[Federal Register Volume 61, Number 47 (Friday, March 8, 1996)]
[Proposed Rules]
[Pages 9411-9413]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-5426]
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FEDERAL COMMUNICATIONS COMMISSION
47 CFR Part 76
[MM Docket No. 93-215; FCC 95-502]
Cable Television Rate Regulation; Cost of Service Rules
AGENCY: Federal Communications Commission.
ACTION: Proposed rule.
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SUMMARY: The Commission adopted the Second Report and Order and First
Order on Reconsideration in MM Docket 93-215 to refine existing cost of
service rules and to create final rules governing standard cost of
service showings filed by cable operators seeking to justify rates for
regulated cable services. In a Further Notice of Proposed Rulemaking
[[Page 9412]]
(``FNPRM''), the Commission proposes use of an operator's actual debt
cost and capital structure to determine the final cost of capital (or
rate of return). The FNPRM requests comment regarding the method to
determine the value of equity and debt, including the use of a market
valuation of equity to establish the proportion of equity in an
operator's capital structure.
DATES: Comments are due May 7, 1996. Replies are due June 6, 1996.
FOR FURTHER INFORMATION CONTACT: Tom Power, Cable Services Bureau,
(202) 416-0800.
SUPPLEMENTARY INFORMATION: This is a synopsis of the Further Notice of
Proposed Rulemaking in MM Docket No. 93-215, FCC 95-502, adopted
December 15, 1995 and released January 26, 1996.
The complete text of this Further Notice of Proposed Rulemaking is
available for inspection and copying during normal business hours in
the FCC Reference Center (room 239), 1919 M Street, NW., Washington,
DC, and also may be purchased from the Commission's copy contractor,
International Transcription Services, Inc. (``ITS Inc.'') at (202) 587-
3800, 2100 M Street, NW., Suite 140, Washington, DC 20017.
I. Further Notice of Proposed Rulemaking
A. Non-Unitary Rates of Return
1. Although a unitary rate of return applied to all cable operators
simplifies the administrative burdens of estimating an operator's rate
of return, it squeezes a wide variety of risk profiles into the same
regulatory box. We tentatively conclude that risk variables among cable
operators may be sufficiently widespread to justify consideration of an
alternative rate of return methodology tailored more closely to the
financial circumstances of individual cable operators. At the same
time, we recognize the risk that individualized rates of return could
involve highly detailed and potentially burdensome capital cost
determinations in rate cases. Thus, if we adopt a more tailored rate of
return methodology, we will nonetheless retain the current presumptive
rate, and its concomitant procedures for overcoming that presumption,
as an alternative to any new methodology.
2. The capital markets have recognized a significant measure of
risk within the cable industry. Cable stocks trade at significant
premiums relative to the overall equity market and cable companies
often have high debt costs due to low investment grades. In addition, a
fair proportion of homes passed by cable do not subscribe to the
service, suggesting consumers and businesses do not regard cable as a
traditional utility service. We believe it may be necessary to
recognize such risk diversity in the cable industry and no longer
presume that a single rate of return should be applied to all cable
operators making cost of service showings. We seek comment on an
alternative to the presumptive 11.24% rate of return. This alternative
would provide an equity cost estimate that recognizes the historic
growth orientation of cable investors and would allow actual debt cost
and use company specific capital structures.
B. Cost of Equity
3. We propose to use the capital asset pricing model (``CAPM'') as
a method to estimate the cost of cable equity as an alternative to the
discounted cash flow (``DCF'') approach used in the initial Cost Order,
59 FR 17975 (April 15, 1994). As a general matter, the DCF method
relies heavily on the consistent payout of dividends as a key part of
its formula, a factor that does not apply generally to equities. The
absence of dividends may reflect fundamental differences in the
strategic nature of cable business operations and the operation of
companies whose stocks make up a broad stock index such as the S&P 400.
