[Federal Register Volume 63, Number 202 (Tuesday, October 20, 1998)]
[Proposed Rules]
[Pages 55988-55996]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-27988]
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FEDERAL COMMUNICATIONS COMMISSION
47 CFR Part 65
[CC Docket No. 98-166; FCC 98-222]
Prescribing the Authorized Unitary Rate of Return for Interstate
Services of Local Exchange Carriers
AGENCY: Federal Communications Commission.
ACTION: Proposed rule.
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SUMMARY: This document initiates a proceeding to represcribe the
authorized rate of return for interstate access services provided by
incumbent local exchange carriers (ILECs). In this proceeding the
Commission revised the rules governing procedures and methodologies for
prescribing and enforcing the rate of return for ILECs not subject to
the price cap regulation.
In the Notice of Proposed Rulemaking (NPRM) the Commission proposes
corrections to errors in the codified formulas for the cost of debt and
cost of preferred stock and seek comment on whether this proceeding
warrants a change in the low-end formula adjustment for local exchange
carriers subject to price caps.
DATES: Comments are due December 3, 1998 and reply comments are due
February 1, 1999.
ADDRESSES: Parties should send comments or reply comments to office of
the Secretary, Magalie Roman Salas, Office of the Secretary, Federal
Communications Commission, 1919 M Street, N.W., Room 222, Washington,
D.C. 20554.
Parties who choose to file by paper should also submit their
comments on diskette. These diskettes should be submitted to Warren
Firschein of the Common Carrier Bureau's Accounting Safeguards
Division, 2000 L Street, N.W., Room 257, Washington, D.C. 20554. Such a
submission should be on a 3.5 inch diskette formatted in an IBM
compatible format using WordPerfect 5.1 for Windows or compatible
software. Spreadsheets should be saved in an Excel 4.0 format. The
diskette should be accompanied by a cover letter and should be
submitted in ``read only'' mode. The diskette should be clearly
labelled with the commenter's name, proceeding (including the docket
number in this case [CC Docket No. 98-166]), type of pleading (comment
or reply comment), date of submission, and the name of the electronic
file on the diskette. The label should also include the following
phrase ``Disk Copy--Not an Original.'' Each diskette should contain
only one party's pleadings, preferably in a single electronic file. In
addition, commenters must send diskette copies to the Commission's copy
contractor, International Transcription Service, Inc., 1231 20th
Street, N.W., Washington, D.C. 20036.
Additional filing information can be found in the Comment Filing
Procedure section of this document.
FOR FURTHER INFORMATION CONTACT: Warren Firschein, Accounting
Safeguards Division, Common Carrier Bureau, (202) 418-0844.
SUPPLEMENTARY INFORMATION: This is a summary of the Commission's Notice
Initiating a Prescription Proceeding and Notice of Proposed Rulemaking,
CC Docket 98-166, adopted September 8, 1998, and released October 5,
1998. The full text of this Notice Initiating a Prescription Proceeding
and Notice of Proposed Rulemaking is available for inspection and
copying during normal business hours in the FCC Public Reference Room
(Room 230), 1919 M St., N.W. Washington, D.C. The complete text of this
document may also be purchased from the Commission's copy contractor
International Transcription Service, 1231 20th Street, N.W.,
Washington, D.C. 20036.
Summary of the Notice Initiating a Rate-of-Return Prescription
1. The Commission is required by section 201 of the Communications
Act of 1934 to ensure that rates are ``just and reasonable.'' To ensure
that their rates for interstate access are just and reasonable, the
Commission prescribes an authorized rate of return for the
approximately 1300 incumbent local exchange carriers (ILECs) that are
subject to rate-of-return rather than price cap regulation. This Notice
initiates a proceeding to represcribe the authorized rate of return for
interstate access services provided by ILECs. In this Notice, we seek
comment on the methods by which we could calculate the ILECs' cost of
capital.
