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Updated 18 August 2005

1. What does “weighted average cost of capital” mean?

The weighted average cost of capital measures the rate of return that a firm needs to earn in order to reward its investors.

2. Why does Ofcom need to estimate the level of risk faced by firms and, based on this, what a reasonable rate of return is?

Measuring the relationship between risk and return provides an important input for a number of aspects of Ofcom’s work. For example, when Ofcom sets the level at which the firms it regulates are permitted to set charges, it needs to include a reasonable rate of return in these charges. Risk and return is also an important factor in other areas of Ofcom’s work, for example when calculating the value of a particular business or project in the context of licence applications.

3. Why did Ofcom publish a second consultation?

In January 2005, Ofcom published a first consultation on calculating the weighted average cost of capital for companies in the communications industry. Some parts of the first consultation were focused on BT, whilst others applied equally across all of the industry, including broadcasting and mobile communications. Some of the responses to the first consultation argued that Ofcom should collect further evidence and carry out further analysis relating to calculating a weighted avergage cost of capital for different parts of BT’s business. We carried out further work following these comments and published a second consultation on these issues in June 2005.

4. How does the final statement fit in with the first and second consultations and the overall review?

The first and second consultations together with the final statement are all part of the overall review. This final statement outlines Ofcom’s final views on the issues covered in both the first and second consultations.

5. What is Ofcom concluding in this review?

In this review, Ofcom has decided to modify the approach that it previously used to calculate the level of a reasonable return. Ofcom has decided to change both some of the inputs into the methodology that it uses to calculate a reasonable return and also how that methodology is applied to calculate a reasonable rate of return.

6. What areas of regulation will be impacted by the outcome of the review?

As outlined in the explanation of why Ofcom needs to carry out this type of analysis, a number of areas of regulation would be affected by Ofcom’s decisions. Firstly, the decisions will influence the level at which the firms Ofcom regulates are permitted to set charges. Secondly, they would have an impact on other aspects of the financial analysis carried out by Ofcom, for example when it has to calculate the value of licences in broadcasting markets.

7. How would Ofcom's decisions change existing regulation?

Ofcom’s decisions would not introduce any new regulation as such, or cause it to revise its opinion in relation to previous regulatory decisions, but would have an impact on future regulatory decisions that involve financial analysis (e.g. setting the maximum level of a company’s charges).

8. Why is Ofcom looking at this now? How does this link to the Strategic Review of Telecoms?

Ofcom is looking at this now because a number of the decisions that it will make this year will require an assessment of the relationship between risk and return. The principles proposed by Ofcom in its Phase 2 Strategic Review of Telecoms consultation are a key determinant of some of the decisions in this review.

9. Will the outcome of this review apply only to BT?

No. Some of the analysis in the first, and especially the second, consultations is discussed with reference to BT, but the principles established in this policy statement will apply equally to other parts of the industry, including broadcasting and mobile communications.

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