) is the correlation between X and M, σ(X) is the standard deviation of X
                        and σ(M) is the standard deviation of M.




                        33
                             In both their submission, Telstra (2000) p.11, and in discussions on 8 June 2000.
                        34
                             As before, USO costs will be based on best available technologies.
                                                                                                                 17
COST OF CAPITAL FOR DELIVERING UNIVERSAL SERVICE OBLIGATIONS: 2000/01 TO 2002/3



                        If benchmark incremental revenues are consistently close to actual incremental revenues,
                        then σ(X) will be small, so will Cov(X,M) and hence so will beta with operation of the
                        Fund. If benchmark incremental revenues always equal actual incremental revenues (a
                        special case) then σ(X) will be zero and so will beta. This is the same result as occurred
                                                                                                            35
                        under the old arrangements, where the USO Fund was always fully compensatory.

                        Thus, under the new arrangements, the minimum value for beta is zero.

                        It seems reasonable to assume that the covariance between earnings from USO provision
                        (in the absence of a Fund) and earnings from a market portfolio are due more to
                        variations in earnings than in costs. For example, during an economic boom, revenues
                        from USO services and earnings from a market portfolio are both likely to rise. It is
                        unlikely, on the other hand, that incremental costs from being the USP will be much
                        affected by general economic conditions.

                        Following this argument, if it can be assumed that Cov(∆C,M)=0, then it follows that

                        β
                             N       Cov(∆R, M)
                                 =
                                      var( M)

                        And since it is also true that

                        β
                             F       Cov(∆R, M) Cov(∆Z ,M)
                                 =             −
                                       var(M)     var(M)

                        then

                         β       =β −
                             F         N   Cov(∆Z, M)
                                             var(M)

                        Under the reasonable assumption that Cov(∆Z, M) >0, beta in the presence of the Fund
                                                                       36
                        will always be less than beta without the Fund. In the unlikely event that Z and M are
                        independent random variables, then Cov(∆Z, M) =0 and the two betas will be equal.

                        Combining this result with result established earlier leads to the following conclusion:

                        Under the new arrangements, the USO Fund will generally compensate losses from
                        USO provision only imperfectly. Beta in the presence of the Fund will lie in a range
                        which has a minimum value of zero and a maximum value equal to beta in the
                        absence of the compensatory Fund.

                        To the extent that benchmark incremental revenues (based on Telstra’s recent
                        historical revenues) reflect incremental revenues that will accrue to Telstra in the
                        Rest of Australia, then payments from the Fund will mitigate non-diversifiable risk
                        and beta will approach zero.




                        35
                             This result would hold under the approach recommended by Cable & Wireless Optus, in their submission
                             CWO (2000) p. 7, where actual revenues would be used ex post to update the NUSC calculation each
                             year.
                        36
                             In the unlikely event that ∆Z and M are independent random variables, then Cov(∆Z, M) =0 and the two
                             betas will be equal. It is also possible (but even more unlikely) that Cov(∆Z, M) =0 even if ∆Z and M are
                             dependent random variables, since independence implies zero covariance, but not vice versa.
                                                                                                                                  18
COST OF CAPITAL FOR DELIVERING UNIVERSAL SERVICE OBLIGATIONS: 2000/01 TO 2002/3



                        Contestable Areas

                        The above analysis was conducted for the Rest of Australia, to avoid the complication of
                        the effects of competition risk. However, the conclusions of this analysis also apply to
                        the contestable areas (the Extended Zones and Pilot Areas) because the NUSC (for the
                        Extended Zones) and the per service subsidies (for the Pilot Areas) will also be
                        calculated on a forward looking basis.

                        The effects of competition per se on beta risk are considered next.


                        3.2       Implications of calculating WACC on a forward
                                  looking basis for the Extended Zones

                        Under the Government’s proposed arrangements, the right to be the sole USP in the
                        Extended Zones is being put to tender. The winning tenderer will receive $150 million
                        as a grant payment to install upgraded equipment to provide untimed local calls in those
                        areas where currently they are not provided.

                        There are essentially two possible outcomes from this tender:

                        •     Telstra, the incumbent USP, wins the tender; or

                        •     another carrier wins the tender and becomes the sole USP.

                        The implications of each of these outcomes are rather different.

