cost of capital

Cost of Capital

Peter KLUNE Dubai, 29th October 2007Peter KLUNE, Dubai 29th October 2007 Page 1

Agenda1. Relevance of cost of capital calculation 2. WACC the most common way to determine cost of capitalDiscussion of input parameters Risk free interest rate Beta factor Risk premium Cost of dept Capital structure Tax rate What are the main drivers of the WACC-calculation?

3. Divisional cost of capital 4. International Benchmarks / SummaryPeter KLUNE, Dubai 29th October 2007 Page 2

A little bit of theory For regulatory purposes it must be ensured that the investor can bear an appropriate rate of return on his investment (minimum level) The rate of return which is required to satisfy the investors expectation is mainly driven by the risk which is associated with the potential investment. In principle investors are risk averse The rate of return increases as the investment becomes more risky This theory is based on historical evidence

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

Peter KLUNE, Dubai 29th October 2007

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Relevance of cost of capitalCost of capital plays a substantial role in the determination of network costs Retail-Productmarketing sales costs customer care RT-billing Cost of capital ~ 10-20%

WholesaleProduct

WS-Billing, administration Cost of capital ~ 15-25%

production costs network infrastructure

depreciation operating costs, etc.

depreciation operating costs, etc.


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The WACC formulaequity ratio dept ratio

E WACC rE * DE

D rD * (1 t) * DEweighted cost of dept

weighted cost of equityrE rD E D t

cost of equity cost of dept market value of equity market value of dept tax rate

rE rf * (rm rf )rf rm (rm rf) risk free interest rate Beta (systematic risk factor) interest rate of market portfolio equity risk premium

rD rf (rd rf )rd company specific dept rate (rd rf) company specific dept premiumPage 6


1. Risk free interest rate [rf ] The risk-free interest rate is the interest rate that it is assumed can be obtained by investing in financial instruments with no default risk. Since this interest rate can be obtained with no risk, it is implied that any additional risk taken by an investor should be rewarded with an interest rate higher than the risk-free rate. Though a truly risk-free asset exists only in theory, in practice a common choice are government bonds or Euribor rates (for investments in the EU). Issues that have to be considered: Maturity period Historic versus current yields Which market?


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Historic/average versus current yieldsMaximum: 5,9 %

4,6 % Average over 8 years

3,9 %average over 3 years

Approach of Austrian NRA regarding mobile termination fee calculationMinimum: 3,2 %


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2. Beta factor (1/2)

[rE rf * (rm rf )]

Two different types of risk are typically identified: specific risk (diversifiable or idiosyncratic) Company specific risks which can be diversified within a portfolio. Not priced into investors required rates of return. systematic risk (market or undiversifiable) Risks which can not be diversified within a portfolio The systematic risk of a company is measured by the Beta factor Beta is calculated by regressing the asset (stock) returns against market returns. Therefore the value of beta reflects the variability of returns of the equity of the company in question, compared with the variability of returns on the equity market (market index). Beta=0: risk free investment Beta1: volatility greater than the reference market What is the right reference index? Theoretically the index should include all risky assets In practice most analysts and regulators use national stock market index (S&P 500, FTSE, etc.)Page 9


2. Beta factor (2/2)

[rE rf * (rm rf )]

Single beta or peer group beta (average)? Beta factors are relative volatile over the time period Reduction of estimation error through group beta Enough observations must be available for regression analysis (time series)Telco Beta Deviation

BT Group Hellenic Telecommunication Organisation Swisscom AG Telekom Austria AG Portugal Telecom Koninklijke KPN NV Average

17% 40% 89% 42% 40% 96% 14%

Deviation between minimum and maximum value (30.06-30.09.2007)

A better way to estimate betas is to look at the average beta for publicly traded firms in the business a company operates in. While these betas come from regressions as well, the average beta is always more precise than any one firms beta estimate. * How to determine the peer group? Comparable companies (same type of business) Companies with similar market capitalisation (size of company) Company of choice be included in reference index To calculate the peer group beta you have to consider different capital structures and tax rates (unlevered beta)* See: Damodaran: Investment Philosophies Page 10


