Draft Report for:
Estimating the cost of capital
for fixed and mobile
SMP operators in Sweden
9 July 2003
Andersen Management International A/S
A part of Ementor Danmark A/S
THE OPINIONS EXPRESSED IN THIS STUDY ARE THOSE OF THE AUTHORS
AND DO NOT NECESSARILY REFLECT THE VIEWS OF POST & TELESTYRELSEN (PTS).
ANDERSEN MANAGEMENT INTERNATIONAL A/S*
Lautrupvang 6 – DK-2750 Ballerup
Phone: +45 70 10 80 80 Fax: + 45 44 78 87 00
* Part of Ementor Danmark A/S
Table of contents
1
INTRODUCTION ............................................................................................................. 1
1.1
BACKGROUND AND SCOPE OF STUDY .................................................................................................... 1
1.2
OUTLINE ...................................................................................................................................................... 1
1.3
DEFINITION OF SMP OPERATOR............................................................................................................ 2
1.4
GUIDING PRINCIPLES FOR THE STUDY .................................................................................................. 2
1.5
OVERALL APPROACH – WACC AND CAPM ........................................................................................ 3
1.6
SUMMARY OF RECOMMENDED PRINCIPLES ........................................................................................... 4
2
PROCEDURAL ISSUES .................................................................................................... 5
2.1
WACC, LRIC AND THE CAPITAL BASE .................................................................................................. 5
2.2
SAME WACC FOR FIXED AND MOBILE? ................................................................................................ 5
2.3
SAME WACC FOR FIXED ACCESS AND CORE? ...................................................................................... 6
2.4
SAME WACC FOR DIFFERENT MOBILE OPERATORS? ......................................................................... 6
2.5
HOW OFTEN SHOULD THE WACC BE RECALCULATED AND BY WHOM? ........................................ 7
2.6
SUMMARY OF RECOMMENDED PRINCIPLES ........................................................................................... 8
3
COST OF CAPITAL ISSUES ............................................................................................. 9
3.1
PRICE BASE .................................................................................................................................................. 9
3.2
TAXATION ................................................................................................................................................... 9
3.3
PRINCIPLES FOR DETERMINING THE CAPITAL STUCTURE ................................................................10
3.4
DIVISIONALISATION VS. NON-DIVISIONALISATION ..........................................................................11
3.5
SUMMARY OF RECOMMENDED PRINCIPLES .........................................................................................12
4
COST OF DEBT................................................................................................................13
4.1
RISK FREE RATE........................................................................................................................................13
4.2
DEBT PREMIUM ........................................................................................................................................15
4.3
SUMMARY OF RECOMMENDED PRINCIPLES .........................................................................................16
5
COST OF EQUITY ...........................................................................................................17
5.1
THE CAPM METHODOLOGY .................................................................................................................17
5.2
DEFINING THE RELEVANT INVESTOR..................................................................................................17
5.3
ESTIMATING THE MARKET RISK PREMIUM ..........................................................................................19
5.4
ESTIMATING BETA ...................................................................................................................................23
5.5
SUMMARY OF RECOMMENDED PRINCIPLES .........................................................................................27
6
INTERNATIONAL EXPERIENCE............................................................................... 29
6.1
UK ..............................................................................................................................................................29
6.2
DENMARK .................................................................................................................................................31
i
7
CONCLUSION................................................................................................................. 34
7.1
SUMMARY OF RECOMMENDED PRINCIPLES .........................................................................................34
7.2
SUMMARY OF WACC CALCULATIONS ..................................................................................................35
ANNEX A
WACC CALCULATIONS ................................................................................... 37
A.1
CAPITAL STRUCTURE .........................................................................................................................37
A.2
RISK FREE RATE .................................................................................................................................38
A.3
DEBT PREMIUM ...................................................................................................................................39
A.4
EQUITY RISK PREMIUM ......................................................................................................................43
A.5
BETA .....................................................................................................................................................44
A.6
EFFECTIVE TAX RATE .......................................................................................................................47
A.7
COST OF CAPITAL FOR FIXED SMP OPERATOR ............................................................................47
A.8
WACC FOR MOBILE SMP OPERATOR ............................................................................................47
ANNEX B
SUMMARY OF INVESTMENT BANK SURVEY ............................................ 49
ANNEX C
REFERENCES ....................................................................................................51
ii
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
1 Introduction
1.1
BACKGROUND AND SCOPE OF STUDY
Andersen Management International A/S (AMI) has been commissioned by PTS to
undertake a study on the cost of capital for fixed and mobile SMP operators in
Sweden. The purpose of the study is to provide PTS with recommendations on how
to estimate the cost of capital in practice and calculate the cost of capital rates in
accordance with these recommendations. It is not the purpose of the study to provide
a lengthy discussion of the underlying theory, which is already well described in the
literature.
The cost of capital rates should be applicable in the two ongoing LRIC1 projects for
the fixed and mobile networks respectively2. Note that the cost of capital is used to
estimate costs. How to determine prices on the basis of these costs is a separate issue.
1.2
OUTLINE
The report is structured as follows:
Below we begin by defining the SMP operators, for which the cost of capital
should be estimated. We then establish some overall guidelines for making
recommendations later on in the study, and set out the overall approach
adopted for the calculations.
Section 2 discusses key procedural issues.
Section 3 outlines the overall methodological issues.
Section 4 moves on to discuss the theoretical and practical issues to consider
when estimating the cost of debt.
Section 5 discusses the theoretical and practical issues to consider when
estimating the cost of equity.
Section 6 presents some relevant experience from LRIC projects in the UK and
Denmark and provides an overview of the cost of capital rates used for setting
access and interconnection charges in other EU countries.
Section 7 finally summarises our recommendations and presents WACC estimates
for fixed and mobile SMP operators in Sweden.
1
Long Run Incremental Costs.
More information on these two projects is available at the PTS web-site:
http://www.pts.se/tele.asp?avdelning=for_branschfolk&uavdelning=tele
2
1
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
Annex A presents our calculations of the WACC in more detail, discussing all
the different parameters of the calculation.
Annex B presents the findings of a survey of investment bank analysts, conducted in
co-operation with PTS in June 2002.
Annex C includes references to the material used in this study.
1.3
DEFINITION OF SMP OPERATOR
As regards the fixed network, the only operator designated to have Significant Market
Power (SMP) in the market for fixed (wholesale) access and interconnection services is
TeliaSonera. This situation is likely to prevail also after the implementation of the new
EU regulatory framework. In the fixed LRIC project it was therefore decided to
estimate the Long Run Incremental Cost (LRIC) of an operator with the scope and
scale of TeliaSonera. This study will therefore focus on estimating the cost of capital of
an SMP operator with the scope and scale of TeliaSonera.
As regards the mobile networks, the situation is somewhat more complex. Currently,
TeliaSonera is the only SMP operator in the (wholesale) market for mobile
interconnection services3. However, the new EU regulatory framework defines a new
market: Voice call termination on individual mobile networks. As an operator by
definition has a 100% market share in this market, one would expect all network
operators to be designated with SMP in this market4. Hence, it will be necessary to
estimate the cost of capital of all the individual operators and/or that of an “average”
operator. This issue is discussed further in section 2.
1.4
GUIDING PRINCIPLES FOR THE STUDY
AMI has established the following guiding principles for making recommendations in
this study:
The approach for estimating the cost of capital should, as far as possible, be:
1. Fair and objective. There should be no inherent bias in the results and the use of
subjective measures should be minimised.
2. Transparent, relying on publicly available information.
In February 2002, PTS decided that Tele2 and Vodafone also had significant market power in the
mobile market. This decision was appealed by both operators, however, and the court recently decided
that neither Tele2 nor Vodafone could be designated as SMP operators in the market for mobile
termination (Vodafone could be designated as SMP operator in the retail market, though).
3
On 25 July, a new legislation will be implemented according to EC recommendations, the Electronic
Communications Act. This implementation requires market analysis to establish SMP, and a separate
PTS project is currently ongoing to perform this market analysis and to determine proportionate
remedies.
4
2
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
3. Robust, providing operators with regulatory certainty and stability.
4. Operational and pragmatic. PTS should be able to undertake the calculations in
accordance with the proposed recommendations with regular intervals and based
on data sources, available to PTS.
5. In line with generally accepted standard practice within the industry and the
financial world in Sweden.
6. Based on a solid theoretical foundation.
7. In line with international experience (as regards methodology, however, not
necessarily parameter values).
8. In line with previous decisions by PTS where this does not conflict with other
guidelines.
1.5
OVERALL APPROACH – WACC AND CAPM
There seems to be general consensus among both operators and regulators in Sweden
and throughout the EU that the cost of capital should be estimated as the Weighted
Average Cost of Capital (WACC) and based on the so-called Capital Asset Pricing
Model (CAPM). AMI supports this approach, which also is in line with the guidelines
stated in the previous section, and we see no need for discussing the alternative
approaches at any length in this study5.
The Weighted Average Cost of Capital (WACC) is calculated as the weighted cost of
debt and equity:
WACC =
E
D
× Ce +
× ( 1 − T) × Cd ,
E+D
E+D
where E is the market value of equity, D the market value of debt, E+D is the market
value of the company, Ce the cost of equity, T the effective tax rate, and Cd the cost of
debt.
The cost of debt, Cd, should reflect the interest rate that lenders would require for
lending their money, i.e. the risk free-rate adjusted to reward lenders for the risk that
the borrower will default.
According to CAPM, the cost of equity can be calculated as
Ce = E(Rj) = Rf + βj [ E(Rm) – Rf ],
Alternatives to CAPM include non-linear models, multifactor models (such as Arbitrage Pricing
Theory), Dividend Growth Models and accounting based returns. All these approaches suffer from a
number of well-known theoretic and/or practical problems and are therefore typically only used as a
cross check on the CAPM. For further discussion of these approaches see, e.g. Wright, Mason and
Miles (2003) or Brealey and Myers (2000).
5
3
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
where E(Rj) is the expected return on asset j; Rf is the risk-free rate; βj measures how
sensitive asset j is to movements in the market portfolio; and E(Rm) is the expected
return on the market portfolio.[ E(Rm) – Rf ] is the market risk premium, in practice
often referred to as the Equity Risk Premium (ERP).
Sections 4-5 discuss how to estimate the cost of debt and equity, respectively,
including the various sub-parameters.
No matter what methodology is adopted for calculating the WACC, one should bear
in mind that the rate obtained will be an estimate based on assumptions and
judgements about both the theory and the data used in the calculation. From a
practical point of view, this means that calculations of the WACC presented in this
report do not remove the requirement for PTS to exercise judgement when deciding
on the final values to be used.
1.6
SUMMARY OF RECOMMENDED PRINCIPLES
The recommended principles are summarised below:
1. The cost of capital should be estimated as the Weighted Average Cost of Capital
(WACC) using the CAPM to estimate the cost of equity.
4
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
2 Procedural issues
This section sets out to discuss the key procedural issues, which PTS needs to
consider. However, we set out by clarifying the way in which the cost of capital is
applied to the capital base in order to calculate the annual costs of capital in a LRIC
context.
2.1
WACC, LRIC AND THE CAPITAL BASE
AMI understands that the interrelationship between the WACC calculation and the
valuation of the capital case have been subject to discussions between PTS and
TeliaSonera in the past. It therefore seems appropriate to discuss this interrelationship
to avoid any misunderstandings before moving on to the WACC itself.
In order to obtain the annual capital costs, the WACC is multiplied by the net value of
the capital tied up in the network (made up of fixed assets and net current assets).
Under historic cost accounting, the assets should be valued at book value, whereas
under current cost accounting, assets should be valued at their economic (or market)
value. Whereas under historic cost accounting, the focus is on recovering the SMP
operator’s costs once, and only once, under current cost accounting, the objective is to
provide correct investment signals to the market. Whether to use historic or current
cost accounting is a regulatory decision that depends on the aims of the regulator.
In a LRIC context, all assets should be valued on the basis of current costs, which
effectively corresponds to a market valuation. Furthermore, the LRIC should mirror
the cost of an efficient operator. Whereas an operator regulated on the basis of historic
(actual) costs may argue that the applied cost of capital should correspond to the cost
of capital actually faced by this operator, this does not apply in a LRIC context.
In this study, we focus on estimating the cost of capital of a notional SMP operator.
2.2
SAME WACC FOR FIXED AND MOBILE?
The first procedural issue to consider is whether PTS could apply the same WACC for
fixed and mobile SMP operators.
The standard theory of corporate finance prescribes that the cost of capital in principle
should be estimated for each individual investment project as the optimal capital
structure and project specific uncertainty may deviate from that of the aggregate
company.