                        If Telstra wins the tender, then the analysis is almost identical to that of the Rest of
                        Australia. Telstra will be the sole USP and will in all likelihood not face any
                        competition at all in the provision of standard telephone services. Telstra will receive a
                        one-off payment of $150 million, but this has no bearing on the cost of capital. There
                        exists some possibility that, at some point in the future, one or more new pilot areas will
                        be carved out of the Extended Zones. If so, Telstra may face some competition as an
                        USP. But if this happens, it seems reasonable to assume that the circumstances will be
                        similar to the current Pilot Areas (see below); in which case Telstra will be explicitly
                        compensated for the risks associated with being the PUSP. There would appear to be no
                        reason for the cost of capital of being the sole USP in the Extended Zones to be affected
                        by this possibility.

                        If, however, another carrier wins the Extended Zones tender, the risks could be rather
                        different, though perhaps not the non-diversifiable risks, which are the risks of relevance
                        in determining the cost of capital. If another carrier wins the Extended Zones tender,
                        Telstra will be under no obligation to leave the market. Conceivably, Telstra could
                        choose to stay and compete for the provision of standard telephone services in these
                        areas. While Telstra will not be eligible to receive any payment from the USO Fund:

                        •     some pockets of the Extended Zones might be profitable to service;

                        •     Telstra’s costs in the Extended Zones may be largely already sunk anyway, so it will
                              have little to lose by staying and competing; and

                        •     even if neither of the above is true, Telstra could make a strategic choice to provide
                              standard telephone service in the Extended Zones as a “loss leader” with a view to
                              making up the shortfall through the sale of other services.




                                                                                                                  19
COST OF CAPITAL FOR DELIVERING UNIVERSAL SERVICE OBLIGATIONS: 2000/01 TO 2002/3



                        Under these circumstances, it is possible that the non-Telstra sole USP will not gain as
                        much market share as expected and so incur losses even with the payments from the
                        Fund, which will be based on Telstra’s (monopoly) benchmark revenues. This is
                        certainly a risk, but one that can be diversified by investors in that carrier by the simple
                        expedient of investing in Telstra, since the non-Telstra carrier’s loss (of market share), if
                        it happens, will be Telstra’s gain. Thus, from the point of view of investors, market
                        share risk is diversifiable and hence does not affect the cost of capital.

                        This said, it is quite possible that if a non-Telstra carrier wins the Extended Zones tender
                        it will, in fact, gain a monopoly, or near monopoly, market position. This is because it
                        will be entering with new technology and a $150 million grant payment, and this
                        technology could conceivably be far superior to what Telstra is currently deploying. The
                        reality may be that the only viable market outcome in these areas is a subsidised
                        monopoly.

                        Like the Rest of Australia, the value of beta for the Extended Zones will be between
                        zero and the beta that would exist in the absence of the USO Fund. To the extent that
                        benchmark incremental revenues (based on Telstra’s recent historical revenues)
                        reflect incremental revenues that will accrue to the winner of the Extended Zones
                        tender, then payments from the Fund will mitigate non-diversifiable risk and beta will
                        approach zero.


                        3.3         Implications of calculating WACC on a forward
                                    looking basis for the Pilot Areas

                        Under the proposed arrangements, several USPs could emerge in the Pilot Areas with
                        each being paid a per-service subsidy. The PUSP (effectively, the USP of last resort)
                        which will be initially Telstra will be paid a premium subsidy to compensate for risks (or
                                                        37
                        costs) entailed in being PUSP.

                        Obviously, market share risk will be significant in the Pilot Areas, but as discussed
                        above, this risk is diversifiable and so should have no effect on the cost of capital. The
                                                                     38
                        PUSP possibly faces risks of stranded assets .

                        The effect of calculating the subsidy in advance is the same as previously discussed ie.
                        the subsidy might only imperfectly align revenues with costs. With the Pilot Areas, the
                        (presumed) fact that multiple USPs will be operating and competing with each other
                        implies a greater probability that benchmark revenues based on Telstra’s previous
                        monopoly revenues will not be a good predictor of actual revenues, as competition could
                        be expected to grow the USO market (though this remains to be seen). This means that
                        the subsidies so calculated might not accurately reflect the level required to break-even
                        (including a normal, competitive profit). If so, the beta for the Pilot Areas will be
                        towards the upper end of the range ie. closer to the beta that would exist in the absence
                        of subsidies (or a USO Fund).




