[Federal Register Volume 63, Number 202 (Tuesday, October 20, 1998)]
[Proposed Rules]
[Pages 55988-55996]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-27988]


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FEDERAL COMMUNICATIONS COMMISSION

47 CFR Part 65

[CC Docket No. 98-166; FCC 98-222]


Prescribing the Authorized Unitary Rate of Return for Interstate 
Services of Local Exchange Carriers

AGENCY: Federal Communications Commission.

ACTION: Proposed rule.

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SUMMARY: This document initiates a proceeding to represcribe the 
authorized rate of return for interstate access services provided by 
incumbent local exchange carriers (ILECs). In this proceeding the 
Commission revised the rules governing procedures and methodologies for 
prescribing and enforcing the rate of return for ILECs not subject to 
the price cap regulation.
    In the Notice of Proposed Rulemaking (NPRM) the Commission proposes 
corrections to errors in the codified formulas for the cost of debt and 
cost of preferred stock and seek comment on whether this proceeding 
warrants a change in the low-end formula adjustment for local exchange 
carriers subject to price caps.

DATES: Comments are due December 3, 1998 and reply comments are due 
February 1, 1999.

ADDRESSES: Parties should send comments or reply comments to office of 
the Secretary, Magalie Roman Salas, Office of the Secretary, Federal 
Communications Commission, 1919 M Street, N.W., Room 222, Washington, 
D.C. 20554.
    Parties who choose to file by paper should also submit their 
comments on diskette. These diskettes should be submitted to Warren 
Firschein of the Common Carrier Bureau's Accounting Safeguards 
Division, 2000 L Street, N.W., Room 257, Washington, D.C. 20554. Such a 
submission should be on a 3.5 inch diskette formatted in an IBM 
compatible format using WordPerfect 5.1 for Windows or compatible 
software. Spreadsheets should be saved in an Excel 4.0 format. The 
diskette should be accompanied by a cover letter and should be 
submitted in ``read only'' mode. The diskette should be clearly 
labelled with the commenter's name, proceeding (including the docket 
number in this case [CC Docket No. 98-166]), type of pleading (comment 
or reply comment), date of submission, and the name of the electronic 
file on the diskette. The label should also include the following 
phrase ``Disk Copy--Not an Original.'' Each diskette should contain 
only one party's pleadings, preferably in a single electronic file. In 
addition, commenters must send diskette copies to the Commission's copy 
contractor, International Transcription Service, Inc., 1231 20th 
Street, N.W., Washington, D.C. 20036.
    Additional filing information can be found in the Comment Filing 
Procedure section of this document.

FOR FURTHER INFORMATION CONTACT: Warren Firschein, Accounting 
Safeguards Division, Common Carrier Bureau, (202) 418-0844.

SUPPLEMENTARY INFORMATION: This is a summary of the Commission's Notice 
Initiating a Prescription Proceeding and Notice of Proposed Rulemaking, 
CC Docket 98-166, adopted September 8, 1998, and released October 5, 
1998. The full text of this Notice Initiating a Prescription Proceeding 
and Notice of Proposed Rulemaking is available for inspection and 
copying during normal business hours in the FCC Public Reference Room 
(Room 230), 1919 M St., N.W. Washington, D.C. The complete text of this 
document may also be purchased from the Commission's copy contractor 
International Transcription Service, 1231 20th Street, N.W., 
Washington, D.C. 20036.

Summary of the Notice Initiating a Rate-of-Return Prescription

    1. The Commission is required by section 201 of the Communications 
Act of 1934 to ensure that rates are ``just and reasonable.'' To ensure 
that their rates for interstate access are just and reasonable, the 
Commission prescribes an authorized rate of return for the 
approximately 1300 incumbent local exchange carriers (ILECs) that are 
subject to rate-of-return rather than price cap regulation. This Notice 
initiates a proceeding to represcribe the authorized rate of return for 
interstate access services provided by ILECs. In this Notice, we seek 
comment on the methods by which we could calculate the ILECs' cost of 
capital.

