[Federal Register Volume 61, Number 47 (Friday, March 8, 1996)]
[Proposed Rules]
[Pages 9411-9413]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-5426]



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FEDERAL COMMUNICATIONS COMMISSION
47 CFR Part 76

[MM Docket No. 93-215; FCC 95-502]


Cable Television Rate Regulation; Cost of Service Rules

AGENCY: Federal Communications Commission.

ACTION: Proposed rule.

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SUMMARY: The Commission adopted the Second Report and Order and First 
Order on Reconsideration in MM Docket 93-215 to refine existing cost of 
service rules and to create final rules governing standard cost of 
service showings filed by cable operators seeking to justify rates for 
regulated cable services. In a Further Notice of Proposed Rulemaking 

[[Page 9412]]
(``FNPRM''), the Commission proposes use of an operator's actual debt 
cost and capital structure to determine the final cost of capital (or 
rate of return). The FNPRM requests comment regarding the method to 
determine the value of equity and debt, including the use of a market 
valuation of equity to establish the proportion of equity in an 
operator's capital structure.

DATES: Comments are due May 7, 1996. Replies are due June 6, 1996.

FOR FURTHER INFORMATION CONTACT: Tom Power, Cable Services Bureau, 
(202) 416-0800.

SUPPLEMENTARY INFORMATION: This is a synopsis of the Further Notice of 
Proposed Rulemaking in MM Docket No. 93-215, FCC 95-502, adopted 
December 15, 1995 and released January 26, 1996.
    The complete text of this Further Notice of Proposed Rulemaking is 
available for inspection and copying during normal business hours in 
the FCC Reference Center (room 239), 1919 M Street, NW., Washington, 
DC, and also may be purchased from the Commission's copy contractor, 
International Transcription Services, Inc. (``ITS Inc.'') at (202) 587-
3800, 2100 M Street, NW., Suite 140, Washington, DC 20017.

I. Further Notice of Proposed Rulemaking

A. Non-Unitary Rates of Return

    1. Although a unitary rate of return applied to all cable operators 
simplifies the administrative burdens of estimating an operator's rate 
of return, it squeezes a wide variety of risk profiles into the same 
regulatory box. We tentatively conclude that risk variables among cable 
operators may be sufficiently widespread to justify consideration of an 
alternative rate of return methodology tailored more closely to the 
financial circumstances of individual cable operators. At the same 
time, we recognize the risk that individualized rates of return could 
involve highly detailed and potentially burdensome capital cost 
determinations in rate cases. Thus, if we adopt a more tailored rate of 
return methodology, we will nonetheless retain the current presumptive 
rate, and its concomitant procedures for overcoming that presumption, 
as an alternative to any new methodology.
    2. The capital markets have recognized a significant measure of 
risk within the cable industry. Cable stocks trade at significant 
premiums relative to the overall equity market and cable companies 
often have high debt costs due to low investment grades. In addition, a 
fair proportion of homes passed by cable do not subscribe to the 
service, suggesting consumers and businesses do not regard cable as a 
traditional utility service. We believe it may be necessary to 
recognize such risk diversity in the cable industry and no longer 
presume that a single rate of return should be applied to all cable 
operators making cost of service showings. We seek comment on an 
alternative to the presumptive 11.24% rate of return. This alternative 
would provide an equity cost estimate that recognizes the historic 
growth orientation of cable investors and would allow actual debt cost 
and use company specific capital structures.