                        37
                              Vodafone, in discussions on 9 June 2000, suggested two WACCs may be needed: one for the per service
                              subsidy and another for the premium payment (where Vodafone considers the risk is lower). This issue
                              will be considered in another consultancy specifically considering the calculation of the premium
                              payment.
                        38
                              It is unclear, however, to what extent the PUSP would face stranded asset risk greater than any other
                              USP.
                                                                                                                               20
COST OF CAPITAL FOR DELIVERING UNIVERSAL SERVICE OBLIGATIONS: 2000/01 TO 2002/3



                        There is another reason to believe that beta for the Pilot Areas should be towards the
                        upper end of the range. This is because earnings for a firm in a competitive market will
                        be more sensitive to events in the economy as a whole than earnings in a monopoly
                        market. This belief reflects the fact that disturbances to demand will result in greater
                        fluctuations in output in a competitive market than in a monopoly market. Appendix A
                        demonstrates the point. Thus, other things being equal, beta for a firm operating in a
                        competitive market will be larger than beta for a monopolist.

                        The USPs for one Pilot Area will also gain access to funding from the BARN scheme.
                        This funding will encourage the development of ‘innovative market models’ for the
                        delivery of regional communications services, and may therefore encourage greater
                        entry by a greater number of USPs. Therefore, BARN funding may encourage greater
                        competition in one Pilot Area relative to the other. This has implications for the WACC
                        only if the non-diversifiable risk incurred by USPs is affected. USPs will have greater
                        market share risk, but this is diversifiable as noted earlier. Greater competition is likely
                        however, and this reinforces the conclusion that the beta will be greater than for a
                        monopolist.

                        In the Pilot Areas, therefore, the cost of capital, reflecting greater non-diversifiable risk,
                        is likely to be greater for the USPs than for the sole USP in the Extended Zones or the
                        Rest of Australia.


                        3.4      Value of Beta

                        Beta without the Effect of the Fund

                        Recent guidance on Telstra’s asset beta (for the PSTN) was provided by the ACCC in its
                        April 2000 draft report on The Assessment of Telstra’s Undertaking for the Domestic
                        PSTN Originating and Terminating Access Services. After consideration of submissions
                        and evidence from market analysts, the Commission decided that Telstra’s asset beta
                        should lie in the range 0.4 to 0.8. However, this range refers to Telstra’s business as a
                        whole. The Commission argued that the (non-diversifiable) risk for the regulated parts
                        of Telstra’s business, such as the PSTN, is likely to be less for Telstra;s entire business
                        and chose an asset beta of 0.5 to estimate the WACC for the PSTN.

                        These arguments apply with even greater force to the USO, which should be certainly no
                        riskier, and is arguably less risky, than the PSTN. Thus an asset beta of 0.5 for the
                        USO (where the USO Fund is assumed to have no mitigating effect on risk) is a
                        reasonable estimate.

                        In response to the draft report, a number of carriers suggested that the asset beta
                        (excluding the effect of the Fund) should, indeed, be lower.

                        AAPT stated that the beta should be less than 0.5 and Vodafone argued that beta should
                               39
                        be 0.3. Vodafone based this suggestion on its forecast that carrier revenues are likely to
                        be higher. However the relevant set of revenues for the NUSC calculation is confined to
                        USO revenue (not enhanced services) and the expected variance of these returns relative
                        to the market.




                        39
                              AAPT (2000) p.2 and Vodafone (2000) p.7
                                                                                                                   21
COST OF CAPITAL FOR DELIVERING UNIVERSAL SERVICE OBLIGATIONS: 2000/01 TO 2002/3



                        Telstra, on the other hand, claimed in its submission that it would be subject to
                        competition in all regions and that it should receive commercial returns (in recognition
                                                                                         40
                        of the opportunity cost of the next best commercial opportunity). Telstra recommended
                                                        41
                        an asset beta of 0.6 or higher.

                        Given an MRP of 5.5 per cent and a debt margin of 1.2 per cent, the debt beta is 0.22.
                        With gearing of 40 per cent, an asset beta of 0.5 implies an equity beta of 0.66.