[[Page 55989]]
2. The rate of return we prescribe for ILECs' interstate operations
links our regulatory processes and carriers' actual costs of capital
and equity. The Commission periodically represcribes this rate to
ensure that the service rates filed by incumbent local exchange
carriers subject to rate-of-return regulation continue to be just and
reasonable. In its 1995 Rate of Return Represcription Procedures Order,
60 FR 28542 (June 1, 1995), the Commission revised its prescription
procedures to require that it consider commencing a new rate-of-return
prescription proceeding whenever yields on 10-year U.S. Treasury
securities remain, for a consecutive six-month period, at least 150
basis points above or below a certain reference point (the ``trigger
point''). The reference point is the average of the average monthly
yields for the consecutive six-month period immediately prior to the
effective date of the current rate-of-return prescription. That
reference point is currently 8.64 percent. For the consecutive six-
month period immediately following the release of the 1995 Rate of
Return Represcription Procedures Order, the yields were more than 150
basis points below this reference point. Accordingly, on February 6,
1996, the Bureau issued a Public Notice, AAD 96-28, 61 FR 6641
(February 21, 1996), seeking comment on whether to commence a rate-of-
return prescription proceeding. Eleven parties filed comments; five
parties filed replies.
3. We agree with MCI and GSA that we should initiate a rate-of-
return prescription proceeding at this time. The sustained low yields
of the U.S. treasury securities strongly suggest that the current
prescribed rate of return is much higher that the rate required to
attract capital and earn a reasonable profit. Our duty to ensure that
service rates are just and reasonable requires that we undertake a
prescription proceeding at this time.
A. General Considerations
4. We prescribe a rate of return in order to ensure that rate-of-
return carriers' rates for interstate access services are ``just and
reasonable.'' Carriers subject to rate-of-return regulation, however,
may also provide interstate interexchange services. For such carriers,
our prescribed rate of return is applied to their interexchange access
services as well. We seek comment on whether the same prescribed rate
should be applied to rate-of-return carriers' interstate access and
interexchange services, or whether the prescribed rate should be
adjusted when applied to provision of interexchange services.
Commenters supporting the application of different rates should
indicate how the prescribed rate for interstate interexchange services
should be determined. We also seek comment on whether the rate of
return prescribed for interstate access should also be used for other
purposes, including determination of universal service support.
B. Weighted Average Cost of Capital
5. The weighted average cost of capital is used to estimate the
rate of return that the ILECs must earn on their investment in
facilities used to provide regulated interstate services in order to
attract sufficient capital investment. Our rules specify that the
composite weighted average cost of capital is the sum of the cost of
debt, the cost of preferred stock, and the cost of equity, each
weighted by its proportion in the capital structure of the telephone
companies. The formulas for determining the cost of debt, cost of
preferred stock, and capital structure are codified in Secs. 65.302,
65.303, and 65.304, respectively of the Commission's rules. Each of
these components are calculated using routinely collected data from the
Automatic Reporting Management Information System (ARMIS) reports. The
rules do not include a formula for calculating the cost of equity.
Instead, they state that ``the cost of equity shall be determined in
prescription proceedings after giving full consideration to the
evidence in the record, including such evidence as the Commission may
officially notice.''
C. Capital Structure
6. Prior to the 1995 Rate of Return Represcription Procedures
Order, Part 65 of the Commission's rules prescribed a method of
computing the capital structure of all ILECs based on a composite of
the capital structures of the Regional Bell operating companies
(RBOCs). In the 1995 Rate of Return Represcription Procedures Order,
the Commission revised its methodology to use instead the capital
structure of all ILECs with annual revenues of $100 million or more.
This capital structure methodology was codified in order to ``simplify
future represcription proceedings without sacrificing needed
accuracy.'' The proportion of each cost-of-capital component in the
capital structure is equal to the book value of that particular
component divided by the book value of the sum of all components. For
example, the proportion of debt in the capital structure is equal to
the book value of debt divided by the sum of the book value of debt,
equity, and preferred stock.
D. Embedded Cost of Debt
7. The cost of debt is based on the sale of bonds and other debt-
related securities to finance telephone operations. Prior to the 1995
Rate of Return Represcription Procedures Order, Part 65 of the
Commission's rules required each of the RBOCs to perform detailed
calculations to determine their embedded cost of debt based upon data
contained in their Form 10-K or 10-Q statements filed with the
Securities and Exchange Commission. In the 1995 Rate of Return
Represcription Procedures Order, the Commission altered the methodology
to be used in a prescription proceeding for calculating the embedded
cost of debt, using data submitted in ARMIS report 43-02 by all ILECs
with annual revenues of $100 million or more. The Commission defined
embedded cost of debt to be the total annual interest expense divided
by average outstanding debt.
