THE CAUSES AND CONSEQUENCES OF REGULATORY RISK
Pricing of Telecommunications Services from 1997
BT’s Response to OFTEL’s Consultative Document of December 1995
BT’s Cost of Capital
British Telecommunications plc
February 1996
Contents
Summary Page 5
Capital Asset Pricing Model (CAPM)
1 CAPM Analysis Page 8
2 Taxation Page 8
3 Risk Free Rates Page10
4 Risk Premium Page 11
5 Beta Page 12
6 BT’s Estimate of Post-tax Cost of Equity Page 14
7 Cost of Debt Page 14
8 Gearing Page 14
9 Post Tax WACC Page 15
10 Pre-Tax WACC Page 15
Dividend Growth Model Page 17
WACC Summary Page 18
Translation of WACC into Accounting Return on Page 19
Capital Employed (ROCE)
Comparative Rate of Return Page 20
Capital Employed Page 21
1 Intangible Assets Page 21
2 Fully Depreciated Assets Page 21
Adjustment for Windfall Gain/Loss Page 22
Conclusions Page 23
Annex A Qualitative Arguments on the determinants
of Beta
Annex B Taxation
Annex C The Risk Free Rate
Annex D Risk Premium
Annex E UK Equity Risk Premium
Annex F Beta for the Price Controlled Activities
Annex G Gearing Calculations
Annex H Dividend Growth Model
Annex I Justification for Including Intangible Capital
In BT’s Capital Base
THE INFLATION RISK ADJUSTMENT TO THE GILT RATE USED BY OFTEL
Ian Cooper
BZW Professor of Finance
London Business School
January 1996
THIS NOTE HAS BEEN PRODUCED FOR THE USE OF BT
IT IS CONFIDENTIAL
btdoc4.doc
1. Introduction
The calculation of the cost of capital in Oftel (1995) refers to an adjustment to the nominal gilt rate for inflation risk. This adjustment is used to eliminate from the nominal gilt rate this risk premium before the rate is used in conjunction with the index-linked gilt (ILG) rate to generate inflation forecasts. The adjustment is not, however, used in the calculation of the cost of capital, which is based on ILG rates. ILG rates are assumed by Oftel to be free of the inflation risk-premium.
The idea that lies behind this adjustment is that the nominal gilt rate is set to be equal to the real interest rate plus expected inflation plus the inflation risk premium:
Nominal gilt yield equals:
Real interest rate
plus Expected inflation
plus Inflation risk premium
To obtain the expected inflation rate the two other components must be removed from the nominal gilt yield.
As the real interest rate, Oftel uses the ILG rate for the maturity of interest. As estimates of the inflation risk premium it uses 0.5% for an horizon of 5 years and 1.0% for an horizon of fifteen years.
2. Gilt Risk-Premium Statistics
Although Oftel does not say how it derived its estimates of the inflation risk premium, the type of statistic that is commonly used for this purpose is shown in Table 1. The source of these data and all those used in this note is BZW (1995). The table shows that the average return on long-dated gilts in the period 1919 to 1994 exceeded the return on treasury bills by 1.17% per annum. This ex-post premium is for the BZW index of gilt returns. The index is based upon perpetual gilts up to 1962 and on 20-year gilts after that date.
Table 1: The Ex-post Risk-premium on Long Gilts
1919-1994 Arithmetic Mean Real Returns
Gilts 2.80%
T-bills 1.63%
Difference 1.17%
3. Discussion of the Oftel Assumptions
Table 2 shows a comparison of the inflation risk-premia used by Oftel and the premium shown in Table 1. At first sight, the Oftel assumptions look reasonable, as they reduce the risk-premium below the historical estimate to allow for the shorter maturity of the gilts that they are considering. Gilts with shorter maturities have lower inflation risk and should, therefore, have lower risk-premia. There are, however, three issues raised by the Oftel treatment of the risk-premium. The first is whether it is reasonable to use the historical average risk-premium as an indication of future risk-premia. The second is whether the Oftel adjustment for the maturity of the gilts is appropriate. Finally, Oftel applies the adjustment for the risk-premium to after-tax rates in some cases. The use of an estimate based on pre-tax rates as an adjustment to after-tax rates is questionable.