                        Beta with the full Effect of the Fund

                        As argued above, if the risk mitigating properties of the USO Fund (or per-service
                        subsidies in the case of Pilot Areas) has full effect, then beta (both asset and equity) will
                        take on a value of zero. However, some allowance should be made for the possibility,
                        however remote, that complete payment from the Fund will not be made because a
                        carrier or carriage service provider defaults on payment into the Fund.

                        In addition, Telstra argued that the beta (taking account of the Fund) should be higher in
                        recognition of the regulatory risk illustrated by past experience where the NUSC amount
                                                                                 42
                        was set lower than the amount calculated by the ACA.
                               As the ACA are aware, the recognised cost for USO cost-sharing for 1997/98 was
                               $253.32m, considerably less than the $540.8m assessed by the ACA. Consequently it is
                               not valid to state or assume that the previous USO regime (equivalent in some ways to
                               the proposed default area [rest of Australia]) is fully compensatory in any meaningful
                               way. Similar outcomes can undoubtedly arise going forward in the new regime. Thus
                               there is a clear regulatory risk borne by the USP in the new regime that the recognised
                               USO costs will again be varied in potentially an artificial manner.

                                                                                               Telstra (2000) p.13-14

                        Regulatory risk is a non-systematic or asymmetric risk which is not incorporated in the
                        CAPM approach. In response to previous WACC reports by ACG, Telstra has argued
                        that the equity beta assuming the effect of the fund should be set higher than 0.1. In
                        response, ACG has noted that existence of other asymmetric risks which may offset this
                        effect.
                               On the other hand, there exist possible asymmetric risks which could warrant a lower
                               USO equity beta.
                               It is considered that USO provider status may afford an organisation benefits from its
                               universal presence and enhanced national brand recognition. These benefits have not
                               been factored into the USO cash flows. ACA is undertaking a study of the benefits of
                               being the USO provider.
                               Furthermore, the design of the USO scheme is one-sided. It attempts to compensate the
                               USO provider against the net costs of providing the USO, but does not retrieve excess
                               returns earned in a notified Net Cost Area.

                                 ACG 1999, Final Report to the ACA: Cost of Capital for Delivering Universal Service
                                              Obligations Estimates for 1998/99 and 1999/2000, 17 December, p. 24

                        In addition, ACG considers that under the new USO arrangements the regulatory risk
                        implied by ad hoc re-determinations of the NUSC amount may be lower given the
                        involvement of additional carriers as USPs and the government’s stated intention to set
                        NUSC amounts in advance in order to provide funding certainty.

                        An asset beta of 0.1 for the USO (where the USO Fund is assumed to have a
                        mitigating effect on risk) is a reasonable estimate. This implies an equity beta of 0.03.


                        40
                             Telstra (2000) p.13
                        41
                             Telstra (2000) p. 16-17
                        42
                             Telstra (2000) p. 15
                                                                                                                         22
COST OF CAPITAL FOR DELIVERING UNIVERSAL SERVICE OBLIGATIONS: 2000/01 TO 2002/3




                        Chapter 4
                        Levelisation

                        A further issue is to determine what changes (if any) may be required to the levelisation
                        methodology which adjusts the cost of capital to account for the fact that it is to be
                        applied in practice to an opening year’s asset base. This is equivalent to calculating a
                        “typical year” regulatory asset base (over the life of the asset), and applying an
                        unadjusted cost of capital. The levelisation methodology previously established by the
                              43
                        ACG was predicated on the assumption (then valid) that the WACC and least-cost new
                        asset values were to be recalculated each year. Under the new arrangements, the cost of
                        universal service is to be calculated three years in advance given technology (and hence
                        the price of assets) in the first year.

                        The levelisation problem can be illustrated as follows. Consider an asset which has a life
                        of three years (eg. a personal computer) and whose purchase price is $5000. Suppose the
                        purchase price in succeeding years falls by 20 per cent per year ie. to $4000 at the
                        beginning of year 2 and $3200 at the beginning of year 3.

                        Suppose (for illustrative purposes only) that the WACC is 10 per cent and finally
                        suppose that depreciation is by the straight line method (1/3 each year).