Alternative way of beta estimation It could be argued to use in stead of a purely benchmark based beta a so called adjusted-beta The basic idea behind this is based on the finding that in the long run all betas show a tendency to the value of 1.* Therefore the use of an adjusted beta, calculated as follows, seems reasonable Adjusted beta = 2/3*(Raw beta) + 1/3*(1)** If the benchmark beta is smaller than 1 the adjusted beta will be higher If the raw-beta is higher than 1 this method will decrease the adjusted beta* see: Blume, M.E.: Betas and their regression tendencies, Journal of Finance** see: Bloomberg Guidelines to adjusted beta estimates


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3. The risk premium (1/2)Definition:

[rE rf * (rm rf )]

The (market) risk premium represents the additional return over the risk-free rate, that investors require as compensation for the risk they expose themselves to by investing in equity markets. It is essentially a measure of investors appetite for risk and it is a market factor, rather than a company-specific factor. Most Common approach to estimate the risk premium: Analyse the difference between realized returns on the market portfolio and those on a risk free asset (based on historical data) Issues to consider: Arithmetic versus geometric mean (depends on predictability) Relevant Index (world or domestic) What time period to use?


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3. The risk premium (2/2)

[rE rf * (rm rf )]

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

The average value is 5,3%

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

The reason my be caused by different calculation methods but also country specific reasonsPeter KLUNE, Dubai 29th October 2007 Page 13

4. Cost of dept (1/2)

rD rf (rd rf )

The cost of debt reflects the cost the company has to sustain in order to get capital to finance its activity either through issuing loans (bonds) or bank credits It corresponds to the weighted average of the costs of the various long-run loans of the company and it is strongly correlated to the current interest rate's level, the company's financial capacity and risk. Different ways to determine cost of dept: Accounting data Look at firms credit rating Dept premium Cost of Debt = Risk Free Rate + Company Specific Debt Premium


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4. Cost of dept (2/2)

rD rf (rd rf )

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

Gearing

Dept Dept Equity

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

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


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5. Capital Structure / gearing ratio The companies capital structure (gearing) is an important input parameter because it influences several other parameters Beta factor Cost of dept (dept premium) Market values should be used instead of book values You may use either the actual structure or a target capital structureExample: Target Capital Structure of Telekom AustriaEquity500 Mio. shares x market price 20,00 Euro 10.000 Mio. 70%

DeptAccounts payable = 2 x EBITDA Line of credit 3.540 Mio. 760 Mio. 4.300 Mio.Peter KLUNE, Dubai 29th October 2007 Page 16

30%

6. Tax rate The WACC may be estimated post-tax or pre-tax For regulatory purposes the pre-tax WACC is of relevance, because the cost of capital must be sufficient to finance tax and interest payments as well as shareholder returns. The pre-tax WACC is calculated as follows:

WACCpost - tax WACCpre - tax (1 tax rate) To estimate an ex-ante post-tax WACC, a decision has to be made as to which tax rate to utilise for the calculation. Headline rate of tax Effective tax rate


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Main driver of WACC calculationThe question is, what are the most important input factors to the WACC calculation? The following table shows a sensitivity analysis regarding the effect of a 10%increase of each individual input factor (ceteris paribus) to the overall WACC:WACC Calculation initial input value 5,0% 1,2 0,667 1,800 5,5% 14,9% effekt on WACC 4,2% 5,5%

Risk Free Interest Rate Beta (unlevered) Gearing Ratio (D/E) Beta (relevered) Equity Risk Premium Cost of Equity

2 1

5,5%

Credit Risk Premium Cost of Debt Equity-to-Total Capital Debt-to-Total Capital (gearing) WACC post-tax Tax rate WACC pre-taxPeter KLUNE, Dubai 29th October 2007

1,0% 6,0% 60,0% 40,0% 10,7% 25,0% 14,3%

0,3%

5 4

1,2%

2,2%

3

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

Example: Purchase value: 300 Mio. Dirham Useful life: 15 years WACC: 10% Cost of capital in total: 225 Mio. Dirham


