Consultation on return rates for mobile networks

Transcription

1 Rapportnummer PTS-ER-2014:17 Datum Consultation on return rates for mobile networks - an update

2 Consultation on return rates for mobile networks - an update (translation of the report in Swedish made by the EU Commission) Report number PTS-ER-2014:17 Registration number ISSN Author Bengt G Mölleryd Post- and tele authority Box Stockholm [email protected]

3 Contents Summary 6 1 The return rate indicates the return The grounds for return rate calculation Premise and procedures The comparison group Decision 14 2 Risk-free return rates Risk-free return rates for treasury bonds year average International comparison Proposal: 2.92% risk-free rate 19 3 The gearing Shows the degree of financial exposure International comparison Proposal: a 35% gearing 22 4 The debt risk premium The debt risk premium is the price of the corporate risk The comparison group The credit rating plays an important role Debt risk premium for corporate bonds The existing rate difference Average rate differences for the period Rate differences and credit rating Summarized assessment International comparison Proposal: the 220 basis points equity risk premium 30 5 Taxation The corporate tax was decreased in The equity risk premium Other points of view on the equity risk premium Three methods to determine the premium Implicit price setting Historical analysis to determine the equity risk premium Interview surveys Summarized assessment International comparison Proposal: 5.50 percent equity risk premium 38 7 Beta indicates the stock risk Beta is the market risk Method questions Comparison companies European operators The comparison index the MSCI World Index Beta is calculated as a 5-year average 42

4 7.2.4 Beta modification Clearing the beta for debts Calculating the asset beta The beta gearing Summarized assessment International comparison Proposal: 0.77 beta 47 8 Summarized assessment From nominal to a real rate of return 50 9 International comparison Significant variations in the rate of return Invitation to communicate points of view 52 Bibliography 54

5 Tables Table 1 Compilation of factors in the return rate... 8 Table 2 The existing return rate for the mobile networks Table 3 Mobile operators in Europe Table 4 Credit rating levels Table 5 The calculation of the equity risk premium (CFA) Table 6 The calculation of the equity risk premium(bloomberg) Table 7 Weighted average of the equity risk premium Table 8 Beta calculation Table 9 Compilation of the various parameters Table 10 Proposal for the updated rate of return Figures Figure 1 Stock exchange rating of comparison companies Figure 2 Comparison companies sales Figure 3 10 year treasury bonds return rates October 2011 April Figure 4 Return rates for 10-year treasury bonds and a 7-year circulating average Figure 5 The international level of the risk-free rates Figure 6 The average gearing in the period Figure 7 The gearing in six countries Figure 8 Rate differences for bonds with 5-year maturity Figure 9 The average for rate differences Figure 10 Rate differences for various credit rating levels Figure 11 The international level of the equity risk premium Figure 12 The equity risk premium in Sweden... 36

6 Figure 13 The equity risk premium Figure 14 Beta in an international comparison Figure 15 The rate of return in 13 European countries Summary There are concurrence concerns regarding the electronic communications market. PTS is therefore working to determine rules to create a predictable and even playing field for all market stakeholders. Ultimately this results in better selection and consumer choices. As part of this work PTS has decided to impose the obligation to apply cost-oriented pricing for call terminations included in the mobile call termination market on a number of mobile operators. PTS uses a spreadsheet model to calculate the cost-oriented prices. A parameter of the calculation model is the return rate which forms the object of this consultation. This report presents an updated return rate, which is used to calculate the return on the investment capital and provide the discount rate in the mobile model which affects the cost results generated by the model. We use a real return rate in the mobile model, which means that the nominal return rate forming the object of this consultation is cleared for inflation. The object is to apply the updated return rate with the update taking effect on 1 July The current applicable return rate was decided in the beginning of 2011 and the consultations were conducted in when PTS announced that the return rate would be reviewed after three years. Since 2011 the market has developed, return rates have fallen and the corporation tax was reduced from 26.3 percent to 22.0 percent in 2013, which means that the return rate must be updated. The method used to calculate the return rate is WACC (Weighted Average Cost of Capital) or in Swedish the weighted average cost of capital. The WACC formula uses the following six factors to calculate the return rate: risk-free return rate: return rate for 10 year treasury bonds gearing: net debts in relation to the corporate assets debt risk premium: the difference between the risk-free return rate and the return of the corporate bonds taxation the equity risk premium: share return in addition to the risk-free return rate

7 beta: a share risk in relation to the entire stock exchange Below we present proposals for the six factors on the basis of the current return rate. In the calculation of the return rate PTS uses a comparison group consisting of 22 European operators which have been selected because they are mobile operators in at least one European country and are listed with a stock exchange. PTS uses the return rate on 10-year treasury bonds in order to determine the risk-free rate, and it calculates it on a circulating 7-year average, which means that the return rate is stable over longer periods of time and can overcome economic cycles. Return rates have dropped since 2011 and according to PTS s proposal, the return rates decreased to 2.92 percent from the existing 3.71% as a result. The gearing among the European operators is currently at an average of 35 percent. PTS s proposal is to use a debt level based on an average for the comparison group instead of the current application of two 15% levels for low debt levels and 35% for high debt levels. This is a simplification since the current calculation is based on two debt levels and the return rate is the average of the two estimates. This means that the PTS is proposing a 35% gearing. A consequence of the financial crisis is the fact that the debt risk premium has increased. As a consequence PTS suggests an increase in debt risk premiums, but only as a consequence of applying a debt level to 220 basis points, compared with the current level of 125 respectively 175 basis points for low respectively high debt levels. The ongoing uncertainty on the financial markets has led to investors requiring higher returns on stocks. PTS therefore suggests that the equity risk premium should be increased from the current level of 5.00 to 5.50 percent. Based on an average for the development of the comparison companies' shares in relation to an international index over the past five years PTS suggests that the assets beta should be set at 0.50 which, with a 35 percent gearing results in a 0.77 beta, versus the current beta which is 0.75 and 0.98 for low and respectively high gearings. To summarize, this means that the PTS is proposing that the return rate should

8 be decreased to 7.8 percent from the current 9.4 percent. In an international comparison PTS s proposal ranks slightly below the European average, but higher than Denmark s which has a return rate of 4.5%, Netherlands 6.7%, Germany 7.1%, all of which have published their respective levels in At the same time, there are countries whose rates are higher than Sweden s, like the United Kingdom at 8.8 percent, France at 10.4 percent and Norway at PTS welcomes feedback on the proposal. The following table summarizes the values and changes proposed by PTS for return rate calculation. Table 1 Compilation of factors in the return rate Risk-free return rate Gearing Debt risk premium Taxation Equity risk premium Beta cleared for debts Beta including debts Trend Existing 3.71% 15%/35% 125/ % 5.00% /0.98 Comments Strong Swedish currency and economy The operators gearing has increased slightly, Significant variations, financial insecurity and increased country Lower corporation tax in 2013 Increased return requirements, increased Average for the comparison group 2011 method 2014 method 2014 updating Sensitivity analysis existing average risk insecurity 7 year average 5 year average Present situation PWC and other sources 7 year average 5 year average Average for the PWC and other comparison group in 5 sources. years Weighted 5 year average 5 year average+ Blume modifications average 2.92% 35% % 5.50% 0.50% 0.77 The decrease clarifies more than half the decrease The modification has lower significance for the return rate The increase has a limited significance for the return rate Significance importance for the return rate The increase has great significance for the return rate The decrease has a significant effect on the return rate

9 1 The return rate indicates the return 1.1 The grounds for return rate calculation As part of an update of the mobile 2014 model, PTS also intends to update the return rate used in the model. The mobile model is used to calculate the costoriented prices in the mobile networks which will form the basis of the cost results for the level of mobile terminations applicable from 1 July The current return rate for the mobile model was established in February 2011, after consultations were conducted during the latter part of The calculations are based on data up to and including the first half of In the consultation of 18 November 2010 PTS underlined that the aim was to establish a return rate which has a duration of circa 3 years. 1 Over the past four years, the market has developed and the situation on the financial markets has changed. The return rate on the Swedish 10-year treasury bonds has fallen since 2010, and reached a lowest point in 2012, and the corporation tax was reduced from 26.3 to 22 percent on 1 January To summarize, therefore, a return rate update which can be applied in the updated mobile model from 1 July 2014 is justified. The return rate is used to calculate the return on invested capital and indicates the discount rate which affects the cost results generated by the model. We use a real return rate in the mobile model, which means that the nominal return rate which represents the object of this consultation is cleared for inflation. PTS uses the WACC-method to calculate the return rate 2, which is an established practice among national regulatory authorities and is based on a theory which manages the relationship between risk and return, a theory named CAPM 3. It was developed in the 1960s and it aims to provide the conditions for creating optimal portfolios for risky assets using the so-called portfolio theory. 4 The first time that PTS determined a return rate for the mobile model based on the WACC method was Afterwards, PTS reviewed the return rate in 1 PTS proposal for modified return rates for mobile networks Consultation, 18 November 2010, page 24, reference number WACC is the abreviation of Weighted Average Cost of Capital 3 CAPM is the abreviation of Capital Asset Pricing Model. CAPM is a model which describes the connection between risk and return in a financial instrument or portfolio 4 History and the Equity Risk Premium, William N. Goetzmann and Roger G. Ibbotson Yale School of Management, October 18, PTS, Estimating the cost of capital for fixed and mobile SMP operators in Sweden, (Andersen Management International A/S). Dnr /23.

