cost of capital in the telco industry

Peter KLUNE, Dubai 29th October 2007

Cost of Capital

Peter KLUNEDubai, 29th October 2007


Agenda

1. Relevance of cost of capital calculation

2. WACC – the most common way to determine cost of capitalDiscussion of input parameters

Risk free interest rate Beta factor Risk premium Cost of dept Capital structure Tax rate

What are the main drivers of the WACC-calculation?

3. Divisional cost of capital

4. International Benchmarks / Summary


A little bit of theory• For regulatory purposes it must be ensured that the investor can bear an appropriate

rate of return on his investment (minimum level)

• The rate of return which is required to satisfy the investors expectation is mainly driven by the risk which is associated with the potential investment.

• In principle investors are risk averse

• The rate of return increases as the investment becomes more risky

• This theory is based on historical evidence

• Therefore one of the main objectives of the cost of capital calculation is to quantify the level of risk and determine uncertainty.


Relevance of cost of capital

marketingsales costscustomer careRT-billing

depreciationoperatingcosts, etc.

productioncostsnetworkinfrastructure

Retail-Product

WS-Billing,administration

depreciationoperatingcosts, etc.

Wholesale-Product

Cost of capital~ 10-20%

Cost of capital~ 15-25%

Cost of capital plays a substantial role in the determination of network costs


Agenda








The WACC formula

rE cost of equity

rD cost of dept

E market value of equityD market value of deptt tax rate

ED

D * t)(1 *r

ED

E * rWACC DE

)r(r*βrr fmfE rf risk free interest rateβ Beta (systematic risk factor)rm interest rate of market portfolio(rm – rf) equity risk premium

equity ratio dept ratio

weighted cost of equity weighted cost of dept

)r(rrr fdfD rd company specific dept rate(rd – rf) company specific

dept premium


1. Risk free interest rate

• The risk-free interest rate is the interest rate that it is assumed can be obtained by investing in financial instruments with no default risk.

• Since this interest rate can be obtained with no risk, it is implied that any additional risk taken by an investor should be rewarded with an interest rate higher than the risk-free rate.

• Though a truly risk-free asset exists only in theory, in practice a common choice are government bonds or Euribor rates (for investments in the EU).

• Issues that have to be considered:– Maturity period– Historic versus current yields– Which market?

]r[ f


Historic/average versus current yields

4,6 %

Average over8 years

3,9 %

Approach of Austrian NRA regarding mobile termination fee calculation

average over 3 years

Minimum: 3,2 %

Maximum: 5,9 %


2. Beta factor (1/2)

Two different types of risk are typically identified:• specific risk (diversifiable or idiosyncratic)

– Company specific risks which can be diversified within a portfolio. Not priced into investors required rates of return.

• systematic risk (market or undiversifiable)– Risks which can not be diversified within a portfolio

• The systematic risk of a company is measured by the Beta factor

• Beta is calculated by regressing the asset (stock) returns against market returns. Therefore the value of beta reflects the variability of returns of the equity of the company in question, compared with the variability of returns on the equity market (market index).– Beta=0: risk free investment– Beta<1: volatility smaller than the reference market– Beta=1: same volatility than reference market– Beta>1: volatility greater than the reference market

• What is the right reference index?– Theoretically the index should include all risky assets– In practice most analysts and regulators use national stock market

index (S&P 500, FTSE, etc.)

)]r(r*βr[r fmfE


2. Beta factor (2/2)• Single beta or peer group beta (average)?

– Beta factors are relative volatile over the time period– Reduction of estimation error through group beta– Enough observations must be available for regression analysis (time

series)

• “A better way to estimate betas is to look at the average beta for publicly traded firms in the business a company operates in. While these betas come from regressions as well, the average beta is always more precise than any one firm’s beta estimate.” *

• How to determine the peer group?– Comparable companies (same type of business)– Companies with similar market capitalisation (size of company)– Company of choice be included in reference index

• To calculate the peer group beta you have to consider different capital structures and tax rates (unlevered beta)

* See: Damodaran: „Investment Philosophies”

Telco Beta DeviationBT Group 17%Hellenic Telecommunication Organisation 40%Swisscom AG 89%Telekom Austria AG 42%Portugal Telecom 40%Koninklijke KPN NV 96%Average 14%

)]r(r*βr[r fmfE

Deviation between minimum and maximum value (30.06-30.09.2007)


Alternative way of beta estimation

• It could be argued to use in stead of a purely benchmark based beta a so called „adjusted-beta“

• The basic idea behind this is based on the finding that in the long run all betas show a tendency to the value of 1.* Therefore the use of an „adjusted beta“, calculated as follows, seems reasonable