[[Page 55989]]

    2. The rate of return we prescribe for ILECs' interstate operations 
links our regulatory processes and carriers' actual costs of capital 
and equity. The Commission periodically represcribes this rate to 
ensure that the service rates filed by incumbent local exchange 
carriers subject to rate-of-return regulation continue to be just and 
reasonable. In its 1995 Rate of Return Represcription Procedures Order, 
60 FR 28542 (June 1, 1995), the Commission revised its prescription 
procedures to require that it consider commencing a new rate-of-return 
prescription proceeding whenever yields on 10-year U.S. Treasury 
securities remain, for a consecutive six-month period, at least 150 
basis points above or below a certain reference point (the ``trigger 
point''). The reference point is the average of the average monthly 
yields for the consecutive six-month period immediately prior to the 
effective date of the current rate-of-return prescription. That 
reference point is currently 8.64 percent. For the consecutive six-
month period immediately following the release of the 1995 Rate of 
Return Represcription Procedures Order, the yields were more than 150 
basis points below this reference point. Accordingly, on February 6, 
1996, the Bureau issued a Public Notice, AAD 96-28, 61 FR 6641 
(February 21, 1996), seeking comment on whether to commence a rate-of-
return prescription proceeding. Eleven parties filed comments; five 
parties filed replies.
    3. We agree with MCI and GSA that we should initiate a rate-of-
return prescription proceeding at this time. The sustained low yields 
of the U.S. treasury securities strongly suggest that the current 
prescribed rate of return is much higher that the rate required to 
attract capital and earn a reasonable profit. Our duty to ensure that 
service rates are just and reasonable requires that we undertake a 
prescription proceeding at this time.

A. General Considerations

    4. We prescribe a rate of return in order to ensure that rate-of-
return carriers' rates for interstate access services are ``just and 
reasonable.'' Carriers subject to rate-of-return regulation, however, 
may also provide interstate interexchange services. For such carriers, 
our prescribed rate of return is applied to their interexchange access 
services as well. We seek comment on whether the same prescribed rate 
should be applied to rate-of-return carriers' interstate access and 
interexchange services, or whether the prescribed rate should be 
adjusted when applied to provision of interexchange services. 
Commenters supporting the application of different rates should 
indicate how the prescribed rate for interstate interexchange services 
should be determined. We also seek comment on whether the rate of 
return prescribed for interstate access should also be used for other 
purposes, including determination of universal service support.

B. Weighted Average Cost of Capital

    5. The weighted average cost of capital is used to estimate the 
rate of return that the ILECs must earn on their investment in 
facilities used to provide regulated interstate services in order to 
attract sufficient capital investment. Our rules specify that the 
composite weighted average cost of capital is the sum of the cost of 
debt, the cost of preferred stock, and the cost of equity, each 
weighted by its proportion in the capital structure of the telephone 
companies. The formulas for determining the cost of debt, cost of 
preferred stock, and capital structure are codified in Secs. 65.302, 
65.303, and 65.304, respectively of the Commission's rules. Each of 
these components are calculated using routinely collected data from the 
Automatic Reporting Management Information System (ARMIS) reports. The 
rules do not include a formula for calculating the cost of equity. 
Instead, they state that ``the cost of equity shall be determined in 
prescription proceedings after giving full consideration to the 
evidence in the record, including such evidence as the Commission may 
officially notice.''

C. Capital Structure

    6. Prior to the 1995 Rate of Return Represcription Procedures 
Order, Part 65 of the Commission's rules prescribed a method of 
computing the capital structure of all ILECs based on a composite of 
the capital structures of the Regional Bell operating companies 
(RBOCs). In the 1995 Rate of Return Represcription Procedures Order, 
the Commission revised its methodology to use instead the capital 
structure of all ILECs with annual revenues of $100 million or more. 
This capital structure methodology was codified in order to ``simplify 
future represcription proceedings without sacrificing needed 
accuracy.'' The proportion of each cost-of-capital component in the 
capital structure is equal to the book value of that particular 
component divided by the book value of the sum of all components. For 
example, the proportion of debt in the capital structure is equal to 
the book value of debt divided by the sum of the book value of debt, 
equity, and preferred stock.

D. Embedded Cost of Debt

    7. The cost of debt is based on the sale of bonds and other debt-
related securities to finance telephone operations. Prior to the 1995 
Rate of Return Represcription Procedures Order, Part 65 of the 
Commission's rules required each of the RBOCs to perform detailed 
calculations to determine their embedded cost of debt based upon data 
contained in their Form 10-K or 10-Q statements filed with the 
Securities and Exchange Commission. In the 1995 Rate of Return 
Represcription Procedures Order, the Commission altered the methodology 
to be used in a prescription proceeding for calculating the embedded 
cost of debt, using data submitted in ARMIS report 43-02 by all ILECs 
with annual revenues of $100 million or more. The Commission defined 
embedded cost of debt to be the total annual interest expense divided 
by average outstanding debt.

