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Introduction

B.1 Ofcom set out its proposals and reasons for those proposals for cost of capital issues in Annex E of the December consultation. As explained in paragraphs E.1 and E.2 of that document, there are a variety of methods for estimating a firm's cost of capital. It is usually calculated as a weighted average of the firm's costs of debt and equity finance.

B.2 The cost of capital can be expressed in real terms (after adjusting for inflation) or nominal terms. It can also be expressed in post or pre-tax terms. A pre-tax cost of capital should be compared with returns calculated on a pre-tax basis and a post-tax cost of capital with post-tax returns. In the context of calculating a charge control for mobile termination, Ofcom has relied on an estimate of the MNOs' pre-tax real cost of capital.

B.3 The following sections deal with responses to the December consultation on the issues set out in Annex E of that document.

B.4 Only one of the MNOs, T-Mobile, provided a response that specifically discussed the cost of capital following the December consultation (although other MNOs had made submissions earlier in the consultation process). The following sections outline Ofcom's views on the comments made by T-Mobile^(-40-).

Asset pricing models

Introduction

B.5 In paragraphs E.3-E.10 of the December consultation Ofcom explained its reasoning for using the Capital Asset Pricing Model (CAPM) to estimate the cost of capital for the MNOs.

B.6 A number of different asset pricing models exist for calculating the cost of capital. The Capital Asset Pricing Model (CAPM), which is a single factor model, measures economy-wide influences through the risk of an individual asset relative to a market portfolio. There are also multifactor models which include factors that capture the risk of other economic factors not captured in the single factor model. These factors can be thought of as representing special portfolios of stocks that are subject to a common influence^(-41-).

B.7 The CAPM has a clear theoretical foundation and is simple to implement in comparison to other asset pricing models. This results in the continued wide use of the CAPM by the UK's economic regulators, and its wide use amongst practitioners. Ofcom used the CAPM to estimate the cost of capital for the MNOs in all of its consultations on mobile termination.

Responses

B.8 In response to the December consultation, T-Mobile questioned the use of the CAPM, its response stating that it, as previously outlined in its response to the May consultation, considered the use of an Arbitrage Pricing Theory (APT) based model to be a superior approach to the CAPM.

B.9 Specifically, T-Mobile criticised the quoting of an independent study that advocated the continued use of the CAPM. This report, A Study into Certain Aspects of the Cost of Capital for Regulated Utilities in the UK, was carried out on behalf of Ofcom and the UK's other economic regulators by Stephen Wright, Robin Mason, and David Miles ("WM&M"), and published in February 2003 (http://www.ofcom.org.uk/static/archive/oftel/publications/pricing/2003/
cofk0203.htm) (the "WM&M report").

B.10 T-Mobile stated that Ofcom's reliance on the findings of the Wright, Mason, and Miles report was misplaced since:

• T-Mobile had made a further submission, in July 2003, which had been, "made in light of the Wright, Mason and Miles paper"; and
• The analysis carried out by Wright et al did not include an appraisal of the quantitative analysis carried out on behalf of T-Mobile in 2002.

Ofcom's view

B.11 Ofcom has considered T-Mobile's response and has decided to continue to use the CAPM in line with the proposals and justification set out in paragraphs E.11 to E.15 of the December consultation. The text below addresses the additional concerns raised by T-Mobile.

B.12 Ofcom appreciates that the WM&M report was published prior to T-Mobile's July 2003 submission. However, Ofcom does not accept that its continued reliance on the WM&M report (together with other considerations) was misplaced, for the reasons set out below.

B.13 In forming an independent view on the appropriate estimation methods on behalf of the economic regulators, WM&M conducted a wide-ranging literature review. The new text provided by T-Mobile in July 2003 was based on summaries of the findings of a number of pieces of academic literature on this subject. This literature was either available to, or used by, WM&M in producing their report. For example, the literature quoted from Merton (1973), Ross (1976), and Fama and French (1993) were all used as references by WM&M. Whilst not referring to the specific articles quoted by T-Mobile, WM&M also cited a number of articles written by Cochrane and Lettau & Ludvigson, authors whose 1999 work was quoted by T-Mobile. The 2000 and 2002 work by Liew and Vassalou was available to WM&M, even though it was not referred to in their study. WM&M also drew on a range of other sources. The difficulties of applicability are picked up in one widely used and respected textbook, Brealey and Myers (Seventh Edition), who state that, "Arbitrage pricing theory doesn't tell us what the underlying factors are - unlike the capital asset pricing model, which collapses all macroeconomic risks into a well-defined single factor, the return on the market portfolio" (page 206).