In practice, however, this is not a very pragmatic approach. Moreover, in the context
of fixed and mobile LRIC, the relevant investment project is normally considered to
be the entire network(s)6.
6
Assuming the increment is defined broadly such as access, core and mobile.
5
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
Fixed and mobile operators share many characteristics, and there is an ongoing
convergence between fixed and mobile telecommunications. However, AMI also
acknowledges the potential differences between mobile and fixed networks in terms of
capital structure and risk profile. As many operators operate standard-alone mobile
networks, it is fairly unproblematic to estimate separate WACC rates using a
benchmark approach. (For the fixed network, however, PTS will to a large degree have
to rely on data from integrated operators, as the majority of the fixed SMP operators
also run a mobile network).
AMI therefore recommends that PTS estimate separate WACC rates for fixed and
mobile SMP operators.
2.3
SAME WACC FOR FIXED ACCESS AND CORE?
In theory, one could also argue that the cost of capital rates for a stand-alone access
and core network could be different due to different capital structures and risk profiles
associated with the different services. In practice, however, it would be very difficult to
find the relevant market data necessary for making such separate calculations, as there
are no operators operating a stand-alone access network7. As it is currently the same
operator (TeliaSonera) who operates both the access and the core network, the use of
an average cost of capital rate for access and core should not have any material affect
on the total revenue from regulated services.
For these reasons, AMI recommends that PTS estimate an aggregate cost of capital
rate for the core and access network.
2.4
SAME WACC FOR DIFFERENT MOBILE OPERATORS?
As regards the mobile networks, the question is whether to apply the same or separate
cost of capital rates for the different operators. Clearly, if PTS decides to apply the
same call termination charge to all operators, it would not make sense to use different
cost of capital rates either8. The question therefore only arises in the situation where
PTS should decide to apply separate termination charges for the individual operators.
PTS might e.g. find that the economies of scale and scope are so significant that this
needs to be taken into account in the regulated charges.
Different operators may have different costs of capital, due to differences in service
mix, capital structure and ownership. Such differences are typically not relevant in the
context of LRIC, however, as the focus is not on the actual operators but on notional
operators with similar scope and scale. As regards services, it should also be noted that
There may be operators, operating a stand-alone core network, but they are unlikely to be comparable
to that of an SMP operator.
7
Input parameters, and the implied cost of capital rates, could be estimated for the individual operators,
but PTS should apply the same rate, when calculating the capital costs used for the price setting.
8
6
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
the new EU regulatory framework is concerned with the market for voice termination
services. Any differences in technology deployed (NMT, 2G or 3G) or service mix
offered therefore seem irrelevant – from the customer’s point of view, it is the same
service.
Finally, there are a number of pragmatic arguments for applying the same WACC for
all operators. First of all, all estimates will be subject to a certain degree of uncertainty.
Even if all operators had the same “true” cost of capital, we might come up with
different estimates. As the uncertainty of these estimates is likely to be much higher
than any difference in the costs of capital between operators, it seems most fair to
apply the same rate to all operators. It would also be difficult to estimate the specific
cost of capital for 3 in Sweden, just like it is becoming increasingly difficult to estimate
the cost of capital for Vodafone, due to the ownership structure of the two companies.
One would therefore need to rely on data from other operators anyway.
For these reasons, AMI recommends that PTS apply the same WACC for all mobile
SMP operators.
2.5
HOW OFTEN SHOULD THE WACC BE RECALCULATED AND BY WHOM?
As the financial market fluctuates, so will many of the input parameters used for
calculating the cost of capital. Hence, a case could be made for re-estimating the cost
of capital regularly, say annually, to constantly provide the market with correct
investment incentives.
As noted in our report on “Cost Oriented Access and Interconnection in Sweden”
from November 2001, however, AMI does not consider estimating the cost of capital
on an annual basis to be appropriate for regulatory price setting. In our view, a main
goal of setting cost-oriented access and interconnection charges should be to provide
operators with a stable and predictable framework on which they can base their
investment decisions. Revising the WACC used in the LRIC calculations annually
could lead to highly volatile access and interconnection prices9. Furthermore, the
calculations are subject to a substantial amount of judgement by the party responsible
for undertaking these calculations. Not only will this increase the uncertainty for
interconnecting operators, it will also imply a risk that these cost of capital calculations
will end up in lengthy appeals to court year after year.
AMI recommends that the cost of capital be re-estimated in conjunction with more
thorough reviews of the adopted LRIC pricing methodologies.
Due to the large scope for making subjective decisions when estimating the cost of
capital and the strong incentive for SMP operators to overestimate the cost of capital
used for regulatory purposes, AMI recommends that PTS should be responsible for
undertaking the calculations to safeguard the fairness and objectiveness of the
As a cross-check on the robustness of the applied methodology, PTS could decide to calculate the
WACC annually for internal use. Our recommendation relates to the regulatory determined WACC rate.
9
7
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
calculations. It is, however, advisable that the calculations be subject to public
consultation before they are applied.
2.6
SUMMARY OF RECOMMENDED PRINCIPLES
The recommended principles are summarised below:
2. PTS should estimate separate cost of capital rates for fixed and mobile SMP operators.
3. PTS should use the same cost of capital for the fixed access and core network.
4. PTS should apply the same cost of capital for all mobile SMP operators.
5. The calculations should be undertaken by PTS in conjunction with the more thorough
reviews of the LRIC pricing methodology.
8
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
3 Cost of capital issues
In this section, we discuss the overall methodological issues to consider when
calculating the cost of capital.
3.1
PRICE BASE
WACC may be measured either in real terms or nominal terms. A nominal WACC is
expressed in current terms, while a real WACC is expressed in real/constant terms.
Hence, the real WACC shows the WACC excluding the impact of inflation.
The choice of price base should be consistent with the regulatory pricing regime. If
access and interconnection prices are regulated in real terms, the cost of capital should
be expressed in real terms, whereas it should be expressed in nominal terms if prices
are regulated in nominal terms. In the past, prices have been regulated in nominal
terms in Sweden, and there is no indication that this will change in the future. Hence
the cost of capital should be estimated in nominal terms. By permitting a nominal
return on assets, investors are compensated for both their opportunity cost of capital
and expected inflation.
In the view of AMI, the WACC should be stated in nominal terms.
3.2
TAXATION
The WACC may be estimated post-tax or pre-tax. The pre tax WACC is the WACC
adjusted to allow for corporate tax payments. When applied to the capital base, it
indicates the (pre-tax) operating profit required to finance tax and interest payments,
while providing shareholders with their required return.
The WACC is usually calculated on a post-tax basis since most market information is
available on this basis. Then, it is converted to a pre-tax WACC. A formula often used
for converting a post-tax WACC to a pre-tax WACC is:
WACCPre-tax = WACCPost-tax / (1-T),
where T is the effective tax rate.
To estimate a pre-tax WACC, a single effective company tax rate must be estimated.
This is problematic as it is difficult to accurately estimate a single effective tax rate,
reflecting a company’s taxation liabilities, as the taxation liabilities will inevitably vary
from year to year. Furthermore, forward-looking costs do not depend on the tax rate
for previous years, but on the corporate tax rate that can be expected in a forwardlooking perspective. Therefore, AMI suggests the pragmatic solution of using the
corporate tax rate as a proxy for the effective tax rate of an SMP operator. Although
we acknowledge that this is not theoretically correct, we note that this eliminates any
uncertainty that would otherwise be introduced by attempting to estimate an effective
rate, and further is in line with generally accepted practice.
9
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
3.3
PRINCIPLES FOR DETERMINING THE CAPITAL STUCTURE
The relative share of debt and equity in a company’s capital structure is called the debt
to equity ratio. Financial gearing refers to the company’s proportions of debt and
equity and is defined as D/(E+D), where D is the debt and E the equity capital10. A
highly geared company has a high ratio of debt to equity.
There are a number of ways to determine the debt to equity ratio:
A ratio measured on the basis of book values – using a ratio based on the
accounting value of the company’s debt and equity
A ratio measured on the basis of current market values - based on the
observed market value of the company’s debt and equity
An (optimal) target ratio that a company decides to use for long-term
financing of its investments.
Calculations of the financial gearing should be based on market values (as opposed to
book values) as these reflect the true economic value of the type of outstanding
financing. The issue is therefore whether to use an operator’s current gearing level
based on current market value or its target ratio.
At a given point in time, a company’s gearing level based on market values (hereafter
simply referred to as “gearing level”) may not reflect the capital structure expected to
prevail over the lifetime of the business or the optimal gearing level11. Furthermore,
the use of actual capital structures will result in different gearing levels for different
operators and may not be in line with the LRIC methodology, which is concerned with
the cost of an efficient operator (with an optimal capital structure) rather than the
costs of actual operators. Finally, as mentioned in section 2.4, it is difficult to estimate
the optimal capital structure for any one SMP operator since service mix, technology
and ownership structure will differ.
AMI’s preferred approach therefore is to use a (optimal) target gearing level. Such a
target is difficult to estimate in practice, however, as there are number of trade-offs to
consider12.
AMI recommends a pragmatic solution where a financing structure is estimated so that
it reflects best practice industry structures of a notional mobile operator and fixed
network operator in Sweden. This entails a benchmarking of gearing levels and credit
ratings of different European fixed and mobile operators, enabling PTS to infer the
10
This implies the following relationship between the debt-equity ratio and the gearing: D/E=g/(1-g).
The optimal gearing level is the capital structure that minimises the cost of capital and hence
maximises the value of the company.
11
For instance, the tax benefits associated with debt financing will reduce a firm’s cost of capital.
However, the benefits of greater debt financing are limited by the risk of financial distress and default at
high debt levels.
12
10
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
range within which a target capital structure should lie. However, in order to
substantiate this benchmarking exercise, AMI also recommends that a survey be
conducted among financial market analysts regarding the optimal gearing level for a
Swedish SMP operator.
3.4
DIVISIONALISATION VS. NON-DIVISIONALISATION
So far, we have discussed the capital structures in a more generic sense. However,
from a theoretical point of view it is also necessary to consider whether the capital
structure should reflect that of the regulated company as a whole or reflect the
efficient funding of an operator providing only regulated services. This is discussed in
the section below.
Divisionalisation refers to the development of a divisional cost of capital. A company
can be thought of as a portfolio of investments with each division within the group
carrying a different degree of risk. In the case of LRIC regulation, only the wholesale
divisions of the operators are subject to this regulation.
Conventional wisdom asserts that regulated activities have a lower risk because profits
from services in which competition is weak are likely to be more certain than those in
which competition is effective and hence should be treated accordingly. However,
there are good reasons to depart from this traditional view and assume that the same
risk level applies regardless of whether the services are regulated or not.
First of all, regulated activities are based on capital-intensive cost structures with high
fixed costs tending to amplify revenue shocks in comparison to business with a high
proportion of variable costs. The high level of fixed costs (operational gearing) in the
regulated business could therefore be a reason for assuming that the systematic risk for
regulated activities is at least as high as for non-regulated activities.
Secondly, although there may be several methodologies available to determine a
divisional cost of capital, in practise these are likely to be subject to a great deal of
subjectivity and uncertainty13 in the case of divisionalisation between retail and
wholesale or regulated and non-regulated. The same is not true for divisionalisation
between fixed and mobile operations, since many operators operate stand-alone
mobile and fixed network operations and therefore data is readily available.
From a pragmatic point of view, AMI therefore recommends that the cost of capital
should be based on a partially divisionalised approach. This means that the businesses
One method is the pure-play approach where beta is estimated for companies that specialise in
providing the services under consideration. For the fixed network, however, no such operators exist,
supplying purely wholesale services. It would therefore be necessary to approximate to similar
operators. Here, one option could be backbone operators for which there is available statistics.
However, there are fundamental differences between backbone operators and the network division of
incumbent PSTN operators and hence such a proxy is very uncertain.
13
11
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
of providing fixed network services and mobile services should be treated separately.
No distinction should be made between regulated and unregulated services.
3.5
SUMMARY OF RECOMMENDED PRINCIPLES
The recommended principles are summarised below:
6. The WACC should be stated in nominal terms.
7. The WACC should be calculated on a pre-tax basis (converted from a post-tax basis),
using the corporate tax rate.
8. PTS should use an (optimal) target gearing.
9. Calculations should be based on a partially divisionalised approach, where the business of
providing fixed network services and mobile services are treated separately.
12
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
4 Cost of debt
In principle there are two methods for calculating the appropriate cost of debt:
Embedded debt rate – using accounting data or the current loan book14
Estimating the cost of debt as the sum of the risk free rate and the
company specific risk premium using data on current borrowing rates.