E. Cost of Preferred Stock
8. The 1995 Rate of Return Represcription Procedures Order revised
the methodology for calculating the cost of preferred stock to be
consistent with the calculation of the cost of debt and directed that
the calculation be based on data routinely submitted by ILECs with
annual revenues of $100 million or more rather than by the RBOCs, as
was done in the 1990 rate-of-return proceeding. The methodology for
calculating the cost of preferred stock is to divide total annual
preferred dividends by the proceeds from the issuance of preferred
stock.
F. Cost of Equity
1. Background
9. Prior to the 1995 Rate of Return Represcription Procedures
Order, Part 65 of the Commission's rules required the RBOCs to prepare
two historical discounted cash flow estimates and submit state cost-of-
capital determinations to assist the Commission in calculating the
ILECs' cost of equity. In the 1995 Rate of Return Represcription
Procedures Order, the Commission concluded that the methodology for
estimating equity costs, as well as the data to be used in applying
particular methodologies, flotation costs, and periods of compounding,
should be determined anew in each proceeding. Accordingly, Part 65 no
longer prescribes a
[[Page 55990]]
methodology for determining ILECs' cost of equity.
10. In this section, we propose several methods for estimating the
cost of equity for interstate services. We seek comment on each of
these methods and invite commenters to propose additional
methodologies. Commenters should discuss whether in this proceeding we
should use only one or more than one methodology to estimate this
component of the carriers' cost of capital. Commenters preferring the
use of more than one methodology are requested to specify how we should
weigh the results of these methods to estimate the cost of equity. We
expect that in the direct cases, parties will use the results from the
cost of equity methods they propose. We note that we will use Standard
and Poor's Compustat PC Plus database as our source for financial data
in this proceeding.
2. Surrogate Companies
11. The methods of estimating the cost of equity that we identify
in this NPRM use stock prices and other measures of investor
expectations regarding the ILECs' interstate services. Because ILECs do
not issue stock or borrow money solely to support interstate service,
investor expectations that would affect the cost of equity for
interstate services cannot be measured directly. For this reason, we
must select a group of companies facing risks similar to those
encountered by the rate-of-return ILECs in providing interstate service
for which we can estimate the cost of equity. Risk is the uncertainty
associated with the ability of an investment to generate the return
expected by investors. As was done in the 1990 proceeding
(Resprescribing the Authorized Rate of Return for Interstate Services
of Local Exchange Carriers, Order, CC Docket No. 89-624, 55 FR 51423
(December 14, 1990)), once the surrogates are selected, their firm-
specific data are applied to the cost-of-equity methodologies selected
herein, and average or median returns for the surrogate group are
calculated in order to determine a zone of reasonableness for cost of
equity.
12. We seek comment on what group of companies we should select as
appropriate surrogates for estimating the cost of equity for interstate
services. In 1986, the Commission adopted the RBOCs as a surrogate
group of firms for the interstate access industry. In 1990, the
Commission again concluded that, despite their diversification into
nonregulated businesses, the RBOCs were still the most appropriate
surrogates. Further, the Commission concluded that most competitive,
nonregulated businesses are riskier than the regulated interstate
access business and therefore, the RBOCs are riskier as a whole than
their regulated telephone operations. As a result, the Commission
determined that the cost-of-equity estimate for an RBOC as a whole may
overstate the cost of equity for interstate access alone and considered
this potential overstatement when determining the cost-of-equity
estimates. In the 1995 Rate of Return Represcription Procedures Order,
the Commission found that the level of risks that RBOCs face was no
longer similar to the risk confronting carriers subject to rate-of-
return regulation and therefore the RBOCs' risk may not provide the
best data upon which to base a uniform rate-of-return prescription.
With the uncertainty following the passage of the 1996 Act, however,
the RBOCs' cost of equity may no longer overstate that of rate-of-
return carriers. As a result, we tentatively conclude that the RBOCs,
more than any other group of companies, once again constitute the best
surrogate for carriers subject to rate-of-return regulation. We
tentatively conclude that the RBOCs' current risk most closely
resembles the current risk encountered by the rate-of-return carriers.