B. Cost of Equity

    3. We propose to use the capital asset pricing model (``CAPM'') as 
a method to estimate the cost of cable equity as an alternative to the 
discounted cash flow (``DCF'') approach used in the initial Cost Order, 
59 FR 17975 (April 15, 1994). As a general matter, the DCF method 
relies heavily on the consistent payout of dividends as a key part of 
its formula, a factor that does not apply generally to equities. The 
absence of dividends may reflect fundamental differences in the 
strategic nature of cable business operations and the operation of 
companies whose stocks make up a broad stock index such as the S&P 400. 
A formula designed to measure a future dividend or income stream may 
not be an appropriate model for estimating the rate of return demanded 
by investors who are willing to forgo an income stream in favor of 
growth through reinvested cash flow. The CAPM attempts to quantify the 
risk necessary to induce an investor to follow this kind of growth-
oriented strategy. Under CAPM, equity cost is calculated by assigning 
an equity premium to a company's stock that is commensurate with the 
stock's systematic risk (risk that cannot be avoided through equity 
diversification). Under this model, a stock's equity rate of return is 
equal to the risk-free rate (obtainable on a risk-free government debt 
instrument) plus a premium based on the systematic risk of a given 
security (the beta).
    4. The Commission, in the Cost Order, decided against using the 
CAPM to determine equity cost due to concerns that insider holdings and 
monopoly profit expectations would distort the measurement of risk 
associated with providing regulated cable services. Based on data 
submitted in response to the Further Notice, we tentatively conclude 
that it is unnecessary to reject alternative methods of measuring 
equity cost. The Commission's initial decision to forgo the use of the 
CAPM stemmed from a concern that insider decisions could overstate the 
size of the risk premium assigned to cable stocks under the CAPM. A 
systematic review of the relationship between insider holdings and 
movements in stock price, however, was not conducted and data submitted 
in response to the Further Notice, do not support the assertion that 
cable insiders exaggerate the stock prices of their companies.
    5. In addition, with respect to monopoly expectations in cable 
stock prices, we do not have sufficient data to determine the extent of 
the relationship, if any, between the existence of monopoly power and 
the stock price volatility premium assigned to cable company stocks.
    6. In establishing an equity cost for cable companies, we propose 
to rely on data from the cable industry itself rather than forgo such 
direct evidence of industry cost in favor of some other surrogate 
industry or stock group. In the Cost Order, we developed an equity cost 
estimate based on a selected quartile of the S&P 400. As set forth 
above, however, we do not believe it necessary to eschew reliance on 
betas of publicly-traded cable stocks as part of the cable equity cost 
calculation. Using data submitted to the Commission in response to the 
Further Notice, the Commission examined betas for 11 cable companies 
that derive the vast majority of their revenues from regulated cable 
services. Recognizing that cable industry investment in recent years 
has focused on long term revenue potential from unregulated services, 
we have limited our analysis of betas to the years 1987 through 1992. 
Based on data submitted to the Commission, the average beta for cable 
industry equity investment is 1.42. This indicates that, on average, 
cable equities are 42% more volatile than the general stock market.
    7. Because we propose to examine an investment period of several 
years, we propose to use the risk-free rate of the average yields on 
five-year U.S. Treasury Notes after 1987. Based on Federal Reserve 
data, the average yield on five-year U.S. Treasury Notes from 1987 
through the third quarter of 1995 is 7.27%. Although this yield exceeds 
the current yield on five-year notes, this figure is an average that 
accounts for numerous rate fluctuations over an extended time period. 
We believe an average risk-free rate may be appropriate for selecting a 
cost of equity for cable because the equity cost estimate would be 
relied upon in cost of service filings for at least the period 
preceding an operator's next major rate filing. 

[[Page 9413]]
Moreover, we proposed to update this rate to account for subsequent 
interest rate changes.
    8. Consistent with the CAPM approach, we estimate the average 
return on investment in the general equity market. Using the S&P 500 
from 1987 through the third quarter of 1995, the average compounded 
return has been 13.53%. Applying the CAPM formula, the general equity 
market premium above the risk-free rate of return is 6.26% (13.53%-
7.27%). The 1.42 beta for cable equity investment multiplied by 6.26% 
provides a cable equity premium of 8.89 percentage points above the 
average risk-free rate. Adding the risk-free rate to the cable equity 
premium results in an equity cost figure of 16.16%. We propose that the 
average cost of equity for investment in cable operators providing 
regulating cable services is 16.16%. We propose to adjust the figures 
used to estimate the equity cost periodically. We ask comment on this 
approach.
    9. We also request comment on a method that would, consistent with 
the goal of maintaining administrative feasibility, adjust the equity 
cost to reflect extraordinary financial risk. For example, should the 
Commission consider debt-to-cash flow multiples as a mechanism to 
quantify risk levels? We solicit data to establish equity cost figures 
above and below the proposed 16.16% average equity cost estimate for 
operators with debt burdens significantly above and below the average 
in our sample.

