The current methodology for calculating the cost of capital rate is based on the weighted average cost of capital (WACC), in the variant of the pre-tax nominal WACC formula.
In methodological terms, the weighted average cost of capital is a weighted average of the cost of equity and the cost of borrowed capital, and corresponds to the minimum rate of return required to attract funds for a specific investment, as explained in the formula below:
CMPCpre-tax= [Ke × (1-G)+Kd×G×(1-ti) ]× 1/(1-ti)
Where:
Kd is the cost of borrowed capital;
G corresponds to gearing, that is the weight of borrowed capital compared to the total amount of invested capital; and
ti is the corporate income tax rate.
Ke corresponds to the equity cost, computed on the basis of the Capital Asset Pricing Model (CAPM), by means of the following formula:
Ke= Risk-free interest rate+ β×Risk premium
Where:
Risk-free interest rate is the rate that compensates investment on risk-free assets.
β: corresponds to the covariance between the profitability of a company’s shares and that of the stock market as a whole, that is to say, it reflects the risk of the company’s shares compared to the market risk.
Risk premium corresponds to the difference between the rate of return provided by the stock market and that provided by risk-free investments.
According to a survey carried out by the Board of European Regulators of Electronic Communications (BEREC), international experience supports the use of the above-mentioned methodologies, which are shared by various operators in regulated industries in several countries (see table 3), and which are deemed to be common practise and recommended by regulators.
Table 3 - Methodologies used in the telecommunications sector
| Country | Methodology for calculating cost of capital rate | Methodology for calculating equity cost |
| Austria | WACC | CAPM |
| Belgium | WACC | CAPM |
| France | WACC | CAPM |
| Spain | WACC | CAPM |
| Italy | WACC | CAPM |
| Ireland | WACC | CAPM |
| Poland | WACC | CAPM |
| Norway | WACC | CAPM |
| Sweden | WACC | CAPM |
| Switzerland | WACC | CAPM |
| UK | WACC | CAPM |
| Netherlands | WACC | CAPM |
Source: BEREC
Again according to the Principles of implementation and best practices (PIBs) as regards the methodology for calculating the cost of capital rate, developed within the Independent Regulators Group - the IRG1 - now referred to as BEREC, the WACC (PIB 1) is a consensual methodology for computing the cost of capital rate, and the CAPM (PIB 4), compared to the alternatives (e.g. Fama French Model, Arbitrage Pricing Theory) is better suited to the calculation of the cost of equity.
The CAMP is the model most commonly used2, as it presents a clear theoretical basis and it is simple to implement. It is based on the efficient portfolio theory, according to which, in a market, economic actors will invest in an efficient portfolio, that is, in a portfolio which maximizes results foreseen for a given level of risk, taking into account each actor’s degree of aversion to risk.
Pre-tax WACC vs. post-tax WACC
The formula to calculate the pre-tax WACC results from the adjustment to the tax in the formula of the post-tax WACC:
CMPCpre-tax= CMCPpost-tax × 1/((1-ti)
The main advantage of the pre-tax methodology, compared to the post-tax methodology, is that the former includes the tax cost, and as such this cost is allocated to products and services via the capital cost. On the contrary, the use of a post-tax methodology tends to allocate the tax cost via common costs. In this context, while this last option promotes the increase of common costs, the pre-tax methodology, in the scope of regulatory accounting, allows for allocation which observes causal links in a more appropriate way.
In the light of the above, and whereas: (i) the Commission’s recommendation provides for the calculation of the cost of capital rate based on the WACC methodology; (ii) WACC and CAPM methodologies were used in the definition of the cost of capital rate for the 2009-2011 three-year period; (iii) these methodologies were consensual in the scope of the public consultation for computing the 2009-2011 rate; (iv) these methodologies continue to be used by European regulators and (v) the use of the pre-tax WACC shows significant advantages, within the egulatory cost scope, compared to the use of the post-tax WACC, it is deemed that there is no reason why the determination of 2010 should be changed, thus the pre-tax nominal WACC and CAPM methodologies must be maintained in the calculation of PTC’s cost of capital rate to be applied from the 2012 accounting year.
Methodology to be applied from 2012
The cost of capital rate shall continue to be calculated based on the pre-tax weighted average cost of capital (pre-tax WACC) and the cost of equity shall be computed based on the Capital Asset Pricing model (CAPM).
1 Available at Principles of Implementation and Best Practice for WACChttp://www.irg.eu/template20.jsp?categoryId=260350&contentId=543313.
2 Graham and Harvey (2001), The theory and practice of corporate finance: evidence from the field, Journal of Financial Economics. The research conducted with 400 CFOs showed that ¾ use the CAPM method.