10 , and subsequently revised the return rate in On the basis of the current return rate PTS has determined both the procedure approach and the level of the parameters included in the calculation. PTS uses the return rate as a WACC concept or in Swedish, as the average weighted cost of capital. Although the aim is to determine a return rate for Swedish conditions, the perspective is international and it is therefore based on data for a comparison group consisting of companies which own mobile operators in Europe and which are listed with a stock exchange. The return rate is calculated in two phases. In the first phase, it calculates the cost of foreign capital or debt, and in the second phase, it calculates the cost of its own equity capital. Then the gearing and tax ratios are calculated: Debt costs Risk-free return rate (Rf) Debt risk premium (DRP) The costs of its own equity Risk-free return rate (Rf) The equity risk premium (ERP) Beta (b) Gearing (g) Taxation (T) Return rate before taxation Return rate after taxation The cost of debt is a function of the risk-free return rate and the debt risk premium. The cost of its own equity is a function of the risk-free return rate, the equity risk premium and beta. It is also used in the calculation of gearing and tax ratios. The equation for calculating the return rate is the following: 7 Return rate after taxation = (1-g)*(Rf+bERP)+g(1-T)*(DRP+rf) Return rate before taxation = Return rate after taxation /(1-T) The current return rate for the mobile network is 9.4 percent and the values of each parameter are the following: 6 PTS, WACC for the mobile telecommunications net in Sweden presentation of Copenhagen Economics , report of Copenhagen Economics Cost of capital for Swedish mobile telecom networks, Ofcom, WACC = (Cost of equity x (1 Gearing )) + Cost of debt x Gearing

11 Table 2 The existing return rate for the mobile networks Low gearing High gearing Risk-free return rate 3.71% 3.71% Debt risk premium 1.25% 1.75% Debt costs 3.66% 4.02% Risk-free return rate 3.71% 3.71% The equity risk premium 5.00% 5.00% Beta with debts Costs for assets/equity 7.47% 8.63% Gearing 15% 35% Taxation 26.3% 26.3% WACC after taxation 6.90% 7.02% WACC before taxation 9.36% 9.52% Average 9.4% Source: PTS Premise and procedures PTS premise for the calculation of return rates states that it should be based on an established practice, have the support of academic research, be factual and be consistent with the calculations used to produce the return rate for the fixed networks and the method PTS has used. Ultimately, however, PTS assessment is the deciding factor, but it wants the procedures to be clear and transparent and based on open data sources, which are reported in the source list The comparison group PTS uses a comparison group consisting of 22 European operators which have been selected because they are mobile operators in at least one European country and are listed on a stock exchange. Most of the companies are integrated operators with both fixed networks and mobile operations, some also carry out other activities and geographic profiles. PTS has chosen not to operate any modifications to the comparison companies' results to reflect the situation in Sweden, but used the reported market and financial data. 8 PTS New return rates for the mobile networks, Points of view on the proposal for mobile return rates , Dnr /2.1.2.

12 Table 3 Mobile operators in Europe Country Mobile operator Belgium Belgacom KPN Mobistar (Orange) Bulgaria Telekom Telenor Bulgarian Telecommunications Austria Denmark TDC Telenor TeliaSonera Hutchison Estonia TeliaSonera Elisa Tele2 Finland TeliaSonera Elisa DNA France Orange Vivendi Bouygues Group Iliad Greece Deutsche Vodafone Largo (Wind) Telekom Ireland Vodafone Telefonica Eircom Hutchison Italy Telecom Italia Vodafone Vimpelcom Hutchison Croatia Telekom Deutsche Tele2 Austria Telekom Latvia TeliaSonera Tele2 Mid Europa Partners Lithuania TeliaSonera Tele2 Mid Europa Teledema Partners Luxembourg Post Belgacom Orange Luxembourg Malta Vodafone Dubai Holding Moldavia Orange TeliaSonera Moldtelecom Netherlands KPN Vodafone Deutsche Telekom Tele2 Norway Telenor TeliaSonera Tele2 Poland Deutsche Orange Polkomtel Telekom Portugal Portugal Vodafone Orange/SonaeCom Telekom Romania Orange Vodafone OTE RCS & RDS Slovakia Orange Deutsche Telefonica Telekom Slovenia Telekom Telekom TusHolding Slovenije Austria Spain Telefonica Vodafone Orange TeliaSonera Sweden TeliaSonera Tele2 Telenor Hutchison/Investor Switzerland Swisscom CVC Capital Apax Partners Partners Great Britain Deutsche Orange Telefonica Vodafone Hutchison Telekom Czech Deutsche Telefonica Deutsche Telekom republic Telekom Germany Deutsche Vodafone KPN Telefonica Telekom Hungary Deutsche Vodafone Telenor Telekom Austria Telekom Deutsche 3 (Hutchison) Austria Telekom Source: Wikipedia The stock exchange enterprise value varies widely. SonaeCom is the smallest and has a stock exchange value of SEK 5 billion and Vodafone is the biggest with a stock exchange value of SEK 558 billion.

13 Figure 1 Stock exchange rating of comparison companies Source: Bloomberg ( ) There is also a great gap between the various companies sales from SEK 7 billion for Telekom Slovenije to SEK 540 billion for Telefonica. Figure 2 Comparison companies sales Source: Bloomberg ( )

14 1.3 Decision The report is prepared in such a way that the elements included in the return rate calculation are dealt with step by step. Chapter 2 deals with the risk-free return rate and the return rate on 10-year treasury bonds, and the following chapter presents the gearing developed for European operators and establishes an average gearing. Chapter 4 analyzes the debt risk premium, which is the investors return from corporate bonds in addition to a risk-free return rate. Chapter 5 presents the new level of corporation tax, which is followed by Chapter 6 with a detailed description of how PTS defines the equity risk premium, which is the investors rate from investing in shares in addition to the risk-free return rate. Chapter 7 presents PTS beta analysis and how the calculation is used to determine the beta in the return rate calculation. Chapter 8 is a compilation of the various factors and assessment of an updated return rate. Chapter 9 presents the return rate in a number of European countries. The final chapter provides information on the consultation. The report concludes with a glossary and reference list.