The RBOCs and rate-of-return ILECs both provide interstate services,
their primary business is still the provision of telephone service and
neither is subject to any meaningful competition for regulated
telecommunications services in their service area. We seek comment on
this tentative conclusion. In addition, we seek comment whether we
should incorporate the financial data of any other publicly traded ILEC
in the cost-of-equity analysis.
13. In the 1990 proceeding, although we concluded that the RBOCs
were the most appropriate surrogate, we made a downward adjustment to
the estimated cost of equity to account for the fact that the RBOCs'
interstate access business was less risky than their business as a
whole. We seek comment on whether a similar adjustment should be made
in this proceeding. Specifically, we seek comment on whether the RBOCs'
interstate access business today is more or less risky than their
operations as a whole. In the 1990 proceeding, ILECs submitted stock
analysts' reports in support of their argument that the proposed DCF
formula did not account for the growth in cellular operations. In
responding, commenters should submit stock analysts' reports indicating
the relative riskiness of the RBOCs' lines of business.
3. Discounted Cash Flow Methodology
14. Under the Discounted Cash Flow (DCF) methodology, a firm's cost
of equity is calculated according to a formula involving the annual
dividend and price of a share of its common stock, along with the
estimated long-term dividend growth rate. The standard DCF formula is
the annual dividend on common stock divided by the price of a share of
common stock (termed the ``dividend yield'') plus the long-term growth
rate in dividends.
15. Growth Rate. The DCF method requires an estimate of the long-
term growth rate. In both the 1986 and 1990 proceedings, the Commission
used the Institutional Brokers Estimate Service (``IBES'') as the
source of the median forecast of long-term growth. In this proceeding,
the Commission will use the S&P Analysts' Consensus Estimates (``ACE'')
of growth in long-term earnings per share as part of the database we
obtain from Standard & Poor's. We seek comment on whether ACE provides
information comparable to IBES and whether ACE estimates should be used
for purposes of this proceeding.
16. Quarterly Dividend. In both the 1986, 51 FR 1795, at 1808
(January 15, 1986) as amended 51 FR 4596, at 4598 (February 6, 1986)
and 1990 proceedings, we rejected the ILECs' arguments that the
quarterly dividend should be compounded to account for the payment of
dividend on a quarterly, rather than annual, basis for three reasons:
(1) Compounding is reflected in the revenue requirement because the
Commission uses a mid-year rate base; (2) the adjustment adds a
complexity that is not offset by increased accuracy; and (3) the
parties did not establish that analysts and investors actually use
quarterly compounding models nor did the parties demonstrate how using
the quarterly model may affect the market price. For these reasons, we
tentatively conclude that we should not use quarterly compounding in
the DCF formula. We seek comment on this tentative conclusion.
17. Flotation Costs. Flotation costs a, the Commission concluded
that it would not include an adjustment for flotation costs for three
reasons: (1) The RBOCs were not issuing stock at that time; (2) no
evidence suggested that past costs remain unrecovered; and (3) the
Commission's treatment of flotation costs had not adversely affected
the carriers' stock prices. We concluded that if carriers were
concerned about recovery of flotation costs, they could seek a change
in the Commission's prescribed accounting system. We reaffirm these
prior decisions, and
[[Page 55991]]
tentatively conclude that in this proceeding we should make no
adjustments to our estimate of the cost-of-equity component of ILECs'
cost of capital to compensate for flotation costs. We seek comment on
this tentative conclusion.
18. Classic DCF Calculation. The ``classic'' DCF method uses the
expected annual dividend for the next year, the current share price and
the current-expected long-term earnings growth rate to calculate the
cost of equity. In the Phase II Reconsideration Order, the Commission
adopted this version of the DCF methodology. In 1990, the Commission
required the RBOCs to submit the ``classic'' DCF methodology as applied
to the RBOCs, the S&P 400, and a group of large electric utilities and
this method was given the greatest weight in calculating the cost of
equity in the 1990 proceeding. The S&P 400 and large electric utilities
were used as equity market benchmarks to determine whether the
estimates calculated for the RBOCs were reasonable. We tentatively
conclude that this ``classic'' form of the DCF should also be applied
to the group of surrogate companies selected as a result of this
proceeding. Consistent with our analysis in 1990, we tentatively
conclude that the ``classic'' DCF formula more accurately estimates the
cost of equity than does the historical DCF method, discussed below. We
seek comment on this tentative conclusion and ask the parties to
comment on the weight to be given to this methodology. In addition, we
tentatively conclude that the S&P 400 (now termed the S&P Industrials)
and the large electric utilities should be used as equity market
benchmarks against which the RBOCs' cost-of-equity estimates can be
evaluated. We seek comment on this tentative conclusion. Finally, in
the 1990 proceeding, for purposes of our cost-of-equity benchmark
analysis, the S&P 400 and large electric utilities groups were screened
to exclude those companies that did not pay dividends, had less than
five analyst estimates of long-term earnings growth reported by IBES,
and had DCF cost-of-equity estimates less than the yield on 10-year
treasury bonds. We seek comment on whether these screens are still
appropriate and, if not, what screens, if any, should be used and why.
