Regulatory Risk, Cost of Capital and Investment Decisions in the
Telecommunications Industry: International Comparisons
Anastassios Gentzoglanis
University of Sherbrooke
Department of Finance and CEREF
Centre for the Study of Regulatory Economics and Finance
Faculty of Business Administration
Sherbrooke, Quebec, Canada, J1K-2R1
Phone: +(819) 821-8000 X2958
e-mail : agentzoglanis@adm.USherbrooke.ca
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Author Keywords: Telecommunications regulation, Capital cost determination; Capital
structure; Regulatory governance
JEL classification codes: G31; G38; K20; K23; L51; L96
Summary
The relationship between changes in regulatory policies and investment in infrastructure
has been studied extensively in the past few years in both the US and Europe (OECD, 2002,
Chang et al., 2003). Apparently, regulatory changes with respect to access pricing regimes are
quite important and statistically significant in explaining the increase pace of investment in the
deployment of new broadband technologies in Europe and the US by incumbent local exchange
carriers (ILECs). It is thus suggested that competition in the telecommunications industry has
worked by facilitating new entry through decreasing interconnection prices.
Although the relationship between changes in regulatory regimes and investment in
digital technologies is not denied, t is argued in this paper that such a relationship fails to account
for performance differences in both continents among firms in the telecommunications industry.
Indeed, European and American firms have increased investment in infrastructure after major
regulatory changes had occurred in these regions. There is, nevertheless, a difference in relative
performance of the firms operating on each side of the Atlantic.
The purpose of this paper is to examine the difference in relative performance in terms of
investment in infrastructure of telecommunication firms operating under alternative regulatory
regimes which do not treat capital costs alike. It is argued that national institutional regulatory
frameworks influence the telecommunication firms' capital structure and the incentives for
investment. The increased volatility of the telecommunications industry that has resulted from
major changes in regulatory regimes has increased firms' business risk and with it the market risk
premium required by investors. Moreover, regulatory risk has become an important component
of total risk faced by the telecommunication firms and both risks should be taken into account by
Regulatory Risk, Cost of Capital and Investment Decisions in the Telcos
A. Gentzoglanis
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the regulators when they regulate the industry either by price caps, revenue caps or some other
hybrid regime.
The determination of the cost of capital is an important part of any regulatory decision.
The application of a WACC to a regulated asset base is done with the purpose to determine an
explicit return on assets employed by the telecommunications firms. In most cases the CAPM is
used to determine the cost of equity capital but other methodologies exist such as the DCF and
the risk premium analysis. Apparently, the regulatory practice is quite different across continents
and countries. By and large, regulatory decisions are taken by using alternative financial models
to calculate the market risk premium to be included in the cost of capital of ILECs. European
regulators and their American counterparts do not necessarily use the same model to determine
the cost of capital. Such differences in approach may influence positively or negatively the risk
as perceived by investors and provide positive or negative incentives for investment and
deployment of broadband technologies. Regulatory regimes that "penalize" the incumbents by
setting the WACC too low may see a reduction or a delay of investment in infrastructure and the
deployment of digital technologies. Both investors and telecommunications firms are seriously
concerned by the approach adopted by regulators and the model they use to make an asset
valuation that necessarily impacts on investment.
Previous models have shown that the change in regulation, particularly the access pricing
rules, is an important factor to explain the increase in investment by ILECs. It argued in this
paper that the capital structure of ILECs depends on the regulatory governance and the financial
models used by regulators to determine the market risk premiums. Factors such as the use of
CAPM or another valuation model to determine a company's WACC seem to be the main
reasons for the difference in investment performance of ILECs. This paper deals with the
relationship between regulatory governance, particularly the regulatory practice, to determine the
ILECs' cost of capital and capital structure and its impact on investment decisions in digital
technologies. It examines the theoretical and empirical literature dealing with this issue and
identifies the necessary conditions for a successful governance strategy which may increase the
capital structure efficiency of ILECs and their investment performance.
Section II provides an overview of some stylized facts about the new body of literature
that has been developed lately that tries to explain cross-national variation in firm characteristics
and product market strategies as a result of differences in national institutional frameworks
(Hollingsworth, 1997, Soskice, 1999) and sets the theoretical framework for the analysis. Section
III analyzes the empirical evidence of the effects of regulatory governance on ILECs capital
structure and investment and draws some conclusions. Section IV discusses the role of
alternative explanatory variables within the regulatory practice that might also be expected to
have some impact on relative investment performance. Lastly, Section V concludes and offers
some policy recommendations.
Regulatory Risk, Cost of Capital and Investment Decisions in the Telcos
A. Gentzoglanis