15 2 Risk-free return rates 2.1 Risk-free return rates for treasury bonds The risk-free return rate is the return rate which an investor can expect to gain from investments in financial instruments which do not carry any risk, such as Treasury bonds. 9 But even risk-free investments can lead to various types of risks, such as: Market risk: changes in market return rates Liquidity risks: risks liked to the inability of selling short-term financial instruments In the period, in several southern European countries the return rate on treasury bonds was very high, with financial instability, but the trend has been positive since the end of 2012 with decreasing return rates. In principle, Sweden has been spared the negative effects of the financial crisis and the rate has increased slightly in the past year as a result of increased economic activity and a slightly brighter future expectations. But the inflation remains low and the strength of the global economic recovery is uncertain. Figure 3 10 year treasury bonds return rates October 2011 April 2014 Source: Bloomberg ( ) 9 Treasury bonds with 2, 5, 7 and 10 year maturity

16 Since November 2010, when the last consultation on the return rate took place, the return rate for Swedish 10-year treasury bonds dropped from 2.94% to 2.065% (10 April 2014), however, the rate increased from the lowest level reached in mid The lower return rate on treasury bonds is a result of the increased demand for Swedish treasury bonds, which have been supported by a stable Swedish currency year average PTS has consistently used the return rate on Swedish 10-year treasury bonds as the risk-free rate because the regulation concerns price regulation in Sweden. PTS sees no reason to change this approach because it has strong academic research support. One of the leading theorists in the field, Professor A. Damodaran of the Stern School of Business, believes that there are significant reasons for the risk-free rate to use the same currency as the currency of the cash flows of the actual project and activities: the risk-free rate should be in the same currency in which the cash flows are estimated. This also implies that it is not where a project or firm is located that determines the choice of a risk-free rate, but the currency in which the cash flows on the project or firm are estimated 11 PTS aims to make a decision with a duration of circa three years and at the same time provide a fair level for the following years. In the current return rate calculation the risk-free rate is based on a 7-year average, which bridges an economic cycle and is a way to determine a normalized rate. PTS sees no reason to change this approach and therefore it calculates the risk-free rate as a 7-year average for 10-year treasury bonds. 12 The resulting rate is 2.92 percent, based on data for the January 2007 to December 2013 period Source: Bloomberg, GSGB10YR, Aswath Damodaran, Applied Corporate Finance, Johan Wiley & Sons, 2010, third edition, page In the 2011 consultation PTS developed arguments based on data from the National Bureau of Economic Research (NBER) and the Economic Conjuncture Institute as support to implement a 7 year calculation period. 13 Source: Bloomberg. It is based on one observation per month and the instrument used as calculation basis is GSGB10YR.

17 Figure 4 Return rates for 10-year treasury bonds and a 7-year circulating average 14 Source: Bloomberg International comparison The calculation and application of the risk-free rate varies between different regulatory authorities: Denmark: Denmark uses a return rate on 10-year Danish treasury bonds with a 2 year average and the current risk-free rate is 1.45%. 16 France: Arcep applies a risk-free return rate of 3.7 percent, calculated on a 10 year average for the index (TEC) which is based on 10-year French bonds In the 7-year circulating average the value is seen as a 7-year average and the one calculation per month is further circulated all the time. 15 It is based on data up to and including December 2013, and based on one observation per month. The instrument used in the calculation is GSGB10YR 16 Erhvervsstyrelsen, Afgørelse om den maksimale pris for terminering af taleopkald, terminering af sms samt samtrafikpunkter i TDC s mobilnet i 2014, 16 oktober 2013, 17 Arcep, Decision no of the Regulatory Authority for electronic and post communications dated 29 January 2013 and fixing the capital return rate used for the calculation of costs and tariff control of mobile operators for the period

18 Netherlands: ACM (the former Opta) applies a risk-free rate of 2.62 percent based on a three year average for the 10-year Netherlands treasury bonds. 18 Norway: the Norwegian regulatory authority, NPT, uses a 4.5 risk-free return rate, which includes a real return rate of 2.5% and an assumed inflation at 2.0 percent. 19 Great Britain: Ofcom applies a nominal risk-free return rate of 4.0 percent, which includes an inflation rate of 2.5 percent and a real return rate of 1.5 percent. The premise is that the risk-free rate should be relevant for the regulatory period which is four years and should be based on historical and current data. It is based on the average of 5 and 10-year treasury bonds (gilts). 20 Figure 5 The international level of the risk-free rates Source: Cullen-International, NRA 18 The Brattle Group, The WACC for mobile, fixed-line and cable termination rates, Prepared for OPTA, 15 March Professor Thore Johnsen, NHH, Capital costs for Norse mobile operators, April 2013, available at: 20 Ofcom Wholesale mobile voice call termination, modelling Annexes, 15 March 2011, link

19 2.4 Proposal: 2.92% risk-free rate To summarize, PTS's assesses that the risk-free rate should be based on the return rate on the 10-year Swedish treasury bonds and calculated as a 7 year average. It results in a 2.92% risk-free rate. How big is the effect of the risk-free rates decrease on the return rate? If we simply change the risk-free rate in the current return rate calculation from 3.71 percent to 2.92 percent, the resulting rate is 8.44 percent instead of 9.44 percent, equivalent to a 100 basis points decrease. And if we were to use a current risk-free rate of 3.71 percent instead of the proposed 2.92 percent the return rate would be 8.7 percent instead of 7.8 percent. This means that the lower risk-free rate corresponds to more than half of the return rate decrease.

20 3 The gearing 3.1 Shows the degree of financial exposure Companies use capital and the stock exchange to raise capital. The credit price for enterprises varies depending on the risk assessment of credit institutions, which is affected by the gearing and how the credit rating institutions rate the companies' ability to pay interest and amortizations. The better the credit worthiness of the company the better the credit rating, which strengthens the company s negotiating position in relation to credit institutions, and therefore allows it to achieve lower credit costs. A company's capital structure can be displayed by the gearing, which indicates the degree of systemic risk 21 of a company. The gearing is calculated by dividing the net debt (interest-bearing liabilities minus liquidities) with the enterprise value (the sum of net debts and the company s market value). 22 The gearing = Net debt/(net debt + stock exchange rating) Companies must balance the operational risks with the financial risk exposure, as shown by the division between its own and foreign (borrowed) capital. The lower the gearing, the greater the equity percentage which gives returns. The opposite is a high gearing to a greater percentage of the activities funded with foreign capital, which results in a lower equity capital percentage which the company can use to generate revenue, but which at the same time increases the risk exposure. The average gearing for the comparison group is 35% (in the period), which can be compared with TeliaSonera and Telenor, registering 22% and 20%, respectively, and Tele2 with 12 percent. Some of the major European operators have a gearing over 40%, with Telecom Italia ranking first place with 67%. 21 The systemic risk cannot be diversified away but is a part of the market risk or the economy in its entirety. The non-systemic risk is specific for the project or business activity such as currency, demand, technological risk and can be reduced by taking various measures 22 Enterprise value (EV): is a market value per company plus the net debt (interest-bearing debts minus liquidities)

21 Figure 6 The average gearing in the period Source: Bloomberg For the current calculation of the return rate PTS uses two debt levels at 15 and 35% for low and respectively high debt. In order to simplify the calculation PTS suggests that the authority should use only one gearing in the return rate calculation, and then use the comparison group average for the last five years. Thus, the gearing calculation is in line with the period on which the beta calculation is based on and therefore it provides a value which reduces the risk that it is affected by short-term fluctuations. 23 This leads to simplification and a certain increase since the current calculation is based on two debt levels with an average of 25 percent, and the return rate is an average of the two calculations. PTS sees no reason to use a theoretically optimal gearing in the calculation of the return rate without applying the comparison group average, which reflects what an efficient operator should have. 24 To summarize, the resulting gearing is 35%. 3.2 International comparison Denmark: the Danish Regulatory Authority uses a 0% gearing. 25 France: Arcep uses a 23% gearing The calculation is based on full year data for the period 24 It is consistent with the Ofcom application, see Ofcom, Wholesale mobile voice call termination, modelling Annexes, 15 March 2011, page Erhvervsstyrelsen, Afgørelse om den maksimale pris for terminering af taleopkald, terminering af sms samt samtrafikpunkter i TDC s mobilnet i 2014, 16 oktober 2013,

22 Netherlands: the Regulatory Authority ACM (formerly Opta) uses a 25% gearing, which mirrors the gearing of operators operating in the country. 27 Norway: the Norse Regulatory Authority uses a 20% gearing. 28 Great Britain: Ofcom uses a 30% gearing, based on a Vodafone average for the last two years. 29 Figure 7 The gearing in six countries Source: Cullen-International, NRA 3.3 Proposal: a 35% gearing PTS suggests that the authority should only use a gearing in the calculation of the return rate, and it should use the comparison group average for the last five 26 Decision no of the Regulatory Authority for electronic and post communications dated 29 January 2013 and fixing the capital return rate used for the calculation of costs and tariff control of mobile operators for the period 27The Brattle Group, The WACC for mobile, fixed-line and cable termination rates, Prepared for OPTA, 15 March Professor Thore Johnsen, NHH, Capital costs for Norse mobile operators, April 2013, page 9 29 Ofcom, Wholesale mobile voice call termination, modelling Annexes, 15 March 2011, page 92

23 years. 30 This means that the PTS is proposing that the gearing should be 35 percent in the calculation of the return rate. How does the gearing affect the return rate? If we decrease the gearing to 20 percent and at the same time modify the beta but maintain the debt risk premium unchanged we obtain a return rate of 7.5 percent compared to 7.8 percent in the proposal, and the opposite would be a 50 percent gearing (and a modification of the beta) meaning that the return rate is 8.0 percent. This means that a change in the gearing has a smaller impact on the return rate. 30 The calculation is based on full year data for the period.