19. In 1990, the primary cost-of-equity conclusions were based on a
series of then-recent monthly DCF estimates for the RBOCs. The
Commission used the average of the monthly high and low stock prices
for each month of the period under analysis to establish the current
stock price. The Commission found that ``these monthly periods are
sufficiently long to eliminate the possibility that a particular price
may be an aberration, but recent enough to assure that data from past
periods do not obscure trends.'' We tentatively conclude that using the
average of the monthly high and low stock prices as inputs to the
``classic'' form of the DCF will provide reliable estimates of the
current stock price. We seek comment on this tentative conclusion. In
reacting to this tentative conclusion, commenters should discuss the
time for which the DCF calculation should be made. For example, the
commenters might propose the most recent quarter available or each
month's estimate during the pendency of the case as was done in the
1990 proceeding.
20. Finally, as part of the specification of the ``classic'' DCF
model in the 1990 proceeding, we determined that the expected dividend
should be calculated by multiplying the current annualized dividend by
one plus one-half the analysts' estimated long-term growth rate due to
timing differences among the companies as to the date of their dividend
increases. The Commission concluded that if the dividend yield was to
be determined ``at a point during the year just before the carriers
were to announce a dividend increase, it might be accurate to grow the
dividend rate by a full year's expected growth.'' The Commission,
however, found that RBOCs' dividends had ``been increased in the six
months prior to the analysis and the stock prices used in the analysis
reflected these higher dividends.'' Multiplying the dividend by the
full growth rate would overstate the estimated annual growth in
dividends and increase the DCF estimated cost of equity. Because we
have no reason to believe that all companies in the surrogate group
will declare dividend increases simultaneously, we tentatively conclude
that we should increase the dividend by one-half the estimated annual
growth. We seek comment on this tentative conclusion.
21. Historical DCF Calculation. At least two other variations of
DCF that in the past we have considered using to estimate ILECs' cost
of equity rely upon historical data to compute that cost. In both
variations, the cost of equity is calculated as the sum of D/P + G,
where D is the average annual dividend during the two calendar years
preceding the prescription filing and P is the average daily price of
the RBOCs' common stock during each trading day during the two calendar
years preceding the prescription proceeding. In the first variation, G
would be the annual rate of growth in dividends derived from the slope
of the ordinary least squares linear trend line of quarterly dividends
that were declared during the two calendar years preceding the
prescription proceeding. In the second variation, G would be the simple
average of the IBES median long-term growth rate estimates of earnings
during the two calendar years preceding the prescription filing. In the
1990 and 1995 proceedings, the Commission rejected both these
variations of the historical DCF methodology because they average
inputs over a period neither short enough to reflect current market
conditions nor long enough to reveal historical trends. For these
reasons, the 1995 Rate of Return Represcription Procedures Order does
not mandate use of historical DCF as part of a rate-of-return
proceeding. We tentatively conclude that this DCF methodology should be
given no weight in this proceeding. We seek comment on this tentative
conclusion.
22. In the 1990 proceeding, parties presented several variations of
the general DCF formula. We seek comment on whether there are other
variations to the DCF methodology that we should now consider using in
this proceeding. Commenters proposing different versions should explain
in detail how the various parameters would be estimated, including how
long the period from which we draw data for analysis should be, why
they believe this is a reasonable period to use and identify the source
of the data on which the DCF calculation would draw. Finally,
commenters should indicate the weight to be given the methodology they
propose.