E. Cost of Preferred Stock

    8. The 1995 Rate of Return Represcription Procedures Order revised 
the methodology for calculating the cost of preferred stock to be 
consistent with the calculation of the cost of debt and directed that 
the calculation be based on data routinely submitted by ILECs with 
annual revenues of $100 million or more rather than by the RBOCs, as 
was done in the 1990 rate-of-return proceeding. The methodology for 
calculating the cost of preferred stock is to divide total annual 
preferred dividends by the proceeds from the issuance of preferred 
stock.

F. Cost of Equity

1. Background
    9. Prior to the 1995 Rate of Return Represcription Procedures 
Order, Part 65 of the Commission's rules required the RBOCs to prepare 
two historical discounted cash flow estimates and submit state cost-of-
capital determinations to assist the Commission in calculating the 
ILECs' cost of equity. In the 1995 Rate of Return Represcription 
Procedures Order, the Commission concluded that the methodology for 
estimating equity costs, as well as the data to be used in applying 
particular methodologies, flotation costs, and periods of compounding, 
should be determined anew in each proceeding. Accordingly, Part 65 no 
longer prescribes a

[[Page 55990]]

methodology for determining ILECs' cost of equity.
    10. In this section, we propose several methods for estimating the 
cost of equity for interstate services. We seek comment on each of 
these methods and invite commenters to propose additional 
methodologies. Commenters should discuss whether in this proceeding we 
should use only one or more than one methodology to estimate this 
component of the carriers' cost of capital. Commenters preferring the 
use of more than one methodology are requested to specify how we should 
weigh the results of these methods to estimate the cost of equity. We 
expect that in the direct cases, parties will use the results from the 
cost of equity methods they propose. We note that we will use Standard 
and Poor's Compustat PC Plus database as our source for financial data 
in this proceeding.
2. Surrogate Companies
    11. The methods of estimating the cost of equity that we identify 
in this NPRM use stock prices and other measures of investor 
expectations regarding the ILECs' interstate services. Because ILECs do 
not issue stock or borrow money solely to support interstate service, 
investor expectations that would affect the cost of equity for 
interstate services cannot be measured directly. For this reason, we 
must select a group of companies facing risks similar to those 
encountered by the rate-of-return ILECs in providing interstate service 
for which we can estimate the cost of equity. Risk is the uncertainty 
associated with the ability of an investment to generate the return 
expected by investors. As was done in the 1990 proceeding 
(Resprescribing the Authorized Rate of Return for Interstate Services 
of Local Exchange Carriers, Order, CC Docket No. 89-624, 55 FR 51423 
(December 14, 1990)), once the surrogates are selected, their firm-
specific data are applied to the cost-of-equity methodologies selected 
herein, and average or median returns for the surrogate group are 
calculated in order to determine a zone of reasonableness for cost of 
equity.
    12. We seek comment on what group of companies we should select as 
appropriate surrogates for estimating the cost of equity for interstate 
services. In 1986, the Commission adopted the RBOCs as a surrogate 
group of firms for the interstate access industry. In 1990, the 
Commission again concluded that, despite their diversification into 
nonregulated businesses, the RBOCs were still the most appropriate 
surrogates. Further, the Commission concluded that most competitive, 
nonregulated businesses are riskier than the regulated interstate 
access business and therefore, the RBOCs are riskier as a whole than 
their regulated telephone operations. As a result, the Commission 
determined that the cost-of-equity estimate for an RBOC as a whole may 
overstate the cost of equity for interstate access alone and considered 
this potential overstatement when determining the cost-of-equity 
estimates. In the 1995 Rate of Return Represcription Procedures Order, 
the Commission found that the level of risks that RBOCs face was no 
longer similar to the risk confronting carriers subject to rate-of-