24 4 The debt risk premium 4.1 The debt risk premium is the price of the corporate risk This chapter deals with the debt risk premium and the operators cost to raise capital on the credit market. Companies mostly use three different sources of financing: equity, bank loans and corporate bonds. In this chapter we focus on corporate bonds. The debt risk premium is the difference between the risk-free rate, as the return rate on 10-year Treasury bonds and the return on corporate bonds. The calculation is done using treasury and corporate bonds with a similar maturity. 31 The debt risk premium is generally called the "credit spread", which in Swedish can be called the rate difference, and shows the returns, in addition to the riskfree rate, demanded to invest in corporate bonds. In addition to macroeconomic conditions the premium level also depends on the assessment of the companies' financial strength and credit rating by the investors in corporate bonds. The logic is that the lower the credit rating the higher the premium, which consequently means that the return requirement increases for investments in riskier corporate bonds. After the company has issued corporate bonds they are traded on the market, which means that the return rate difference varies over time. 4.2 The comparison group The starting point is represented by the comparison group, presented in Chapter 1.2.1, but all companies which issued corporate bonds or bonds with short maturities are omitted in the calculation of the return rate difference. In addition, the basis also depends on the fact that the bonds must be traded on the market for us to be able to record the prices. 4.3 The credit rating plays an important role The credit rating plays a crucial role in credit pricing, and many investment funds require that the corporate bonds should have a rating for investing in them. This means that generally speaking, companies are required to be reviewed and rated by credit rating institutions, such as Standard & Poor's and Moodys. The level is determined by using a number of parameters, among which the gearing and cash flows are of great importance. The companies in the comparison group are included in the following table which shows the 31 This means that the period remaining before the maturity of the corporate bond is compared with a treasury bond with a similar maturity.

25 different credit rating levels, provided that they have been rated by credit rating institutions. Table 4 Credit rating levels Moodys S & P Description Operator Investment degree: high/ average credit rating Aaa AAA Treasury bonds, maximal security Aa1 AA+ Aa2 AA very high credit rating Aa3 AA- A1 A+ Belgacom (Moodys) A2 A other, average credit rating Belgacom (S&P), Swisscom A3 A- TeliaSonera, Telenor, Vodafone Baa1 BBB+ lower, average credit rating Bouygues, Deutsche Telekom, Orange Baa2 BBB Elisa, KPN (Moodys), TDC, Telekom Austria (Moodys), Telefonica, Vivendi Baa3 BBB- KPN (S&P), Telekom Austria (S&P) Risky: lower/low credit rating Ba1 BB+ Telekom Austria (S&P), Telecom Ba2 BB low degree, risky credit rating Italia, Portugal Telecom, OTE (Moodys), Telekom Slovenije, Vimpelcom (S&P) Ba3 BB- OTE (S&P), Vimpelcom (Moodys) B1 B+ B2 B high risk B3 B- Very risky: high bankruptcy risk Caa CCC Substantial risk Source: Bloomberg (feb 2014) 4.4 Debt risk premium for corporate bonds Corporate bonds are issued with different amounts, maturities and interest rates, depending on the capital needs and investor demand. To reflect the credit costs for long-term investments, as is the case for the investments in mobile networks, PTS uses data for corporate bonds with a maturity of at least five years, and at each measurement point the corporate bonds must still have at least five remaining maturity years. This means that the calculation is based on the capital cost of a company based on long-term financing and in which the time factor, the company s stability and creditworthiness are rated by the capital market. It therefore reflects the situation of operators who invest in the mobile network infrastructure.

26 4.4.1 The existing rate difference The average rate difference 32 for the comparison group in April 2014 was 142 basis points, but with a large spread between the companies. The figures below show the average return rate difference for 17 European operators, based on data for a total of 75 corporate bonds which have at least a remaining maturity of five years. It is a large span of return rate difference from 49 basis points for Swisscom to 338 basis points for Portugal Telecom. Figure 8 Rate differences for bonds with 5-year maturity Source: Bloomberg Average rate differences for the period Based on data for 75 corporate bonds issued by comparison companies which were traded during the period, which means that the calculation includes periods of macroeconomic and financial instability, financial austerity as well as a period of capital expansion. PTS calculated an average return rate difference per company, and then calculated an average for the comparison group. The calculation is based on 196 data points for annual averages which in their turn are based on one observation per month, which means that overall, the 32 The rate difference is taken from Bloomberg and uses their function for the Bloombergs spread to benchmark mid (BLP_SPRD_TO_BENCH_MID), this is a measurement point on the process levels and therefore it is not a teoretical calculated spread. The rate difference is calculated on a comparison with the rate for treasury bonds with similar maturity and in the same currency.

27 calculation of the return rate difference is based on more than 1000 data points. The review shows an average of 205 basis points for the period, with a wide spread in the comparison group. Swisscom has the lowest level at 98 basis points and Portugal Telecom 544 basis points. Figure 9 The average for rate differences Source: Bloomberg Rate differences and credit rating There is a clear correlation between the credit rating and the credit spread. Based on an average of the return rate difference for companies which have the same credit rating, the credit spread is shown in the following figure.

28 Figure 10 Rate differences for various credit rating levels Source: Bloomberg Summarized assessment The summary shows the development of the average rate difference for 75 corporate bonds issued by 17 comparison companies for a maturity period of minimum five years it was 142 basis points in April 2014, for 75 corporate bonds issued by comparison companies with a remaining maturity of minimum five years during the period it was 205 points. In order to also cover financing costs, we are justified in adding 15 basis points for the various types of transaction costs such as fees and incorporation costs for issuing and launching corporate bonds on the credit market. To summarize, this means that it is reasonable to raise the credit risk premium to 220 basis points from the current average level of 150 basis points (125 basis points for low debt respectively 175 basis points for high debt). 4.5 International comparison The debt risk premium for a number of European countries ranges from 0 to 150 basis points.

29 Denmark uses a 0% gearing and therefore a 0% debt risk premium. 33 France: Arcep uses a 70 basis points debt risk premium, which is based on the credit spread for companies with an A credit rating. 34 Norway: NPT uses a 150 basis point debt risk premium. 35 Netherlands: ACM uses a 124 basis point debt risk premium and adds a 15 basis points fee cost, which results in a total debt risk premium of 139 basis points. 36 Great Britain: Ofcom uses a 150 basis point debt risk premium. The level of the debt risk premium is based on the credit spread for Vodafone, Deutsche Telekom, Orange and Telefonica. 37 Figure 11 The international level of the equity risk premium Source: NRA, Cullen-International 33 Erhvervsstyrelsen, Afgørelse om den maksimale pris for terminering af taleopkald, terminering af sms samt samtrafikpunkter i TDC s mobilnet i 2014, 16 oktober 2013, 34 Arcep, Decision no of the Regulatory Authority for electronic and post communications dated 29 January 2013 and fixing the capital return rate used for the calculation of costs and tariff control of mobile operators for the period 35 Professor Thore Johnsen, NHH, Capital costs for Norse mobile operators, April The Brattle Group, The WACC for mobile, fixed-line and cable termination rates, Prepared for OPTA, 15 March Ofcom, Wholesale mobile voice call termination, modelling Annexes, 15 March 2011, page 105

30 4.6 Proposal: the 220 basis points equity risk premium To summarize, the review shows that the equity risk premium has increased since the last consultation in PTS therefore suggests that the equity risk premium should be increased from the current 125 respectively 175 basis points for low respectively high debt levels and set at 220 basis points. How does the increase in equity risk premiums affect the calculation of the return rates? If we use a credit risk premium of 150 basis points instead of 220 the return rate is 7.6 per cent instead of 7.8 percent. And if we only raise the credit risk premium in the current return rate calculation by 70 basis points then the resulting return rate is 9.6 percent instead of 9.4 percent. Overall, it shows that the credit risk premium has a smaller impact on the return rate level. 38 Revised return rate for fixed networks from 2 February 2011, reg. no /2.1.2

