Introduction

Review of the cost of capital of PTC

The present document details the findings of ANACOM on the definition of the methodology to be used for calculating the cost of capital of PT Comunicações, S.A. (PTC).

The term "cost of capital" is usually associated with the return that a particular investment must provide, defined as the rate of return required by investors, in light of the business risk.

At a corporate level, the concept of cost of capital relates to the decisions of investors with respect to the assets they invest in and the form of financing, with consideration to the maximisation of the value of the company. In a capital-intensive market, such as electronic communications, this is a particularly important issue.

In this context, ICP-ANACOM drew up principles ¹ for the development of an Analytical Accounting System (AAS), arguing that the total of incurred costs, including a margin of return, should be allocated to the entirety of PTC's businesses. Therefore, the unit costs of the various services include a margin of return on capital. ICP-ANACOM also determined that PTC communicate the parameters used in calculating the rate of return on capital.

PTC has been using the methodology of Weighted Average Cost of Capital (WACC) to calculate the rate of cost of capital and, as part of this methodology, the Capital Asset Pricing Model (CAPM) to calculate the cost of equity. In each of its financial years, PTC has presented details of its method for calculating the cost of capital, which is audited by ICP-ANACOM.

However, considering that: (i) the methodology for calculating the cost of capital has not been revised since its implementation, and may therefore be inappropriate given the current situation; and (ii) the determination of certain parameters (e.g. gearing, effective tax rate, cost of borrowed capital) is not independent from the management decisions of the company, ICP-ANACOM deems it essential and necessary to revise the methodology currently used.

Additionally, the process of calculating and charging the cost of capital which has been followed historically lacks predictability, insofar as it is undertaken subsequent to the financial year in question. Moreover, PTC's cost of capital has direct and material impact on the costs of the products and services subject to "ex-ante" regulation, influencing the prices of several offers subject to this regulation, and, as a result, affecting its customers. As such, ICP-ANACOM is of the position that a review is required of this process in order to reduce this lack of predictability and to provide greater regulatory certainty, in a framework of greater transparency for all stakeholders.

The "ex ante" establishment of transparent rules regarding the determination of the cost of capital contributes to a predictable environment in which agents can adapt, anticipate and manage their expectations more effectively. Additionally, establishing preventive rules reduces the need for later investigation on the possible abuse of market power by setting excessive capital costs, which investigation is normally complex, time-consuming and potentially a cause of dispute.

The obligation of cost orientation of prices, applicable in certain relevant markets to operators with significant market power (SMP), aims to establish prices at a level which enables the market to function properly, as far as possible as if it were a competitive market, also taking into account the investment made by the operator and the need to guarantee an appropriate return in view of the risks involved.

In this sense, WACC is fundamental and key to regulatory decisions. The definition of an appropriate rate of return aims to (i) compensate the opportunity cost of the investment concerned, to ensure investment incentive; (ii) ensure that there are no distortions in the markets brought through discriminatory and anti-competitive practices; (iii) eliminate potential barriers to the entry of new competitors; and (iv) protect consumers from excessive prices.

Therefore, ICP-ANACOM considers it appropriate and urgent to reassess the methodology that has been used by PTC, as regards the determination of various parameters used in the calculation of the rate of the cost of capital, in particular the risk-free interest rate, the beta factor, the risk premium, gearing ², the tax rate and the cost of borrowed capital.

In addition to an internal analysis, ICP-ANACOM contracted a consultancy study on the methodology to be used for determining the cost of capital of PTC, as the undertaking with SMP, from the company PriceWaterhouseCoopers, SROC, S.A. (PwC) with the following objectives: (i) obtaining a detailed analysis and critique of the parameters used in the calculation of the rate of cost of capital of PTC; and (ii) obtaining a presentation of alternative methodologies for calculating these parameters. The study ³ resulting from this consultation, from which ICP-ANACOM has struck the elements considered confidential, was released to the market as part of the consultation process.

As a result of the analysis conducted, the objective of the present document is to define a set of methodological principles governing the calculation of the rate of the cost of capital of PTC and the subsequent determination of its value for the three-year period 2009-2011, which reflects, in a balanced way, an adequate return on the activity of the company.

Regulatory Framework

Law No 5/2004 ⁴ of 10 February states in paragraph 2 of Article 74 that "in imposing the obligations (in respect of cost recovery and price controls, including obligations for cost orientation of prices and obligations concerning cost accounting systems), the NRA shall: a) Take into account the investment made by the operator and allow said operator a reasonable rate of return on the capital invested, taking the risks involved into account(...)"

Meanwhile, it is stated in Commission Recommendation 98/322/EC of 8 April (paragraph 5.1 of its Annex) that: "charges for interconnection be cost-oriented, including a reasonable return on investment" and that "the cost of capital of operators should reflect the opportunity cost of funds invested in network components and other related assets".

Furthermore, according to paragraph 5.1 of this Annex "The cost of capital of operators should reflect the following: the (weighted) average cost of debt for the different forms of debt held by each operator; the cost of equity as measured by the returns that shareholders require in order to invest in the network given the associated risks; and the values of debt and equity. This information can then be used to determine the weighted average cost of capital (WACC) using the following formula: CMPC = re * E/(D+E) + rd *  D/(D+E) where re is the cost of equity, rd is the cost of debt, E is the total value of equity and D is the total value of interest-bearing debt."