return regulation and therefore the RBOCs' risk may not provide the 
best data upon which to base a uniform rate-of-return prescription. 
With the uncertainty following the passage of the 1996 Act, however, 
the RBOCs' cost of equity may no longer overstate that of rate-of-
return carriers. As a result, we tentatively conclude that the RBOCs, 
more than any other group of companies, once again constitute the best 
surrogate for carriers subject to rate-of-return regulation. We 
tentatively conclude that the RBOCs' current risk most closely 
resembles the current risk encountered by the rate-of-return carriers. 
The RBOCs and rate-of-return ILECs both provide interstate services, 
their primary business is still the provision of telephone service and 
neither is subject to any meaningful competition for regulated 
telecommunications services in their service area. We seek comment on 
this tentative conclusion. In addition, we seek comment whether we 
should incorporate the financial data of any other publicly traded ILEC 
in the cost-of-equity analysis.
    13. In the 1990 proceeding, although we concluded that the RBOCs 
were the most appropriate surrogate, we made a downward adjustment to 
the estimated cost of equity to account for the fact that the RBOCs' 
interstate access business was less risky than their business as a 
whole. We seek comment on whether a similar adjustment should be made 
in this proceeding. Specifically, we seek comment on whether the RBOCs' 
interstate access business today is more or less risky than their 
operations as a whole. In the 1990 proceeding, ILECs submitted stock 
analysts' reports in support of their argument that the proposed DCF 
formula did not account for the growth in cellular operations. In 
responding, commenters should submit stock analysts' reports indicating 
the relative riskiness of the RBOCs' lines of business.
3. Discounted Cash Flow Methodology
    14. Under the Discounted Cash Flow (DCF) methodology, a firm's cost 
of equity is calculated according to a formula involving the annual 
dividend and price of a share of its common stock, along with the 
estimated long-term dividend growth rate. The standard DCF formula is 
the annual dividend on common stock divided by the price of a share of 
common stock (termed the ``dividend yield'') plus the long-term growth 
rate in dividends.
    15. Growth Rate. The DCF method requires an estimate of the long-
term growth rate. In both the 1986 and 1990 proceedings, the Commission 
used the Institutional Brokers Estimate Service (``IBES'') as the 
source of the median forecast of long-term growth. In this proceeding, 
the Commission will use the S&P Analysts' Consensus Estimates (``ACE'') 
of growth in long-term earnings per share as part of the database we 
obtain from Standard & Poor's. We seek comment on whether ACE provides 
information comparable to IBES and whether ACE estimates should be used 
for purposes of this proceeding.
    16. Quarterly Dividend. In both the 1986, 51 FR 1795, at 1808 
(January 15, 1986) as amended 51 FR 4596, at 4598 (February 6, 1986) 
and 1990 proceedings, we rejected the ILECs' arguments that the 
quarterly dividend should be compounded to account for the payment of 
dividend on a quarterly, rather than annual, basis for three reasons: 
(1) Compounding is reflected in the revenue requirement because the 
Commission uses a mid-year rate base; (2) the adjustment adds a 
complexity that is not offset by increased accuracy; and (3) the 
parties did not establish that analysts and investors actually use 
quarterly compounding models nor did the parties demonstrate how using 
the quarterly model may affect the market price. For these reasons, we 
tentatively conclude that we should not use quarterly compounding in 
the DCF formula. We seek comment on this tentative conclusion.
    17. Flotation Costs. Flotation costs a, the Commission concluded 
that it would not include an adjustment for flotation costs for three 
reasons: (1) The RBOCs were not issuing stock at that time; (2) no 
evidence suggested that past costs remain unrecovered; and (3) the 
Commission's treatment of flotation costs had not adversely affected 
the carriers' stock prices. We concluded that if carriers were 
concerned about recovery of flotation costs, they could seek a change 
in the Commission's prescribed accounting system. We reaffirm these 
prior decisions, and