Table 2: A Comparison of the Oftel Inflation Risk-Premium
and the Historical Risk-Premium
Source Maturity Benchmark Premium
Oftel 5 years ILG rate 0.5%
Oftel 15 years ILG rate 1.0%
Historical 20 years to perpetual T-bill rate 1.17%
The long-run averages in Table 1 include very different behaviour in the three sub-periods: prior to WWII, during WWII, and post-war. Table 3 shows the ex-post premium in these sub-periods. BZW reports the data for these sub-periods as geometric mean returns rather than arithmetic mean returns, so they are not directly comparable with those in Table 1. Table 3 shows two strong features of the data. The first is that the post-war period did not show an ex-post risk-premium to gilts. In fact, gilst gave a lower return than T-bills during this period. The second feature is that the period of the war gave a much higher premium than other times. If the six years of the war are excluded from the calculation of the average premium, then it falls by 0.55%.
Oftel suggests that it is appropriate to use capital market statistics that weight recent periods more highly or exclude anomalous periods. If these criteria are applied to their estimates of the gilt inflation risk-premium, they would suggest lower estimates than those that they propose.
Table 3: A Comparison of the Historical Inflation
Risk-Premium in Different Periods
(Geometric Mean Real Returns)
Period Gilt Return T-bill Return Difference
1919-38 6.82% 4.65% 2.17%
1939-45 3.04% -2.69% 5.73%
1946-94 -0.40% 0.73% -1.13%
1919-94 1.77% 1.43% 0.34%
1919-94 (exc WWII) 1.64% 1.85% -0.21%
The second issue concerning the Offer estimates is the adjustment for the maturity of the gilts. Different gilts have different levels of risk and, therefore, should carry different risk-premia. The most common measure used to assess the risk of a gilt is its duration (see, for instance, Brealey and Myers (1991) Chapter 25). So we can look at the relative durations of the gilts that are being considered to see whether the Oftel assumptions about relative risk-premia appear reasonable. Table 4 shows the durations of four gilts: 5 year, 15 year, 20 year and perpetual. The first two are the gilts used by Oftel for the maturities that it wishes to consider. The last two are the gilts in the BZW gilt index. The calculation of duration depends on the yield of the gilt. The yield that has been used in Table 4 is 6.6%, the average yield for the period covered by the BZW figures.
Table 4: The Durations of Diffferent Par Gilts at 6.6% Yield
Maturity Duration
5 years 4.3 years
15 years 9.7 years
20 years 11.5 years
Perpetual 15.7 years
These durations can be used as relative measures of risk to adjust the inflation risk-premium for the maturities of different gilts. Starting from the historical estimate of 1.2% on the BZW index we can obtain duration-adjusted estimates for gilts of five and fifteen years maturity. Unfortunately, however, the BZW index is not of constant maturity. Prior to 1963 it is a perpetual, after that date it is a 20-year gilt. As an approximation we can weight together the durations of these two gilts in the proportions of the number of years that they form the BZW index. This gives an approximate duration for the BZW index of 13.9 years.
If we adjust the historical risk-premium of 1.17% that applies to the BZW index by the relative durations of five year and fifteen year gilts, we obtain duration-adjusted estimates of 0.36% and 0.84% respectively. These are somewhat below the estimates of 0.5% and 1.0% used by Oftel.
Finally, Oftel applies the adjustment for the risk-premium to after-tax rates in some cases. The use of an estimate based on pre-tax rates as an adjustment to after-tax rates is questionable. If the estimate of the risk-premium is adjusted to an after-tax equivalent, it will be lower. The size of this effect will depend on the tax rate.
4. Conclusions
Estimates of the inflation risk-premia in nominal gilts can be obtained by looking at the historical risk-premium on gilts relative to treasury bills. This premium in the period 1919-94 has been 1.17%. If this is adjusted for the relative risk of the BZW gilt index compared with the gilts being considered by Oftel, the Oftel estimates of the inflation risk-premium appear high. If, in addition, more weight is given to recent data and anomalous periods are excluded, then the Oftel estimates appear to be very high. Finally, Oftel applies the adjustment for the risk-premium to after-tax rates in some cases. The use of an estimate based on pre-tax rates as an adjustment to after-tax rates is questionable.
Thus all the assumptions used by Oftel bias upwards their estimate of the inflation risk-premium in gilts. This biases downwards their estimate of the nominal gilt rate adjusted for this risk-premium and also biases downwards their estimate of the expected inflation rate.
REFERENCES
Brealey, R.A. and S.C. Myers, 1991, Principles of Corporate Finance, McGraw-Hill.
BZW, 1995, The BZW Equity-Gilt Study, Barclays de Zoete Wedd.
Oftel, 1995, Pricing of Telecommunications Services from 1997, Office of Telecommunications.
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