B.14 Similarly, WM&M were aware of the outputs of the quantitative analysis carried out on behalf of T-Mobile in 2002 in forming their independent opinion of the relative merits of different asset pricing models. While they had not carried out a detailed appraisal of T-Mobile's methodology (e.g. they did not attempt to reproduce the results of the quantitative analysis carried out on behalf of T-Mobile), the authors were aware of its content, for example explicitly citing the broad similarity of some of the results obtained by CRA on behalf of T-Mobile to those of similar work carried out by Fama & French in the 1990s.

B.15 For the reasons set out in paragraphs E.3 and E.10 of the December consultation and the reasons set out above, Ofcom's view remains that the CAPM represents the most appropriate available model to be used in estimating the WACC of the MNOs. This view is supported by the continued use of the CAPM by the CC and the UK's economic regulators, most recently by OFGEM in March 2004. At present no compelling evidence exists which would change Ofcom's mind on this issue. Departing from the use of the CAPM would represent a significant regulatory precedent in the UK, and Ofcom would need to be thoroughly and independently convinced about the validity of any new approach before doing so. However, Ofcom is open-minded on this issue, and intends to review new evidence in this area as it becomes available.

Equity risk premium

Introduction

B.16 The equity risk premium measures the difference between the overall return on equities and the nominal risk free rate. Its value in the UK reflects the risk of investing in UK equities generally. In paragraph E.28 of the December consultation, Ofcom explained that it proposed to use an equity risk premium of 5%, based on the view that such a value would represent an appropriate, conservative, estimate from within a range of plausible estimates. The reasons for that view were set out in paragraphs E.30-E.38.

Responses

B.17 T-Mobile suggested that a value of 5% for the equity risk premium would be too low, advocating instead the use of a value of 5.9%, based on a figure calculated in a recent journal article published by Dimson, Marsh, and Staunton (Dimson, Elroy, Paul Marsh and Mike Staunton, Global Evidence on the Equity Risk Premium, Journal of Applied Corporate Finance, Volume 15, Number 4, Fall 2003).

Ofcom's view

B.18 As explained in paragraph E.30 of the December consultation, there is considerable debate about the appropriate method of calculating the value of the equity risk premium and the calculation is problematic because different methods produce different values. In particular, methods based on an analysis of current market expectations tend to give lower values than those based on analysis of historical estimates from stock market data. But determining current market expectation is a difficult and controversial task.

B.19 There are a large number of possible approaches to estimating the equity risk premium, and a wide range of estimates are available for the UK and, especially, the US.

B.20 The value of 5.9% advocated by T-Mobile appears to be based on the suggestion that a very high weight should be given to a single type of estimate, specifically one based on extrapolating the arithmetic mean of historical returns. This means that a very low weight is given to all other estimates, including those based on forward-looking estimates (as used by the UK's other economic regulators), on survey-based estimates, and on extrapolating the geometric mean of historical returns (see WM&M for a discussion of the relative merits of estimates based on geometric and arithmetic means). Another factor to consider is that, as outlined by Dimson, Marsh, and Staunton in their 2003 article cited by T-Mobile, there are strong reasons to suggest that historical estimates such as their figure of 5.9%, (which is the historical average adjusted downwards to reflect the impact of re-rating), should be subject to further downwards adjustments if it is intended to be used as an expected risk premium. Dimson, Marsh, and Staunton conclude,

"Further adjustments should almost certainly be made to historical risk premiums to reflect long-term changes in capital market conditions. Since, in most countries, corporate cash flows historically exceeded investor expectations, a further downward adjustment to the equity risk premium is in order..."

B.21 In this context, despite (and as highlighted by T-Mobile in its recent response) the investment imperative in mobile communications and consequent need for Ofcom to err on the side of conservative, i.e. high estimates, Ofcom's view is that T-Mobile's suggested value is, while within a reasonable range of possible estimates, very close to the upper limit of such a range. This view is shared by, Professor Julian Franks of London Business School who has advised Ofcom on this issue.