                        If in each of the three years, depreciation is 1/3 of the purchase price and the return on
                        capital is 10 per cent of the purchase price, the net present value of total capital returns
                        over the life of the asset is $5484, an overpayment of $484. On the other hand, if
                        depreciation each year is set at 1/3 of the purchase price prevailing in that year, and
                        likewise return on capital is set at 10 per cent of each year’s purchase price, the NPV of
                        total capital returns is $4517, an underpayment of $483.

                        The solution to this problem is tilted annuity formula proposed by ACG, which gives
                        total capital returns in this example of $2438, $1950 and $1560 years 1,2 and 3
                        respectively. The NPV of this stream of payments is $5000.

                        The formula which generates these returns is
                                                                                                              T −1
                                         P * ( WACC      − INF + TECH         ) * (1 + INF − TECH         )
                                  At =
                                                 (1 − ( 1 + INF − TECH          ) n /( 1 + WACC )n )


                        where A is the total capital return each year (depreciation plus return on capital), P is
                        the purchase price, INF is annual general inflation, TECH is the annual percentage
                        change in prices due to technological (or other asset-specific) causes and n is the life of
                        the asset.

                        The complication, under the new arrangements, is that the regulatory problem is no
                        longer to recalculate the cost of capital year by year, taking into account latest
                        developments in technology and equipment prices. Rather, as stated above, regulation
                        for three years is going to be based on prices and technologies in the first year.




                        43
                             ACG (1999c) Final Report to the Australian Communications Authority: The “Year 1”Cost Problem
                             Application to the USO and Proposed Solution, 29 April
                                                                                                                       23
COST OF CAPITAL FOR DELIVERING UNIVERSAL SERVICE OBLIGATIONS: 2000/01 TO 2002/3



                        The alternative solutions to the problem are:

                        •   ignore the levelisation probem ie. do not adjust the WACC at all;

                        •   use a simple annuity that does not take account of price changes; and

                        •   continue to use the tilted annuity, as previously.

                        The first alternative solution would lead to an overpayment of capital returns and so
                        should be discarded.

                        The second solution would be correct if the assets in question had an economic life
                        equal to the regulatory period (3 years). After three years, new assets would be then be
                        purchased, at new prices, and this would be the start of a new regulatory period.
                        However, typically, assets used in the delivery of the USO will have an economic life
                        longer than 3 years. Using an untilted annuity will result in underpayment of capital.

                        The third solution, which is to continue to use the tilted annuity, is to be preferred.
                        While the tilted annuity formula is based on the assumption on annual prices changes,
                        over the life of the asset it will give the correct answer. The annuity factor generated by
                        the formula (the adjusted WACC) will be consistent with the net present value of total
                        capital returns, for the assets, being equal to their purchase price.

                        Appendix B shows a worked example of the tilted annuity.




                                                                                                                24
COST OF CAPITAL FOR DELIVERING UNIVERSAL SERVICE OBLIGATIONS: 2000/01 TO 2002/3




                                     Chapter 5
                                     Cost of Capital Estimates

                                     Given the conclusions in chapter 3 regarding the differing beta level relevant for
                                     different USO schemes, this chapter provides the WACC calculations for each of the
                                     three schemes, where the WACC for USPs in:

                                     •     Extended Zones and Rest of Australia, calculated on the basis that the USO Fund
                                           does impact on beta risk; and the

                                     •     Pilot Areas, calculated on the basis that the USO Fund does not have an impact on
                                           the beta risk.


                                     5.1       Cost of Capital for Universal Service Providers in the
                                               Extended zones and Rest of Australia

                                     The recommended WACC for the years 2000/01, 2001/02 and 2002/03 for the sole USP
                                                                                                      44
                                     in the Extended zones and Rest of Australia is shown in Table 2.

                                     On the basis on the analysis in sections 3.1 and 3.2 of chapter 3, the recommended cost
                                     of capital for sole USPs in these areas is calculated on the basis that the operation of the
                                     USO Fund almost entirely mitigates the beta risk. That is, an asset beta equal to 0.1 is
                                     used to calculate the WACC.

                                     Under the alternative scenario, where the operation of the USO Fund has no impact on
                                     the sole USPs’ beta risk in the Extended Zones and Rest of Australia, the CAPM
                                     parameters and WACC results would be those shown in Table 3.