31 5 Taxation 5.1 The corporate tax was decreased in 2013 On 1 January 2013 the corporate tax rate was reduced to 22.0 percent from 26.3 percent. 39 In the calculation of the return rate we calculate first a return rate including tax, because the calculation of the debt cost takes into account taxes, and then we calculate the return rate before taxation. This means that the decrease in corporate tax also affects the return rate before taxation. Based on the current return rate, a tax reduction from 26.3 percent to 22 percent would mean a return rate reduced from 9.4 percent to 9.0 percent. And the opposite would be a corporate tax of 26.3 percent instead of 22 percent which means that the return rate is 8.1 per cent instead of 7.8 percent. 39

32 6 The equity risk premium 6.1 Other points of view on the equity risk premium The equity risk premium quantifies the extra return which the investors demand to compensate for the risk of investing in shares, compared with the risk-free assets and shows what the investors do about risk assessment at market level. 40 A central concept in finance theory is that investments with higher risk have higher expected returns than safe investments to be considered good investments. This means that an expected return on investments can be seen as the sum of the risk-free rate and the risk premium in order to obtain compensation for the taken risk. But there are different views within both the theory and the practical application of how the investment risks should be measured, and how the risk measurement should be transformed into an expected return Three methods to determine the premium According to Professor A. Damodaran there is no accurate equity risk premium, only different methods to determine the premium which produce different results. 42 In other words, it is a matter of assessment which Mehra and Prescott have called a puzzle, which indicates that we can have arguments for different levels. 43 Jason Voss, CFA Institute agrees with this opinion and underlines that there is no generally accepted method for calculating the equity risk premium. 44 Most models use historical data or market trends in order to determine the risk premium. The lack of consensus in setting a correct value for the equity risk premium can be explained by the fact that expectations cannot be observed, only estimated. The equity risk premium ex ante refers to the expectations of investors on stock return in addition to the risk-free rate. This is unlike the excess return which returns to the ex post results of the historical returns. 40 William N. Goetzmann and Roger G. Ibbotson, History and the Equity Risk Premium, Yale School of Management 41 Aswath Damodaran, Equity Risk Premiums (ERP): Determinants, Estimation, and Implication and implications A post-crisis Update, October 2009, Stern School of Busienss, Oluwatobi Oyefeso, Would There Ever Be Consensus Value and Source of the Equity Premium? A Review of the Extant Literature, International Journal of Theoretical and Applied Finance Vol. 9, No. 2 (2006) c World Scientific Publishing Company 42 Aswath Damodaran, Equity Risk Premiums (ERP): Determinants, Estimation, and Implication and implications A post-crisis Update, October 2009, Stern School of Business 43 Rajnish Mehra and Edward C. Prescott, The equity premium: A puzzle, Journal of Monetary Economics 1985, 15, Jason Voss, What the equity risk premium tells us today, Financial Times, FTfm, November 7, 2011

33 Unlike the equity risk premium the excess return can be observed. 45 Professor A. Damodaran presents the three methods used to determine the equity risk premium: Implicit price setting: based on market prices of traded assets 2. Historical development: historical stock return in addition to risk-free rates 3. Interview survey: the investors or company managers expectations for the future stock return The equity risk premium can be measured using a geometric or arithmetic average. 47 The geometric mean is calculated as the nth root of the product for n values. It's the excess stock return compared with a risk-free investment, and the arithmetic average is an average of the excess return. The arithmetical average will always be equal to or higher than a geometric average, and in accordance with our experience it is best suited for use in return measurements. 48 Naturally, the various methods are criticized. Professor A. Damodaran believes that the interview method has weaknesses because the premium depends on who asks the question and how the question is asked. There are also weaknesses with the historically based risk premium because the market volatility influences the results Implicit price setting According to a CFA model, which is an interest organization in the financial sector, 50 we use the P/E reverse (which shows the relationship between the price of a share and the return per share) for a current market or index and 45 Oluwatobi Oyefeso, Would There Ever Be Consensus Value and Source of the Equity Premium? A Review of the Extant Literature, International Journal of Theoretical and Applied Finance Vol. 9, No. 2 (2006) , World Scientific Publishing Company 46 Aswath Damodaran, Equity Risk Premiums, Determinants, Estimation, and Implication and implications A post-crisis Update, October 2009, Stern School of Business 47 The arithmetic average is the sum of all results divided by the number of results. The geometrical average is used in work with percentages (which are based on the value), the geometrical average means that the actual invested sums need not be known, the calculation is fully focused on the return itself and presents an "apples to apples" comparison when we look at the two investment alternatives. 48 Dimson, March and Staunton, Risk and Return in the 20th and 21st Centuries, Business Strategy Review 2000, Volume 11 Issue 2, cited in Nera Economic Consulting, The Cost of Capital for KPN s Wholesale Activities, A final report for OPTA, 9 July Aswath Damodaran, Equity Risk Premiums, Determinants, Estimation, and Implication and implications A post-crisis Update, October 2009, Stern School of Business 50 The CFA Institut works to develop the finance sector and to have it apply the highest possible ethical and professional levels, see

34 then subtract the risk-free rate. 51 For the Swedish Stock Exchange a P/E of OMX 30, which includes the 30 most traded stocks on the Stockholm Stock Exchange, for 2012 is 13.8 and takes its reverse calculating the risk-free rate then the equity risk premium is 5.7 percent. In the equivalent calculation for 2013, which has a P/E of 17.0, the equity risk premium is 3.7 percent. 52 It shows that with the sharply rising stock exchange prices the valuation is increasing and the return requirement is decreasing, if not the return, while increasing with the corresponding rate. Table 5 The calculation of the equity risk premium (CFA) Funds P/E for OMX P/E reverse 8.3% 10.0% 5.1% 7.0% % 5.9% Risk-free rate 4.2% 3.8% 3.3% 2.9% % 2.1% (10-year treasury bonds) The equity risk 4.1% 6.1% 1.8% 4.2% 4.8% 5.7% 3.7% 4.4% premium Source: Bloomberg, CFA Bloomberg applies a two step calculation of the equity risk premium. First, it calculates the expected market return based on forecasts for profit growth, dividends and stock values. The risk-free rate is then subtracted from the market return to obtain the risk premium for a specific country, which in this case is Sweden. In the second step of the calculation the beta is multiplied by the risk premium which gives us the equity risk premium. Based on Bloomberg's calculations for Sweden with an average of market returns for the period, the risk-free rate is calculated as risk premium for Sweden with which the beta is multiplied. The beta is based on a TeliaSonera and Tele2 average. This results in a equity risk premium of 5.6 percent. Table 6 The calculation of the equity risk premium(bloomberg) Funds Expected 10.8% 9.2% 9.2% 13.9% 9.8% 10.2% 9.7% 10.4% market return Risk-free rate 4.0% 2.4% 3.3% 3.3% 1.6% 1.5% 2.5% 2.9% Country risk 6.8% 6.8% 5.9% 10.7% 8.2% 8.6% 7.2% 7.7% premium Beta* 0.72 Equity risk premium 5.6% Source: Bloomberg. * Beta is calculated for Tele2 and TeliaSonera with OMX 30 as index in the period 51Jason Voss, What the equity risk premium tells us today, Financial Times, FTfm, November 7, Source Bloomberg February 2014

35 6.4 Historical analysis to determine the equity risk premium The second way to determine the equity risk premium is to use the historical returns by determining the difference between the annual return on stocks compared to treasury bonds. 53 Credit Suisse calculates an equity risk premium of 4.8 percent for the period, measured as the stock result compared with Treasury bonds. 54 Dimson, Marsch and Staunton s use a historical method based on stock price development on the world's largest markets. 55 In their 2011 update they assess the global equity risk premium to 3.8 percent. Dimson, Marsh and Staunton calculates an equity risk premium for Sweden with an arithmetic average of 6.1 percent, based on long-term treasury bonds. 56 Damodaran has calculated the historical equity risk premium for the period, resulting in an arithmetic average on 5,79 percent, but based on the period it reached 3.36 percent. Based on data for Sweden Damodaran calculated a 5.8 percent arithmetic average for the period. 57 Tomas Sörensson at the department of Industrial Economics at KTH has analyzed the equity risk premium on the Swedish stock market. 58 Sörensson analyzed data for the period and the arithmetic average is 5.9 percent based on stock returns minus the risk-free rate in the form of 10-year treasury bonds Aswath Damodaran, Equity Risk Premiums (ERP): Determinants, Estimation, and Implication and implications A post-crisis Update, October 2009, Stern School of Business 54 Credit Suisse, Credit Suisse Global Investment Returns Yearbook 2011, Research Institute, February Dimson, Marsch and Staunton, Global Investment Returns Yearbook Elroy Dimson, Paul Marsch and Mike Staunton, Equity Premia Around the World, London Business School, 19 July Aswath Damodaran, Equity Risk Premium (ERP): Determinants, Estimation and Implications The 2012 Edition, updated March Tomas Sörensson, The Equity Risk Premium on the Swedish Stock Market, Royal Institute of Technology, Industrial Engineering and Management, second draft The stock return is calculated using the standard definitions established by Ibbotson and Sinquefield. Ibbotson, R., G. and Sinquefield, R.A., SBBI Yearbook, Ibbotson Associates, Chicago 1989