B.22 As explained in the December consultation paragraphs E.37 and E.38, Professor Franks' view was that Ofcom should review the use of its estimate in light of evidence recently made available. Consequently, in 2004 Ofcom has begun to review a number of different approaches to the estimation of the equity risk premium. However, given that the rationale behind the use of a figure of 5% has been consulted on in the context of mobile termination on a number of occasions, and, that the figure is well within (albeit towards the upper end of) the range implied by the submissions of the MNOs to the December consultation and previously (which have been higher in certain cases) and the ranges used by the CC and other economic regulators (which are all considerably lower), Ofcom's view is that, in the context of the proposed charge control, the use of the figure of 5% remains appropriate.

Risk free rate

Introduction

B.23 As explained in paragraph E.16 of the December consultation, Ofcom proposed a value of 5% for the risk free rate. Ofcom explained its reasons for doing so in paragraphs E.19-E.27.

B.24 The risk free rate of interest is an input into the calculation of both the cost of debt and the cost of equity. For an investment to be truly free of risk, the risk of default needs to be zero, and additionally there must be no reinvestment risk. The first condition can be satisfied approximately by using the yields on UK government debt, where the risk of default can be taken to be negligible. Strictly speaking, to satisfy the second condition, risk free rates should be estimated based on a series of short run risk free investments. This second condition is difficult to satisfy in practice, meaning that the nominal risk free rate is usually proxied by the yield on fixed term government debt of certain maturity. There is a range of maturities on government debt that could be used as the basis for an estimate of the risk free rate. These maturities range from less than 1 year to over 30 years.

B.25 There are arguments in favour of both short and long-term gilts as the best estimate of the risk free rate for the purposes of this market review. Ofcom's estimate was based on the nominal risk free rate for 5-year gilts in November 2003. The average rate at this time was 4.9%. As explained in the December consultation, this figure was rounded up to 5.0% (see paragraph E.25).

Responses

B.26 None of the MNOs commented on the value proposed in the December consultation.

Ofcom's view

B.27 Ofcom's view is that the approach used in the December consultation is appropriate. However, it proposes to review the value used in order to reflect more recent data on gilt rates. The chart below shows the trend in nominal and real gilt rates since the beginning of January 2000, together with an approximate implied inflation rate calculated by the Bank of England.

Figure 1 - Real and nominal gilt rates since January 2004

B.28 The data underpinning the chart above shows the following:

• the average nominal gilt rate between the beginning of 2000 and the end of the first quarter of 2004 (i.e. the end of March) has been 4.90% (maximum = 6.4%, minimum = 3.5%);
• the average nominal gilt rate between the beginning of 2001 and the end of Q1 2004 has been 4.65% (maximum = 5.4%, minimum = 3.5%);
• the average nominal gilt rate between the beginning of 2002 and the end of Q1 2004 has been 4.23% (maximum = 5.0%, minimum = 3.5%);
• the average nominal gilt rate between the beginning of 2003 and the end of Q1 2004 has been 4.30% (maximum = 5.0%, minimum = 3.5%); and
• the average nominal gilt rate between the beginning of 2004 and the end of Q1 2004 has been 4.60% (maximum = 4.77%, minimum = 4.42%).

B.29 The above data shows that gilt rates are subject to considerable degrees of fluctuation. Ofcom's view is that an average of 4.65%, observed between the beginning of January 2004 and the end of April 2004 makes use of up-to-date information whilst also using a long enough sample period to avoid taking account of very short run fluctuations.

B.30 It could be argued that interest rates calculated from government securities currently provide too low a benchmark for a risk free investment due to factors such as, notably, recent strong demand from pension funds. This might suggest that the risk free rate should be calculated with reference to redemption yields over a longer historical period of time as well as current spot rates. Such techniques tend to give rise to slightly higher estimates than those based on current returns (as described in, for example, the CC report).

B.31 With both of these factors in mind, Ofcom has decided to round up the average figure of 4.65% to the end of April 2004, referred to above, to 4.75%. The use of this value reflects any ambiguity as to the appropriate bond maturity to use (e.g. it might be argued that longer values than 5 years would be appropriate). This figure is lower than the value of 5.0% used in the December consultation, this higher value being based on the high nominal gilt rates observed in November 2003.

Equity beta

Introduction

B.32 The value of a company's equity beta measures the movements in return from its shares relative to the movement in the return from the equity market as a whole. It will rise with an operator's debt/equity ratio (gearing), since a higher level of gearing implies higher volatility in the returns to shareholders.