As stated above, the WACC is forward-looking in nature. AMI therefore recommends
the latter approach, as this will eliminate any transitional effects such as temporary
holdings of short-term debt due to recent acquisitions or extraordinary finance
requirements that may not be consistent with a forward-looking approach.
4.1
RISK FREE RATE
The risk free rate is the expected return on an asset, which bears no risk at all.
In practice, it is not possible to find an investment that is free of all risks. However,
freely traded investment-grade government bonds can generally be regarded as having
close to zero default risk (governments are unlikely to default) and zero liquidity risk.
In nominal terms, the yield to maturity on such bonds, which take into account future
expectations of inflation and any differences between the coupon rate of interest and
prevailing market rates, are typically regarded as an appropriate proxy for the risk free
rate.
In order to calculate an appropriate risk free rate for an SMP operator in Sweden, we
therefore need to consider the following factors:
Maturity period for government bonds (length of the regulatory review
period versus the length of the investment period)
Use of nominal versus real government bonds
Historic versus current yields as estimates of the forward-looking risk free
rate.
4.1.1
Maturity period
For non-regulatory purposes, the relevant time to maturity is determined by the
investment horizon, i.e. the average life of the group of assets making up the
investment project. In such circumstances, matching the duration of the risk-free asset
to the cash flows being analysed would imply the use of a time period of at least 10
years.
The “historic embedded rate” is calculated by taking the historic annual interest charge and dividing
by the book value of debt. The “current embedded rate” is estimated by analysing the financing
arrangements currently in place for the operator in question.
14
13
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
In a regulatory context, on the other hand, the WACC is not used to discount
expected cash flows over the investment horizon, but rather to determine these cash
flows (indirectly) in the regulatory period, providing lenders and investors with a
reasonable return.
Following a regulatory review process, the opportunity is offered to re-adjust the ex
ante return on the asset base if financial market conditions have changed. Thereby,
asset owners are largely protected from movements in market interest rates as returns
may be re-set during the regulatory review. Therefore, it could be argued that
operators should not be allowed to charge prices with an interest rate risk premium
measured over a period in excess of the regulatory review period. Doing so would
compensate the operator for an interest rate (or inflation) risk that is not being borne15.
This suggests that the maturity period should be linked to the regulatory review period.
This principle is e.g. adopted in the UK, where Oftel uses yields on nominal gilts with
a maturity length consistent with that of the price control, i.e. approximately 4-5 years.
In principle, AMI would therefore favour using a short maturity period of, say, 5-years.
However, we are aware that most, albeit not all, previous studies on TeliaSonera’s cost
of capital has applied a 10-year bond yield as a proxy for the risk-free rate16. Finally,
the equity risk premium is normally determined by reference to a 10-year government
bond. If one were using a different time to maturity for the risk free rate, one should
therefore also adjust the estimated equity risk premium in order to ensure consistency
in the calculations.
Although we in theory consider that the time to maturity should reflect the period
between pricing reviews, for pragmatic reasons we therefore suggest using a maturity
period of 10 years.
4.1.2
Nominal vs. real government bonds
As we are considering a nominal WACC, we should use a nominal government bond17.
4.1.3
Historic vs. current yield
A further consideration is whether the risk free rate of return should be estimated
using current or historical yields.
If capital markets were perfectly efficient, current yields would reflect all expectations
of future earnings and the appropriate measure of the risk free rate would clearly be
the current yield. In practice, capital markets are not perfectly efficient. However, at
any point in time, current yields will still reflect the best available information on
future yields.
15
For further discussions on this issue see Davis (1998).
16
In Denmark, there was also a common consensus for using 10-year bonds.
17
If the WACC were to be estimated in real terms, the yield on an inflation-linked bond should be used.
14
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
Although risk free rates can be affected by institutional factors and be volatile in the
short run, AMI therefore considers it appropriate to calculate a risk free rate based on
recent bond market yields. It is however recommended that this yield be calculated as
a 6-month average of the latest yields, minimising any short-term fluctuations in rates
while capturing the most up to date information and expectations.
4.2
DEBT PREMIUM
In practise, a company specific debt premium can be estimated by observing published
credit ratings, which in turn are based on financial fundamentals such as market
capitalisation, earnings volatility and business risks specific to the company and/or the
sector. Companies pay close attention to their credit ratings, as such ratings will affect
the market’s perception of the company’s risk of default and therefore, the cost at
which they can obtain funds in the market.
Credit rating agencies, such as Standard and Poor’s (S&P), consider a wide range of
financial indicators that inform on a different but related aspect of a business’ debt
service capacity18. One financial ratio of particular importance is interest coverage defined
as the number of times a company can meet its interest payments out of its earnings. A
company with low interest coverage is less likely to maintain a premium credit rating
since the probability of default on its interest payments will be relatively high.
Likewise, a company with a high gearing is also less likely to maintain a high credit
rating, as the probability of default on interest payments will be higher. Therefore,
credit ratings are closely related to the capital structure as discussed in section 3.3 and
cannot be determined without consistent reference to the gearing level.
AMI recommends that the debt premium should be estimated by conducting a
benchmark analysis of debt premiums. This will entail collecting information as stated
in the table below for a number of operators.
Table 1: Example of data needed to conduct debt premium comparisons
Company
Integrated operators
Operator X
[Others...]
Mobile operators
Operator Y
[Others...]
Rating
(Moody/
S&P)
Coupon
Currency Maturity Corporate Relevant
Debt
Bond Yield risk-free premium
rate
A-
5.5
EUR
01/01/11
4.9
4.1
0.8
A-
6.9
EUR
01/08/10
5.8
4.2
1.6
Credit rating agencies employ both quantitative and qualitative factors in determining an overall credit
rating for a business. While financial ratios may go some way to capturing the quantitative factors used
in determining a credit rating, they cannot capture the qualitative factors, which are also important in a
credit rating assessment.
18
15
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
As indicated in the table, operators should be separated by their scope of business. For
integrated operators the analysis could include, but not be limited to the following
operators: TeliaSonera AB, Telenor ASA, TDC A/S, Telefonica Europe BV, Elisa
Communications G., France Telecom, Esat Telecom, British Telecom, KPN NV and
Deutsche Telekom. In the mobile operator category the following operators could be
included: Tele2 AB, Vodafone/Europolitan AB, Vodafone AirTouch plc, Orange plc
and Netcom AS.
When conducting the analysis, most weight should be put on observations of the debt
premium that are consistent with the maturity period of the risk free rate and that best
reflect a credit rating consistent with an assumed optimal gearing level for a Swedish
SMP operator. Further, it should be ensured that the calculated debt premium uses the
yield on a relevant government bond that has a maturity date as closely as possible to
that of the corporate bond.
Since such information is difficult to collect from publicly available sources, operators are
encouraged to provide such information to PTS. This data may be extracted from own
financial records or through other sources available to them.
4.3
SUMMARY OF RECOMMENDED PRINCIPLES
The recommended principles are summarised as below:
10. PTS should calculate the cost of debt as the sum of the risk free rate and a debt premium.
11. PTS should use the yield on a nominal government bond with a 10-year maturity as
proxy for the risk free rate.
12. PTS should use a 6-month average of recent yields. PTS should examine whether current
yields are misleading by comparing to historic rates.
13. The debt premium should be consistent with the adopted capital structure and credit
rating.
14. PTS should use a benchmarking approach to estimate the debt premium, ensuring
consistency with the maturity period of the government bond used to estimate the risk free
rate.
16
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
5 Cost of equity
In this section we discuss the various issues involved in calculating the cost of equity.
5.1
THE CAPM METHODOLOGY
The key principles underlying the Capital Asset Pricing Model (CAPM) is that the risks
borne by an investor can be divided into company specific (diversifiable) risk and systemic
(non-diversifiable) market risk. It is then assumed that investors can eliminate all the
company specific risks through a well-diversified portfolio of assets.
The CAPM calculates the return required by investors for accepting the (systematic)
risk associated with a specific company, by reference to the volatility of returns on the
particular company relative to those of the market portfolio as a whole.
According to the CAPM, the cost of equity can be calculated as
Ce = E(Rj) = Rf + βj [ E(Rm) – Rf ],
where E(Rj) is the expected return on asset j; Rf is the risk-free rate; βj measures how
sensitive asset j is to movements in the market portfolio; and E(Rm) is the expected
return on the market portfolio. [ E(Rm) – Rf ] is the market risk premium, in practice
often referred to as the Equity Risk Premium (ERP).
The risk free rate should be the same as the one used for calculating the debt
premium, cf. section 4.
5.2
DEFINING THE RELEVANT INVESTOR
Before turning to the estimation of beta and the market risk premium, it is necessary
to decide on the market portfolio to be used.
The portfolio used for estimating beta should in principle be consistent with the
portfolio used for estimating the market premium - a point sometimes ignored in
practice.
The standard theory of corporate finance prescribes that one should take the view of
the marginal investor - the investor most likely to make the next trade in the stock - as
this investor will determine the price and hence the expected return on the stock. This
marginal view is obviously the correct one to take when considering marginal
investments. As regards LRIC, however, the issue is somewhat subtler, as the
investment relates to the entire network (access, core or mobile network). Hence, a
case could also be made for using the average investor. From a pragmatic point of
17
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
view, it is also much easier to establish the identity of the average rather than the
marginal investor 19.
Empirical research indicates that the market premium differs between countries and
suggests a strong “home bias” in the selection of stocks to ones portfolio, i.e. holding
a disproportionately large share of national stocks20. When selecting the relevant
portfolio, it is therefore necessary to take the nationality of stockholders into account.
Looking at the fixed network, the table below shows the distribution of shareholders
in TeliaSonera by type and nationality. Operators outside the two “home countries”,
Sweden and Finland, hold only ten percent of the stock.
Table 2 Ownership of TeliaSonera December 31, 2002
Shareholder
Share of
capital/votes %
Swedish State
Finnish State
Private individuals, Sweden
Private individuals, Finland
Institutions and corporations, Sweden
Institutions and corporations, Finland
Shareholders outside Sweden and Finland
46.0
19.4
3.9
2.4
14.7
2.8
10.8
Total
100.0
Source: TeliaSonera, annual report
If we try to isolate the Swedish part of the company, which is the relevant part for this
study, the Swedish State owns around 2/3 of the shares and would therefore form an
important part of the average investor. On the other hand, the Swedish state does not
actively trade its stocks, and may therefore not be regarded as representative for the
marginal investor where one needs to take account of both size and trading volume.
Here, a Swedish institutional investor might seem like a better candidate. No matter
which approach is taken by PTS, however, the most likely nationality of both the
average investor and the marginal investor would be Swedish.
In the view of AMI, one should therefore take the view of a well-diversified Swedish
investor when assessing the company beta and the market risk premium for a fixed
SMP operator in Sweden.
The picture is somewhat more blurred for the three other mobile operators: Tele2,
Vodafone and 3. Like TeliaSonera, Swedish shareholders predominantly own Tele2,
with Invik & Co AB and Industriförvaltnings AB Kinnevik holding more than 55% of
Below, we argue that the nationality of the marginal and average shareholder of an SMP operator in
Sweden is likely to coincide. We shall therefore not pursue this issue further, here. Instead, we will stick
to the conventional wisdom of using the perspective of the marginal investor.
19
20
See e.g. Dimson, Marsch and Staunton (2003).
18
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
the shares alone. Swedish institutional investors primarily hold the remaining shares.
Vodafone and 3, on the other hand, are dominated by foreign shareholders with
Vodafone Group and Hutchison Whampoa owning 71% and 60% of the respective
companies. Swedish shareholders own the remaining part of the shares.
Seen as a whole, however, it is fair to say that the Swedish mobile network operators
are dominated by Swedish shareholders. It therefore also seems reasonable to assume
that the relevant shareholder of a notional Swedish SMP operator would be a Swedish
investor.
In the view of AMI, one should therefore again take the view of a well-diversified
Swedish investor when assessing the company beta and the market risk premium for a
mobile SMP operator in Sweden.
The practical implications of this is that for both fixed and mobile SMP operators, the
market risk premium should be estimated for the Swedish market and returns (beta)
should be measured against the returns on a portfolio of a well diversified Swedish
investor. All returns should be measured in SEK.
5.3
ESTIMATING THE MARKET RISK PREMIUM
The market risk premium (E(Rm) – Rf ) is the additional return required by investors
for accepting the systemic risk associated with investing in the market portfolio instead
of a risk-free asset. In practice, the market risk premium is often referred to as the
Equity Risk Premium (ERP), as the focus is on equities rather than the market as a
whole.
