Q. Are investors primarily concerned with current or future expected competition when they assess the investment risk of BA-MD?

A. Investors are primarily interested in future expected competition when they assess the investment risk of BA-MD because expected future competition is a primary determinant of volatility in the expected returns on their investment.

A. Yes. Local exchange service competition is initially focused primarily on large business customers in urban markets. These customers are particularly attractive targets for competitors because they account for a large percentage of LEC revenues and profits and a small percentage of LEC costs. With interexchange companies like MCI offering service a much larger segment of the local exchange market is now being targeted. In addition, as the cost of wireless technology declines and the cable TV companies begin providing local exchange service, competition will exist in all segments of the local exchange market. The risk of local exchange service is even greater with full facilities-based competitors such as MFS and TCG operating in the local exchange market.

A. No. BA-MD has a number of disadvantages in its efforts to compete in a fully competitive local exchange market. As the incumbent LEC, BA-MD has the obligation to provide telecommunications services to all customers, even those whose revenues fail to cover the cost of providing service. Telecommunications prices have historically been set to provide subsidies to high-cost customers in low density geographic areas. Such subsidies are inconsistent with the competitive framework of the Act. Although both the FCC and this Commission are in the process of considering alternative mechanisms for subsidizing universal service, there is a fundamental difficulty of the task. In truly competitive markets, there are no sources to subsidize prices that are lower than cost. Investors are concerned that incumbent LECs may have to continue to provide service in high-cost areas, while its competitors are free to serve only the most profitable markets.

Finally, BA-MD's competitors are able to offer a full menu of telecommunications services, including inter- and intraLATA toll, local exchange, wireless, and video.

A. Rapid advances in telecommunications technology are a primary driver behind the increasing level of competition faced by the local exchange companies. Advances in semiconductor technology have both increased the capability and lowered the cost of telecommunications equipment, so other firms can compete more easily with local exchange companies. Breakthroughs are also occurring in fiber optic technology. The capacity of fiber optic networks is increasing dramatically, thus allowing fiber-based competitors to offer more services. As SONET (Synchronous Optical Network) standards are implemented, the price of installing a fiber optic network will fall, further increasing competitive pressures. In sum, technological developments have substantially eroded the competitive advantage once enjoyed by local exchange companies.

A. Rapidly changing technology increases the LECs' risk in two ways. First, it threatens their ability to recover the cost of their embedded equipment. Second, it reduces the cost of entry for competitors. Rapid advances in fiber optics and multi-media transmission technologies, for example, have shortened the economic lives of the LECs' current investments in copper-based facilities and allowed cable TV and interexchange companies to compete efficiently to offer local exchange service. Advances in wireless, satellite, and computer technologies further threaten the LECs' heavy investment in landline telecommunications service.

A. Since regulation impairs BA-MD's ability to compete on the same terms as its competitors, regulation increases the risk of investing in BA-MD.

A. To lease unbundled network elements, one must first invest in the facilities and software required to provide unbundled network elements. Since the network elements to be leased are essentially all the elements of the local exchange, the risk of leasing unbundled network elements is identical to the risk of investing in the local exchange network of BA-MD. The risks of investing in the local exchange include high operating leverage, competition, rapidly changing technology, and regulation. As I have previously noted, local exchange networks require a large commitment to fixed costs in relation to variable costs; thus, the investment involves high operating leverage. Furthermore, recent advances in telecommunications technology and changes in regulation have greatly increased competition in the local exchange. In fact, BA-MD's long-run incremental cost study is based on the assumption that the local exchange is already fully competitive. Since the investment portion of BA-MD's long-run incremental cost study is based on the assumption of a fully competitive local exchange network, the cost of capital must also be based on this assumption.

1. 
   Prior to the advent of competition, BA-MD was considered to be a relatively low risk company operating in a monopoly environment. By opening BA-MD's markets to the full effects of competition, the Act has dramatically increased the risk of investing in local exchange companies such as BA-MD. BA-MD now faces significant competition from well-financed competitors such as AT&T, MCI, Sprint, and the major cable TV companies, who have greater name recognition than BA-MD and offer a wider variety of services. (BA-MD is not permitted to offer interLATA toll service.) In addition, BA-MD's competitors have the flexibility to operate only in the most profitable markets and to price based on market demand, while BA-MD is forced to provide universal service in both high-cost and low-cost areas. In today's environment, BA-MD's investment risk is at least equal to that of the average industrial company.
   

A. I calculated a weighted average of the cost of debt and equity, using a cost of debt equal to 7.6 percent, a cost of equity equal to 14.9 percent, and a capital structure containing 23.8 percent debt and 76.2 percent equity

A. I used the average rate of newly-issued debt for Aa-rated industrial firms for August 1996, as reported in the September 1996 Moody's Bond Record. Because BA-MD's long-run incremental cost study is forward looking, it requires the use of a forward-looking, rather than an embedded, cost of debt.

A. Since BA-MD's long-run incremental cost study is based on the forward-looking economic expenses and capital costs of companies operating in a competitive environment, the cost of equity must also be reflective of companies operating in a competitive environment. The forward-looking cost of equity for companies operating in a competitive environment can be estimated by applying the Discounted Cash Flow (DCF) Model to the S&P Industrials, a composite of large competitive companies in the U.S. economy.⁶ As shown on Vander Weide Schedule 1, the market-weighted average DCF cost of equity for the S&P Industrials is 14.9 percent.

A. The average market-based percentages of debt and equity in the capital structures of the S&P Industrials is a good proxy for the capital structures of competitive firms on a forward-looking economic basis. It would be inconsistent to use forward-looking competitive assumptions in the investment and expense components of a forward-looking study, but historical accounting-based capital structures in the cost of capital component. As shown in Vander Weide Schedule 2, the average market-based capital structure of the S&P Industrials contains 23.8 percent debt and 76.2 percent equity.

A. As shown in Schedule 3, the average market-based capital structure of the RHCs contains 22.4 percent debt and 77.6 percent equity. Thus, the average market-based capital structure of the RHCs is approximately equal to the average market-based capital structure of the S&P Industrials.

A. I conclude that the appropriate overall cost of capital for use in BA-MD's long-run incremental cost studies is 13.2 percent. This estimate is based on a 7.6 percent cost of debt, a 14.9 percent cost of equity, and a capital structure containing 23.8 percent debt and 76.2 percent equity.

A. Yes, it does.