Assessing the cost of capital : the underlying methodologies and assumptions : a case study on Maltacom plc

Abstract

The cost of capital, defined as the minimum rate of return that a company must earn on its assets to satisfy investors, is a key input in the regulatory process for utilities such as telecom companies. An important function of utility regulators is to set price limits on firms having significant monopoly power in fixing prices to be charged to customers. ln setting these price limits, regulators need to decide what would constitute a 'fair' rate of return. There exists a significant degree of judgement in selecting appropriate methods and bases for estimating an entity's cost of capital. The values of most of the elements necessary to estimate the cost of capital are not known with certainty, albeit some are more uncertain than others. The basis of estimating cost of capital also depends on the intended use of such an estimate. Indeed, calculating the cost of capital for regulatory purposes takes on a whole different significance. This dissertation estimates the weighted average cost of capital for Maltacom plc. Although this study reviews a range of competing asset pricing models, the cost of capital is estimated using the Capital Asset Pricing Model (CAPM). In fact, the CAPM was found to be the most widely used model by the private sector, financial institutions as well as in utility regulation throughout Europe, to estimate firms' cost of capital. ln particular, this study focuses on the estimation of the CAPM parameters such as the market risk premium and the beta value, in relation to which there is the greatest difficulty in measurement, resulting in an ample degree of controversy. The environment in which the company operates as well as other macro factors particular to Malta, were also taken into consideration. Notwithstanding a few possible improvements with respect to the regulator's approach in estimating the cost of capital, different assumptions in estimating the cost of capital parameters will inevitably lead to different cost of capital estimations. In this study, the weighted average cost of capital was estimated to be equal to 15 .48%. The result differs from both the rate established by the MCA, as well as the rate submitted by Maltacom's officials in the 2004 review. Still, all three WACC estimates are valid results based on different valid assumptions.