The size of this premium is highly disputed, not only in Sweden. AMI has seen figures
as low as 0% (some international studies even suggest that it is difficult to statistically
reject a negative premium, especially ex post) and as high as 10% for the market
premium in Sweden reported by respectable financial analysts21. The reason for this is
that the market premium may be estimated in a number of different ways, and due to
the very limited consensus about which approach to adopt.
The key issues are:
Whether to use a historic or prospective approach
Whether to use a arithmetic or geometric mean
What time period to use
What to do in practice.
In the view of AMI, risk premiums as low as 0% may be ruled out on a logical basis, as stockholders
will always have a larger risk of loosing their money than bondholders.
21
19
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
5.3.1
Historic versus prospective approach
Investors care about expected returns, not historic returns. In theory, the market
premium should therefore be estimated on a forward-looking basis. Such calculations
will always be somewhat speculative, however, and may therefore be subject to
substantial debate as it is impossible to estimate expected returns without relying on
subjective forecasts22.
Historic returns are therefore often used as a proxy for the expected forward-looking
returns. The historic approach is not without its problems, however. First of all, it is
not as objective as one might think, cf. the previous section. Also, there are reasons to
believe the historic approach overestimates the return required by investors:
Price to earning (P/E) ratios have increased over the last 50 years. If these shifts
in valuations are unlikely to be repeated, historic returns will overestimate future
returns23.
Historical data for the US, UK or Sweden suffers from a survivor bias: Investors
who had bought into the German, Japanese, Russian or Argentine markets in
1900 would e.g. have been wiped out along the way24.
Several considerations suggest that the equity risk premium may have shifted
downwards due to lower inflation, improved regulatory and legal infrastructures
to protect investors, lower trading costs, improved market liquidity, and greater
scope to diversify internationally.
In the view of AMI, PTS should therefore not rely solely on the historic approach.
Historic premiums should serve as a valuable starting point, but should be
supplemented by surveys on investors and market analysts in Sweden to ensure that
current expectations are factored in25. These two analyses may finally be supplemented
by a true prospective approach, where the equity risk premium is estimated as:
ERP = Earnings yield + growth rate in earnings – bond yield26,
A forward-looking risk premium may be calculated on the basis of so-called implied risk premiums.
The approach assumes that the market, generally, is correctly priced. The implied risk premium is then
estimated as the expected return, consistent with the current market price, expected dividends for the
next period and the expected growth rate in earnings. For a further discussion of the implicit approach,
see e.g. Damodaran, “Estimating Equity Risk Premiums”.
22
AMP Henderson (2003) notes an increase in the P/E-ratio of US equities from just 7 times in 1950 to
over 20 times today.
23
24
AMP Henderson (2003).
25 The key thing is to use the figures used in the calculations of investors. Whether these figures have
been estimated on the basis of historic premiums or prospective premiums are less important.
26
AMP Henderson (2003).
20
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
where the earnings yield is the inverse of the P/E ratio, and the growth rate is the
increase in company earnings, typically assumed equal to the long-term inflation rate.
In the view of AMI, the latter approach should primarily be used as a crosscheck.
In the following, we consider the different issues involved when estimating the historic
market risk premium.
5.3.2
Arithmetic versus geometric mean
One of the most debated issues concerns the calculation of the historic mean. Two
approaches have been proposed: the arithmetic mean and the so-called “geometric”
mean (more correctly referred to as the “compounded” mean). As the arithmetic mean
is typically around two percentage points higher than the geometric mean (according
to both theoretical and empirical studies), depending on volatility and time period, it is
worthwhile providing at least the intuition behind this theoretical controversy27:
N
The arithmetic (or simple mean) is calculated as:
∑r
t =1
N
tj
,
where N is the number of years and rtj the annual return for asset j.
N
The geometric mean (or compounded mean) is calculated as
N
∏ (1 + r ) .
tj
t =1
If one is concerned with estimating the average annual return actually obtained over a
longer time period, more than one year, one should clearly use a geometric mean,
which takes account of the interest of interests. Earning 10% the first year and 20%
the next year would correspond to earnings of, not 15%, but 14.9% two years in a row.
The difference between the two approaches arises due to the variance of returns. If
one is earning a constant annual return, the geometric mean will be the same as the
arithmetic mean28.
The issue is somewhat subtler when trying to estimate the expected return for the next
year on the basis of past observations. If returns were completely unpredictable
(uncorrelated) from one year to the other, one might consider the past observations as
possible outcomes with a certain probability attached to them, say 10% or 20% with
50/50 probability. In this case, the expected return should be calculated as 10% x 50%
+ 20% x 50% = 15%, corresponding to the arithmetic average29.
For a more technical but still fairly intuitive discussion of the issue, see e.g. Wright, Mason and Miles
(2003), “A study into certain aspects of the cost of capital for regulated utilities in the U.K.”, available at
http://www.oftel.gov.uk/publications/pricing/2003/cofk0203.htm
27
28 Note also the somewhat counter-intuitive result that in principle an asset may have a negative
geometric mean return (i.e. over long periods of time the investor will loose money), but at the same
time a positive arithmetic mean return. Consider e.g. an asset yielding –10% and +11% every other year.
29
Cf. Brealey and Myers Ch. 7 (2000).
21
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
Therefore, the choice of approach therefore basically depends on one’s view regarding
the predictability of returns over longer time periods and the distribution of these
returns30. The more unpredictable the return, the better the case for using the
arithmetic average.
The ultimate aim must be to derive an estimate of the arithmetic mean return, since
this corresponds to the theoretical “true” expectation. But if the distribution and
predictability of returns are ignored, the risk premium will be overestimated.
Empirical research suggests that returns are neither fully predictable nor fully
unpredictable – the longer the time period, the more predictable (correlated) the
returns31.
In the view of AMI, it is not possible to recommend one approach strongly over the
other. If returns were fully predictable, a geometric approach should be used. If they
were fully unpredictable, the arithmetic mean should be used instead. As there is no
consensus to rely on either, AMI recommends PTS to use a fair and pragmatic
approach: Select an estimate somewhere in the middle between the standard arithmetic
mean and the standard geometric mean.
5.3.3
Time period
The second issue to consider, when estimating the market risk premium on the basis
of historic data, is the time period. Should one use a relatively long or relatively short
time period?
If the risk premium is assumed to be constant over time, one may reduce the variance
of the estimate by increasing the time period and hence the number of observations.
On the other hand, if there has been a permanent shift in the size of the risk premium
during the applied time period (meaning that the current market premium is different
from the historical returns), too long a time period will bias the estimation by attaching
equal weights to old and recent observations. Too short a time period may on the
other hand place too much weight on single events and therefore result in misleading
estimates of the “true” premium.
As Table 3 shows, the historic premium is highly sensitive to the selected time period.
Extending the period 1950-1999 by three years to 1950-2002, for example, lowers the
historic equity risk premium from 7.5 to 5.4. This indicates that one should be careful
not to attach too much weight to one specific historic estimate.
If returns are assumed to be lognormal, this supports the use of a compound mean. The difference
between the arithmetic mean log return and the compound mean return is much smaller than the
difference between the arithmetic mean return and the compound mean return.
30
31
Wright, Mason and Miles (2003)
22
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
Table 3 Annual Real return, %
US
1821-1900
1900-1950
1950-1999
1950-2002
1900-2002
1821-2002
Equities
Bonds
ERP
6.2
5.2
9.0
7.4
6.3
6.3
5.5
1.7
1.5
2.0
1.9
3.2
0.7
3.5
7.5
5.4
4.4
3.1
UK
Equities
Bonds
ERP
1900-1949
1950-1999
1950-2002
1900-2002
3.0
8.9
7.3
5.2
0.9
1.6
1.7
1.3
2.1
7.3
5.6
3.9
Source: AMP Henderson Global Investors and Dimson, Marsh and Staunton,
Global Investment Returns Yearbook, London Business School/ABN Amro
The choice of time period includes a trade-off between the above considerations. In
order to reduce the variance of the estimate to a reasonable level, however, AMI
recommends using a period of at least 50 years32. Ideally, a judgement should be made
on the basis of different time periods to ensure that the estimate is not too sensitive to
the selected period.
5.3.4
What to do in practice
As the market premium is determined by the expectations of the market participants
and relates to the market as a whole, not just telecommunications, we think it would
be inappropriate for PTS to try and come up with its own view on the market
premium. Instead, we recommend that PTS rely on independent studies of the historic
market premium as well as surveys of the current expectations of market participants33.
5.4
ESTIMATING BETA
When the expected return on the market portfolio has been estimated (as the risk free
rate plus the market premium), the next step is to examine how the return on the
investment (approximated by the company stock) co-varies with the return on the
Using a period of 10 years would e.g. imply a standard error of 6.32, implying that the true risk
premium with 95% certainty could be 12% higher or lower than the reported mean! (Damodaran:
“Estimating the equity risk premium”, using the historic variance in returns on US stocks of 20%).
Increasing the number of observation to 50 will reduce the variance to 2.38.
32
Öhrlings PriceWaterHouseCoopers e.g. conducts annual surveys on the equity risk premium in
Sweden. Dimson, Marsh and Staunton in cooperation London Business School and ABN Amro publish
annual estimates of the historic risk premiums around the world: Global Investment Returns Yearbook.
33
23
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
market portfolio, expressed by beta. This correlation may be estimated using standard
OLS34 regression analysis.
Beta-values should be estimated on the basis of beta-values for publicly traded
companies, re-geared to reflect the (optimal) target gearing of the notional SMP
operator.
PTS needs to decide on a number of issues, including
Frequency of observation
Time period to be used
Choice of market index
Whether to make a so-called Bayesian adjustment.
5.4.1
Frequency of observations
Beta may be estimated on the basis of daily (or even hourly), weekly, monthly or
quarterly observations.
By increasing the frequency of observations, the number of observations also
increases, thereby reducing the variance/uncertainty of the estimate. However, it also
increases the risk of serial correlation35. It should also be ensured that the stock is
traded during the selected period to ensure that the price reflects a market value (this
precludes the use of hourly observations).
As the variance is related to the number of observations rather than the frequency of
observations, the choice of frequency needs to be made in conjunction with the choice
of time period, discussed in the next section. The longer the period, the lower the
frequency required for obtaining a reasonable number of observations.
AMI recommends PTS to start by daily observations and to examine whether there is
any sign of serial correlation. This can be done by regressing daily returns against the
return the previous day and verify that there is no statistically significant relationship
between the two. If there are indications of serial correlation, PTS could then use
weekly observations instead36.
34
Ordinary Least Squares.
Serial correlation of returns may be explained by either overreaction by the market (giving rise to
negative correlation) of rigidity (giving rise to negative correlation).
35
This raises the issue of what day of the week to use. Experience indicates that beta estimates may vary
by weekday. As there is no obvious argument for choosing one weekday over the other, AMI would
recommend to simply use the default day reported by the relevant statistics of weekly data. Otherwise,
simply use end-of-week. This issue may be avoided if daily data are used instead.
36
24
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
5.4.2
Time period
As beta values are likely to change over time (due to changes in the gearing or changes
in the risk profile), care should be taken not to employ too long a time period. This
point is particularly important in the telecom market, which in recent years has been
characterised by acquisitions and debt restructuring. However, consideration should
also be given to the selection of a time period with a sufficient number of
observations. AMI recommends using a time period of 1-3 years. For example, start by
estimating beta over 1, 2 and 3 years. If the beta estimates are fairly stable, use 3 years.
If they are not stable, use the shorter periods of either 1 or 2 years, keeping in mind
the variance of the estimate.
5.4.3
Choice of market index
As noted in the beginning, beta should in principle be estimated on the basis of the
same portfolio of assets as is used for estimating the market risk premium37. And in
theory, this market portfolio should consist of all risky assets, including both stocks,
bonds, property and commodities in various international markets38.
A more pragmatic approach would be to take the CAPM as a guide and instead use the
market portfolio of the dominant owners of the company examined. This would imply
that the relevant portfolio is one with a high weight on national stocks (as previously
noted, empirical evidence shows that real-world portfolios tend to be heavily biased in
favour of national stocks – referred to as a “home bias”39). In practice, however, most
analysts and regulators simply use the national stock market as a proxy for the market
portfolio. As long as there is consistency between the portfolio used for estimating the
market premium and the beta value, AMI does not consider this to be a problem.
A potential problem with using a national stock market index, though, is that the stock
being examined may constitute such a large part of the share index that beta estimates
may be overestimated due to a feedback effect: A large fall in the stock value may give
rise to a substantial decrease in the market index as well, even though the price change
is completely unrelated to the changes in other assets. In this situation, the approach
The underlying rational for CAPM is that asset/company specific risk can be eliminated by investors
through diversification in the market portfolio. The expected return on a specific asset should therefore
only depend on the correlation between the returns on the asset and the return on the portfolio. Hence,
the two figures are linked.