[[Page 55991]]

tentatively conclude that in this proceeding we should make no 
adjustments to our estimate of the cost-of-equity component of ILECs' 
cost of capital to compensate for flotation costs. We seek comment on 
this tentative conclusion.
    18. Classic DCF Calculation. The ``classic'' DCF method uses the 
expected annual dividend for the next year, the current share price and 
the current-expected long-term earnings growth rate to calculate the 
cost of equity. In the Phase II Reconsideration Order, the Commission 
adopted this version of the DCF methodology. In 1990, the Commission 
required the RBOCs to submit the ``classic'' DCF methodology as applied 
to the RBOCs, the S&P 400, and a group of large electric utilities and 
this method was given the greatest weight in calculating the cost of 
equity in the 1990 proceeding. The S&P 400 and large electric utilities 
were used as equity market benchmarks to determine whether the 
estimates calculated for the RBOCs were reasonable. We tentatively 
conclude that this ``classic'' form of the DCF should also be applied 
to the group of surrogate companies selected as a result of this 
proceeding. Consistent with our analysis in 1990, we tentatively 
conclude that the ``classic'' DCF formula more accurately estimates the 
cost of equity than does the historical DCF method, discussed below. We 
seek comment on this tentative conclusion and ask the parties to 
comment on the weight to be given to this methodology. In addition, we 
tentatively conclude that the S&P 400 (now termed the S&P Industrials) 
and the large electric utilities should be used as equity market 
benchmarks against which the RBOCs' cost-of-equity estimates can be 
evaluated. We seek comment on this tentative conclusion. Finally, in 
the 1990 proceeding, for purposes of our cost-of-equity benchmark 
analysis, the S&P 400 and large electric utilities groups were screened 
to exclude those companies that did not pay dividends, had less than 
five analyst estimates of long-term earnings growth reported by IBES, 
and had DCF cost-of-equity estimates less than the yield on 10-year 
treasury bonds. We seek comment on whether these screens are still 
appropriate and, if not, what screens, if any, should be used and why.
    19. In 1990, the primary cost-of-equity conclusions were based on a 
series of then-recent monthly DCF estimates for the RBOCs. The 
Commission used the average of the monthly high and low stock prices 
for each month of the period under analysis to establish the current 
stock price. The Commission found that ``these monthly periods are 
sufficiently long to eliminate the possibility that a particular price 
may be an aberration, but recent enough to assure that data from past 
periods do not obscure trends.'' We tentatively conclude that using the 
average of the monthly high and low stock prices as inputs to the 
``classic'' form of the DCF will provide reliable estimates of the 
current stock price. We seek comment on this tentative conclusion. In 
reacting to this tentative conclusion, commenters should discuss the 
time for which the DCF calculation should be made. For example, the 
commenters might propose the most recent quarter available or each 
month's estimate during the pendency of the case as was done in the 
1990 proceeding.
    20. Finally, as part of the specification of the ``classic'' DCF 
model in the 1990 proceeding, we determined that the expected dividend 
should be calculated by multiplying the current annualized dividend by 
one plus one-half the analysts' estimated long-term growth rate due to 
timing differences among the companies as to the date of their dividend 
increases. The Commission concluded that if the dividend yield was to 
be determined ``at a point during the year just before the carriers 
were to announce a dividend increase, it might be accurate to grow the 
dividend rate by a full year's expected growth.'' The Commission, 
however, found that RBOCs' dividends had ``been increased in the six 
months prior to the analysis and the stock prices used in the analysis 
reflected these higher dividends.'' Multiplying the dividend by the 
full growth rate would overstate the estimated annual growth in 
dividends and increase the DCF estimated cost of equity. Because we 
have no reason to believe that all companies in the surrogate group 
will declare dividend increases simultaneously, we tentatively conclude 
that we should increase the dividend by one-half the estimated annual 
growth. We seek comment on this tentative conclusion.
    21. Historical DCF Calculation. At least two other variations of 
DCF that in the past we have considered using to estimate ILECs' cost 
of equity rely upon historical data to compute that cost. In both 
variations, the cost of equity is calculated as the sum of D/P + G, 
where D is the average annual dividend during the two calendar years 
preceding the prescription filing and P is the average daily price of 
the RBOCs' common stock during each trading day during the two calendar 
years preceding the prescription proceeding. In the first variation, G 
would be the annual rate of growth in dividends derived from the slope 
of the ordinary least squares linear trend line of quarterly dividends 
that were declared during the two calendar years preceding the 
prescription proceeding. In the second variation, G would be the simple 
average of the IBES median long-term growth rate estimates of earnings 
during the two calendar years preceding the prescription filing. In the 
1990 and 1995 proceedings, the Commission rejected both these 
variations of the historical DCF methodology because they average 
inputs over a period neither short enough to reflect current market 
conditions nor long enough to reveal historical trends. For these 
reasons, the 1995 Rate of Return Represcription Procedures Order does 
not mandate use of historical DCF as part of a rate-of-return 
proceeding. We tentatively conclude that this DCF methodology should be 
given no weight in this proceeding. We seek comment on this tentative 
conclusion.
    22. In the 1990 proceeding, parties presented several variations of 
the general DCF formula. We seek comment on whether there are other 
variations to the DCF methodology that we should now consider using in 
this proceeding. Commenters proposing different versions should explain 
in detail how the various parameters would be estimated, including how 
long the period from which we draw data for analysis should be, why 
they believe this is a reasonable period to use and identify the source 
of the data on which the DCF calculation would draw. Finally, 
commenters should indicate the weight to be given the methodology they 
propose.
4. Risk Premium Methodologies
    23. Risk premium methodologies can also be used to calculate the 
cost of equity. In this section we discuss two types of risk premium 
methodologies. The first was termed traditional risk premium analysis 
in the 1990 proceeding and we will continue to use that term. The 
second type of risk premium analysis is the Capital Asset Pricing Model 
(``CAPM''). These two methods share fundamental similarities in that 
they select a ``risk free'' investment such as long-term United States 
Treasury bonds and add a risk premium to return on that ``risk free'' 
investment to derive a cost-of-equity estimate. The differences between 
the two methods arise in the manner by which the risk premium is 
calculated. Under a more traditional risk premium methodology, the risk 
premium is typically estimated as the historical or estimated spread 
between equity security returns and bond yields. Under