A formula designed to measure a future dividend or income stream may
not be an appropriate model for estimating the rate of return demanded
by investors who are willing to forgo an income stream in favor of
growth through reinvested cash flow. The CAPM attempts to quantify the
risk necessary to induce an investor to follow this kind of growth-
oriented strategy. Under CAPM, equity cost is calculated by assigning
an equity premium to a company's stock that is commensurate with the
stock's systematic risk (risk that cannot be avoided through equity
diversification). Under this model, a stock's equity rate of return is
equal to the risk-free rate (obtainable on a risk-free government debt
instrument) plus a premium based on the systematic risk of a given
security (the beta).
4. The Commission, in the Cost Order, decided against using the
CAPM to determine equity cost due to concerns that insider holdings and
monopoly profit expectations would distort the measurement of risk
associated with providing regulated cable services. Based on data
submitted in response to the Further Notice, we tentatively conclude
that it is unnecessary to reject alternative methods of measuring
equity cost. The Commission's initial decision to forgo the use of the
CAPM stemmed from a concern that insider decisions could overstate the
size of the risk premium assigned to cable stocks under the CAPM. A
systematic review of the relationship between insider holdings and
movements in stock price, however, was not conducted and data submitted
in response to the Further Notice, do not support the assertion that
cable insiders exaggerate the stock prices of their companies.
5. In addition, with respect to monopoly expectations in cable
stock prices, we do not have sufficient data to determine the extent of
the relationship, if any, between the existence of monopoly power and
the stock price volatility premium assigned to cable company stocks.
6. In establishing an equity cost for cable companies, we propose
to rely on data from the cable industry itself rather than forgo such
direct evidence of industry cost in favor of some other surrogate
industry or stock group. In the Cost Order, we developed an equity cost
estimate based on a selected quartile of the S&P 400. As set forth
above, however, we do not believe it necessary to eschew reliance on
betas of publicly-traded cable stocks as part of the cable equity cost
calculation. Using data submitted to the Commission in response to the
Further Notice, the Commission examined betas for 11 cable companies
that derive the vast majority of their revenues from regulated cable
services. Recognizing that cable industry investment in recent years
has focused on long term revenue potential from unregulated services,
we have limited our analysis of betas to the years 1987 through 1992.
Based on data submitted to the Commission, the average beta for cable
industry equity investment is 1.42. This indicates that, on average,
cable equities are 42% more volatile than the general stock market.
7. Because we propose to examine an investment period of several
years, we propose to use the risk-free rate of the average yields on
five-year U.S. Treasury Notes after 1987. Based on Federal Reserve
data, the average yield on five-year U.S. Treasury Notes from 1987
through the third quarter of 1995 is 7.27%. Although this yield exceeds
the current yield on five-year notes, this figure is an average that
accounts for numerous rate fluctuations over an extended time period.
We believe an average risk-free rate may be appropriate for selecting a
cost of equity for cable because the equity cost estimate would be
relied upon in cost of service filings for at least the period
preceding an operator's next major rate filing.
[[Page 9413]]
Moreover, we proposed to update this rate to account for subsequent
interest rate changes.
8. Consistent with the CAPM approach, we estimate the average
return on investment in the general equity market. Using the S&P 500
from 1987 through the third quarter of 1995, the average compounded
return has been 13.53%. Applying the CAPM formula, the general equity
market premium above the risk-free rate of return is 6.26% (13.53%-
7.27%). The 1.42 beta for cable equity investment multiplied by 6.26%
provides a cable equity premium of 8.89 percentage points above the
average risk-free rate. Adding the risk-free rate to the cable equity
premium results in an equity cost figure of 16.16%. We propose that the
average cost of equity for investment in cable operators providing
regulating cable services is 16.16%. We propose to adjust the figures
used to estimate the equity cost periodically. We ask comment on this
approach.
9. We also request comment on a method that would, consistent with
the goal of maintaining administrative feasibility, adjust the equity
cost to reflect extraordinary financial risk. For example, should the
Commission consider debt-to-cash flow multiples as a mechanism to
quantify risk levels? We solicit data to establish equity cost figures
above and below the proposed 16.16% average equity cost estimate for
operators with debt burdens significantly above and below the average
in our sample.
