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Rate Unbundling: Are We There Yet? A Reality Check

Fortnightly Magazine - June 1 1996

was higher at 1.13 in 1985, when they operated in a monopoly environment, compared to 0.98 in 1995, when they operated in a competitive environment. The average betas for the RHCs and the Moody's eight LDCs also declined between 1985 and 1995. Yet, in 1995 both are exposed to at least some competition. The beta for Edison International also declined, yet its principal subsidiary faces greater business risk today. Table 2 also shows that the AT&T beta rose modestly, but that rise is attributable to an increase in financial risk through a substantial decline in

its common equity ratio (em from 58 percent in 1985 to about

40 percent in 1995. Thus, based upon CAPM computations that take into account differences in financial risk, the increase in beta for AT&T is not attributable to an increase in business risk, despite AT&T's having moved to a competitive environment.

Investment risk represents the sum of business and financial risk. Beta presumably captures elements of both. A change in beta may indicate a change in either business or financial risk, or both. To demonstrate the point, consider the fact that AT&T's beta was 0.80 in 1985 (just after the AT&T break-up and the creation of seven HCs), but rose to 0.85 by 1995. The authors assert:

[D]uring the last decade the telephone industry was deregulated and long-distance carriers were exposed to competitive risks. ROEs for long-distance carriers increased steadily due to increased competition, while ROEs for the regional Bell operating companies (the regulated arm) remained relatively constant.

It is unclear which ROEs the authors relied upon to support their statement. The fact is, however, that the RHCs have seen their achieved ROEs rise dramatically since the AT&T breakup, to a current average of more than 23 percent. AT&T's ROE also stands currently at about 23 percent, in spite of massive write-offs unrelated to the telephone industry. The market appears to prefer the risk of competition compared to the risk of original-cost, ROE price regulation, as evidenced by the fact that telephone P/E's and M/B's now appear significantly higher than prior to competition. When financial risk difference is taken into account, the beta comparisons between 1985 and 1995 lead to the same conclusion: Namely, in spite of the introduction of competition, investment risk stands lower today than 10 years ago (em not higher, as implied by the authors.

Financial Risk

vs. Business Risk

One method that addresses the impact of financial risk on the estimated cost of common equity can be found in an article from 1987 written by Brigham, Gapenski, and Aberwald.1 The article states that for each one percentage point change in debt ratio between 40 and 50 percent, there is a change of 7 to 15 basis points

in cost rate. The cost rates for long-term debt and equity move in the same direction (although not in tandem).

For simplicity, assume the cost rate change is 10 basis points for each 1 percentage change in common equity ratio. For AT&T, the cost rate change between 1985 and 1995 related only to financial risk