C. Cost of Debt

    10. The other principal component of the overall cost of capital is 
the cost of debt. In the Cost Order, we relied on debt cost estimates 
for the cable industry specifically and concluded that the range for 
the average cost of fixed rate debt established by information 
submitted in the cost of service proceeding was 7.8% to 8.65%. The 
Commission noted the substantial proportion of floating rate debt among 
cable entities and determined that a cautious estimate would place 
average debt cost at 8.5%.
    11. We propose to rely on more direct estimates of capital cost by 
gauging an operator's debt cost to its actual cost. This debt cost 
would encompass fees or other premiums that the operator may pay to 
obtain debt financing. We invite comment on this proposal.

D. Capital Structure

    12. In the Cost Order, we decided against using embedded capital 
structures and market equity values to establish the capital structure 
used to calculate the overall rate of return. We indicated that a 
capital structure range may be more appropriate for the debt-laden 
cable industry and set that range at 40% to 70% debt and used that 
range in setting the overall capital cost.
    13. We tentatively conclude, however, that actual, i.e., 
individualized, capital structures should be applied to the estimation 
of the overall cost of capital. The estimation of debt costs is 
relatively straightforward because the cost of debt can be documented 
and certified by independent accounting services. Because debt costs 
can be measured directly, we tentatively conclude that reliance on the 
actual percentage of debt in an operator's capital structure will 
ensure the most accurate estimation of interest costs. Thus, if an 
operator elected not to rely on the presumptive 11.25% rate of return 
in favor of the alternative capital cost measure described in this 
Order, we would look to the actual capital structures of the operator 
to determine the appropriate overall capital cost.
    14. Estimating the amount of equity in an operator's structure is a 
complex proposition. Many operators have a negative net worth. We 
recognize, however, that, in the case of several publicly-traded cable 
companies, the stock of operators with negative book values trades in 
significant volumes in the open market. While public utility regulation 
has relied traditionally on book value estimations of equity in 
determining capital structures for regulated utilities, it may be 
appropriate to take note of the equity transactions in the cable 
industry that occur frequently, including the decisions of cable 
investors to pay multiples of cash flow for cable systems that, based 
on book value, should be worth less than nothing.
    15. In order to rely on actual capital structures, however, we must 
ensure that measurement of the equity proportion filters out a 
``premium'' for anticipated gains in unregulated services. As we 
consider this alternative, however, we recognize that several issues 
must be addressed and resolved. Moreover, we remain committed to an 
approach that is administratively feasible. To assist the Commission in 
this endeavor, we request comment on the following issues:
    a. What mechanism or analysis should guide the Commission in 
estimating the equity proportion of an operator's capital structure 
that is dedicated to regulated services?
    b. How should the Commission estimate the proportion of equity in 
an operator's capital structure when that operator is not publicly-
traded?
    c. Should the Commission rely on the book value of debt or the 
market value of debt in estimating the proportion of debt in an 
operator's capital structure?
    d. Can the Commission develop a reasonable estimate of an 
operator's capital structure by combining the market value of its 
equity and the book value of its debt?
    e. If market capitalization is used to measure the proportion of 
equity in an operator's capital structure, will increases in the 
operator's stock price drive up subscriber rates by increasing the 
proportion of equity in the operator's capital structure? If so, how 
can the Commission ensure that reliance on market capitalization 
measures for equity will not unduly impact subscriber rates?

III. Regulatory Flexibility Analysis

    16. Pursuant to Section 603 of the Regulatory Flexibility Act, the 
Commission has prepared the following initial regulatory flexibility 
analysis (``IRFA'') of the expected impact of these proposed policies 
and rules on small entities:
    The proposals, if adopted, will not have a significant effect on a 
substantial number of small entities.

List of Subjects in 47 CFR Part 76

    Cable television, Reporting and recordkeeping requirements.

Federal Communications Commission.
William F. Caton,
Acting Secretary.
[FR Doc. 96-5426 Filed 3-7-96; 8:45 am]
BILLING CODE 6712-01-P