37
There are a number of problems associated with using such a composite index in practice, however.
For example, CAPM is based on the assumptions of normally distributed rates of return. This may be a
reasonable assumption for stocks, but cannot be justified for bonds. It would also be necessary to
establish a separate market risk premium for this composite folio. As the return on stocks tend to be
higher than for bonds, the risk premium for the composite portfolio will typically be lower than the
equity risk premium. Estimating beta on the basis of a composite portfolio and then applying it to the
equity market premium would therefore correspond to having one’s cake and eat it. AMI is not aware of
any examples, where regulators have adopted such a composite approach.
38
39
See e.g. Lewis (1999).
25
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
should be applied with some care. As the only potential problem could be for
TeliaSonera, and TeliaSonera “only” makes up around 10% of the Swedish OMX
index40, it seems reasonable to use the OMX index for calculating the beta of both
fixed and mobile operators. AMI considers a 10% market share to be the absolute
maximum, however. As the stock of TeliaSonera is also traded on Nasdaq, it would
therefore be useful to conduct a cross check on the sensitivity to an American index,
such as e.g. S&P500.
Using OMX would be in line with the previous cost of capital studies we have seen for
Sweden. One should be careful not to expand the market portfolio to comprise assets,
which are not traded on a regular basis, as this could lead to an underestimation of
beta.
In May 2003, it was decided to merge the Swedish stock exchange (OM) with HEX,
including Finland, Estonia and Latvia. In the future, it could therefore be considered
to move away from OMX to a new index including the most frequently traded stocks
from Sweden, Finland, Estonia and Latvia.
5.4.4
Peer group analysis and re-levering of beta
As an alternative to simply calculating the beta value for the specific operators, peer
group analysis could also be applied, using publicly available beta rates of comparable
operators. This would also help reduce potential problems associated with having
estimated beta values on the basis of a market portfolio in which the specific operators
make up too large a share of the portfolio.
When selecting suitable peers, it is necessary to consider the key market, operating and
financial features that will have an impact on the level of risk faced by each of the
companies. Relevant parameters include: turnover, profitability, regulation, the level of
competition, and ownership structure.
When comparing the beta values for different companies, one needs to take
differences in financial gearing (leveraging) and tax rates into account. Beta values are
estimates on the basis of financially geared companies. These beta values should be
“unlevered” and subsequently “re-levered” to reflect the appropriate financial gearing
for the SMP operator.
D

A commonly used formula for doing this is β L = β U 1 + (1 − T )  41
E

where βL is the levered published beta value, βU the unlevered asset beta value, T the
effective corporate tax rate of the company, and D/E the debt equity ratio calculated
on the basis of the market value of debt and equity.
The OMX index includes the largest and most frequently traded stocks and the index weights are
updated daily on the basis of market values.
40
41
This formula assumes no market risks on debt (βd = 0)
26
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
As the debt equity ratio may have changed over the estimation period, beta should in
principle be unlevered on the basis of the average debt-equity over the estimation
period, while it should be re-levered on the basis of the current debt-equity ratio.
5.4.5
Bayesian adjustments
As the (weighted) average beta across all stocks in the portfolio/index by definition
will be one and beta estimates on individual stocks will be estimated with error,
sampling theory would prescribe that we should use the known average to improve
our (forward-looking) beta estimate. The larger the variance on the estimated beta, the
more weight one should attach to the average of 1.
AMI does not have any strong preference for or against making this adjustment. A
pragmatic approach would be to ignore it, as it does not systematically bias the
estimate (the direction of the adjustment depends on the size of beta). Making the
adjustment, on the other hand, will give a more robust result, which is less sensitive to
changes (and errors) in the beta estimate.
Based on a weighting on these overall guidelines, AMI has a weak preference for
making the Bayesian adjustment, provided that it is done in a fairly pragmatic and
uncontroversial manner42. As rule of thumb, the adjusted beta can be estimated as43:
βadjusted = 0.67 x βOLS + 0.33 x 1
5.4.6
Estimating beta for a notional mobile SMP operator in practice
A specific issue arises for mobile, where there are four different operators and
therefore potentially four different estimates of beta. First of all, the betas should be
unlevered, to put them at a comparable basis (using average debt-equity ratios over the
estimation period). Then we suggest taking a simple average of these unlevered betas,
also taking any peer group analysis into account. Having decided on a representative
unlevered beta, this should then be re-levered on the basis of the optimal gearing level.
5.5
SUMMARY OF RECOMMENDED PRINCIPLES
The recommended principles are summarised as below:
15. Cost of equity should be estimated as the expected return required by a well-diversified
Swedish investor. All returns should be measured in SEK.
42
The Bayesian estimate is calculated as:
βadjusted = βOLS ×
Var ( β pop )
Var ( β pop ) + SE 2 ( βOLS )
+ 1×
SE 2 ( βOLS )
,
Var ( β pop ) + SE 2 ( βOLS )
SE2(βOLS) is the standard error squared of the OLS estimate of beta and Var(βpop) is the variance of beta
across the sample of stocks, for which the beta is unity (Wright, Mason and Miles (2003).
43
This is the approach used by Bloomberg (Damodaran, “Estimating risk parameters”).
27
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
16. PTS should use historic returns as a starting point for the market risk premium. The
historic estimates should be combined with estimates used by market analysts in Sweden to
ensure that current market expectations are factored in.
17. The historical mean return should be estimated to be in the range between the arithmetic
and geometric mean.
18. The risk premium should be calculated for a time period of at least 50 years. Ideally, a
judgement should be made on the basis of different time periods to ensure that the estimate
is not too sensitive to the selected period.
19. Beta should be estimated on the basis of daily observations using a time period of 1-3
years. One could begin by estimating beta over 1, 2 and 3 years. If the beta estimates are
fairly stable, one should use 3 years. If they are not stable, one should use the shorter
periods of either 1 or 2 years. If there are signs of serial correlation, use weekly
observations instead of daily observations.
20. Beta should be estimated by reference to the OMX stock index.
21. Beta estimates should be compared with beta estimates for comparable operators.
22. A Bayesian adjustment should be applied.
28
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
6 International experience
In this section, we briefly review selected international experiences on the estimation
of the cost of capital.
The section focuses on the experiences from the UK and Denmark, as regulation in
these countries is transparent and the arguments surrounding the calculation of the
cost of capital are well argued and understood.
The UK has an unprecedented experience in applying the theory of regulation as the
first European country to conduct a sector-wide privatisation of state-owned
monopolies, liberalise its markets and restructure industries. Therefore, argumentation
surrounding the calculation of the cost of capital has been subject to thorough public
and regulatory scrutiny in many different sectors, including telecom (Oftel), electricity
(Ofgem), water (Ofwat) and railways (ORR).
In Denmark, the cost of capital for a fixed SMP operator has recently been calculated
following a lengthy LRAIC process not too dissimilar to the one currently being
conducted for fixed access and interconnection services in Sweden.
Finally, in both the UK and Denmark, an abundant amount of information on the
approaches taken is available on the respective regulators’ websites.
6.1
UK
Oftel has estimated the Cost of Capital for both fixed and mobile SMP operators. In
February 2001, Oftel estimated BT’s cost of capital with the purpose of determining
regulated charges for its fixed network division from mid-2001 until mid-200344. In
September 2001, Oftel published similar calculations of LRIC for mobile termination.
Following complaints from the mobile network operators (MNO), the case was
referred to the Competition Commission (CC), who published its decision in
December 2002.45 As regards mobile, we have chosen to focus on the views expressed
by the CC.
We will distinguish between common issues and issues specific to fixed and mobile. As
regards the common issues, we have used the calculations for mobile (2003), as these
are the most recent.
6.1.1
Common issues
Oftel (CC) uses a number of methodologies for estimating the cost of
equity but the main emphasis is on the CAPM.
Oftel, Proposals for Network Charge and Retail Price Controls from 2001, February 2001, available at
http://www.oftel.gov.uk/publications/pricing/pcr0101.htm
44
Competition Commission, Vodafone, O2, Orange and T-Mobile, December 2002, available at
http://www.oftel.gov.uk/publications/mobile/ctm_2003/index.htm
45
29
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
A real (pre tax) cost of capital is used as prices (for both fixed and mobile)
are regulated in real terms (charges are allowed to increase by the rate of
inflation – minus an efficiency factor).
The risk free rate is estimated on the basis of current yields on 5-year gilts
(government bond).
The market risk premium is calculated by first calculating historical
averages and second using surveys and other evidence of investors’
current expectations over the short term.
A standard corporate tax rate is used as proxy for the effective tax rate.
6.1.2
Fixed
Oftel moved from a divisionalised approach (used in 2000) to a nondivisionalised approach.
Oftel relied on LBS46 estimates of beta for BT values, estimated on the
basis of a 5-year moving average. Beta was then re-geared according to a
range of optimal gearing for BT.
The optimal gearing was considered to lie in the range of 20 to 40%.
Oftel estimated a debt premium of 1.5 to 2.0% for a gearing of 20-40%
Oftel’s calculations are shown in the table below.
Table 4 Oftel estimate of cost of capital for BT
Gearing
%
20%
30%
40%
Risk free rate
Equity risk premium
Equity beta
Cost of equity (post-tax)
Debt premium
Cost of debt (pre-tax)
Gearing
WACC (post tax nominal)
Corporate tax rate
WACC (pre tax nominal)
5.1
5
1.16
10.90
1.50
6.60
20
9.65
30
13.78
5.1
5
1.29
11.55
1.75
6.85
30
9.53
30
13.61
5.1
5
1.45
12.34
2.00
7.10
40
9.39
30
13.41
Source: Oftel, February 2001
On this basis, Oftel estimated the pre-tax nominal cost of capital of BT’s regulated
business to be in the range of 13.41 to 13.78%, with a mid-point of 13.5% (rounding
to the nearest 0.5%).
46
London Business School.
30
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
6.1.3
Mobile
Oftel considered that the same WACC should be applied for all MNOs.
CC examined company-specific inputs as well, but did not find the
variation in these inputs sufficient to justify using different WACCs for
different MNOs.
In theory, beta should be estimated for 2G termination. In practice,
however, beta values were estimated for the entire 2G network operators,
as there was not enough evidence indicating how the beta of the quoted
companies should be estimated to exclude non-2G termination services.
Lower end of range for beta was estimated on the basis of monthly
observations, higher end was estimated on the basis of daily observations.
CC considered it appropriate to give more weight to actual gearing rather
than estimates and applied a gearing of 10% instead of the range 10-30%
proposed by Oftel.
The CC calculations are quoted in the table below:
Table 5 Estimates range of Cost of Capital for mobile SMP operators
%
Risk-free rate
Equity Risk Premium
Equity beta
Cost of equity
Debt premium
Cost of debt
Gearing
Taxation
Pre-tax WACC
Pre-tax WACC (real)
Low case
High case
5.1
2.6
1.0
7.6
1.0
6.1
10
30
10.4
7.7
5.3
4.6
1.6
12.7
4.0
9.3
10
30
17.3
14.4
Source: Competition Commission, December 2002
On this basis, the CC estimated a WACC of 11%, which subsequently was increased
by 0.25% (in real terms) to take account of uncertainty related to the risk premium.
This corresponds to a nominal pre-tax WACC of 14%.
6.2
DENMARK
By the end of 2002, the Danish National IT- and Telecom Agency (NITA) finalised a
process, not too dissimilar to the one currently being conducted in Sweden, with the
aim of estimating the cost of capital for a fixed SMP operator. This involved an
estimation of the cost of capital.
During the process, the incumbent fixed network operator TDC and a Forum,
consisting of competing operators, each submitted their views on the appropriate cost
31
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
of capital. These submissions were then scrutinised by the NITA, who then formed a
consolidated opinion on the appropriate level of the required return on capital
following a thorough public hearing process.
NITA made the following decisions/considerations in relation to the WACC:
Estimated for a notional SMP operator in Denmark.
Estimated as the WACC on the basis of CAPM.
Danish data was used as the alternative investment was considered to be
in Denmark.
The risk free rate was determined on the basis of a 10-year government
bond.
A market risk premium of 3.75% for Denmark was used based on a
number of independent estimates, calculated on the basis of both
arithmetic and geometric means.
Beta was calculated on the basis of S&P 500, an American index for the
500 largest companies.
Beta was estimated for a 5-year period.
Gearing of 35-40% was used as an estimate for the optimal gearing of the
network division of the SMP operators (divisionalised approach). The
gearing rate was considered to be higher for the network division than a
full-scale operator, due to the larger proportion of fixed assets.
Risk premium was estimated to lie between 1-2 % with a gearing between
30-45%.