4. Risk Premium Methodologies
23. Risk premium methodologies can also be used to calculate the
cost of equity. In this section we discuss two types of risk premium
methodologies. The first was termed traditional risk premium analysis
in the 1990 proceeding and we will continue to use that term. The
second type of risk premium analysis is the Capital Asset Pricing Model
(``CAPM''). These two methods share fundamental similarities in that
they select a ``risk free'' investment such as long-term United States
Treasury bonds and add a risk premium to return on that ``risk free''
investment to derive a cost-of-equity estimate. The differences between
the two methods arise in the manner by which the risk premium is
calculated. Under a more traditional risk premium methodology, the risk
premium is typically estimated as the historical or estimated spread
between equity security returns and bond yields. Under
[[Page 55992]]
the CAPM methodology, the risk premium is formally quantified as a
linear function of market risk (beta).
24. Traditional Risk Premium Analyses. This methodology estimates
the cost of equity as the current yield on a ``risk free'' investment,
such as long-term U.S. Treasury bonds, plus an historical or expected
equity risk premium. As noted in the 1995 Rate of Return Represcription
Procedures NPRM, ``[t]raditionally, such analyses have determined the
risk premium by comparing historically realized returns on stocks and
bonds.'' In the 1990 Order, we stated:
A bond's yield is simply the discount (interest) rate that makes
the present value of its contractual cash flow equal to its market
value. Since the cash flows are fixed, if the bond goes up in price,
the yield must go down. An increase in the price of the stock,
however, may leave the stock's expected return unchanged if the
price rose to adjust for higher anticipated profits rather than
lower investor perceived risk. Risk premium analyses solve this
problem by comparing the past returns (capital gains, dividends and
interest, divided by the market price) on stocks and bonds. The
historic premium in return on stocks over bonds is assumed to be a
stable and accurate forecast of investor's expectations about the
future premium.
25. Capital Asset Pricing Model (CAPM). Under the CAPM, the
variance of the company's stock price is measured relative to the
market as a whole to adjust the premium. Similar to traditional risk
premium methodologies, the CAPM calculates a cost of equity equal to
the sum of a risk-free rate and a risk premium. In the CAPM formula,
however, the risk premium is proportional to the security's market risk
and the market price of the risk.
26. Historical Risk Premium. In the 1995 Rate of Return
Represcription Procedures NPRM, the Commission found that risk premium
analyses, including the CAPM, could be used to estimate the cost of
equity for interstate access. The Commission, however, was concerned
about the use of historical stock and bond yields to estimate the risk
premium. The Commission found that the results obtained from a
historical analysis depend on the period chosen and therefore
questioned whether the Commission should rely on historical stock and
bond yields to calculate a risk premium. We seek comment on whether
such historical data should be relied upon in this proceeding.
Commenters supporting the use of historical data should clearly
indicate from what time period such information should be drawn,
explain why they believe this is a reasonable period to use, and
identify the source of these data. Commenters should also indicate the
appropriate weight to be given such analyses.
27. Expected Risk Premium. With regard to the issue of expected
risk premiums, we seek comment on how such estimates should be
determined. In the 1995 Rate of Return Represcription Procedures NPRM,
we suggested that relying on stock market data such as the DCF cost-of-
equity estimates for the S&P 400 may provide a forward-looking risk
premium for purposes of calculating both the traditional risk premium
cost of equity and the CAPM cost of equity. Commenters proposing the
use of expected risk premiums should clearly specify how they would
determine the expected risk premium estimates. In addition, commenters
should identify from what period such information should be drawn,
explain why they believe this is a reasonable period to use, and
identify the source for these data. Commenters proposing the use of
expected analyses should indicate the weight they would give to these
analyses.
28. Risk-Free Rate. Both models require the selection of a risk-
free rate. United States Treasury securities are regarded as virtually
risk free. We seek comment on whether we should use U.S. Treasury
securities as the investment we use to define risk free for purposes of
calculating the Risk Premium and CAPM cost-of-equity estimates. On the
one hand, the yields on short-term U.S. Treasury bills (with maturities
from 90 days to one year) may measure the risk-free rate but may not
consider long-term inflationary expectations that are embedded in bond
yields and stock returns. On the other hand, long-term U.S. Treasury
bonds (maturities from 10 to 30 years) incorporate long-term
inflationary yields, but because of their long maturities, also include
an interest-rate risk premium that is not embodied in the more short-
term securities such as T-bills. We seek comment on how we should set
the risk-free rate. In responding, commenters should state the length
of maturity for U.S. Treasury securities that should be used in this
calculation and explain why securities of this maturity length should
be used. Commenters should also indicate whether the data used to
compute the risk-free rate should be historical or forward-looking.