Table 2
RECOMMENDED CAPM PARAMETERS AND WACC FOR SOLE USPs IN THE EXTENDED
ZONES AND REST OF AUSTRALIA

 Parameter                                             2000/01                2001/02               2002/03
 Gearing Ratio                                           40%                    40%                   40%
 Risk Free Rate                                         6.33%                  6.33%                 6.33%
 Market Risk Premium                                     5.5%                   5.5%                  5.5%
 Asset Beta                                               0.1                    0.1                   0.1
 Debt Beta                                               0.22                   0.22                  0.22
 Equity Beta (β)                                         0.03                   0.03                  0.03
 Debt Premium                                            1.2%                   1.2%                  1.2%
 Corporate Tax Rate                                      34%                    30%                   30%
 Imputation Factor (γ)                                    0.5                    0.5                   0.5

 Post Tax Nominal WACC                                   5.1%                   5.3%                  5.3%
 Pre Tax Nominal WACC                                    7.7%                   7.6%                  7.6%
 Real Pre Tax WACC                                       4.9%                   4.8%                  4.8%

Source: Allen Consulting Group analysis


                                     44
                                           The real pre tax WACC is found by substracting expected inflation from the nominal post tax WACC.
                                           Expected inflation is derived from market data on nominal and index-linked (real) 10 year government
                                           bonds, via the Fisher equation:
                                           (1+ i) = (1+ r) *(1+ π )
                                           where i is the nominal interest rate, r is the real rate and π is inflation.
                                                                                                                                            25
COST OF CAPITAL FOR DELIVERING UNIVERSAL SERVICE OBLIGATIONS: 2000/01 TO 2002/3



                                     In 2000/01, the nominal pre tax WACC is estimated to be 7.7 per cent, and slightly
                                                                                                             45
                                     lower in succeeding years, reflecting the drop in the company tax rate.


                                     5.2         Cost of Capital for Universal Service Providers in
                                                 the Pilot Areas

                                     The recommended WACC for the years 2000/01, 2001/02 and 2002/03 for USPs in
                                     Pilot Areas is shown in Table 3.

                                     As discussed in section 3.3, the key difference is that the competition expected in the
                                     Pilot Areas means that the revenue estimates used to calculate the NUSC and the per
                                     service subsidies are less likely to be accurate. In this case the USO Fund will not
                                     mitigate the USPs’ risk. In addition, the earnings of USPs operating in competition with
                                     other USPs will be more sensitive to non-diversifiable market risk than a sole USP
                                     providing the USO service as a monopolist.

                                     Conversely, if it is considered the operation of the USO Fund does reduce beta risk for
                                     USPs in the Pilot Areas, then the CAPM parameters and WACC results would be those
                                     shown in Table 2.

Table 3
RECOMMENDED CAPM PARAMETERS AND WACC FOR USPs IN THE PILOT AREAS

 Parameter                                           2000/01            2001/02            2002/03
 Gearing Ratio                                         40%                40%                40%
 Risk Free Rate                                       6.33%              6.33%              6.33%
 Market Risk Premium                                   5.5%               5.5%               5.5%
 Asset Beta                                             0.5                0.5                0.5
 Debt Beta                                             0.22               0.22               0.22
 Equity Beta (β)                                       0.66               0.66               0.66
 Debt Premium                                          1.2%               1.2%               1.2%
 Corporate Tax Rate                                    34%                30%                30%
 Imputation Factor (γ)                                  0.5                0.5                0.5

 Post Tax Nominal WACC                                 6.7%               7.0%               7.0%
 Pre Tax Nominal WACC                                 10.2%              10.0%              10.0%
 Real Pre Tax WACC                                     7.4%               7.2%               7.2%

Source: Allen Consulting Group analysis


                                     The nominal pre-tax WACC for the pilot areas is estimated to be 10.2 per cent in
                                                                           46
                                     2000/01 and 10.0 per cent thereafter.




                                     45
                                           This compares to estimates for the nominal pre tax WACC (including impact of USO Fund) for 1998/99
                                           of 7.2 per cent, and for 1999/00 of 8.5 per cent.
                                     46
                                           This compares to estimates for the nominal pre tax WACC (excluding impact of USO Fund) for 1998/99
                                           of 10.5 per cent, and for 1999/00 of 11.8 per cent.
                                                                                                                                          26
COST OF CAPITAL FOR DELIVERING UNIVERSAL SERVICE OBLIGATIONS: 2000/01 TO 2002/3




                                     Recommended WACC Estimates for the years 2000/01 to
                                          20002/03

                                     Table 4 summarises the recommended nominal pre-tax WACC estimates for USPs in
                                     each the three USO schemes to apply.