36 6.5 Interview surveys During the past decade Graham and Harvey have conducted annual interviews with financial executives and company managers to examine what the financial executives consider to be a reasonable equity risk premium for the next ten years. In their 2012 study the authors find that the risk premium rose sharply during the financial crisis and reached a peak in February 2009, and then decreased in the second quarter of Their latest study suggests that the risk premium has increased, near levels it reached during the financial crisis, and for the first quarter of 2012 the equity risk premium reached 4.48 percent. 60 PriceWaterhouseCoppers does an annual survey on market premiums on the Swedish stock market. 61 It is based on responses from stakeholders working with portfolio management, transaction counseling and stock valuation. The report published in March 2013 showed that the risk premium has increased by 0.2 percentage points in comparison with 2012 and reached 6.0 percent. Figure 12 The equity risk premium in Sweden Source: PriceWaterhouseCoopers 6.6 Summarized assessment The review shows a large range of the equity risk premium from 3.4 percent to 6.1 percent. PTS is of the opinion that it is justified to put the greatest 60 John R. Graham, Campbel R. Harvey, The Equity Risk Premium in 2012, SSRN working paper PriceWaterhouseCoopers. The risk premium on the Swedish stock exchange, study in March 2013,

37 emphasis on PWC s interview survey because it reflects the investors ' current views on the risk premium for investing in stocks. All the examples are presented in the table below in order to apply a structured approach, the table presents a weighted average. We have assigned a value of 40 percent for PWCs interview survey and distributed the remaining 60 percent on other variables. The reason for this division is that the PTS deems it reasonable to weigh several different methods and data sources to determine the risk premium, while the PWCs survey provides a useful picture of how investors view the risk premium. Table 7 Weighted average of the equity risk premium Value Weight Percentage (value*weight)*100 CFA 4.4% 6.0% 0.26 Bloomberg 5.6% 6.0% 0.34 Credit Suisse 4.8% 6.0% 0.29 World DMS 3.8% 6.0% 0.23 Swedish DMS 6.1% 6.0% 0.37 Damodaran 5.8% 6.0% 0.35 Damodaran 3.4% 6.0% 0.20 Damodaran 5.8% 6.0% 0.35 Sörenssen 5.9% 6.0% 0.35 Graham Harvey 4.5% 6.0% 0.27 PWC 6.0% 40.0% 2.40 Weighted average value 5.40% 5.40% It results in a weighted average of 5.40 percent, which is slightly lower than the value PTS reported in the consultation for the return rate for the fixed networks on 03 June PTS overall assessment is that it is justified to round it to 5.50 percent, which according to PTS's assessment reflects current market conditions in a reasonable manner and is the same equity risk premium which is used for the fixed networks. 6.7 International comparison In Europe the equity risk premium for mobile networks ranges from 3.85 percent to 5.0 percent in the Netherlands. Denmark: the Danish authority applies a 3.85 percent equity risk premium. 62 France: Arcep applies a 5.0 percent equity risk premium Erhvervsstyrelsen, Afgørelse om den maksimale pris for terminering af taleopkald, terminering af sms samt samtrafikpunkter i TDC s mobilnet i 2014, 16 oktober 2013,

38 Netherlands: the regulatory authority applies a 5.0 percent equity risk premium. It is based on an average of both the geometrical and arithmetical average of the stock returns premium in relation with the bonds during the period in 13 European countries. 64 Norway: NPT applies a 4.5 percent equity risk premium based on an assessment of the range of the excess stock returns of 3-6 percent. 65 Great Britain: Ofcom bases its assessment of the equity risk premium at 5.0 percent among other on the work of Professors Dimson, March and Staunton with the London Business School as well as on a comparison with other national regulatory authorities and the Competition Commission. 66 Figure 13 The equity risk premium Source: NRA, Cullen-International 6.8 Proposal: 5.50 percent equity risk premium PTS overall assessment is that the return requirement on stock investments has increased since and based on the review and analysis considers 63 Arcep, Decision no of the Regulatory Authority for electronic and post communications dated 29 January 2013 and fixing the capital return rate used for the calculation of costs and tariff control of mobile operators for the period 64 The Brattle Group, The WACC for mobile, fixed-line and cable termination rates, Prepared for OPTA, 15 March Professor Thore Johnsen, NHH, Capital costs for Norse mobile operators, April Ofcom, Wholesale mobile voice call termination, modelling Annexes, 15 March 2011

39 that a 5.50 percent is an appropriate level of equity risk premium, which means an increase from the current level of 5.00 percent. What does the increase in the equity risk premium mean for the proposed return rate? If the equity risk premium would be maintained unchanged at 5.00 percent, the proposed return rate would be 7.4 percent instead of the proposed 7.8 percent. It shows that a large part of the change in the equity risk premium influences the return rate.

40 7 Beta indicates the stock risk 7.1 Beta is the market risk The financial market theory using the CAPM model 67 takes into account the asset's sensitivity to non-diversifiable risk, called the systematic risk or market risk. It is represented by the beta, which is a measure of the stock's risk in relation to the entire stock market and thus represents the risk which the portfolio manager must handle. Beta measures the degree of correlation between the volatility 68 of a particular stock, and the entire market in the form of an index. 69 Beta is a function of the expected return on a company's stock in relation to a market index, and the extent in which the company's expected return is correlated with the expected return of the market index. A beta of 1 indicates that the risk of a specific stock is equal to the market risk, and a beta greater than 1 indicates that the risk is greater than the market risk. Stock with a beta less than 1 have less risk than the entire market. The principle used by fund managers is that stocks with higher betas will generate bigger returns because they contribute to an increased portfolio risk. The theory behind the CAPM stresses that the beta should be calculated on the stock price performance over a full business cycle in order to avoid temporary market fluctuations. The beta value is calculated by applying a linear regression using the decreasing squares method to find the best fitting line between a dependent variable and one or more independent variables. The stock price return for a company is the dependent variable and the market portfolio return is the independent variable in a linear regression analysis: Formula 1 To calculate the beta Y = a + bx where: Y = taxed value of the company s stock return a = Alfa value which indicates the intersection where X is zero 67 CAPM (Capital Asset Pricing Model): Ea=rf+β(Em-rf); where: Ea = expected results from specific stock; rf = risk-free rate; β = beta value; Em = expected results from a market portfolio 68 The volatility describes how much the price of a financial asset changes or varies. The greater the asset value the higher the volatility. The volatility is usually measured as a standard divergence from the asset result. Source 69 Model introduced by Jack Treynor (1961, 1962), William Sharpe (1964), John Lintner (1965) and Jan Mossin (1966).

