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If you need the complete document, download the WordPerfect version or Adobe Acrobat version, if available. ***************************************************************** Before the FEDERAL COMMUNICATIONS COMMISSION Washington, D.C. 20554 In the Matter of ) ) Prescribing the Authorized ) CC Docket No. 98-166 Unitary Rate of Return for ) Interstate Services of Local ) Exchange Carriers ) NOTICE INITIATING A PRESCRIPTION PROCEEDING AND NOTICE OF PROPOSED RULEMAKING Adopted: September 8, 1998 Released: October 5, 1998 Direct Case Submission Date: December 3, 1998 Responsive Submission Date: February 1, 1999 Rebuttal Submission Date: February 22, 1999 NPRM Comment Date: December 3, 1998 NPRM Reply Comment Date: February 1, 1999 By the Commission: Commissioner Furchtgott-Roth dissenting and issuing a statement. TABLE OF CONTENTS Para. No. I. INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . 1 II. INITIATING A RATE-OF-RETURN PRESCRIPTION . . . . . . . . . . . 2 A. Background . . . . . . . . . . . . . . . . . . . . . . . . . 2 B. Position of Parties. . . . . . . . . . . . . . . . . . . . . 3 C. Discussion . . . . . . . . . . . . . . . . . . . . . . . . . 5 III. PRESCRIBING THE RATE OF RETURN . . . . . . . . . . . . . . . . 8 A. General Considerations . . . . . . . . . . . . . . . . . . . 8 B. Weighted Average Cost of Capital . . . . . . . . . . . . . . 9 C. Capital Structure. . . . . . . . . . . . . . . . . . . . . 10 D. Embedded Cost of Debt. . . . . . . . . . . . . . . . . . . 12 E. Cost of Preferred Stock. . . . . . . . . . . . . . . . . . 15 F. Cost of Equity . . . . . . . . . . . . . . . . . . . . . . . 17 1. Background . . . . . . . . . . . . . . . . . . . . . . 17 2. Surrogate Companies. . . . . . . . . . . . . . . . . . 19 3. Discounted Cash Flow Methodology . . . . . . . . . . . 22 4. Risk Premium Methodologies . . . . . . . . . . . . . . 31 G. Other Cost-of-Capital Showings . . . . . . . . . . . . . . . 38 H. Other Factors to Be Considered in Determining the Allowed Rate of Return 39 I. Procedural Matters . . . . . . . . . . . . . . . . . . . . . 43 1. Ex Parte Presentations . . . . . . . . . . . . . . . . 43 2. Procedures For Filing Rate of Return Submissions . . . 44 3. Further Information. . . . . . . . . . . . . . . . . . 50 IV. NOTICE OF PROPOSED RULEMAKING. . . . . . . . . . . . . . . . . . 51 A. Discussion . . . . . . . . . . . . . . . . . . . . . . . . . 51 1. Changes to the cost-of-debt calculation. . . . . . . . 51 2. Changes to the Cost-of-Preferred Stock Calculation . . 52 3. Changes to the Low-End Adjustment for Price Cap LECs . 53 B. Initial Regulatory Flexibility Analysis. . . . . . . . . . . 56 C. Comment Filing Procedure . . . . . . . . . . . . . . . . . . 66 D. Further Information. . . . . . . . . . . . . . . . . . . . . 70 V. ORDERING CLAUSES . . . . . . . . . . . . . . . . . . . . . . . . . 71 I. INTRODUCTION 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. It marks the first prescription proceeding since we revised the rules governing procedures and methodologies for prescribing and enforcing the rate of return for ILECs not subject to price cap regulation, and the first prescription proceeding since the Commission adopted its price cap rules for local exchange carriers. In this Notice, we seek comment on the methods by which we could calculate the ILECs' cost of capital. In the Notice of Proposed Rulemaking (NPRM), attached to the end of the Notice, we propose 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. II. INITIATING A RATE-OF-RETURN PRESCRIPTION A. Background 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, 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 seeking comment on whether to commence a rate-of-return prescription proceeding. Eleven parties filed comments; five parties filed replies. B. Position of Parties 3. In response to the Public Notice, the commenting ILECs and the organizations representing their interests urge the Commission not to conduct a rate-of-return proceeding. These commenters offer three primary arguments to support their view that the Commission should not begin a rate-of-return prescription proceeding now. First, they assert that the rate-of-return prescription process is designed to target the return on ILEC investments to the risk of the local exchange business and the current cost of capital and that realistic evaluation of the new risk level is not yet possible because of the uncertain impact of the Telecommunications Act of 1996 and the introduction of competition in the local exchange and exchange access markets. Second, these commenters argue that current volatility in the financial markets contributes to the uncertainty faced by ILECs. Finally, they argue that conducting a rate-of-return proceeding would require extensive analysis and place substantial demands on the Commission when the Commission is least able to commit the staff and time needed to conduct the analysis required by a prescription effort. Therefore, the commenters conclude, considering the demands of implementing the 1996 Act and the small segment of the telecommunications industry affected by rate represcription, the Commission should decide against proceeding with represcription. 4. Two commenters, MCI and GSA, support initiating a rate-of-return prescription proceeding. GSA disagrees that the 1996 Act has created uncertainty for the ILECs by opening local markets to competition, and argues that the Act has in reality reduced uncertainty by establishing the rules under which competition will be permitted. MCI argues that the Commission should examine the relevant data to determine whether and how passage of the Act affected the ILECs' business risk. MCI estimates that the ILECs' current cost of capital has fallen to 9.48%, and concludes that a represcription is warranted. C. Discussion 5. 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. Although the ultimate impact of the 1996 Act on the telecommunications industry is not yet known, this does not preclude us from commencing a prescription proceeding. Our rate prescriptions are always prospective, and there is always some degree of uncertainty about the future. Market-based cost-of-capital methodologies incorporate the capital markets' assessment of all the forms of risk, including risk associated with a changing legal and regulatory environment. 