B.33 In the May and December consultations, a range of 1.0 to 1.6 at 10% gearing was used as a value for the equity beta of an MNO (see paragraphs E.39-E.76 of the December consultation for Ofcom's reasoning). These values are the same as those used by the CC in its inquiry into mobile termination. The rationale behind the use of this range was outlined in some detail (based on analysis carried out by The Brattle Group) in the December consultation. It was noted that Ofcom had erred on the side of caution in doing so in view of uncertainty involved as to which of the estimates is most appropriate to use for the charge control (see paragraphs E.72 and E.73 of the December consultation).

Responses

B.34 In 2002 and 2003, T-Mobile made submissions to both the CC and Ofcom, advocating the use of higher beta estimates than those that were finally used by Ofcom and the CC. These higher estimates were based on using both data sets and methodologies that differed to some extent from those used in the December consultation.

B.35 In its response to the December consultation, T-Mobile focused its main criticism of the beta estimates on three broad areas of the approach that had been advocated on the basis of the recommendations of The Brattle Group. These areas related to:

• the treatment of Vodafone's foreign operations;
• the length of data windows for beta estimation; and
• Ofcom's reliance on estimates calculated using Dimson adjustments.

B.36 Ofcom's view on beta estimation in the context of each of these criticisms is outlined below. This view is based on supporting analysis carried out by The Brattle Group in April 2004, Review of CRA submission concerning "Issues In Beta Estimation For UK Mobile Operators: Update, December 2003," April 2004.

Ofcom's view

B.37 The first of T-Mobile's criticisms concerns the failure of Ofcom and The Brattle Group to make upwards adjustments to raw beta estimates based on Vodafone's foreign operations. Ofcom does not agree with these criticisms of its approach. In the December consultation Ofcom placed a significantly higher weight on beta estimates for O2 than on estimates for Vodafone, since using O2 data is likely to largely remove the need to use a potentially controversial adjustment in order to model the impact of overseas holdings. This preference for estimates based on O2 rather than Vodafone data was suggested in the December consultation, e.g. in paragraph E.60.

The issue of foreign operations may suggest that O2 data is more suitable for this exercise than Vodafone data

B.38 The CC followed a similar approach, as indicated in paragraph 7.241 of the CC report,

"In order to avoid the difficulties caused by overseas ownership, our upper estimate of beta is based on mmO2 and not Vodafone."

B.39 Ofcom's conclusion is that relying on O2 data is the most appropriate approach to beta estimation.

B.40 T-Mobile's second criticism of the beta estimates relied upon in the December consultation was that it gave significant weight to estimates calculated based on what T-Mobile viewed as insufficiently long time horizons. This approach followed the recommendation of The Brattle Group that the most appropriate approach to estimation was to make calculations using a single year's worth of data rather than three year's worth of data as used by T-Mobile.

B.41 Ofcom continues to share the view of The Brattle Group that, while recognising that using longer data windows can have statistical benefits, the recent instability over time of equity betas has been such that, from an economic point of view, it is inappropriate to use beta estimates that rely on longer data windows. It might be appropriate to do so if, for example, the statistical gains from using longer data windows were very great relative to the losses caused by making estimates based on data sets that encompass significant structural "breaks". But Ofcom is not persuaded that this is the case based on current data for the MNOs.

B.42 Further analysis carried out on Ofcom's behalf by The Brattle Group in April 2004 (see above for reference) suggests that, for the MNOs, the statistical gains inherent in using longer data windows are insufficient to outweigh the significant associated problems of beta instability. Results of Chow Tests carried out by The Brattle Group suggest that using longer data windows such as those advocated by T-Mobile runs a risk of undermining the validity of estimates. Ofcom's view is therefore that, in terms of length of data window, the estimates recommended by The Brattle Group are likely to form a more appropriate basis for estimation that those advocated by T-Mobile.