The calculation of the WACC is included in the table below:
Table 6 Calculation of WACC for Danish fixed SMP operators
Gearing
30 %
37 ½ %
45%
Risk free rate
Debt premium
5.10
1.00
0.8
5.10
1.50
0.8
5.10
2.00
0.8
β-ungeared
β-regeared
Market premium
Cost of equity
Cost of debt
1.04
1.14
1.36
3.75
12.86
6.10
3.75
13.37
6.60
3.75
14.03
7.10
WACC
10.83
10.83
10.91
Source: NITA, ”Rapport om hybridmodellen”, December 200247
NITA estimated the cost of capital to lie between 10.8-10.9%. As a cross check, the
Agency also estimated the cost of capital on the basis of the Dividend Growth Model
47
Available at http://www.itst.dk/wimpblob.asp?objno=116572562
32
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
(DGM) deriving a rate of 9.6%, which supported the figure calculated on the basis of
CAPM. On this basis, NITA decided to use a (nominal pre-tax) cost of capital rate of
10.85%.
6.2.1
Overview of cost of capital rates used by EU regulators:
In 2002, (Arthur) Andersen conducted a benchmark study for the EU commission on
Cost Accounting Methodologies48. The study included a comparison of the approach
adopted by EU regulators for determining the cost of capital. This overview is
included in the table below:
Table 7 Comparison of Cost of Capital rates used in different EU Countries.
Return on capital (pre-tax)
Approach
Determined by
Originating: 13.67%
Terminating: 12.77%
CAPM WACC
NRA
DK
10.85%*
CAPM WACC*
NRA*
D
NRA: 8.75%
SMP: 12.5%
CAPM WACC
NRA
EL
13.12%
CAPM WACC
SMP and approved by NRA
E
12.34%
CAPM WACC
NRA
F
Interconnection: 12%
Mobile: 17%
ULL: 10.4%
CAPM WACC
NRA
IRL
12%
CAPM WACC
NRA
NL
Terminating: 10.7%
Originating: 12.3%
Price cap: 10.8%
CAPM WACC
NRA
A
NRA: 9.34%
SMP: 12%
CAPM WACC
NRA
B
P
SMP: 13.31%
CAPM WACC
NRA
Various
Various
SMP
S
Fixed: 15%
Mobile: 15.02%
Fixed: Historic rate
of return
Mobile: WACC
Fixed: Validated by NRA
Mobile: NRA
UK
Fixed: 13.5%
Mobile: 14%*
CAPM WACC
NRA
FIN
Source: Andersen, July 2002. * Updated by Andersen Management International
The return on capital ranges from 8.75% to 17% and is typically estimated by the NRA
and based on the CAPM. The rate applied for mobile operators is typically higher than
for fixed operators.
Andersen, “Study on the implementation of cost accounting methodologies and accounting
separation by telecommunication operators with significant market power”, July 2002, available at
http://europa.eu.int/information_society/topics/telecoms/implementation/studies/costaccounting200
2/costaccountingmethodologies.pdf
48
33
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
7 Conclusion
7.1
SUMMARY OF RECOMMENDED PRINCIPLES
The recommended principles are summarised below:
1. The cost of capital should be estimated as the Weighted Average Cost of Capital
(WACC) using the CAPM to estimate the cost of equity.
2. PTS should estimate separate cost of capital rates for fixed and mobile SMP operators.
3. PTS should use the same cost of capital for the fixed access and core network.
4. PTS should apply the same cost of capital for all mobile SMP operators.
5. The calculations should be undertaken by PTS in conjunction with the more thorough
reviews of the LRIC pricing methodology.
6. The WACC should be stated in nominal terms.
7. The WACC should be calculated on a pre-tax basis (converted from a post-tax basis),
using the corporate tax rate.
8. PTS should use an (optimal) target gearing.
9. Calculations should be based on a partially divisionalised approach, where the business of
providing fixed network services and mobile services are treated separately.
10. PTS should calculate the cost of debt as the sum of the risk free rate and a debt premium.
11. PTS should use the yield on a nominal government bond with a 10-year maturity as
proxy for the risk free rate.
12. PTS should use a 6-month average of recent yields. PTS should examine whether current
yields are misleading by comparing to historic rates.
13. The debt premium should be consistent with the adopted capital structure and credit
rating.
14. PTS should use a benchmarking approach to estimate the debt premium, ensuring
consistency with the maturity period of the government bond used to estimate the risk free
rate.
15. Cost of equity should be estimated as the expected return required by a well-diversified
Swedish investor. All returns should be measured in SEK.
34
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
16. PTS should use historic returns as a starting point for the market risk premium. The
historic estimates should be combined with estimates used by market analysts in Sweden
to ensure that current market expectations are factored in.
17. The historical mean return should be estimated to be in the range between the arithmetic
and geometric mean.
18. The risk premium should be calculated for a time period of at least 50 years. Ideally, a
judgement should be made on the basis of different time periods to ensure that the estimate
is not too sensitive to the selected period.
19. Beta should be estimated on the basis of daily observations using a time period of 1-3
years. One could begin by estimating beta over 1, 2 and 3 years. If the beta estimates are
fairly stable, one should use 3 years. If they are not stable, one should use the shorter
periods of either 1 or 2 years. If there are signs of serial correlation, use weekly
observations instead of daily observations.
20. Beta should be estimated by reference to the OMX stock index.
21. Beta estimates should be compared with beta estimates for comparable operators.
22. A Bayesian adjustment should be applied.
7.2
SUMMARY OF WACC CALCULATIONS
In Annex A, we have estimated the WACC for notional fixed and mobile SMP
operators in Sweden in line with the above recommendations. The calculations are
summarised below.
7.2.1
Fixed SMP operator
We have estimated the input parameters using a low-gearing scenario and a highgearing scenario. In this way, it is possible to ensure consistency between the different
input parameters. Instead of a point estimate, we have included a range for the
different input parameters, reflecting the uncertainty associated with each parameter.
We consider this to be the most fair and transparent approach.
35
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
Table 8 Calculation of WACC for fixed SMP operator in Sweden
%
Low gearing
Low case
High case
Risk-free rate
Equity risk premium
Unlevered Beta
Equity Beta
Cost of equity
Debt premium
Cost of debt
Gearing
Tax rate
Post-tax WACC
Pre-tax
Range
Mid-point
4.5
4.0
0.85
1.00
8.5
1.00
5.5
20
28
7.6
10.6
10.3 - 13.0
11.6
4.5
5.5
0.95
1.12
10.7
1.00
5.5
20
28
9.3
13.0
High gearing
Low case High case
4.5
4.0
0.9
1.26
9.5
1.40
5.9
40
28
7.4
10.3
4.5
5.5
1.0
1.41
12.2
1.40
5.9
40
28
9.0
12.6
Source: Andersen Management International
We have then estimated the cost of capital as the mid-point between the highest and
lowest estimate, corresponding to a cost of capital of 11.6% for a fixed SMP operator.
7.2.2
WACC for mobile SMP operator
Similar calculations have been undertaken for a mobile SMP operator:
Table 9 Calculation of WACC for mobile SMP operator in Sweden
%
Low gearing
Low case
High case
Risk-free rate
Equity risk premium
Unlevered Beta
Equity Beta
Cost of equity
Debt premium
Cost of debt
Gearing
Tax rate
Post-tax WACC
Pre-tax
Range
Mid-point
4.5
4.0
1.00
1.08
8.8
2.50
7.0
10
28
8.4
11.7
11.7 - 14.5
13.1
4.5
5.5
1.10
1.19
11.0
2.50
7.0
10
28
10.4
14.5
High gearing
Low case High case
4.5
4.0
1.00
1.18
9.2
2.90
7.4
20
28
8.4
11.7
4.5
5.5
1.10
1.30
11.6
2.90
7.4
20
28
10.4
14.4
Source: Andersen Management International
These calculations indicate an interval for the cost of capital between 11.7 and 14.5 %
with a mid-point value of 13.1%.
36
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
Annex A WACC calculations
A.1
CAPITAL STRUCTURE
Table 10 presents actual market gearing ratios and credit ratings for selected Western
European operators. The operators have been grouped in those providing fixed and
mobile services (integrated operators) and those providing primarily mobile services.
Within these groups, the operators are further ordered by credit rating (S&P taking
precedence).
The table shows a wide range of different gearing levels, ranging from 10% to 74%.
More than half the surveyed companies (8 out of 14) have a gearing ratio between 10%
and 40%.
Table 10: Market gearing and credit rating for Swedish SMP operators and comparator operators*
Operator
Country
Rating
(S&P / Moody)
Debt/Equity ratio
(market values)
Gearing
(market values)
Integrated operators
TeliaSonera
Telenor
BT Group
Elisa Communications Group
TDC
KPN
Deutsche Telekom
France Telecom
Sweden
Norway
UK
Finland
Denmark
Netherlands
Germany
France
A / A2
A- / A2
A- / Baa1
A- / Baa2
BBB+ / A3
BBB+ / Baa1
BBB+ / Baa3
BBB- / Baa3
0.26
0.48
0.54
0.79
0.84
0.85
1.15
2.84
20%
32%
35%
44%
46%
46%
53%
74%
Mobile operators
Vodafone plc
Vodafone AB
Orange
mmO2
Mobistar
Tele2
UK
Sweden
France
UK
Belgium
Sweden
A / A2
A- / BBB+ / Baa1
BBB- / Baa2
-/-/-
0.18
0.18
0.11
0.32
0.23
15%
15%
10%
24%
18%
*Data has in some cases been updated by AMI using annual reports and company websites49
Source: Goldman Sachs, Bloomberg (Alfred Berg) and Andersen Management International
The data shows that TeliaSonera’s gearing level of 20% is the lowest among the
surveyed integrated operators, where the average gearing ratio is 44%. Furthermore,
TeliaSonera is the only integrated operator with an A rating from S&P (we note that
TeliaSonera has the same Moody rating as Telenor). On this basis, there does not
appear to be evidence to suggest that TeliaSonera’s actual gearing structure is
substantially sub-optimal. Although the investment bank survey (see Annex B)
49
Note that we have used the book value of debt as a proxy for the market value.
37
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
suggests that a target gearing level for integrated operators in Scandinavia (40%) is
higher than TeliaSonera’s current market gearing, the general opinion also seems to be
that a rating of A is optimal for an integrated operator.
At the other end of the scale we find Deutsche Telekom and France Telecom with
high gearing ratios and relatively low ratings. Both companies have large debt burdens
and have had difficulty in providing credible reduction plans.
For integrated operators, the table also clearly shows the relationship between gearing
level and credit rating that one would expect – higher gearing levels are accompanied
by lower credit ratings. Further, the table indicates that a gearing level between 20% 45% is consistent with an A/A- credit rating and that operators with gearing levels
above 45% generally have low credit ratings. This evidence together with market
opinions (as stated above) and a general commitment among incumbent operators to
debt reducing schemes, suggests that a reasonable cut-off point would be 40% as the
maximum target gearing, whereas the lower boundary may be set with reference to
TeliaSonera actual market gearing. AMI therefore proposes to use a minimum gearing
level of 20% and maximum of 40% consistent with an A/A- rating for a fixed SMP
operator.
The average gearing levels for the set of integrated comparators is considerably higher
than the average observed for mobile comparators. mm02’s gearing level of 10%
appears to be somewhat low, although is it not significantly lower than those levels
observed for Vodafone plc and Orange, all with a gearing of 15% (just below the
average of 17%). Tele 2 has a gearing level slightly above the average but is otherwise
in line with other operators. Vodafone’s gearing has not been reported as it is
somewhat misleading due to the ownership structure between Vodafone AB and the
parent company Vodafone Group Plc.
Thus, evidence suggests that the gearing levels for mobile operators are significantly
lower than that of their integrated counterparts. This may be explained by the fact that
incumbents with a combination of mobile and fixed assets have a greater capacity for
debt financing provided by the more cash generative fixed investments albeit of lower
growth potential. If the optimal gearing for TeliaSonera were 25%, the optimal gearing
of its mobile operations would be lower.
We therefore propose using a lower gearing level for a Swedish mobile operator than
for integrated operators. We estimate that an interval of 10% - 20% is reasonable and
consistent with long-term grade A/A- credit rating.
A.2
RISK FREE RATE
Based on the recommendation in section 4, we believe PTS should use the yield on a
nominal government bond with a 10-year maturity as proxy for the risk free rate.
Further, PTS should use an (arithmetic) average of the yield for a 6-month period.
The figure below shows the yield of different bonds June 1999, where a 6-month
moving average has been plotted for the 5 and 10-year bond.