C. Cost of Debt
10. The other principal component of the overall cost of capital is
the cost of debt. In the Cost Order, we relied on debt cost estimates
for the cable industry specifically and concluded that the range for
the average cost of fixed rate debt established by information
submitted in the cost of service proceeding was 7.8% to 8.65%. The
Commission noted the substantial proportion of floating rate debt among
cable entities and determined that a cautious estimate would place
average debt cost at 8.5%.
11. We propose to rely on more direct estimates of capital cost by
gauging an operator's debt cost to its actual cost. This debt cost
would encompass fees or other premiums that the operator may pay to
obtain debt financing. We invite comment on this proposal.
D. Capital Structure
12. In the Cost Order, we decided against using embedded capital
structures and market equity values to establish the capital structure
used to calculate the overall rate of return. We indicated that a
capital structure range may be more appropriate for the debt-laden
cable industry and set that range at 40% to 70% debt and used that
range in setting the overall capital cost.
13. We tentatively conclude, however, that actual, i.e.,
individualized, capital structures should be applied to the estimation
of the overall cost of capital. The estimation of debt costs is
relatively straightforward because the cost of debt can be documented
and certified by independent accounting services. Because debt costs
can be measured directly, we tentatively conclude that reliance on the
actual percentage of debt in an operator's capital structure will
ensure the most accurate estimation of interest costs. Thus, if an
operator elected not to rely on the presumptive 11.25% rate of return
in favor of the alternative capital cost measure described in this
Order, we would look to the actual capital structures of the operator
to determine the appropriate overall capital cost.
14. Estimating the amount of equity in an operator's structure is a
complex proposition. Many operators have a negative net worth. We
recognize, however, that, in the case of several publicly-traded cable
companies, the stock of operators with negative book values trades in
significant volumes in the open market. While public utility regulation
has relied traditionally on book value estimations of equity in
determining capital structures for regulated utilities, it may be
appropriate to take note of the equity transactions in the cable
industry that occur frequently, including the decisions of cable
investors to pay multiples of cash flow for cable systems that, based
on book value, should be worth less than nothing.
15. In order to rely on actual capital structures, however, we must
ensure that measurement of the equity proportion filters out a
``premium'' for anticipated gains in unregulated services. As we
consider this alternative, however, we recognize that several issues
must be addressed and resolved. Moreover, we remain committed to an
approach that is administratively feasible. To assist the Commission in
this endeavor, we request comment on the following issues:
a. What mechanism or analysis should guide the Commission in
estimating the equity proportion of an operator's capital structure
that is dedicated to regulated services?
b. How should the Commission estimate the proportion of equity in
an operator's capital structure when that operator is not publicly-
traded?
c. Should the Commission rely on the book value of debt or the
market value of debt in estimating the proportion of debt in an
operator's capital structure?
d. Can the Commission develop a reasonable estimate of an
operator's capital structure by combining the market value of its
equity and the book value of its debt?
e. If market capitalization is used to measure the proportion of
equity in an operator's capital structure, will increases in the
operator's stock price drive up subscriber rates by increasing the
proportion of equity in the operator's capital structure? If so, how
can the Commission ensure that reliance on market capitalization
measures for equity will not unduly impact subscriber rates?
III. Regulatory Flexibility Analysis
16. Pursuant to Section 603 of the Regulatory Flexibility Act, the
Commission has prepared the following initial regulatory flexibility
analysis (``IRFA'') of the expected impact of these proposed policies
and rules on small entities:
The proposals, if adopted, will not have a significant effect on a
substantial number of small entities.
List of Subjects in 47 CFR Part 76
Cable television, Reporting and recordkeeping requirements.
Federal Communications Commission.
William F. Caton,
Acting Secretary.
[FR Doc. 96-5426 Filed 3-7-96; 8:45 am]
BILLING CODE 6712-01-P