41 b = Beta value of the company s stock return X = a value for the market portfolio result 7.2 Method questions To calculate the beta used in the calculation of the return rate PTS poses seven questions 1. Which companies (stock) are included in the comparison group? 2. Which index should be used? 3. Which time period should be used to calculate the beta? 4. Should the beta be modified to better reflect future risks? 5. How should the gearing be eliminated from the beta? 6. How is the asset beta determined? 7. How should the beta be back taxed? Below we present PTS view on the questions and choices of the authority in beta calculations Comparison companies European operators PTS uses a comparison group consisting of 22 companies which own mobile networks in Europe, which are presented in chapter The comparison index the MSCI World Index PTS calculates the return rate using an international perspective and therefore uses the MSCI World Index as a benchmark. 70 The index principles are based on the MSCI Global Investable Market Indicies methodology. 71 The index makes no adjustment of the underlying stock price if dividends are paid. The index uses the market price which is determined by supply and demand to calculate the index price. 72 PTS deems it reasonable to base the analysis on the MSCI World Index since it is established on the stock market, used by other regulatory authorities, shows the evolution on the international stock market and PTS has used it in previous return rate calculations. 70 MSCI World is a stock weighted index based on 1500 shares on developed markets in 23 countries: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, Netherlands, New Zeeland, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, Great Britain, USA. Source: 71 For more information see: 72 Source: Bloomberg

42 7.2.3 Beta is calculated as a 5-year average The present application to calculate the return rate measures the movements in stock performance over five years, with one measuring point per week. The extent in which the historical data reflects the future risk is debatable, it is underlined by the operators' activities and is under varying degrees of pressure for change. It could tell us to use a shorter period of time in order to better reflect the later years developments. However, an argument against this approach is the fact that the calculation must reflect the developments over a period of time. PTS therefore sees no reason to change the calculation period and therefore uses five years for beta calculation and also to calculate the gearing which is used to clear beta for the gearing. PTS has not made any modifications to the rate changes due to dividends Beta modification In the most recent return rate calculation PTS chose not to operate any historical beta modifications. 73 PTS has, however, taken into account the research in this field and therefore suggests that the beta should be modified according with Blume s theory. Blume s theory states that the beta should be modified to better reflect the future risk because over time the beta moves towards an average. 74 According to M. Gangemi Blume s research work focused on the issue of the stability of beta estimates, and what is referred to as Blume s mean reversion tendencies that beta exhibits. 75 Hawani underlines that the beta coefficient must be stable in order to provide representative estimates, and shows how the individual asset beta can be weakly estimated for future beta estimates. Hawani, however, stresses that the quality of the estimates increases with the number of shares in the portfolio. 76 Fernandez presents a number of aspects which mean that the beta calculations on historical data include uncertainty. It underlines that the beta changes from day-to-day, that the beta is affected by which index is used, the period which forms the basis for the calculation, that the relative beta magnitude is 73 See page 48, PTS, Proposal for revised return rate for fixed networks Consultation II, , Dnr / Blume, M.E. On the Assessment of risk, Journal of Financial, 26, M Gangemi, Robert Brooks, Robert Faff, Mean reversion and the forecasting of country betas: a note, Global Finance Journal 10:2, 1999, Is Adjusting Beta Estimates an Illusion? Gabriel A. Hawawini and Ashok Vera, The Journal of Portfolio Management Fall 1983, Vol. 10, No. 1: pp

43 questionable, and that high risk companies often have a calculated beta lower than lower risk companies. 77 Bloomberg makes a modification to the beta which is based on historical data, but it is modified based on the assumption that over time a stock's beta moves towards the market average of 1. Modified Beta 78 = (0,67)*beta + (0.33)*1.0 In line with Bloomberg the PTS modifies the beta which is obtained using regression analysis, and the modification is done before the beta is cleared for debts, to what might be called the asset beta Clearing the beta for debts Most operators have a net debt which includes both the stock beta and the corporate risk and financial risk. It is therefore justified to separate the corporate risk, which is common to all operators, from the financial risk and convert the stock beta affected by the gearing to a beta cleared for debts, which is referred to as the asset beta. Two questions can be asked here. First there is the question whether one should take into account the national tax rate in the calculation of the asset beta, and then there is the question of how the calculation is to be carried out. According to Fernandez 79 there are different ways to calculate taxes in calculating the asset beta. The issue of the so-called tax shield (tax shields), that the increased levels of debt with interest payments will reduce the actual level of taxation, is an essential element of corporate rating which was presented by Modigliani-Miller in the 1950s. PTS applies the method Fernandez calls "Practitioners", which is widely used by investment banks and consultancies with reference to Ruback 80 and does not take into account the national tax rate. The reason is the fact that the companies' average tax rate can vary depending on the accounting and various types of tax modifications, which means that the application of national tax rates is likely to distort the results. In the calculation of the asset beta PTS therefore applies the formula which Fernandez calls the Practitioners. 77 Pablo Férnandez, Beta used by professors: A survey with 2500 answers, IESE CIIF, Business School, University of Navarra, Working Paper, WP-822, September, Bloomberg uses this formula. It is also presented in The Cost of Capital for KPN s Wholesale Activities, A Final Report for OPTA, 9 July 2012, NERA Economic Consulting 79 Pablo Fernández, Levered and Unlevered Beta, Working paper no 488, January 2003 (Rev May 2006), IESE Business School, University of Navarra 80 R. Ruback, A Note on Capital Cash Flow Valuation, Harvard Business School, , 1995

44 Formula 2: Beta cleared for debt Source: Fernández Where BU is beta cleared for debts, asset beta. E is the market value of the company, which is calculated by multiplying the number of shares with the stock exchange price. (E + D) is the enterprise value, which is calculated by adding the net debt and the market value. The enterprise value is then divided by the share value. BL is the beta including the gearing Calculating the asset beta Based on the share price performance of the comparison group in relation to the MSCI World Index in the period, resulting in an average beta of 0.66, called raw stock beta in table By operating a modification in line with Blume s theory the modified beta becomes By calculating the gearing according to the formula as presented in the previous paragraph, which is 0.65 for the comparison group, PTS can eliminate the gearing from the beta and obtain the asset beta for the comparison group. Table 8 shows that the asset beta for the comparison group is Because PTS calculates a return rate in an international context, it is therefore justified to use the average of the comparison group The beta gearing The next step is to calculate the beta based on an asset beta of 0.50 using an average gearing of 35 percent for the comparison group. PTS applies what Fernandez termed the "Practitioners" method. With a 35%, gearing, the ratio of foreign and private capital at 35 in debt results in a 65 ratio in equity, which represents a financial leverage of 0.54 (35/65). Formula 3 The beta gearing 81 Data from Bloomberg. Several modifications were operated in the calculation for dividends or former data which is different. The formule to be used is Excel and is named Banking and calculates the regression line. According to Microsoft the formule is: Return banking of a liniar regression line by means of data points in known_y and known_x. Banking is the vertical distance divided by the horizontal distance between the two points on the line, which corresponds to the change rate together with the regression line.

45 By multiplying the 0.54 ratio by the asset beta of 0,50 we have a value of 0.27, which is then added to the 0.50 asset beta. This results in a debt inclusive beta of Table 8 Beta calculation Company Tick Raw share Modified MV/BV* Asset Gearing *% Its own Beta beta share beta beta capital % Belgacom BELG BB Bouygues EN FP Group Deutsche DTE GY Telekom Elisa ELI1V FH Iliad ILD FP KPN KPN NA Mobistar MOB BB Orange ORA FP OTE OTE GR Portugal PTC PL Telekom SonaeCom SNC PL Swisscom SCMN VX Telecom TIT IM Italia Telefonica TEF SM Telekom TKA AV Austria Telekom TLSG SV Slovenije Telenor TEL NO Tele2 TEL2B SS TeliaSonera TLSN SS TDC TDC DC Vimpelcom VIP US Vivendi VIP FP Vodafone VOD LN Average *MV= market value, BV= enterprise value, debt/ gearing= degree of debt Source: Bloomberg, PTS calculations 7.3 Summarized assessment To summarize, the examination of beta calculation means that PTS sees a support to set the asset beta at 0.50 and based on a 35 percent gearing, the resulting beta is International comparison Denmark: the Danish authority applies a 0.50 asset beta in the calculation of the return rate and is based on the performance of the

46 stock in relation to the MSCI World Index over a period of five years. Because Denmark applies a 0% gearing the stock beta is also France: Arcep uses a 0.8 asset beta and a 1.04 debt-inclusive beta. 83 Netherlands: the regulatory authority uses a 0.49 asset beta and a 0.61 debt-inclusive beta. It is based on the average for a comparison group made up of Vodafone, Mobistar, Sonaecom and Telenor. 84 Norway: the regulatory Norse authority (NPT) uses a 0.90 asset beta, which with a 20% gearing results in a debt-inclusive beta it is based on the assessment of the relevant level for the mobile operators in Norway and on the stock rate development in relation to the MSCI World Index. 85 Great Britain: Ofcom believes that the asset beta should be set at 0.56, based a range between 0.5 and Ofcom calculates the beta as a 2- year average with one observation per day and uses the FTSE Allshare Index 86. In the beta calculation it uses a 2-year average gearing, which is 30 percent and therefore obtains a debt-inclusive beta of Erhvervsstyrelsen, Afgørelse om den maksimale pris for terminering af taleopkald, terminering af sms samt samtrafikpunkter i TDC s mobilnet i 2014, 16 oktober 2013, 83 The Arcep decisions, Decision fixing the capital return percentage used for the calculation of costs and tariff control of the regulated activities of France Telecom for the year 2012, 22 December The Brattle Group, The WACC for mobile, fixed-line and cable termination rates, Prepared for OPTA, 15 March Professor Thore Johnsen, NHH, Capital costs for Norse mobile operators, April FTSE All-share index is a market valued weighted index which consists of the FTSE 350 and FTSE Small cap index with companies listed in London. 87 Ofcom, Wholesale mobile voice call termination, modelling Annexes, 15 March 2011, pages