Table 4
RECOMMENDED NOMINAL PRE TAX WACC ESTIMATES FOR USPS IN NEW USO SCHEMES

 Real Pre Tax WACC                              2000/01       2001/02       2002/03
 Rest of Australia                               7.7%          7.6%           7.6%
 Extended zones                                  7.7%          7.6%           7.6%
 Pilot Areas                                    10.2%          10.0%         10.0%

Source: Allen Consulting Group analysis




                                                                                                               27
COST OF CAPITAL FOR DELIVERING UNIVERSAL SERVICE OBLIGATIONS: 2000/01 TO 2002/3




                        Appendix A
                        Beta in Competitive and Monopoly
                        Markets

                        The analysis in this appendix demonstrates how beta risk (non-diversifiable risk) is
                        likely to be greater in competitive markets than in monopoly markets. It does so by
                        showing that random variations in demand, such as those associated with business
                        cycles, will result in greater variations in output in competitive markets than where there
                        is just one seller (a monopoly). Hence, the earnings of a firm with competitors will
                        covary more with a market portfolio than will the earnings of a monopolist ie. the beta of
                        the firm in a competitive market will be higher.


                        A.1    Case 1

                        Suppose that (inverse) market demand for USO telecommunications services is given by
                        the function

                                  P = a – bQ + ε
                                               2
                        Demand:

                        where ε is a random disturbance to demand.

                        Assume that marginal cost (c) is constant.

                        A profit-maximising monopolist will set output such that marginal revenue is equal
                        marginal cost. The marginal revenue function is found by multiplying both sides of the
                        demand function by Q and differentiating with respect to Q. This gives

                        Marginal Revenue:   P = a – 3bQ 2 + ε

                        Setting marginal revenue equal to marginal cost and solving for Q:

                               a−c+ε
                        Q=
                                 3b
                        The variance of Q is therefore

                                       1
                        var(Q) =         var ε
                                      3b
                        On the other hand, in a competitive market, the equilibrium (profit-maximising) level of
                        output will be determined by the condition that price is equal to marginal cost. In this
                        instance, this implies

                               a−c+ε
                        Q=
                                 b
                        and so the level of output is higher (and price correspondingly lower) in a competitive
                        market, vis a vis a monopoly.

                        The variance of Q in the competitive market is




                                                                                                                28
COST OF CAPITAL FOR DELIVERING UNIVERSAL SERVICE OBLIGATIONS: 2000/01 TO 2002/3



                                        1
                        var(Q) =          var ε
                                        b
                        and so it can be seen that the variance of output in the competitive market will be larger
                        than the variance of output in the monopoly market, given demand disturbances of equal
                        size.


                        A.2    Case 2

                        To check that the above result is not an artefact of the particular form of the demand
                        function, suppose that (inverse) demand is given by a different function,

                        Demand:    P = a – blnQ + ε

                        The marginal revenue function is

                        Marginal Revenue:    P = a – b(lnQ +1) + ε

                        Setting marginal revenue equal to marginal cost and solving for profit-maximising Q for
                        the monopolist gives

                        Q = e a− c − + ε
                                    1



                                             var(Q) = e a−c − var(e ε )
                                                             1
                        and hence var(Q) =

                        In a competitive market, equilibrium output is given by

                        Q = e a− c +ε

                        And so   var(Q) = e a−c var(eε )

                        Once again, the variance of output in response to demand disturbances is greater in the
                        competitive market.

                        The implication of these results is that, other things being equal, non-diversifiable risk
                        (and hence beta) will be greater in a competitive market than in a monopoly market.




                                                                                                               29
COST OF CAPITAL FOR DELIVERING UNIVERSAL SERVICE OBLIGATIONS: 2000/01 TO 2002/3




                                      Appendix B
                                      Example of Tilted Annuity Approach to
                                      levelise WACC Estimates


                                      B.1         Worked Example showing the use of the Tilted
                                                  Annuity Formula to levelise WACC Estimates

                                      This worked example showing the use of the tilted annuity formula to levelise WACC
                                      estimates is reproduced from ACG’s previous report to the ACA entitled The “Year
                                      1”Cost Problem: Application to the USO and Proposed Solution (29 April 1999).