29. Beta. The CAPM methodology also requires the estimation of a
security's risk, or ``beta.'' Beta is a measure of a security's price
sensitivity to changes in the stock market as a whole. In the 1990
proceeding, parties proposed using betas calculated by ValueLine. The
Commission found that because ValueLine betas are adjusted to raise the
level of betas less than one and lower the level of betas greater than
one such betas were not consistent with the theory of CAPM. We seek
comment on whether we should reconsider the use of adjusted betas for
purposes of the CAPM methodology. We seek comment on whether S&P betas
should be used for this proceeding.
G. Other Cost-of-Capital Showings
30. In the 1990 Rate of Return proceeding, state cost-of-capital
determinations were used as a check on the results obtained through our
quantitative analysis. Although state cost-of-capital determinations
are no longer required filings in a federal prescription proceeding, we
tentatively conclude that such information continues to serve as a
valuable check on the results obtained by applying the methods
described above to the surrogate group of companies selected.
Therefore, we plan to consider the information contained in the most
recent National Association of Regulatory Utility Commissioners
(``NARUC'') publication ``Utility Regulatory Policy in the United
States and Canada.'' Specifically, this resource provides the overall
rates of return on rate base for telecommunications companies
prescribed recently by the state commissions as well as the related
prescribed cost-of-equity returns. We seek comment on our proposed use
of this source. In responding, commenters should indicate any concerns
they may have regarding the validity of the information contained in
the document. Commenters should file any data that they believe are
more reliable.
H. Other Factors To Be Considered in Determining the Allowed Rate of
Return
31. As part of this proceeding, the Commission will identify a
``zone of reasonableness'' for the cost of equity and the overall cost
of capital for interstate access services. Once these ``zones of
reasonableness'' have been determined, the Commission will prescribe an
authorized rate of return that lies within the cost-of-capital ``zone
of reasonableness.'' In determining the ``zone of reasonableness'' for
cost of equity in the 1990 proceeding, the Commission reviewed the
range of DCF estimates among the RBOCs to ensure that all ILECs had
adequate access to capital, and concluded that the range of reasonable
cost-of-equity estimates should be bounded on the lower end by the RBOC
average DCF estimate for the month with the highest RBOC average DCF
estimate, and by that estimate
[[Page 55993]]
increased by 40 basis points as the upper bound. This resulted in an
estimated cost-of-equity range based on unadjusted RBOC data of 12.6%
to 13.0%. The Commission also accepted the parties' argument that,
while the RBOCs' prices reflected the growth potential of their
cellular radio services, analysts' earnings growth estimates did not,
resulting in understated DCF estimates. Accordingly, the Commission
adjusted the DCF inputs to address this concern. The Commission offset
this adjustment because the interstate access business was expected to
be less risky than the RBOCs' business as a whole. As a result of these
three adjustments, the Commission established a ``zone of
reasonableness'' for interstate access cost of equity of 12.5% to 13.5%
and a ``zone of reasonableness'' for cost of capital of 10.85% to
11.4%.
32. In determining the authorized rate of return to be set within
the cost-of-capital ``zone of reasonableness,'' the Commission also
considered two other factors. First, the Commission made an allowance
for infrastructure development after noting that concern over
investment in new telecommunications technologies warranted selecting
an authorized rate of return in the upper range of the zone of
reasonable cost-of-capital estimates. Second, the Commission considered
the ILECs' argument that competition in interstate access increased the
ILECs' risk, but was only partially reflected in the quantitative cost-
of-capital analysis. The Commission concluded, however, that the
market-based cost-of-capital estimates captured risks from competition
in interstate access, and therefore declined to make an adjustment on
this basis. Based on these factors and a concern that capital costs
could fluctuate in the future, the Commission prescribed a rate of
return of 11.25%, which was located near the upper end of the ``zone of
reasonableness.''