47 Figure 14 Beta in an international comparison Source: NRA, Cullen-International 7.5 Proposal: 0.77 beta PTS overall assessment is that beta (including debt) should be set at It is based on an asset beta of 0.50 and a 35 percent gearing. This means an asset beta decrease from the current rate of 0.64 and a debt-inclusive beta of 0.75 for a 15% debt level and 0.98 for a 35% debt level. What is the effect of the asset beta difference on the return rate? If we apply an asset beta at 0.64 and a 35% gearing the rate of return is 8.7 percent instead of 7.8 percent. And based on the current return rate the asset beta would be 0.50 and the debt-inclusive beta 0.59 respectively 0.77 based on a 15 gearing level respectively 35 percent would result in a return rate of 8.5 percent instead of 9.4 percent. To summarize, this means that the beta has a significant effect on the calculation of the rate of return.

48 8 Summarized assessment The rate of return determined by PTS is a parameter of the mobile model which is later modified based on the inflation so that a real return rate is used. The review of the parameters used for the calculation of the return rate and the proposals reported by PTS indicate some changes in relation to the current level, which is presented in brackets below. The report has dealt with the following parameters and proposed: Risk-free rate: Based on the rate of the 10-year maturity Swedish treasury bonds and is calculated av a 7-year average. The resulting rate is 2.92 percent (3.71 percent) Gearing: The proposal suggests to use only one gearing in the calculation of the rate of return and then use the average for the comparison group for the last five years. This results in a 35% gearing in the calculation of the rate of return (15 and 35 percent for low respective high gearing) Debt risk premium: because the debt risk premium has increased since 2010 PTS proposes that the debt risk premium should be increased from the current 125 respectively 175 basis points for low respectively high gearing, and set at 220 basis points for a 35% gearing. Tax: The corporate tax was decreased on 1 January 2013 to 22.0 percent from 26.3 percent. Equity risk premium: in PTS assessment the return requirement on stock investments has increased compared to the time when the rate of return was set and it proposes that the equity risk premium should be increased to 5.50 percent (5.00 percent). Beta: PTS overall assessment is that the beta (including debts) should be set at It is based on a 0.50 asset beta and a 35% gearing. This represents a decrease from the current 0.75 and 0.98 for low respectively high gearing. Rate of return: to summarize this means that the rate of return is 7.8 percent (9.4 percent). The table below briefly presents the various factors.

49 Table 9 Compilation of the various parameters Risk-free return rate Gearing Debt risk premium Taxation Equity risk premium Beta cleared for debts Beta including debts Trend Existing 3.71% 15%/35% 125/ % 5.00% /0.98 Comments Strong Swedish currency and economy The operators gearing has increased slightly, Significant variations, financial insecurity and increased country Lower corporation tax in 2013 Increased return requirements, increased Average for the comparison group 2011 method 2014 method 2014 updating Sensitivity analysis existing average risk insecurity 7 year average 5 year average Present situation PWC and other sources 7 year average 5 year average Average for the PWC and other comparison group in 5 sources. years Weighted 5 year average 5 year average+ Blume modifications average 2.92% 35% % 5.50% 0.50% 0.77 The decrease clarifies more than half the decrease The modification has lower significance for the return rate The increase has a limited significance for the return rate Significance importance for the return rate The increase has great significance for the return rate The decrease has a significant effect on the return rate Based on the various variables which are included in the calculation of the return rate in accordance with CAPM this means that PTS suggests that the return rate should be set at 7.8 percent, which represents a decrease from the current 9.4 percent. Table 10 Proposal for the updated rate of return Return rate Risk free rate 2.92% Debt risk premium 2.20% Debt costs 3.99% Risk free rate 2.92% Equity risk premium Beta 5.50% 0.77 Costs for its own equity 7.15% Gearing 35.0% Taxation 22.0% WACC after taxation 6.05% WACC before taxation 7.8%

50 8.1 From nominal to a real rate of return The calculation of the rate of return which in this proposal is 7.8 percent before taxation is the nominal rate of return. It is later modified in the mobile model where it is used as the discount rate. Based on a 2.0 percent inflation we obtain a real rate of return of 5.7 percent The calculation is the following: (1+7,8%)/(1+2,0%)-1. The real rate of return in the current mobile model is 7.3%, which is calculated as follows (1+9,44%)/(1+2,0%)-1

51 9 International comparison 9.1 Significant variations in the rate of return The review has shown that the level of the factors in the calculation of the return rate varies between the countries we investigated. Part of the explanation is that these analyses are published at different times and are not updated in two to three years. The return rate level (nominal and before taxation) for mobile networks ranges from 4.5% in Denmark to 11.8 percent in Norway, which results in an average of 9.0 percent for those countries listed in the following figure. This means that in PTS proposal, Sweden is placed below the European average. Figure 15 The rate of return in 13 European countries Källa: Cullen International, NRA Danmark: Erhvervsstyrelsen, Afgørelse om den maksimale pris for terminering af taleopkald, terminering af sms samt samtrafikpunkter i TDC s mobilnet i 2014, 16 oktober 2013, Netherlands: The Brattle Group, The WACC for mobile, fixed-line and cable termination rates, Prepared for OPTA, 15 March Great Britain: Ofcom, Wholesale mobile voice call termination, modelling Annexes, 15 March 2011, pages Norway: Professor Thore Johnsen, NHH, Capital costs for Norse mobile operators, April 2013 For the other countries the data is taken from Cullen-International which presents data for decisions according to the following: Finland 2 May 2013, Francee 29 Jan 2013, Austria 30 Sept 2013,

52 10 Invitation to communicate points of view Those who want to communicate their points of view on the proposal for the updated rate of return can do so in writing to PTS at the following address: before 9 May The answer will be published on the PTS web-site. If you believe that your comments contain information subject to confidentiality, please mark the information in question and specify the reasons for the confidentiality request. PTS will make an independent assessment of the information covered by the confidentiality obligation before an answer is published on the PTS website. If you have questions regarding the consultation, please contact: Mattias Wellander, or [email protected]

53 Glossary Equity risk premium (Equity Risk Premium): the return which a stock, or the entire stock market provides over the risk-free rate. The premium replaces the investors to have a relatively higher risk for investing in shares, compared with investing in risk-free assets. Beta: the Beta is a coefficient which measures the degree of correlation between price movement/returns on shares in a particular company and the price movement/return on the entire market or index. This means that the higher the beta of a company, the greater the systemic risk. A beta of one indicates that the risk is equal to the market risk. Enterprise value (Enterprise value): this is the market value (the number of shares multiplied by the share price) for a company plus the net debt (interestbearing liabilities less liquidities). CAPM (Capital Asset Pricing Model): It is a model used to calculate a company's capital costs. The method provides the tools to create optimal portfolios of risky assets, the so-called portfolio theory. Debt risk premium (Debt Risk Premium): the Premium is the difference between the risk-free rate and the return of the company stock. To make the comparison correctly the treasury and company bonds must have the same maturity. The premium is often called credit spread, or rate difference. Net debt (Net Debt): Interest-bearing debts minus liquidities. Risk-free rate (Risk free rate): It is the return rate which an investor can expect to gain from investments in financial instruments which do not have any risk, such as Treasury bonds. Gearing (Gearing): Net debts (interest-bearing liabilities minus liquidities) divided by the enterprise value (market value plus net debt). WACC (Weighted Average Cost of Capital), or in Swedish the average weighted cost of capital (return rate): WACC consists of two parts, one is the debt cost and the other is the cost of capital. In addition there is gearing and taxes.

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