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

Federal RegisterOct 20, 1998

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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>.