B.43 T-Mobile's third criticism of the beta estimations relied upon in the December consultation concerns giving weight to beta estimates calculated using Dimson adjustments. It argues that these adjustments were not statistically significant in the period shortly after the sample used by The Brattle Group. Ofcom's view is that giving weight to Dimson adjusted betas was valid given the data available to The Brattle Group at the time of estimation. The subsequent analysis carried out on Ofcom's behalf by The Brattle Group in April 2004 supports the view that its initial estimation method was robust. The Brattle Group's analysis shows that:

• Dimson adjustments were significant for the great majority of the sample period available to The Brattle Group in calculating beta estimates to support the December consultation; and
• while Dimson adjustments may not be consistently significant when beta estimates are made with a newer data set, the corresponding unadjusted beta estimates are substantially lower than the Dimson adjusted betas referred to in the December consultation (e.g. The Brattle Group estimates an unadjusted beta for O2 at 31December 2003 of 1.26. At this time O2's gearing level was estimated by The Brattle Group to be above the 30% level corresponding to Ofcom's "high gearing" scenario for which an average beta estimate of 1.6 has been used).

B.44 In the light of the above factors, and the reasons set out in the December consultation at paragraphs E.39-E.76, Ofcom's view is that an equity beta range of 1.0 to 1.6 at 10% gearing remains appropriate.

Debt premium

Introduction

B.45 The cost of corporate debt is made up of a risk free component and a company specific risk premium. Historical evidence suggests that blue chip corporate debt, such as that of mobile operators, commands a small risk premium, although estimates of this premium vary considerably.

B.46 In the May and December consultations, a range of 1% to 3.5% was used as an estimate of the debt premium of an MNO (see paragraph E.77 of the December consultation).

Responses

B.47 None of the MNOs commented on the range proposed in the December consultation.

Ofcom's view

B.48 For the reasons set out in paragraphs E.79-E.85 of the December consultation, Ofcom will continue to use the range of 1% to 3.5% for the debt premium.

Optimal gearing

Introduction

B.49 Under the standard Capital Asset Pricing Model and the Modigliani and Miller assumptions of debt and taxes, a firm can potentially lower its overall cost of capital by increasing its gearing. This is because debt is generally cheaper than equity as a result of tax advantages to debt.

B.50 In the May and December consultations, a range of 10% to 30% was used as an estimate of the gearing ratio of an MNO (see paragraph E.86 of the December consultation).

Responses

B.51 None of the MNOs commented on the range proposed in the December consultation.

Ofcom's view

B.52 For the reasons set out in paragraphs E.88-E.90 of the December consultation, Ofcom proposes to continue to use the range of 10% to 30% for the optimal gearing of a UK MNO.

Calculation of WACC - correct transformation from nominal to real

Introduction/responses

B.53 Under the heading, "Correct transformation from nominal to real" in Annex B of its response to the December consultation, T-Mobile discussed the correct way to transform nominal WACC estimates into real estimates.

Ofcom's view

B.54 Ofcom fully agrees with the need for consistency between its real/nominal WACC transformation and the values used in setting the charge control. With this in mind, Ofcom's preferred approach is to:

• calculate, using a geometric formula (see below for explanation), the rate of inflation based on the difference between nominal and real gilt yields. Data on both of these yields is supplied by the Bank of England. In the context of this calculation, the nominal risk free rate for 5-year gilts in period from the beginning of January to the end April 2004 ranged from 4.5% to 4.9%, with an average of 4.65%. This rate compares with an average real rate of return of 1.8% for similar term index-linked gilts. This difference between the real and nominal rate implies an inflation rate of approximately 2.8%; and
• use this inferred rate of inflation as an input into further calculations.

B.55 Ofcom has calculated a rate of inflation based on the formula shown below (using the notation supplied by T-Mobile in its response to the December consultation):

iinflation =	1 + rgilt	- 1
	1 + rindex-linked

B.56 In the December consultation, the preferred approach was to use an inflation rate calculated as above to transform its calculated nominal WACC to a real WACC using the following formula (using the notation supplied by T-Mobile in its response to the December consultation):

WACCreal =	1 + WACCnominal	- 1
	1 + iinflation

B.57 In its response T-Mobile states that the use of the above formula in translating a nominal WACC into real terms is incorrect. It states that the correct translation is to use the following "arithmetic" transformation (as opposed to the "geometric" transformation above):

WACC_real = WACC_nominal - i_inflation

B.58 Its preference for this arithmetic transformation is justified by means of a worked example.