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The divisional cost of capital Reasons for calculating a divisional cost of capital Different type of business (e.g.: fixed/mobile) Project specific risk is reflected in cash-flow scenarios A divisional WACC is difficult to calculate: lack of capital market information on the level of company divisions Beta on a division level not observable Gearing ratio not available Only OFCOM in GB did calculate a disaggregated WACC for: copper access network business: WACC=10.0% the rest of BT WACC=11.4% All other regulators in Europe are currently assessing the WACC at company levelPeter KLUNE, Dubai 29th October 2007 Page 21



WACC [%]10,00 12,00 14,00 16,00 18,00 0,00 2,00 4,00 6,00 8,00

H un g

M ac

1 6 ,5 1 5 ,5 ,2 1 1 1 1 1 1 1 1 1 1 1 1 1 0 1 1 1 1 1 1 0 ,4 2 2 ,5 ,4 ,3 ,2 ,0 ,0 ,8 3 3 ,3 ,1 ,3 ,1 4 ,5 1 5


ar y ed on i R om a an ia M al Po ta rt ug al N or w ay Li th ua ni a C yp ru s Ir el an d B el gi um C Po ze ch la Re nd pu bl ic Es tla nd S lo va ki a S w ed en G re ec e Fi n A It al la us t y nd ria Es U K Fr a G pa ni a nc e

Cost of Capital (WACC) in Europe

International benchmarks (wireline)

Source: Cullen Internationaler m an D en y m N ar et he k rla S w itz nd er la nd M ea nPage 23

1 1 1 1 9 9 9 8 7 7 ,6 ,6 ,6

0 0 0 0 ,9 ,8 ,5

,2 ,1 ,0 ,0

1

1

,3

WACC [%]10,00 12,00 14,00 16,00 18,00 20,00 0,00 2,00 4,00 6,00 8,00

H un ga ry 1 7 ,5 ,5 7 1 ia an R om

M al ta 1 7 1 3 ,1 3 1 2 ,1 ,2 1 3 1 ,3 2 ,6 1 4 1 la A us t nd ria U K Es pa ni Fr a N et he a nc e rla nd ,8 2 Fi n ,4 1 3 ,5 1 1 7 1 ,4 ,2 1 1 3 2 1 ,3 ,4 1 ,6 ,0 N or w ay C yp r us m 1 iu B ze c h Re p ub lic ed e n S w el g


C

International benchmarks cont.

Cost of Capital - Wireline versus Wireless

wireline

G re ec e It al y

wireless

Approx. 20% mark-upPage 24

Summary WACC does have a substantial impact on network cost calculation Many input parameters facilitating a wide range of results, depending on underlying assumptions Focus on parameters with significant leverage effect Suitable instrument for NRA to get out results which are desired (fine tuning) Its often not the question of what is right ore wrong, it is more about who has the better arguments for his position/assumption


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Thank you for your time Questions?

Peter KLUNE Regulatory Affairs TELEKOM AUSTRIA AG Lassallestrae 9 A-1020 Austria ( E-Mail Phone Fax Mobile [email protected] +43 (0)59059 1 16012 +43 (0)59059 91 16012 +43 (0)664 629 61 76Page 26


Appendix: helpful links and related documents Principles of Implementation and Best Practice for WACC calculation, IRG WG Regulatory Accounting, February 2007 (http://www.erg.eu.int/doc/publications/erg_07_05_pib_s_on_wacc.pdf ) KPMGs Corporate and Indirect Tax Rate Survey 2007 (http://www.kpmg.com/Services/Tax/Business/IntCorp/CTR/ ) Ofcoms approach to risk in the assessment of the cost of capital, Final statement; Issued: 18 August 2005 (http://www.ofcom.org.uk/consult/condocs/cost_capital2/ ) FTSE Group calculates over 100,000 indices covering more than 48 countries and all major asset classes (http://www.ftse.com/ ) Bloomberg-financial information service (www.bloomberg.com ) Cullen International, Regulatory monitoring services (http://www.cullen-international.com/documents/cullen/index.cfm ) The journal of finance (http://www.afajof.org/ )


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Back up


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Calculation with nominal versus real values Depends on asset valuation Actual costs (FL-LRIC) -> real WACC Historic costs -> nominal WACC Formula: WACCreal = WACCnom - Inflation

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


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cost of capital

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