33. Similar to the 1990 proceeding, the Commission will consider
other factors in determining the ``zone of reasonableness'' of cost of
equity. Specifically, we seek comment on whether an adjustment should
be made to account for actual or potential changes in the
telecommunications marketplace as a result of the 1996 Act. We seek
comment on how we should calculate such an adjustment. We also ask
commenters to propose other adjustments deemed necessary in determining
the cost-of-equity ``zone of reasonableness'' and to explain why they
believe these adjustments to be necessary. Commenters should also
propose where within the cost-of-capital ``zone of reasonableness'' the
authorized rate of return should be set and why. For example, we note
that mergers have occurred among the telecommunications companies. We
seek comment on whether adjustments should be made to account for the
effects of proposed or completed mergers. In addition, we seek comment
on whether we should consider adjustments to account for the ILECs'
entry (or anticipated entry) into the long distance market. Finally, we
note that the 1996 Act creates an exemption from obligations otherwise
imposed by the Act for qualifying ILECs serving rural areas. We seek
comment on whether the rural exemption should be a factor we weigh in
determining whether any adjustment should be made.
34. We also seek comment on whether any of the adjustments made in
the 1990 proceeding are still necessary in estimating the current
authorized rate of return for interstate access services. Commenters
arguing in favor of retaining one or more of these adjustments should
state whether the level of adjustment should increase, decrease, or
remain the same and identify the characteristics of the current market
for telecommunications that warrant our making such adjustment.
Procedural Matters
1. Ex Parte Presentations
35. This is a permit-but-disclose notice and comment proceeding. Ex
parte presentations are permitted, except during the Sunshine Agenda
period, provided that they are disclosed as provided in the
Commission's rules. See generally 47 CFR 1.1202, 1.1203, and 1.1206(a).
2. Procedures for Filing Rate-of-Return Submissions
36. All relevant and timely direct case submissions, responses, and
rebuttals will be considered by the Commission. In reaching its
decision, the Commission may take into account information and ideas
not contained in the submissions, provided that such information or a
writing containing the nature and source of such information is placed
in the public file, and provided that the fact of the Commission's
reliance on such information is noted in the final Order disposing of
this proceeding.
37. Pursuant to applicable procedures set forth in Secs. 65.103
(b), (c), and (d) of the Commission's rules, 47 CFR 65.103, interested
parties may file direct case submissions on or before December 3, 1998,
responsive submissions on or before February 1, 1999 and rebuttal
submissions on or before February 22, 1999. Pursuant to Sec. 65.104, 47
CFR 65.104, the direct case submission of any participant shall not
exceed 70 pages, responsive submissions shall not exceed 70 pages, and
rebuttal submissions shall not exceed 50 pages. Comments may be filed
using the Commission's Electronic Comment Filing System (ECFS) or by
filing paper copies. See Electronic Filing of Documents in Rulemaking
Proceedings, 63 FR 24121 (May 1, 1998). In addition, a copy of each
rate-of-return submission, other than the initial submission, shall be
served on all participants who have filed a designation of service
notice pursuant to Sec. 65.100(b).
38. Comments filed through the ECFS can be sent as an electronic
file via the Internet to http://www.fcc.gov/e-file/ecfs.html>.
Generally, only one copy of an electronic submission must be filed. If
multiple docket or rulemaking numbers appear in the caption of this
proceeding, however, commenters must transmit one electronic copy of
the comments to each docket or rulemaking number referenced in the
caption. In completing the transmittal screen, commenters should
include their full name, Postal Service mailing address, and the
applicable docket or rulemaking number. Parties may also submit an
electronic comment by Internet e-mail. To get filing instructions for
e-mail comments, commenters should send an e-mail to ecfs@fcc.gov, and
should include the following words in the body of the message, ``get
form http://www.fcc.gov/e-file/ecfs.html>.
Generally, only one copy of an electronic submission must be filed. If
multiple docket or rulemaking numbers appear in the caption of this
proceeding, however, commenters must transmit one electronic copy of
the comments to each docket or rulemaking number referenced in the
caption. In completing the transmittal screen, commenters should
include their full name, Postal Service mailing address, and the
applicable docket or rulemaking number. Parties may also submit an
electronic comment by Internet e-mail. To get filing instructions for
e-mail comments, commenters should send an e-mail to ecfs@fcc.gov, and
should include the following words in the body of the message, ``get
form 