B.59 Ofcom's view is that, provided that the inflation estimate has been calculated correctly, the transformation originally used in the December consultation is appropriate. This formula is repeated below:

WACCreal =	1 + WACCnominal	- 1
	1 + iinflation

B.60 This formula is widely used, e.g. by the CC in the CC report. An equivalent formula is given in Brealey & Myers Principles of Corporate Finance (7th Edition, page 122), in relation to calculating a real rate of return given a nominal rate of return, as shown below:

1 + r_nominal = (1 + r_real ).(1 + inf lation)

B.61 Brealey and Myers note the real discount rate, when calculated using an arithmetic transformation, is close, but not equal, to the true real discount rate:

"Note that the real discount rate is approximately equal to the difference between the nominal discount rate of 15% and the inflation rate of 10%. Discounting at 15%-10% = 5% would give NPV... not exactly right, but close."

B.62 The following short example illustrates why Ofcom believes that the geometric transformation is appropriate. Suppose that the real WACC, r, i.e. the real return demanded by investors was 10%, and the inflation rate, i, was 50%. At the end of every given period, by which time the general price level would be at (1+i) times its level at the start of the period, investors would demand a return on every unit of their investment that would compensate them for both:

• for the decline in the real value of their initial investment, which, absent any returns would decline on an annual basis at the rate i; and
• the opportunity cost of their investment. The compensation they would require for this, if paid at the end of the period, would have to reflect the new (higher) general price level prevailing at this time.

B.63 Using the example figures quoted in the previous paragraph, using an arithmetic transformation would make the investor's nominal compensation equal to r + i = 60%, whereas a geometric transformation would make it equal to (1+i)(1+r) -1 = 65%. The difference between the two terms, ri, is equal to 5% in this example. Without being compensated for this extra term, as explained above, the real value of the return received by the investor to reflect the opportunity cost of his investment would have been partially eroded by inflation.

B.64 Ofcom is not convinced that T-Mobile's numerical example provides a sound justification for using an arithmetic formula. Ofcom's view is that T-Mobile's numerical example is flawed. This view is explained below:

• In T-Mobile's example, in both the nominal and real cases, it discounts the recurring cash inflows in year t using a discount factor calculated based on the formula Dt = 1/(1+d)^t. This suggests that the recurring cash inflows in year t occur at the end of year t; but;
• this appears to be inconsistent with the amount of inflation applied to the recurring cash inflows in the nominal case, which is set equal to It = (1+i)^(t-1). This application of inflation suggests that the recurring cash inflows in year t occur at the beginning of year t, which is inconsistent with the way in which the recurring cash flows are discounted as indicated in the previous bullet.

B.65 If this inconsistency is removed, the result obtained by T-Mobile (i.e. that the arithmetic transformation is superior) does not hold when its example is re-calculated in an internally consistent manner. In the light of this, and the widespread use of the "geometric" transformation as outlined above, Ofcom proposes to use the "geometric" transformation between nominal and real WACC as set out in the December consultation.

Calculation of WACC - consistency of values

Introduction/responses

B.66 Under the heading, "Inconsistent values in the table" in Annex B of its response to the December consultation, T-Mobile drew Ofcom's attention to some unexplained values in Table 5 of Annex E in the December consultation.

Ofcom's view

B.67 The reason for the significant discrepancy between the figures calculated by T-Mobile and those in the December consultation is that T-Mobile assumed a zero beta of debt, whereas Ofcom did not, as outlined in paragraph E.84. This paragraph stated that Ofcom's estimates were based on beta of debt of zero for the first one percent of the debt premium and increasing by 0.2 for every one percent of debt premium above one percent. The debt beta measures the systematic risk of the returns on debt. Ofcom's estimate of the debt beta implies that the first one percent of premium on mobile operators' debt is due to factors not priced into the CAPM, for example liquidity. Any increase in debt premium beyond that level is attributed to the risk of default.

B.68 The figures below show the difference in estimates calculated using a zero debt beta, and those calculated using the "threshold" formula referred to above.

Table 1: WACC calculation assuming zero debt beta (e.g. T-Mobile)

	Low Gearing		High Gearing
	Low Beta	High Beta	Low Beta	High Beta
Risk-free	5.00	5.00	5.00	5.00
ERP	5.00	5.00	5.00	5.00
Equity beta for low gearing	1.00	1.60
Debt beta	0.00	0.00	0.00	0.00
Asset beta	0.90	1.44	0.90	1.44
Equity beta	1.00	1.60	1.29	2.06
Cost of equity (post tax)	10.00	13.00	11.43	15.29
Debt premium	1.00	3.50	1.00	3.50
Cost of debt (pre tax)	6.00	8.50	6.00	8.50
Corporate tax rate	30%	30%	30%	30%
Cost of debt (post tax)	4.20	5.95	4.20	5.95
Gearing	10%	10%	30%	30%
WACC (post tax)	9.42%	12.30%	9.26%	12.49%
WACC (pre tax)	13.46%	17.56%	13.23%	17.84%
Inflation assumption	2.8%	2.8%	2.8%	2.8%
WACC (pre tax - real)	10.33%	14.33%	10.11%	14.59%
Average WACC (pre tax - real)	12.349%

