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ERNST & YOUNG BALTIC UAB Ryši reguliavimo tarnyba Weighted average cost of capital 2005, June 28 Table of Contents 1 INTRODUCTION ........................................................................................................... 3 2 GENERAL METHODOLOGY ..................................................................................... 3 3 COST OF DEBT.............................................................................................................. 4 3.1 ESTIMATING SHARE OF DEBT ..................................................................................... 4 3.2 ESTIMATING COST OF DEBT ....................................................................................... 5 4 COST OF EQUITY ......................................................................................................... 6 4.1 ESTIMATING COST OF EQUITY .................................................................................... 6 4.2 RISK FREE RATE OF RETURN ...................................................................................... 7 4.3 RISK PREMIUM ........................................................................................................... 7 4.4 RISK LEVEL BETA....................................................................................................... 8 4.5 ESTIMATING SHARE OF EQUITY ................................................................................. 9 4.6 EFFECTIVE PROFIT TAX MARGIN ................................................................................ 9 5 RESULTS OF WACC CALCULATION .................................................................... 10 2 1 INTRODUCTION The purpose of this document is to describe methodology of calculating weighted average cost of capital and present calculation results. The calculated WACC will be further used in LRAIC model to estimate fixed line voice interconnection services. The methodology in this document is reconciled with opinion of European Regulators Group (ERG) on the proposed Review of the Recommendation on cost accounting and accounting separation. WACC represents opportunity cost of capital of investments in telecommunications network. Opportunity cost of capital may also be called reasonable rate of return (ROI). WACC must be estimated on a forward looking basis oriented to the period when interconnection tariffs will be present. Thus, in this document WACC results are calculated based on the latest available data at the issue of this document. 2 GENERAL METHODOLOGY Weighted average cost of capital is estimated taking into account weighted cost of equity and weighted cost of debt. WACC can be calculated on a pre-tax and post-tax basis. For capital budgeting purposes companies usually estimate WACC on a post-tax basis, however, from regulatory perspective pre-tax WACC should be used. This has to be done because profit tax in LRAIC model is not treated as a cost. Arithmetical WACC formula is defined as: 1 WACC R d Wd Re We 1 t D Wd = D E E We = D E Explanations: Rd – cost of debt; Re – after tax cost of equity; We – share of equity in capital employed; Wd – share of debt in capital employed; 3 D –market value of debt; E – market value of equity; t – effective tax rate. 3 COST OF DEBT Cost of debt calculation is comprised out of two parts: estimating share of debt (Wd); estimating cost of debt (Rd). 3.1 Estimating share of debt Assessing capital structure market values of debt (D) and equity (E) are to be used. It is assumed that book value of debt is equal to market value of debt. This is because long term loans are provided with variable interest rate structure i.e. LIBOR + interest rate margin. Loans with fixed rates are usually of short maturity (1-3 years), thus, changes in interest rates have little impact on debt value. In WACC model calculations should be based on the assumptions that market value of debt equals book value of debt. Market value of equity is estimated based on stock market data i.e. number of stocks is multiplied by share price at the end of the year. Our calculations of capital are based on audited financial statements of AB Lietuvos telekomas1: 2002 12 31 2003 12 31 2004 12 31 Debt (balance at the end of the year, 000 Lt) 373.029 187.763 13.454 Equity (balance at the end of the year, 000 Lt) 1.218.541 1.135.861 1.121.415 Debt (geometric average2, 000 Lt) 462.055 264.653 50.261 Equity (geometric average, 000 Lt) 1.227.730 1.176.475 1.128.615 Number of stocks, 000 814.912,8 814.912,8 814.912,8 Share price at the end of the year, Lt 0,9 1,57 2,15 Market value of equity (balance at the end of the year, 733.421 1.279.413 1.752.062 000 Lt) Market value of equity (geometric average, 000 Lt) 864.346 968.684 1.497.201 1 The results can be obtained at: http://www.telekomas.lt/lt/investuotojams/rezultatai 2 The value is obtained by taking the geometric average of item in the beginning and at the end of the year. 4 According to ERG opinion geometric average of debt and equity should be used while calculating relevant capital structure ratios. Based on the data presented above the relevant capital structure ratios are as follow: 2002 12 31 2003 12 31 2004 12 31 Share of debt (based on outstanding balance), Wd 50,86% 14,68% 0,77% Share of debt (based on geometric average), Wd 34,84% 21,46% 3,25% Share of equity (based on geometric average), We 65,16% 78,54% 96,75% Share of equity (based on outstanding balance), We 49,14% 85,32% 99,23% Share of debt in total capital employed has fallen rapidly during the last few years. As of 2004 December 31 outstanding debt as percent of total