• Adjusted beta = 2/3*(Raw beta) + 1/3*(1)**• If the benchmark beta is smaller than 1 the adjusted beta

will be higher• If the raw-beta is higher than 1 this method will decrease

the adjusted beta

* see: Blume, M.E.: Betas and their regression tendencies, Journal of Finance

** see: Bloomberg Guidelines to adjusted beta estimates


3. The risk premium (1/2)

Definition:

The (market) risk premium represents the additional return over the risk-free rate, that investors require as compensation for the risk they expose themselves to by investing in equity markets. It is essentially a measure of investors’ appetite for risk and it is a market factor, rather than a company-specific factor.

Most Common approach to estimate the risk premium:Analyse the difference between realized returns on the market portfolio and those on a risk free asset (based on historical data)

Issues to consider:– Arithmetic versus geometric mean (depends on predictability)– Relevant Index (world or domestic)– What time period to use?

)]r(r*βr[r fmfE


3. The risk premium (2/2)

If you compare the equity risk premiums applied in European countries you will obtain significant differences:

The reason my be caused by different calculation methods but also country specific reasons

Source: IRG, Regulatory Accounting Workgroup data collection (last update January 2007)

The average value is 5,3%

)]r(r*βr[r fmfE


4. Cost of dept (1/2)• The cost of debt reflects the cost the company has to sustain in

order to get capital to finance its activity either through– issuing loans (bonds) or– bank credits

• It corresponds to the weighted average of the costs of the various long-run loans of the company and it is strongly correlated to the current interest rate's level, the company's financial capacity and risk.

• Different ways to determine cost of dept:– Accounting data– Look at firms credit rating– Dept premium

Cost of Debt = Risk Free Rate + Company Specific Debt Premium

)r(rrr fdfD


4. Cost of dept (2/2)

• The dept premium depends on the capital structure:The company specific debt premium increases with the company's gearing, reflecting the company's higher financial risk.

From finance theory it is known that an increasing debt will increase the risk and therefore the risk premium.

Source: IRG, Regulatory Accounting Workgroup data collection (last update January 2007)

EquityDept

Dept Gearing

)r(rrr fdfD


5. Capital Structure / gearing ratio• The companies capital structure (gearing) is an important input

parameter because it influences several other parameters– Beta factor– Cost of dept (dept premium)

• Market values should be used instead of book values

• You may use either the actual structure or a target capital structure

Example: Target Capital Structure of Telekom Austria

Equity

500 Mio. shares x market price 20,00 Euro 10.000 Mio. 70%

Dept

Accounts payable = 2 x EBITDA 3.540 Mio.

Line of credit 760 Mio. 30%

4.300 Mio.


6. Tax rate

• The WACC may be estimated post-tax or pre-tax• For regulatory purposes the pre-tax WACC is of relevance,

because the cost of capital must be sufficient to finance tax and interest payments as well as shareholder returns.

• The pre-tax WACC is calculated as follows:

• To estimate an ex-ante post-tax WACC, a decision has to be made as to which tax rate to utilise for the calculation.– Headline rate of tax– Effective tax rate

rate)tax (1

WACC WACC

tax-posttax-pre


Main driver of WACC calculation

The question is, what are the most important input factors to the WACC calculation?The following table shows a sensitivity analysis regarding the effect of a 10%-increase of each individual input factor (ceteris paribus) to the overall WACC:

1

2

3

5

4

WACC Calculation initialinput value

Risk Free Interest Rate 5,0% 4,2%Beta (unlevered) 1,2 5,5%Gearing Ratio (D/E) 0,667Beta (relevered) 1,800Equity Risk Premium 5,5% 5,5%

Cost of Equity 14,9%

Credit Risk Premium 1,0% 0,3%Cost of Debt 6,0%

Equity-to-Total Capital 60,0% 1,2%Debt-to-Total Capital (gearing) 40,0%

WACC post-tax 10,7%

Tax rate 25,0% 2,2%

WACC pre-tax 14,3%

effekt on WACC


Two types of reference base

The cost of capital could be either calculated on book values (green bars) or the average capital employed =1/2 purchase value (yellow bars)

Example:

Purchase value: 300 Mio. Dirham

Useful life: 15 years

WACC: 10%

Cost of capital in total: 225 Mio. Dirham

Different ways of calculating cost of capital

29,0

27,0

25,0

23,0

21,0

19,0

17,0

15,0

13,0

11,0

9,0

7,0

5,0

3,0

1,0

0

5

10

15

20

25

30

35

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

purchase valueresidual book value


Agenda








The divisional cost of capital

• Reasons for calculating a divisional cost of capital– Different type of business (e.g.: fixed/mobile)