[[Page 55992]]

the CAPM methodology, the risk premium is formally quantified as a 
linear function of market risk (beta).
    24. Traditional Risk Premium Analyses. This methodology estimates 
the cost of equity as the current yield on a ``risk free'' investment, 
such as long-term U.S. Treasury bonds, plus an historical or expected 
equity risk premium. As noted in the 1995 Rate of Return Represcription 
Procedures NPRM, ``[t]raditionally, such analyses have determined the 
risk premium by comparing historically realized returns on stocks and 
bonds.'' In the 1990 Order, we stated:

    A bond's yield is simply the discount (interest) rate that makes 
the present value of its contractual cash flow equal to its market 
value. Since the cash flows are fixed, if the bond goes up in price, 
the yield must go down. An increase in the price of the stock, 
however, may leave the stock's expected return unchanged if the 
price rose to adjust for higher anticipated profits rather than 
lower investor perceived risk. Risk premium analyses solve this 
problem by comparing the past returns (capital gains, dividends and 
interest, divided by the market price) on stocks and bonds. The 
historic premium in return on stocks over bonds is assumed to be a 
stable and accurate forecast of investor's expectations about the 
future premium.

    25. Capital Asset Pricing Model (CAPM). Under the CAPM, the 
variance of the company's stock price is measured relative to the 
market as a whole to adjust the premium. Similar to traditional risk 
premium methodologies, the CAPM calculates a cost of equity equal to 
the sum of a risk-free rate and a risk premium. In the CAPM formula, 
however, the risk premium is proportional to the security's market risk 
and the market price of the risk.
    26. Historical Risk Premium. In the 1995 Rate of Return 
Represcription Procedures NPRM, the Commission found that risk premium 
analyses, including the CAPM, could be used to estimate the cost of 
equity for interstate access. The Commission, however, was concerned 
about the use of historical stock and bond yields to estimate the risk 
premium. The Commission found that the results obtained from a 
historical analysis depend on the period chosen and therefore 
questioned whether the Commission should rely on historical stock and 
bond yields to calculate a risk premium. We seek comment on whether 
such historical data should be relied upon in this proceeding. 
Commenters supporting the use of historical data should clearly 
indicate from what time period such information should be drawn, 
explain why they believe this is a reasonable period to use, and 
identify the source of these data. Commenters should also indicate the 
appropriate weight to be given such analyses.
    27. Expected Risk Premium. With regard to the issue of expected 
risk premiums, we seek comment on how such estimates should be 
determined. In the 1995 Rate of Return Represcription Procedures NPRM, 
we suggested that relying on stock market data such as the DCF cost-of-
equity estimates for the S&P 400 may provide a forward-looking risk 
premium for purposes of calculating both the traditional risk premium 
cost of equity and the CAPM cost of equity. Commenters proposing the 
use of expected risk premiums should clearly specify how they would 
determine the expected risk premium estimates. In addition, commenters 
should identify from what period such information should be drawn, 
explain why they believe this is a reasonable period to use, and 
identify the source for these data. Commenters proposing the use of 
expected analyses should indicate the weight they would give to these 
analyses.
    28. Risk-Free Rate. Both models require the selection of a risk-
free rate. United States Treasury securities are regarded as virtually 
risk free. We seek comment on whether we should use U.S. Treasury 
securities as the investment we use to define risk free for purposes of 
calculating the Risk Premium and CAPM cost-of-equity estimates. On the 
one hand, the yields on short-term U.S. Treasury bills (with maturities 
from 90 days to one year) may measure the risk-free rate but may not 
consider long-term inflationary expectations that are embedded in bond 
yields and stock returns. On the other hand, long-term U.S. Treasury 
bonds (maturities from 10 to 30 years) incorporate long-term 
inflationary yields, but because of their long maturities, also include 
an interest-rate risk premium that is not embodied in the more short-
term securities such as T-bills. We seek comment on how we should set 
the risk-free rate. In responding, commenters should state the length 
of maturity for U.S. Treasury securities that should be used in this 
calculation and explain why securities of this maturity length should 
be used. Commenters should also indicate whether the data used to 
compute the risk-free rate should be historical or forward-looking.
    29. Beta. The CAPM methodology also requires the estimation of a 
security's risk, or ``beta.'' Beta is a measure of a security's price 
sensitivity to changes in the stock market as a whole. In the 1990 
proceeding, parties proposed using betas calculated by ValueLine. The 
Commission found that because ValueLine betas are adjusted to raise the 
level of betas less than one and lower the level of betas greater than 
one such betas were not consistent with the theory of CAPM. We seek 
comment on whether we should reconsider the use of adjusted betas for 
purposes of the CAPM methodology. We seek comment on whether S&P betas 
should be used for this proceeding.