capital employed was 0,77%. According to the information presented in audited financial statements in 2006 m. AB Lietuvos telekomas will have no debts outstanding. While estimating WACC on a forward looking basis we make assumption that Wd = 0%. All capital is supplied by shareholders (in comparison –in AS Eesti Telekom3; debt as of 2004 December 31 comprised 0,0013% of total capital employed; in SIA Lattelekom4. the company had no long-term debt as of 2004 December 31. We may raise a question whether current capital structure of AB Lietuvos telekomas is optimal and whether new market participant would finance its activity by using 100% of equity capital. According to methodology suggested by Aswatah Damodaran, professor of finance of „New York University Leonard N. Stern School of Business“ we estimated what should the capital structure look like based on current financial indicators of the company. The obtained results suggested that AB Lietuvos telekomas should not use any debt. In practice capital structure ratios can be set based on long-term targets of financial leverage ratios of AB Lietuvos telekomas. 3.2 Estimating cost of debt Since we already established that share of debt in WACC model is 0% there is no further use estimating Kd. However, in this section we discuss the methodology of estimating cost of debt based on actual AB Lietuvos telekomas situation. Since the Operator use borrowed capital of various type and maturity (bank loans, leasing, bonds), the cost of debt should represent weighted cost of using various types of borrowed 3 Audited financial statements can be obtained at http://www.telekom.ee/index.php3?lang=eng&lk=47 4 Audited financial statements can be obtained at http://www.lattelekom.lv/ltk/content/?cat=1252 5 funds. Mathematically this is estimated by dividing interest expense for the year by outstanding or average values of debt. The calculations based on AB Lietuvos telekomas data are presented in table below: 2002 12 31 2003 12 31 2004 12 31 Interest expense (during the year), 000 Lt 34.299 24.747 5.760 Debt (outstanding balance), 000 Lt 373.029 187.763 13.454 Debt (geometric average), 000 Lt 462.055 264.653 50.261 Debt (arithmetic average), 000 Lt 472.679 280.396 100.609 Cost of debt (based on outstanding balance) 9,19% 13,18% 42,81% Cost of debt (based on geometric average) 7,42% 9,35% 11,46% Cost of debt (based on arithmetic average) 7,26% 8,83% 5,73% Based on ERG opinion weighted cost of debt should be calculated using geometric average of debt values. Cost of debt based on geometric average was 11,46% in 2004. Historically cost of debt was higher due to relatively expensive bond issue with yield to maturity of 10,2% which has already been bought back. The current interest rate at AB Lietuovs telekomas could borrow from the banks is 4,2%. This value could be used to calculate cost of debt in WACC model. 4 COST OF EQUITY Cost of equity calculation is comprised out of three steps: (post tax) cost of equity calculation (Re); estimating share of equity We in total capital employed; calculating effective tax rate (t). 4.1 Estimating cost of equity In order to estimate cost of equity usually capital asset pricing model is employed. CAPM assesses required rate of return for company’s shareholders based on the risk level of the company. Companies listed on a national stock exchange are involved in the analysis. Mathematical expression of CAPM is: Re Rf ( Rm Rf ) Where Rf – risk free rate of return; Rm – market rate of return; 6 Rm- Rf – market risk premium; – beta, relative risk indicator. 4.2 Risk free rate of return Based on ERG recommendations risk free rate of return should be estimated based on long term (10-30 years) government bonds. In WACC model risk free rate of return will be set based on Lithuanian government bonds’ rate. According to the last auction of bonds issue, which took place on 2005 May 23 risk free rate of return is currently 3,77%5. 4.3 Risk premium Risk premium reflects additional rate of return compared to risk free rate of return that investors require while investing in stocks. Theoretically risk premium should be calculated subtracting risk free rate of return from historical average equity yield. Since stock market in Lithuania is under development the described method of evaluate risk premium would yield false results. For example 2000.06-2005.06 Lithuanian stock index VILSE rose from 99 to 392, which means that annual rate of return was 31,5%. These results do not reflect required rate of return but rather indicate that stock prices were undervalued and rose reaching or even exceeding their true values. Risk premium could be calculated based on methodology suggested by A. Damodaran. Lithuanian risk premium is comprised out of two parts: risk premium of country’s with mature capital markets; additional equity risk premium for Lithuania. Mature market equity risk premium is calculated based on USA market data. Risk premium is a difference between average equity return and risk free return. Based on A. Damodaran calculations historical risk premium in USA during the period of 1994-2004 was 4,51%6. Additional equity risk premium for Lithuania reflects additional risk that investors require when investing in a country with not fully developed capital markets and lower stability. Risk premium is higher due to lower liquidity, higher risk, higher inflation and other negative economic and political phenomena. Additional risk premium in Lithuania is set based on risk 5 Based on Baltic News Service information. 