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In the framework of the most recent meeting of
Permanent Consultative Committee I: Telecommunication Standardization,
a document was presented entitled “Theoretic-practical Approach in the
Determination of Capital Cost.” The first part of this document is a
theoretical review of methodological elements to be taken into account
and distinguished in financial analysis from the regulatory
standpoint. This generally involves determining a reasonable rate of
return based on the necessary economic costs of providing a given
service, especially if that service is offered by a monopolist or a
company in a dominant position.
In general, investments made by telecommunication
companies are associated with investments in performing assets.
Therefore, the analysis focuses on how to determine the most
appropriate capital cost to generate return on capital employed in
this type of investment and its use as a measure of risk coverage.
Capital cost may be determined using different
models. Among the most widely used are Arbitrage Pricing Theory (APT)
and the Capital Asset Pricing Model (CAPM). However, despite the
advantages of these theories, in some cases they cannot be applied in
practice; such incompatibilities should therefore be evaluated in the
analysis and application process.
The document presented develops a theoretical
approach to methods commonly used to estimate the capital cost of a
given investment. The choice of method will depend on the needs and
amount of information available in each situation. The CAPM model may
be considered easier to use when estimating the price of an asset.
However, the APT model provides greater detail to explain return on
assets, as each investor would have a unique portfolio, with a unique
vector of betas, it being more efficient in showing the sensitivity of
assets to economic factors not represented in the market index.
The topic is particularly relevant as it recognizes
that characteristics and realities differ from one country to another,
as is the case among the American countries. Such differences are
essentially of tariff regulation landscape, as these reflect the need
to establish tariffs based on economic performance, with leverage
considerations corresponding to the companies, it being important for
the tariff discount rate to reflect return on total investment or on
total assets and business risk.
Serious difficulties exist in implementing in
emerging markets financial models generally used to evaluate assets in
developed financial markets, mainly owing to distortions of the
elements necessary for efficient determination of market prices, as
stock markets in this type of economy are small and illiquid.
Nonetheless, the advantages and simplicity of the
CAPM model have been the rational for its use. In order to correct for
the landscape postulated, some theoreticians propose, among other
solutions, adding a percentage of the risk premium to the opportunity
cost obtained in the usual way.
In accordance with the usual reasoning of the CAPM
model, three parameters must be estimated to determine capital cost:
the risk-free rate, market risk premium, and beta. The first two may
be generic for the industry as a whole, while beta is specific to each
company, sector, or subsector of the industry. This element is one of
the most controversial topics in financial theory, as calculation of
beta is more laborious and complicated than estimation of the other
two parameters.
A company’s beta is determined by three variables:
type of business(es) in which the company is involved, the degree of
leverage of the company’s operation, and the company’s financial
leverage. Accordingly, a financial beta and an economic beta may be
distinguished, which generates sufficient bases for evaluation.
To incorporate a correction factor, such as the
country risk premium for an emerging economy, many authors have
discussed this, in particular, Jaime Sabal, who suggests that:
1. Country risk is not equal for all projects: a
country’s reputation may vary from one activity to another, and be
better for some activities than it is for the rest of the economy, so
that it might be erroneous to assume that the country risk effect is
uniform for all projects.
2. Country risk is not totally systematic, and is
unstable: if the country risk premium is added to the risk-free rate,
and therefore, to the discount rate, this would be to assume that
country risk cannot be reduced by diversifying an investment portfolio
to contain a wide variety of assets. Therefore, as a general rule, if
the country risk is totally systematic, it would be correct to add all
of it in; whereas, when it is partially systematic, only a fraction of
the country risk should be included.
3. Credit risk is not country risk: it is assumed
that the government’s default risk is the correct measure of country
risk, which is not true in all cases.
The author therefore recommends that an effort be
made to identify the non-diversifiable component of what may be
understood as country risk and only incorporate that fraction in the
discount rate. However, he recognizes the difficulty of applying this
in specific cases.
Lastly, the ongoing challenge to financial theory,
as for all theories, is to determine on an ongoing basis the extent to
which its principles genuinely reflect reality. It is therefore
important for policymakers to be aware of gaps existing in developing
countries between some key assumptions of financial theory and the
realities of the developed world.
Fabimar Franchi
Head Tariff policies and Economic Affairs
Comisión Nacional de Telecomunicaciones
República Bolivariana de Venezuela
ffranchi@conatel.gov.ve
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