G. Other Cost-of-Capital Showings

    30. In the 1990 Rate of Return proceeding, state cost-of-capital 
determinations were used as a check on the results obtained through our 
quantitative analysis. Although state cost-of-capital determinations 
are no longer required filings in a federal prescription proceeding, we 
tentatively conclude that such information continues to serve as a 
valuable check on the results obtained by applying the methods 
described above to the surrogate group of companies selected. 
Therefore, we plan to consider the information contained in the most 
recent National Association of Regulatory Utility Commissioners 
(``NARUC'') publication ``Utility Regulatory Policy in the United 
States and Canada.'' Specifically, this resource provides the overall 
rates of return on rate base for telecommunications companies 
prescribed recently by the state commissions as well as the related 
prescribed cost-of-equity returns. We seek comment on our proposed use 
of this source. In responding, commenters should indicate any concerns 
they may have regarding the validity of the information contained in 
the document. Commenters should file any data that they believe are 
more reliable.

H. Other Factors To Be Considered in Determining the Allowed Rate of 
Return

    31. As part of this proceeding, the Commission will identify a 
``zone of reasonableness'' for the cost of equity and the overall cost 
of capital for interstate access services. Once these ``zones of 
reasonableness'' have been determined, the Commission will prescribe an 
authorized rate of return that lies within the cost-of-capital ``zone 
of reasonableness.'' In determining the ``zone of reasonableness'' for 
cost of equity in the 1990 proceeding, the Commission reviewed the 
range of DCF estimates among the RBOCs to ensure that all ILECs had 
adequate access to capital, and concluded that the range of reasonable 
cost-of-equity estimates should be bounded on the lower end by the RBOC 
average DCF estimate for the month with the highest RBOC average DCF 
estimate, and by that estimate

[[Page 55993]]

increased by 40 basis points as the upper bound. This resulted in an 
estimated cost-of-equity range based on unadjusted RBOC data of 12.6% 
to 13.0%. The Commission also accepted the parties' argument that, 
while the RBOCs' prices reflected the growth potential of their 
cellular radio services, analysts' earnings growth estimates did not, 
resulting in understated DCF estimates. Accordingly, the Commission 
adjusted the DCF inputs to address this concern. The Commission offset 
this adjustment because the interstate access business was expected to 
be less risky than the RBOCs' business as a whole. As a result of these 
three adjustments, the Commission established a ``zone of 
reasonableness'' for interstate access cost of equity of 12.5% to 13.5% 
and a ``zone of reasonableness'' for cost of capital of 10.85% to 
11.4%.
    32. In determining the authorized rate of return to be set within 
the cost-of-capital ``zone of reasonableness,'' the Commission also 
considered two other factors. First, the Commission made an allowance 
for infrastructure development after noting that concern over 
investment in new telecommunications technologies warranted selecting 
an authorized rate of return in the upper range of the zone of 
reasonable cost-of-capital estimates. Second, the Commission considered 
the ILECs' argument that competition in interstate access increased the 
ILECs' risk, but was only partially reflected in the quantitative cost-
of-capital analysis. The Commission concluded, however, that the 
market-based cost-of-capital estimates captured risks from competition 
in interstate access, and therefore declined to make an adjustment on 
this basis. Based on these factors and a concern that capital costs 
could fluctuate in the future, the Commission prescribed a rate of 
return of 11.25%, which was located near the upper end of the ``zone of 
reasonableness.''
    33. Similar to the 1990 proceeding, the Commission will consider 
other factors in determining the ``zone of reasonableness'' of cost of 
equity. Specifically, we seek comment on whether an adjustment should 
be made to account for actual or potential changes in the 
telecommunications marketplace as a result of the 1996 Act. We seek 
comment on how we should calculate such an adjustment. We also ask 
commenters to propose other adjustments deemed necessary in determining 
the cost-of-equity ``zone of reasonableness'' and to explain why they 
believe these adjustments to be necessary. Commenters should also 
propose where within the cost-of-capital ``zone of reasonableness'' the 
authorized rate of return should be set and why. For example, we note 
that mergers have occurred among the telecommunications companies. We 
seek comment on whether adjustments should be made to account for the 
effects of proposed or completed mergers. In addition, we seek comment 
on whether we should consider adjustments to account for the ILECs' 
entry (or anticipated entry) into the long distance market. Finally, we 
note that the 1996 Act creates an exemption from obligations otherwise 
imposed by the Act for qualifying ILECs serving rural areas. We seek 
comment on whether the rural exemption should be a factor we weigh in 
determining whether any adjustment should be made.
    34. We also seek comment on whether any of the adjustments made in 
the 1990 proceeding are still necessary in estimating the current 
authorized rate of return for interstate access services. Commenters 
arguing in favor of retaining one or more of these adjustments should 
state whether the level of adjustment should increase, decrease, or 
remain the same and identify the characteristics of the current market 
for telecommunications that warrant our making such adjustment.