                                      Example

                                      An asset with:

                                      •         a purchase price of $100;

                                      •         an expected economic life of 10 years;

                                      •         zero scrap value;

                                      •         WACC of 9 per cent;

                                      •         general inflation of 2.5 per cent per year; and

                                      •         price reductions due to technological progress of 4 per cent per year; therefore

                                      •         the price of the asset is falling by 1.5 per cent (4 minus 2.5 per cent).

Table B.1
ASSET PRICE, CAPITAL RETURNS AND ANNUITY FACTOR

      (1)              (2)                (3)               (4)              (5)             (6)
     Year         Asset Price         Total               Notional        Notional        Annuity
                     ($)             Capital             Deprec.($)      Return on       Factor (%)
                                    Return ($)            =0.1*(2)       Capital ($)      =(5)/(2)
                                                                          =(3)–(4)
       1             100.0             16.5                 10.0            6.5              6.5
       2              98.5             16.2                 9.9             6.4              6.5
       3              97.0             16.0                 9.7             6.3              6.5
       4              95.6             15.8                 9.6             6.2              6.5
       5              94.1             15.5                 9.4             6.1              6.5
       6              92.7             15.3                 9.3             6.0              6.5
       7              91.3             15.1                 9.1             5.9              6.5
       8              90.0             14.8                 9.0             5.8              6.5
       9              88.6             14.6                 8.9             5.7              6.5
      10              87.3             14.4                 8.7             5.7              6.5
     NPV                              100.0
    (@9%)

Note: Totals may not sum exactly due to rounding.

Source: Allen Consulting Group analysis




                                                                                                                                   30
COST OF CAPITAL FOR DELIVERING UNIVERSAL SERVICE OBLIGATIONS: 2000/01 TO 2002/3



                        In this case, the total capital return for each year (A) is given by the formula:

                                         100     * (WACC     − INF + TECH                 ) * ( 1 + INF − TECH              )T−1
                                 At =
                                                     (1 − (1 + INF − TECH                ) /( 1 + WACC ) )
                                                                                           n               n




                        where INF is the expected change in the general level of prices in the economy over the
                                                                                               47
                        life of the asset, TECH is the effect on prices of technological change and T is the year
                        of operation (starting with T=1).
                                                                       48                 49
                        Subsituting WACC=9%, INF=2.5% , TECH=4% and n=10, gives total capital return
                        for each year, shown in Column (3).

                        The important points to note are:

                        •    The NPV of the total capital return is $100, so the original investment has been
                             returned in full.

                        •     The ratio of total capital return to asset price is 16.5 per cent in each year.

                        •    The total capital return is front loaded with more paid in the early years and less in
                             the later years (so it is not an annuity in the strict sense);

                        •     Notional return to capital is defined as total capital return less notional depreciation.

                        •     Notional depreciation is set a 10 per cent of the asset price.

                        •    The annuity factor, defined as the notional return to capital divided by the asset
                             price, is constant at 6.5 per cent;

                        The reason that the return on capital and depreciation in Table B.1 are notional is that
                        while they are used to calculate the annuity factor, taking into account the change in
                        price of the asset, they are not what is actually returned the asset owner. Actual return on
                        capital is calculated using the WACC, not the annuity factor, while actual depreciation is
                        the difference between the total capital return and the actual return on capital.




                        47
                             Or some other factor, the appearance in the market of an alternative less expensive asset that has the
                             same service potential.
                        48
                             2.5 per cent is the mid-point of the Reserve Bank’s medium term target of 2–3 per cent per year for
                             inflation.
                        49
                             In practice, estimates for expected annual changes in asset price(s) would be based on recent price trends,
                             and information in the marketplace. Note that TECH is the percentage change in the asset price, due to
                             technological change (or other asset–specific effect); it excludes the effects on the asset price of inflation.
                             Thus, if TECH is 4% and INF is 2.5%, the expected overall annual fall in the asset price is 4% less 2.5%
                             i.e. 1.5%. If technological change per se is expected to reduce the asset price by 2.5% and inflation is
                             2.5%, then TECH and INF offset each other and there is no overall change expected in the asset price.
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