6. Furthermore, contrary to the contention of the ILECs, a rate-of-return prescription proceeding would not unduly tax the Commission's resources. In addition, the 1995 Rate of Return Represcription Procedures Order significantly streamlined the rate-of-return prescription process by eliminating our trial-type procedures that included discovery, possible cross-examination, proposed findings of fact and conclusions, reply findings and conclusions, possible oral argument, and use of a separated trial staff at the discretion of the Common Carrier Bureau. Moreover, despite the burden that a prescription proceeding would impose on the Commission, we have an overarching duty under the Act to ensure that the rate-of-return ILECs' rates are just and reasonable. 7. For the reasons described above, we are not persuaded by the commenters that we should delay commencing a prescription proceeding. It is important that our prescribed rate of return correspond to current market conditions. The recent yields on 10-year U.S. treasury securities have remained more than 150 basis points below the reference point, suggesting that the prescribed rate does not coincide with current market conditions. Therefore, we conclude that we should begin a rate-of-return prescription proceeding. III. PRESCRIBING THE RATE OF RETURN A. General Considerations 8. 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 9. 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 sections 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 10. 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. 11. In Appendix B, we calculate the ILECs' capital structure based on 1997 data contained in the ARMIS 43-02 reports. Based on ARMIS data, the ILECs' capital structure is 42.88% debt, .14% preferred stock and 56.98% equity. D. Embedded Cost of Debt 12. 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. 13. In Appendix B, we calculate the ILECs' embedded cost of debt based on 1997 data contained in the ARMIS 43-02 reports filed by reporting ILECs. Based on this data, the ILECs' cost of debt is 7.35%. 14. In response to the Public Notice, USTA observed that the total debt calculation as contained in the Appendix to the Public Notice was performed incorrectly. USTA pointed out that Unamortized Debt Issuance Expense should be deducted from, rather than added to, total debt. We tentatively conclude that USTA is correct. The calculations contained in Appendix B reflect this tentative conclusion. We seek comment on this tentative conclusion. E. Cost of Preferred Stock 15. 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. 16. In Appendix B, we calculate the ILECs' cost of preferred stock based on 1997 data contained in the ARMIS 43-02 reports. According to this ARMIS data, the ILECs' cost of preferred stock is 3.52%. F. Cost of Equity 1. Background 17. 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 methodology for determining ILECs' cost of equity. 18. 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 19. The methods of estimating the cost of equity that we identify in this Notice 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, 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. 20. 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. 21. 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 22. 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. 23. 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. 24. Quarterly Dividend. In both the 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. 25. Flotation Costs. Flotation costs are the out-of-pocket expenses associated with issuing stock as well as any temporary reduction in the market value of the stock attributable to the issuance of additional shares. In the 1986 proceeding, the Commission provided a one-time, cost- of-equity adjustment of ten basis points for flotation costs, but stated that no subsequent upward adjustments should be permitted. In the 1990 proceeding, 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 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. 26. 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. 27. 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. 28. 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. 29. 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. 30. 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 31. 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 the CAPM methodology, the risk premium is formally quantified as a linear function of market risk (beta). 32. 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. 33. 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. 34. 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. 35. 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. 36. Risk-Free Rate. As indicated above, 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. 37. 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 38. 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 39. 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 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%. 40. 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." 41. 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. 42. 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. I. Procedural Matters 1. Ex Parte Presentations 43. 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 C.F.R. Sections 1.1202, 1.1203, and 1.1206(a). 2. Procedures For Filing Rate-of-Return Submissions 44. 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. 45. Pursuant to applicable procedures set forth in Sections 65.103(b)(c) and (d) of the Commission's rules, 47 C.F.R.  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 Section 65.104, 47 C.F.R.  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 Fed. Reg. 24,121 (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  65.100(b). 46. Comments filed through the ECFS can be sent as an electronic file via the Internet to . 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 ecfs@fcc.gov, and should include the following words in the body of the message, "get form . 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 ecfs@fcc.gov, and should include the following words in the body of the message, "get form