Procedural Matters

1. Ex Parte Presentations
    35. This is a permit-but-disclose notice and comment proceeding. Ex 
parte presentations are permitted, except during the Sunshine Agenda 
period, provided that they are disclosed as provided in the 
Commission's rules. See generally 47 CFR 1.1202, 1.1203, and 1.1206(a).
2. Procedures for Filing Rate-of-Return Submissions
    36. All relevant and timely direct case submissions, responses, and 
rebuttals will be considered by the Commission. In reaching its 
decision, the Commission may take into account information and ideas 
not contained in the submissions, provided that such information or a 
writing containing the nature and source of such information is placed 
in the public file, and provided that the fact of the Commission's 
reliance on such information is noted in the final Order disposing of 
this proceeding.
    37. Pursuant to applicable procedures set forth in Secs. 65.103 
(b), (c), and (d) of the Commission's rules, 47 CFR 65.103, interested 
parties may file direct case submissions on or before December 3, 1998, 
responsive submissions on or before February 1, 1999 and rebuttal 
submissions on or before February 22, 1999. Pursuant to Sec. 65.104, 47 
CFR 65.104, the direct case submission of any participant shall not 
exceed 70 pages, responsive submissions shall not exceed 70 pages, and 
rebuttal submissions shall not exceed 50 pages. Comments may be filed 
using the Commission's Electronic Comment Filing System (ECFS) or by 
filing paper copies. See Electronic Filing of Documents in Rulemaking 
Proceedings, 63 FR 24121 (May 1, 1998). In addition, a copy of each 
rate-of-return submission, other than the initial submission, shall be 
served on all participants who have filed a designation of service 
notice pursuant to Sec. 65.100(b).
    38. Comments filed through the ECFS can be sent as an electronic 
file via the Internet to <http://www.fcc.gov/e-file/ecfs.html>. 
Generally, only one copy of an electronic submission must be filed. If 
multiple docket or rulemaking numbers appear in the caption of this 
proceeding, however, commenters must transmit one electronic copy of 
the comments to each docket or rulemaking number referenced in the 
caption. In completing the transmittal screen, commenters should 
include their full name, Postal Service mailing address, and the 
applicable docket or rulemaking number. Parties may also submit an 
electronic comment by Internet e-mail. To get filing instructions for 
e-mail comments, commenters should send an e-mail to [email protected], and 
should include the following words in the body of the message, ``get 
form http://www.fcc.gov/e-file/ecfs.html>. 
Generally, only one copy of an electronic submission must be filed. If 
multiple docket or rulemaking numbers appear in the caption of this 
proceeding, however, commenters must transmit one electronic copy of 
the comments to each docket or rulemaking number referenced in the 
caption. In completing the transmittal screen, commenters should 
include their full name, Postal Service mailing address, and the 
applicable docket or rulemaking number. Parties may also submit an 
electronic comment by Internet e-mail. To get filing instructions for 
e-mail comments, commenters should send an e-mail to [email protected], and 
should include the following words in the body of the message, ``get 
form