38
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
Figure 1 Development in (2,5 and 10 year) nominal Swedish government bond yield since June 1999
Source: AMI analysis based on www.riksbanken.se
The figure shows that the yield has decreased substantially from mid 2002 to today. As
stated in section 4, we regard current bond yields as the best estimate of the current
market expectations. However, as the figure shows these yields vary or fluctuate
considerably over time and are at the lowest level for the period in question.
We have recommended a 6-month average of yields, but note that such a period may
not be long enough to even out any abnormalities. However, the figure shows a
reasonable spread between the three bond yields during the illustrated period. Further,
the downward trend follows the trend of other Eurozone interest rates that also have
decreased during the same period. Therefore, AMI does not consider this
development to be atypical. We conclude that a 6-month average yield of 4.5% should
be used as a proxy for the nominal risk-free rate for an SMP operator in Sweden.
A.3
DEBT PREMIUM
As stated in section 4.2, AMI recommends a benchmarking approach to the estimation
of an appropriate debt premium of a Swedish SMP operator based on the most recent
available data. Since the availability of such information in the public domain is very
limited, the analysis conducted below has to a large extent been based on data from
2002.
Table 11 shows the corporate bonds issued by integrated operators for a variety of
maturities. All bond issues are denominated in EUR and spreads have been calculated
39
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
over the relevant Euro bond. The table also provides information on the companies’
credit ratings.
Table 11: Debt premium comparisons
British Telecom
Deutche Telekom
France Telecom
KPN
Sonera
TDC
Telia
Moody’s
Baa1
Baa1
Baa3
Baa3
Baa2
A3
A1
S&P
ABBB+
BBBBBBBBB
AA+
Debt Premium
147
258
294
217
113
134
113
Maturity
2011
2011
2008
2006
2005
2012
2010
Source: Bloomberg and UBS Warburg (for TDC October 2002)
According to this data, the debt spreads from October 2002 are in a range of 113 to
294 basis points. Although this range is very broad, the data can be used to draw some
conclusions concerning the differences in credit ratings and debt spreads. Telia’s A+
rated bond with a maturity of 8 years exhibits a spread over the risk free rate of 113
points. In comparison, British Telecom’s bond of approximately the same maturity but
the lower credit rating A- exhibits a slightly higher debt spread of 147 points. As one
would expect, this indicates that higher credit ratings imply lower risk premiums.
Although not directly observable in the table above due to the relatively few
observations, evidence also suggests that bonds with longer maturities tend to have
wider spreads, i.e. the cost of debt is influenced by the maturity one chooses.
This may be seen when considering a wide range of debt issues where each credit
rating is categorised by maturity, cf. the following figure for US utilities.
40
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
Figure 2: Spreads for debts issued by US utilities
Source: www.bondsonline.com (publicly available)
This is further substantiated by the following table showing debt premium for
different maturities by type of operator.
Table 12: Debt premium by sector and maturity
Year
Fixed line
Mobile operator
1
2
3
5
7
40
80
55
115
70
150
90
200
105
260
10 Credit rating
120
305
A
A
Source: SBC Warburg (prepared for TDC 2002)
This table also demonstrates that the debt spread for mobile operators is more than
150 points above that for a fixed line operator, if one uses a maturity consistent with
the maturity period of the government bond used to estimate the proxy for the risk
free rate.
Turning to the recent developments, the figure below shows debt spreads for US
corporate bonds during the last 6 months.
41
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
Figure 3: Development in debt spreads for US corporate bonds
Source: Bloomberg (Alfred Berg)
The figure shows a downward trend in the debt premium during the last six months.
For A rated bonds there has been a fall of approximately 60 basis points, while the
BBB rated bonds has experiences a fall of approximately 80 basis points. This trend of
narrowing debt premiums for bonds may also be observed in the European market
(including European telecom bonds).
For the telecom industry in particular, news flows have constantly been positive in the
recent past, which explains why S&P recently gave a positive assessment of the
European telecom groups50. S&P considers the progress achieved in reducing debt and
the cutback in capital spending as good reasons to expect the positive trend to
continue on the condition that the telecoms industry continue their conservative
corporate policies. Some analysts51 suggest that this tendency for debt reduction
among telecom operators may result in a short-term correction of spreads and hence a
widening of risk premiums over the long term. This suggests that one should be
careful not to put to much weight on the recent downward adjustment in debt
premiums.
The debt premiums suggested by tables 8 and 9 combined with the recent fall in
observed premiums suggest that a debt premium of 1.0% - 1.4% is appropriate for an
integrated fixed network SMP operator with a gearing and credit rating as indicated in
50
See www.cellular-news.com/story/8646.shtml
51
See www.treasury.erstebank.com
42
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
section A.1. For a mobile SMP operator, we suggest an interval of 150 points above
that of the integrated operator, equivalent to 2.5% - 2.9%.
A.4
EQUITY RISK PREMIUM
As stated in the report, AMI recommends that the Equity Risk Premium (ERP)52
should be estimated on the basis of both previous estimates of the historic premium as
well as current expectations of market participants. Prospective premiums could be
used as a crosscheck.
Historic premium
Ridder & Vindel has estimated the risk premium for the Swedish market for the period
1937-1987 to 8.9%, while Frennberg & Hansson estimated a premium of 5.5% for the
period 1937-198753. Dimson, Marsh and Staunton have estimated the market premium
for a number of countries for the period 1900-2001, deriving an (arithmetic) average
of 5% for Sweden, slightly higher than the (arithmetic) world-wide average of 4.6%54.
Survey of current market expectations
Öhrlings PriceWaterHouseCoopers conducts an annual survey on the equity risk
premium in Sweden. The most recent survey, published in March 2003, included 32
respondents. The average of the premiums reported was 4.55%, the median 5.00% and
the standard error 0.97. 95% of the respondents reported an estimate between 3.5 and
6%. A survey conducted by Goldman Sachs in 2002 for over 100 of its international
clients globally, revealed an average equity risk premium of 3.9%.
In PTS’s own June 2003 investment bank survey (see Annex B), the respondents
reported using market risk premiums between 4.0-5.4% in their calculations.
Prospective approach
Finally, we estimated a prospective equity risk premium as
ERP = Earnings yield + growth rate in earnings – risk free rate =
5.1%55
+
2.1% 56
-
3.9%
= 3.3%.
In the report we have recommended using a market portfolio of stocks only. We therefore use the
term equity risk premium instead of market risk premium.
52
PriceWaterhouseCoopers (2003). Frennberg, Per and Björn Hansson. (1992) ”Computation of a
Monthly Index for Swedish Stock Returns 1919-1990.” Scandinavian Economic History Review, 40(1)
p. 3-27.
53
54
Dimson, Marsh and Staunton, March 2003, quoting a study of theirs from 2002.
55
Using the inverse of the P/E-ratio for OMX of 19.8% (Financial Times 25 June 2003)
56
Using an average of the Economist poll for consumer price changes in 2003 and 2004, 21 June 2003.
43
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
Conclusion
Historically, the Swedish ERP has been slightly higher than the world average. AMI
finds good reasons to believe this to be explained by country-specific events, which
cannot be expected to recur. In light of the increasing international nature of the
capital markets, AMI expects the (forward-looking) risk premium in Sweden to
converge with the international market premium.
On this basis, AMI estimates the Swedish market risk premium to lie between 4.05.5%, exceeding our estimated prospective premium of 3.3%.
A.5
BETA
AMI has estimated beta values for TeliaSonera, Tele2 and Europolitan/Vodafone on
the basis of daily observations using both 1, 2 and 3 years periods. We also regressed
the daily returns for all three stocks as well as the OMX index against the lagged daily
returns to check for serial correlation. We did not find any sign of such serial
correlation (i.e. the correlation was not statistically different from zero) and we
therefore decided to use daily observations.
The results are shown in the tables below:
Table 13 Estimation of beta for TeliaSonera using OMX and daily observations for 1, 2 and 3 years.
Period
Obs.
Beta
Beta adj.
Std.error
Low 95%
High 95%
R2 *
15.06.00-30.05.03
01.06.01-30.05.03
31.05.02-30.05.03
741
496
251
1.052
1.163
1.203
1.035
1.109
1.136
0.0452
0.0546
0.0777
0.963
1.055
1.050
1.146
1.270
1.357
0.42
0.48
0.49
*) R2 indicates the share of total variance in returns on the TeliaSonera stock, explained by changes in OMX
Source: Andersen Management International
Beta for TeliaSonera seems to have increased slightly during the last three years, which
can be somewhat, albeit not entirely, explained by an increase in the debt equity ratio.
As mentioned in this report, AMI considers that PTS should put most weight on
recent figures. This suggests using a beta value of 1.1. Using an average debt/equity
ratio of 0.23, this corresponds to an unlevered beta of 0.94.
Since October 2002, TeliaSonera share has also been traded on Nasdaq. Although, we
consider a Swedish stock index to be the most appropriate proxy for the portfolio of a
Swedish investor, we have also estimated beta for the TeliaSonera stock traded on
Nasdaq against the American S&P500 index. The result is presented in the table
below:
Table 14 Estimation of beta for TeliaSonera (Nasdaq) using S&P500 and daily observations
Period
Obs.
Beta
Beta adj.
Std.error
Low 95%
High 95%
R2
12.11.02-27.06.03
137
0.981
0.987
0.184
0.618
1.344
0.17
Source: Andersen Management International
44
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
Beta is estimated to 0.987. However, this estimate is associated with substantial
uncertainty (with 95% certainty beta could lie between 0.618 and 1.344). Only 17% of
the total variance in the return on TeliaSonera can be explained by changes in S&P500.
Finally, we do not consider S&P500 to be a reasonable proxy for a Swedish investor.
One should therefore not attach to much weight to this beta estimate. However, we
find the estimate of 0.987 to provide additional support for using a beta value close to
one. It also reduces our concern of using the OMX index, where TeliaSonera makes
up 10% of the total value.
The estimated beta of 0.987 corresponds to an unlevered beta of 0.831 using an
average debt/equity ratio of 0.26.
Table 15 Estimation of beta for Tele2 using OMX and daily observations for 1, 2 and 3 years
Period
Obs.
Beta
Beta adj.
Std.error
Low 95%
High 95%
R2
05.06.00-30.05.03
01.06.01-30.05.03
31.05.02-30.05.03
748
496
251
1.022
1.126
1.007
1.015
1.084
1.005
0.0436
0.0531
0.0692
0.937
1.022
0.871
1.107
1.231
1.144
0.42
0.48
0.46
Source: Andersen Management International
The beta for Tele2 seems fairly stable over the period, which suggests using the value
estimated over three years: 1.015, which corresponds to an unlevered beta of 0.850
(using an average debt/equity ratio of 0.27).
Table 16 Estimation of beta for Europol./Vodafone using OMX and daily observations for 1, 2 and 3 years.
Period
Obs.
Beta
Beta adj.
Std.error
Low 95%
High 95%
R2
05.06.00-30.12.02
01.06.01-30.12.02
646
396
0.936
0.960
0.957
0.973
0.0505
0.0606
0.837
0.841
1.035
1.079
0.35
0.39
Source: Andersen Management International
Europolitan/Vodafone’s share has not been traded very often during 2003. Hence,
there is a risk of underestimating beta due to the non-trading bias. This is also the case,
even for weekly observations. AMI therefore decided to disregard the observations for
2003 and instead estimated beta up until the end of 2002. Again, beta seems fairly
stable, which suggests using the longer period value of 0.957. This corresponds to an
unlevered beta of 0.936 (using an average debt-equity ratio of 0.03).
Peer-group analysis and conclusion
Fixed
Below, we have included calculations of beta for a number of European full-scale
operators, comparable to TeliaSonera. The adjusted beta values have been adjusted on
the basis of Bloomberg’s methodology, cf. section 5 of the report.
45
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
Table 17 Estimated beta values for selected European full-scale operators, using a 3-year period.
Company
Country
Raw Beta
Adj Beta
Debt/Equit
y ratio
Unlevered
raw beta*
Unlevered
adj beta*
TeliaSonera AB
TDC A/S
Telefonica
British Telecom
France Telecom
KPN NV
Deutche Telecom
Telenor ASA
Elisa Communications G.
Sweden
Denmark
Spain
UK
France
Netherlands
Germany
Norway
Finland
0.89
1.23
1.35
1.81
2.13
0.95
0.94
1.02
1.36
0.93
1.15
1.23
1.54
1.76
0.97
0.96
1.01
1.24
15%
78%
38%
56%
105%
67%
98%
38%
79%
0.81
0.79
1.07
1.30
1.23
0.65
0.56
0.80
0.87
0.84
0.75
0.98
1.11
1.01
0.66
0.57
0.80
0.80
0.90
0.83
Simple average
Source: Bloomberg (Alfred Berg). *) Calculated by AMI using a tax rate of 30%
On average, the unlevered betas are slightly below unity (0.9 using raw betas and 0.83
using the Bloomberg-adjusted betas), and slightly lower than our beta estimate for
TeliaSonera of 0.94 (0.85 using the US listing and S&P500)57.