 

Table 2: WACC calculation assuming nonzero debt beta (e.g. Ofcom)

	Low Gearing		High Gearing
	Low Beta	High Beta	Low Beta	High Beta
Risk-free	5.00	5.00	5.00	5.00
ERP	5.00	5.00	5.00	5.00
Equity beta for low gearing	1.00	1.60
Debt beta	0.00	0.50	0.00	0.50
Asset beta	0.90	1.49	0.90	1.49
Equity beta	1.00	1.60	1.29	1.91
Cost of equity (post tax)	10.00	13.00	11.43	14.57
Debt premium	1.00	3.50	1.00	3.50
Cost of debt (pre tax)	6.00	8.50	6.00	8.50
Corporate tax rate	30%	30%	30%	30%
Cost of debt (post tax)	4.20	5.95	4.20	5.95
Gearing	10%	10%	30%	30%
WACC (post tax)	9.42%	12.30%	9.26%	11.99%
WACC (pre tax)	13.46%	17.56%	13.23%	17.12%
Inflation assumption	2.8%	2.8%	2.8%	2.8%
WACC (pre tax - real)	10.33%	14.33%	10.11%	13.89%
Average WACC (pre tax - real)	12.217%

B.69 As shown in Tables 1 and 2 above, the difference between WACC estimates calculated using a zero debt beta & using a nonzero debt beta may be significant. As outlined in the section on debt premium, Ofcom will use the December consultation estimates in the context of the MNOs' cost of debt. Ofcom has calculated the WACC of the MNOs using both a zero debt beta and obtained results that are broadly similar - the average real pre-tax WACC calculated using a zero debt beta is 11.89%, whereas the corresponding figure assuming that the debt beta is nonzero, and calculated based on a threshold as set out in the December consultation is 12.03%. With this in mind, Ofcom's view is that using a rounded figure of 12.0% is reasonable, and the value of the debt beta is not a critical issue. Were this value to have a more significant impact on results then Ofcom would consider the issue more closely.

WACC- conclusion

B.70 Table 3 below shows Ofcom's estimate of the real pre-tax WACC of the MNOs. As outlined above, Ofcom proposes to use a rounded average of 12.0% as a basis for the proposed charge control. This average is lower than the value of 12.25% used in the December consultation because of the use of new data on the risk free rate, showing lower yields in 2004 than had been observed by Ofcom in November 2003. As discussed above, some of the values in the table below would differ slightly if an alternative assumption regarding the beta of debt were to be used (e.g. if, as assumed by T-Mobile in its calculations, that it were zero), but this would not alter Ofcom's chosen rounded average of 12.0% for the real pre-tax WACC.

Table 3: WACC calculation

	Low Gearing		High Gearing
	Low Beta	High Beta	Low Beta	High Beta
Risk-free	4.75	4.75	4.75	4.75
ERP	5.00	5.00	5.00	5.00
Equity beta for low gearing	1.00	1.60
Debt beta	0.00	0.50	0.00	0.50
Asset beta	0.90	1.49	0.90	1.49
Equity beta	1.00	1.60	1.29	1.91
Cost of equity (post tax)	9.75	12.75	11.18	14.32
Debt premium	1.00	3.50	1.00	3.50
Cost of debt (pre tax)	5.75	8.25	5.75	8.25
Corporate tax rate	30%	30%	30%	30%
Cost of debt (post tax)	4.03	5.78	4.03	5.78
Gearing	10%	10%	30%	30%
WACC (post tax)	9.18%	12.05%	9.03%	11.76%
WACC (pre tax)	13.11%	17.22%	12.90%	16.80%
Inflation assumption	2.8%	2.8%	2.8%	2.8%
WACC (pre tax - real)	9.99%	13.99%	9.79%	13.58%
Average WACC (pre tax - real)	11.891%

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