6 Calculations may be obtained at http://pages.stern.nyu.edu/~adamodar/New_Home_Page/data.html 7 rating assigned by Moody’s (which is currently A3 for Lithuania) and on relative equity and bond market variation. Based on A. Damodaran calculations additional Lithuanian risk premium comprise 2,03%7). 4.4 Risk level beta Beta reflects relative risk level of a company or an industry compared to all companies in the market. Beta is influenced by the amount of leverage the companies use. Thus we may distinguish between two beta values: U –unlevered beta reflects risk level when a company does not use debt; L– levered beta reflects risk level when a company uses debt. Companies with higher leverage beta will be higher reflecting higher risk. The relationship between leverage and beta is expressed as: D L U (1 (1 t ) ) E Mathematically beta is estimated taking into account co-variation of stock price yield and market yield. Beta value higher than one reflects that a company being analyzed is riskier compared to average risk in the market and thus, investors require higher rate of return. Beta value less than one reflects that a company being analyzed is less risky compared to average risk in the market and thus, investors require a lower rate of return. We estimated beta of AB Lietuvos telekomas and compared the results with other companies: D/E t L U AB Lietuvos telekomas 3,36% 17,21% 1 0,97 Telecom service providers, ES8 18,56% 13,35% 1,32 1,14 Telecom service provider’s, USA9 27,61% 12,71% 1,32 1,06 Beta of AB Lietuvos telekomas was calculated based on VILSE index for the period 2000 – 2005. Debt equity ratio reflects geometric average of debt and equity at the end of 2004. Effective tax rate calculated for the year 2004. 7 Calculations may be obtained at http://pages.stern.nyu.edu/~adamodar/New_Home_Page/data.html 8 Calculations were updated for 2005 January 1 and may be obtained at http://pages.stern.nyu.edu/~adamodar/New_Home_Page/data.html 9 Calculations were updated for 2005 January 1 and may be obtained at http://pages.stern.nyu.edu/~adamodar/New_Home_Page/data.html 8 The obtained beta is 1, which means that on average shareholders of AB Lietuvos telekomas require the same rate of return compared to other companies in the market. The comparative betas of USA and EU telecommunication service providers cannot be fully to attributable to Lithuanian situation, since those companies made large investments related to 3G technologies, which is associated with higher risk. Higher risk is reflected by higher betas. 4.5 Estimating share of equity Share of equity is calculated using following formula: We 1 Wd As share of debt is equal to 0%, it means that equity is equal to 100% of total capital employed. 4.6 Effective profit tax margin Although theoretically profit tax margin in Lithuania is 15%, usually companies have expenditures or revenues, that do not affect the profit tax base. This gives the reason for calculating effective profit tax rate in WACC model. Effective profit tax rate is calculated by dividing total profit tax by profit before tax and share of result of subsidiaries and associates. Audited AB Lietuvos telekomas financial reports provide us with the following data: 2004 12 31 Profit (loss) before tax and share of result of subsidiaries and associates, 000 Lt 40.133 Tax calculated at a tax rate of 15%, 000 Lt 6.020 Income not subject to tax and expenses not deductible for tax purposes, 000 Lt 432 Profit taxed at different rate, 000 Lt (128) Tax losses for which no deferred income tax was recognized, 000 Lt 949 Income tax on dividends, 000 Lt (493) Correction of previous years tax balance, 000 Lt 130 Tax charge before share of tax of subsidiaries and associates, 000 Lt 6.910 According to this data, AB Lietuvos telekomas effective profit tax rate in 2004 was: 6.910 17,22% 40.133 However, before using this profit tax rate in WACC model we have to evaluate what positions, resulting in different from 15% profit tax margin, may be constant through the years. 9 Factors that have influenced profit tax margin but will not repeat in the future are listed below: profit taxed at different rate; tax losses for which no deferred income tax was recognized; income tax on dividends; correction of previous years tax balance. After corrections listed above AB Lietuvos telekomas effective profit tax rate will be: 6.020 432 16,08% 40.133 In WACC model we recommend to use rounded value of effective profit tax rate – 16,00%. 5 RESULTS OF WACC CALCULATION Weighted average cost of capital is calculated based on the data described in previous chapters: 1. Calculation of cost of equity (after tax): Re Rf ( Rm Rf ) 3,77% 1 6,54% 10,31% 2. Calculation of pre tax WACC: 1 1 WACC R d Wd Re We 0 10,31% 12,27% 1 t 1 0,16 Calculated value of WACC (12,27%) should be used in LRAIC model to derive the total cost of capital. 3. For comparison purposes possible EU and USA WACC values for telecommunication companies are presented: AB Lietuvos EU average USA average telekomas Share of debt 0,00% 15,65% 21,64% Share of equity 100,00% 84,35% 78,36% Effective tax rate 16,00% 13,35% 12,71% Beta 1,00 1,32 1,32 Risk-free return 3,77% 3,27% 4,50% Risk premium 6,54% 4,51% 4,51% Cost of equity (post tax) 10,31% 8,40% 9,30% Cost of debt 4,20% 3,70% 4,93% WACC (after tax) 10,31% 7,59% 8,22% WACC (before tax) 11,42% 8,75% 9,41% 10 4. WACC sensitivity analysis to determine the impact of a change in different parameters: Pre tax WACC Impact on result Risk level, beta + 0,1 13,05% 0,78% Risk level, beta -0,1 11,50% -0,78% Risk premium + 1% 13,46% 1,19% Risk premium -1% 11,08% -1,19% Effective tax rate +5% 13,05% 0,78% Effective tax rate -5% 11,58% -0,69% Risk free return +1% 13,46% 1,19% Risk free return -1% 11,08% -1,19% 11