On this basis, we have adopted a range for the unlevered beta for a notional fixed
SMP operator in Sweden of 0.85-0.95.
Mobile
Below we have reported unlevered beta estimates for selected mobile operators:
Table 18 Estimated unlevered beta values for selected European mobile operators.
Company
MmO2
Mobistar
Orange
Tele2
Vodafone plc
Unlevered beta
1.40
1.25
1.30
1.40
1.20
Source: Goldman Sachs (2003)
This comparison indicates that our estimates for unlevered betas for Tele2 and
Vodafone of 0.850 and 0.936 respectively may be too low for a notional SMP
operator.
On this basis we have used an unlevered beta of 1.0-1.1 in our calculations for a
notional SMP operator in Sweden.
The difference in the beta estimate for TeliaSonera may be explained by the fact that Bloomberg uses
a European Stock Index, whereas we use OMX.
57
46
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
A.6
EFFECTIVE TAX RATE
As stated in the report, AMI recommends using the corporate tax rate as a proxy for
the effective tax rate. Currently, the corporate tax in Sweden is 28%. AMI is not aware
of any planned changes in this rate and has therefore used the 28% directly in the
calculations.
A.7
COST OF CAPITAL FOR FIXED SMP OPERATOR
Below, we present our calculations of the cost of capital of a fixed SMP operator. We
have estimated the input parameters using a low-gearing scenario and a high gearing
scenario. In this way, it is possible to ensure consistency between the different input
parameters. Instead of a point estimate, we have included a range for the different
input parameters, reflecting the uncertainty associated with each parameter. We
consider this to be the most fair and transparent approach.
Table 19 Calculation of WACC for fixed SMP operator in Sweden
Low gearing
Low case
High case
%
Risk-free rate
Equity risk premium
Unlevered Beta
Equity Beta
Cost of equity
Debt premium
Cost of debt
Gearing
Tax rate
Post-tax WACC
Pre-tax
Range
4.5
4.0
0.85
1.00
8.5
1.00
5.5
20
28
7.6
10.6
4.5
5.5
0.95
1.12
10.7
1.00
5.5
20
28
9.3
13.0
High gearing
Low case High case
4.5
4.0
0.9
1.26
9.5
1.40
5.9
40
28
7.4
10.3
4.5
5.5
1.0
1.41
12.2
1.40
5.9
40
28
9.0
12.6
10.3 - 13.0
Mid-point
11.6
Source: Andersen Management International
We have then estimated the cost of capital as the mid-point between the highest and
lowest estimate. For a fixed network operator, this corresponds to a cost of capital of
11.6%
A.8
WACC FOR MOBILE SMP OPERATOR
Similar calculations have been undertaken for a mobile SMP operator:
47
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
Table 20 Calculation of WACC for mobile SMP operator in Sweden
%
Risk-free rate
Equity risk premium
Unlevered Beta
Equity Beta
Cost of equity
Debt premium
Cost of debt
Gearing
Tax rate
Post-tax WACC
Pre-tax
Range
Mid-point
Low gearing
Low case
High case
4.5
4.0
1.00
1.08
8.8
2.50
7.0
10
28
8.4
11.7
4.5
5.5
1.10
1.19
11.0
2.50
7.0
10
28
10.4
14.5
High gearing
Low case High case
4.5
4.0
1.00
1.18
9.2
2.90
7.4
20
28
8.4
11.7
4.5
5.5
1.10
1.30
11.6
2.90
7.4
20
28
10.4
14.4
11.7 - 14.5
13.1
Source: Andersen Management International
These calculations indicate an interval for the cost of capital between 11.7 and 14.5%
with a mid-point value of 13.1%.
48
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
Annex B Summary of investment bank survey
Respondent
The Swedish equity market
risk premium
Beta estimates for Telia,
Tele2 and (if available)
Vodafone Sverige
Target (optimal) D/E ratios for
Estimated 2003 (post-tax)
Telia and for a generic Swedish WACC rates for Telia, Tele2
mobile operator
and (if available) Vodafone
Sverige
A
We have had 4.5% for several
years now. It is not only for the
Swedish market, but we use it
for the whole European equity
market, as free transfer of
capital does not warrant
different premium requirements.
We have used 1.45 as
industry beta for all operators.
However, the latest betas
would suggest a slightly lower
beta of 1.21 for operators
(1.27 for wireless, 1.17 for
fixed line). We use logarithmic
weekly returns of Dow Jones
Europe Stoxx sectors since
1998.
Telia: 20%
Telia: 9.5%
B
Our strategists believe a 4%
equity risk premium for the
Swedish market is appropriate.
The 5-year averages for Telia
and Tele2 would be around
1.1. The Vodafone Sweden
beta would be slightly higher
(i
t t d) i
b t
We believe the optimal degree of
leverage is 2x net debt/EBITDA
for European telecoms operator
(including Telia, Tele2 and
f
l V d f
S d ) At
We would use a 9.3% WACC.
Note our WACC calculations
are not bottom-up calculations
but based on an IRR for the
t
h th t
i
"Optimal" credit rating for a fixed
and mobile operator, or the longrun fixed / mobile industry average
Here we do not have a firm view, other
than the rating should be a clear
Europolitan: 30%
Tele2: 8.9%
investment grade rating, perhaps in
Tele 2: 40%
Europolitan: 9.0%
the middle of highest and lowest. The
highest possible ratings should not be
TDC, Telenor, Elisa: 50%, which The higher requirement for Telia
required in the sense that operators
we regard as the target level for
and Europolitan is due to lower
are not a very cyclical business
any Scandinavian mixed operator D/E ratio than Tele2. Debt risk
requiring high solidity. On the other
with relatively limited growth
premium is higher for Tele2 due
hand, the relatively low entry barrier to
opportunities. A higher ratio may to the more risky business
operators' service businesses expose
be used for TeliaSonera, under
model for the whole firm, but
existing operators to competition,
the assumption that the industry is that is not enough to
which in turn requires more than a
no longer growing at a fast rate,
compensate the D/E ratio
minimal investment grade rating. A
thus allowing for higher leverage. impact which lowers Tele2's
Net debt/EBITDA level of 2.5 and
But as the current marketWACC.
below should allow a clear investment
weighed equity and book-weighed
grade rating.
debt suggest levels below 20%,
we have adjusted the ratio closer
to current ratios.
We believe a single A credit rating to
be optimal. Again, we believe at this
point the trade-off between default risk
and tax shield are maximised.
49
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
Respondent
C
The Swedish equity market
risk premium
4%
Beta estimates for Telia,
Tele2 and (if available)
Vodafone Sverige
Target (optimal) D/E ratios for
Estimated 2003 (post-tax)
Telia and for a generic Swedish WACC rates for Telia, Tele2
mobile operator
and (if available) Vodafone
Sverige
(i.e. overstated) since betas
using more recent data are
generally lower.
formerly Vodafone Sweden). At
sector, such that we can give a
this level, we would argue that the balanced set of
tax shield benefits outweigh the
recommendations.
default risk.
Telia (0.9 for fixed line voice;
1.1 for group)
Telia (30:100)
Vodafone Sverige (1.2)
Telia (6.7% for fixed line and
7.4% for group), Tele2 and (if
available) Vodafone Sverige
(8.7%)
"Optimal" credit rating for a fixed
and mobile operator, or the longrun fixed / mobile industry average
An A credit rating is optimal.
D
The Swedish equity market risk Beta estimates for Telia -premium 5.4% -- (backed out
Fixed 0.85 Mobile 1.1
from current Swedish equity
index value)
Target (optimal) D/(E+D) ratios for Estimated 2003 WACC rates for Single A
Telia (25%)
Telia Fixed -- 8.1% Mobile
8.1%
E
We estimate the Market risk
premium in Sweden at some
4%.
We have no view on this issue
We have not calculated this.
Telia Sonera: 6.4%
Tele2: 7.4%
Operators themselves target single A
ratings
This is based on Gordons
model (dividend yield + real
earnings growth) or 2.9% +
1.5%.
50
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
Annex C References
AMP Henderson, “The equity risk premium – what is it and is it enough?”, 5 March
2003, available at
http://www.ampam.co.nz/MarketViews/Economic/EquityRisk.pdf
Andersen Management International, “Cost Oriented Access and Interconnection in
Sweden”, November 2001, available at:
http://www.pts.se/Archive/Documents/SE/
Konsultrapport-Andersen%2030%20nov%2001.pdf
Andersen, “A report on TDC’s cost of capital”, October 2001
Andersen, “Study on the implementation of cost accounting methodologies and
accounting separation by telecommunication operators with significant market
power”, July 2002, available at:
http://europa.eu.int/information_society/topics/telecoms/
implementation/studies/costaccounting2002/costaccountingmethodologies.pdf
Brealey and Myers, “Principles of Corporate Finance”, 2000
Competition Commission, Vodafone, O2, Orange and T-Mobile, December 2002,
available at http://www.oftel.gov.uk/publications/mobile/ctm_2003/index.htm
Damodaran, “Estimating Risk Parameters”, available at:
http://www.stern.nyu.edu/~adamodar/pdfiles/papers/beta.pdf
Damodaran, “Estimating the equity risk premium”, available at:
http://www.stern.nyu.edu/~adamodar/pdfiles/papers/riskprem.pdf
Davis, Kevin, “The Weighted Average Cost of Capital for the Gas Industry, 12
March 1998, available at: http://www.reggen.vic.gov.au/docs/gas/davis.pdf
Dimson, March and Staunton, “New evidence puts risk premium in context”,
Corporate Finance, March 2003, available at
http://faculty.london.edu/edimson/risk.pdf
Ernst and Young, LRAIC projektet, Cost of Capital, September 2001
Goldman Sachs, “Europe: Telecom Services – The phone book”, 17 June 2003
Goldman Sachs, ”Global Economic Commentary: The Equity Risk Premium From
an Economic Perspective”, Global Economics Weekly, 31 July 2002.
Lewis, Karen K., 1999, “Trying to Explain Home Bias in Equities and
Consumption”, Journal of Economic Literature 37, 571–608.
MCMC, “A Consultation Paper on the Cost of Capital”, 2002, available at
http://www.mcmc.gov.my/mcmc/fact_figures/papers/discussion/pdf/costcapital.p
df
National IT and Telecom Agency, “Høringsnotat vedrørende revideret udkast til
51
Estimating the cost of capital for fixed and mobile SMP operators in Sweden
9 July 2003 – Andersen Management International A/S
LRAIC-hybrid model, December 2002, available at:
http://www.itst.dk/image.asp?page=image&objno=116028493
National IT and Telecom Agency, “Høringsnotat vedrørende udkast til LRAIChybrid”, October 2002, available at:
http://www.itst.dk/image.asp?page=image&objno=112315292
National IT and Telecom Agency, “Rapport om hybridmodellen, December 2002,
available at: http://www.itst.dk/image.asp?page=image&objno=112315289
OFTA (2000), “The Cost of Capital Estimation for Fixed Telecommunications
Service”, available at: http://www.ofta.gov.hk/report-paper-guide/
report/rp20001025.pdf
Oftel, Proposals for Network Charge and Retail Price Controls from 2001, February
2001, available at http://www.oftel.gov.uk/publications/pricing/pcr0101.htm
PriceWaterHouseCoopers, “Application of TSLRIC pricing methodology –
Discussion paper, 16 August 2002, available at:
http://www.comcom.govt.nz/telecommunications/pdf/TSLRIC%20discussion%20
paper%202%20July%202002.pdf
TDC, Corporate Valuation, Økonomisk Sekretariat, 10 October 2002, available at:
http://www.econ.au.dk/fag/4075/e02/corp_val.pdf
Tele 2, Annual Report 2002, available at:
http://www.tele2.com/eng/investorrelations/annualreports/index.html
TeliaSonera, Annual Report 2002, available at:
http://www.teliasonera.com/efocus/DOCUMENT/20030411/Annual_Report_200
2_eng.pdf
Vodafone, Annual Report 2001/2002, Europolitan Holdings Ab, available at:
http://www.vodafone.se/dokument/financial_papers_9276_1.pdf
Wright, Mason and Miles (2003), “A study into certain aspects of the cost of capital
for regulated utilities in the U.K.”, available at
http://www.oftel.gov.uk/publications/pricing/2003/cofk0203.htm
52