• Project specific risk is reflected in cash-flow scenarios

• A divisional WACC is difficult to calculate:– lack of capital market information on the level of company

divisions– Beta on a division level not observable– Gearing ratio not available

• Only OFCOM in GB did calculate a disaggregated WACC for:– copper access network business: WACC=10.0%– the rest of BT WACC=11.4%

• All other regulators in Europe are currently assessing the WACC at company level


Agenda








International benchmarks (wireline)Cost of Capital (WACC) in Europe

16,5

15,5

15,2

14,5

13,3

13,1

12,3

12,1

11,5

11,4

11,3

11,2

11,0

11,0

10,8

10,4

10,2

10,1

10,0

10,0

9,9

9,8

9,5

8,6

7,6

7,6

11,3

0,00

2,00

4,00

6,00

8,00

10,00

12,00

14,00

16,00

18,00

Hunga

ry

Maced

onia

Roman

iaMal

ta

Portu

gal

Norway

Lithu

ania

Cypru

s

I rela

nd

Belgiu

m

Pola

nd

Czech

Rep

ublic

Estla

nd

Slovak

ia

Sweden

Greec

eI ta

ly

Finla

nd

Austri

a UK

Espa

nia

Fran

ce

Germ

any

Denm

ark

Nethe

rland

Switzer

land

Mean

WA

CC

[%

]

Source: Cullen International


International benchmarks cont.

Cost of Capital - Wireline versus Wireless

17,5

17,5

17,0

13,1

13,1

12,2 13

,3

12,6

14,8

12,4 13

,5

17,4

11,2

13,3

12,4

11,6

0,00

2,00

4,00

6,00

8,00

10,00

12,00

14,00

16,00

18,00

20,00

Hunga

ry

Roman

iaMal

ta

Norway

Cypru

s

Belgiu

m

Czech

Rep

ublic

Sweden

Greec

eI ta

ly

Finla

nd

Austri

a UK

Espa

nia

Fran

ce

Nethe

rland

WA

CC

[%

]

wireline wireless

Ap

pro

x.

20%

m

ark

-up


Summary

• WACC does have a substantial impact on network cost calculation

• Many input parameters facilitating a wide range of results, depending on underlying assumptions

• Focus on parameters with significant leverage effect• Suitable instrument for NRA to get out results which are

desired (fine tuning)• Its often not the question of what is right ore wrong, it is

more about who has the better arguments for his position/assumption


Thank you for your timeQuestions?

Peter KLUNERegulatory Affairs

TELEKOM AUSTRIA AGLassallestraße 9A-1020 Austria

›E-Mail [email protected] +43 (0)59059 1 16012Fax +43 (0)59059 91 16012Mobile +43 (0)664 629 61 76

mailto:[email protected]


Appendix: helpful links and related documents

• Principles of Implementation and Best Practice for WACC calculation, IRG WG Regulatory Accounting, February 2007 (http://www.erg.eu.int/doc/publications/erg_07_05_pib_s_on_wacc.pdf )

• KPMG’s Corporate and Indirect Tax Rate Survey 2007 (http://www.kpmg.com/Services/Tax/Business/IntCorp/CTR/ )

• Ofcom’s approach to risk in the assessment of the cost of capital, Final statement; Issued: 18 August 2005 (http://www.ofcom.org.uk/consult/condocs/cost_capital2/ )

• FTSE Group calculates over 100,000 indices covering more than 48 countries and all major asset classes (http://www.ftse.com/ )

• Bloomberg-financial information service (www.bloomberg.com )• Cullen International, Regulatory monitoring services (

http://www.cullen-international.com/documents/cullen/index.cfm )• The journal of finance (http://www.afajof.org/ )

http://www.erg.eu.int/doc/publications/erg_07_05_pib_s_on_wacc.pdf

http://www.kpmg.com/Services/Tax/Business/IntCorp/CTR/

http://www.ofcom.org.uk/consult/condocs/cost_capital2/

http://www.ftse.com/

http://www.bloomberg.com/

http://www.cullen-international.com/documents/cullen/index.cfm

http://www.afajof.org/


Back up


Calculation with nominal versus real values

• Depends on asset valuation– Actual costs (FL-LRIC) -> real WACC– Historic costs -> nominal WACC

• Formula: WACCreal = WACCnom - Inflation

• In practice nominal WACC in combination with FL-LRIC is the common way of calculation

cost of capital in the telco industry

Economy & Finance