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companies are, as a group, very risky and this is clearly demonstrated by the average VAR
value of -22.36. By comparison, the U.S. stock market has a VAR value at -9.04 and this


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50 Henriques & Sadorsky


value is well above the telecommunications industry average. The average downside risk
measures are each larger than twice the corresponding values for the U.S. market (Table
3). The average values for downside beta 1 (DB1) and downside beta 2 (DB2) are each
larger than the average value for systematic risk. The results in Tables 3 show that the
global telecommunications industry is a very risky industry to invest in.
A correlation matrix between mean stock returns and the ten risk variables indicate that
company stock returns are most highly correlated with the two measures of regret (Table
4). Market returns are the least correlated with systematic Σµ. Total risk and downside
risk are very highly correlated with each other and downside risk, and VAR are very highly
correlated with each other. Total risk is perfectly correlated with VAR. The risk measures,
downside beta 1 and downside beta 2, are each less highly correlated with market returns
than is systematic risk.
A cross section regression analysis is used to investigate the relationship between mean
returns and various risk variables (Table 5). The adjusted R2 values for these regression
models range from -0.03% to 20%. The probability value associated with the estimated
coefficient on the risk variable indicates that each of the risk variables (Σf, Σ0, REGf, and
REG0) is statistically significant. None of the regression models exhibit evidence of mis-
specification as evident from the RESET test. These results provide evidence of a linear
relationship between market returns and these four risk variables.




Table 4. Correlations

Σf Σ0
Σµ
MEAN SR TR VAR DB1 DB2 REGf REG0

MEAN 1.00 0.21 0.10 -0.09 0.01 -0.37 -0.36 -0.17 0.11 -0.48 -0.42

SR 0.21 1.00 0.82 -0.82 0.86 0.73 0.74 0.77 0.96 0.60 0.70

TR 0.10 0.82 1.00 -1.00 0.93 0.83 0.84 0.80 0.79 0.80 0.81

VAR -0.09 -0.82 -1.00 1.00 -0.93 -0.83 -0.85 -0.80 -0.78 -0.81 -0.82

Σµ 0.01 0.86 0.93 -0.93 1.00 0.92 0.92 0.87 0.81 0.78 0.87


Σf -0.37 0.73 0.83 -0.83 0.92 1.00 0.99 0.88 0.72 0.91 0.97


Σ0 -0.36 0.74 0.84 -0.85 0.92 0.99 1.00 0.87 0.73 0.93 0.97

DB1 -0.17 0.77 0.80 -0.80 0.87 0.88 0.87 1.00 0.78 0.75 0.82

DB2 0.11 0.96 0.79 -0.78 0.81 0.72 0.73 0.78 1.00 0.63 0.71

REGF -0.48 0.60 0.80 -0.81 0.78 0.91 0.93 0.75 0.63 1.00 0.95

REG0 -0.42 0.70 0.81 -0.82 0.87 0.97 0.97 0.82 0.71 0.95 1.00




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Risk and Investment in the Global Telecommunications Industry 51


Several risk measures (REGf, REG0) exhibit a high degree of explanatory power as
indicated by the high R2 values. These R2 values range from 18% to 23% and there is no
evidence of mis-specified functional form. Notice how little of the variability in market
returns can be explained by systematic risk.




Table 5. Cross section regression analysis

c1 c2 R squared R squared adj RESET

SR -0.01 0.01 0.05 0.01 0.21
0.41 0.21

TR 0.00 0.04 0.01 -0.03 0.26
0.96 0.59

VAR 0.00 0.00 0.01 -0.03 0.15
0.93 0.61

Σµ 0.00 0.00 0.00 -0.04 0.95
0.69 0.97

Σf 0.03 -0.22 0.13 0.10 0.99
0.02 0.05

Σ0 0.03 -0.23 0.13 0.09 0.77
0.01 0.05

DB1 0.01 -0.01 0.03 -0.01 0.77
0.16 0.38

DB2 0.00 0.00 0.01 -0.03 0.57
0.87 0.56

REGf 0.04 -0.46 0.23 0.20 0.93
0.00 0.00

REG0 0.03 -0.44 0.18 0.14 0.93
0.00 0.02


Regression equation is: MRi = c1 + c2 RVi + ui


Notes: MR is the mean stock return and RV is the risk variable. White™s (1980)
heteroskedasticity corrected probability values are reported below coefficient estimates.
RESET shows the probability values for a Ramsey (1969) regression specification F test
with 2 and 22 degrees of freedom.



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52 Henriques & Sadorsky


The Cost of Equity
The cost of equity is important in valuing new investment opportunities and evaluating
the ongoing performance of existing business projects. From equation (1) any required
return consists of a risk-free rate and a risk premium.


RRi = Rf + (RPM)(RMi) (6)


In equation (6), RRi is the required return on equity i, Rf is the risk-free rate, RPM is the
U.S. market risk premium, and RMi is a risk measure for equity i. This section focuses on
ten risk measures based on systematic risk (RMSR), total risk (RMTR), value at risk
(RMVAR), three measures of downside risk (RMDR), two measures of downside beta, and
two measures of regret. The appendix contains the equations for the cost of equity
calculations.
In order to calculate the cost of equity for each company, numerical values for a risk-free
rate and market-risk premium are required. In the calculations of the cost of equity, a risk
free rate of 1.19% was used as this was the value of the three-month U.S. Treasury bill
rate at the end of December 2002. A market risk premium of 4.0% was employed. With
globalization and capital market convergence, the U.S. market-risk premium may by the
best proxy for the global market risk premium (Pettit, Gulic and Park, 2001). Estimates of
the U.S. market-risk premium range from 3% to 8%. In this chapter, we choose a market-
risk premium of 4%. This value is slightly higher than the 3% market-risk premium now
being advocated (Tully, 2003), but 3% is also lower than the 5.5% global market-risk
premium previously used by other authors (Estrada, 2000, 2002).
For almost all companies, the cost of equity based on systematic risk is the lowest of the
cost-of-equity measures (Table 6). The cost of equity based on systematic risk varies
from a low of 3.41% (Verizon) to a high of 9.95% (Nextel). Telecom Italia has the lowest
cost of equity using total risk or value at risk. APT Satellite Holdings has the highest cost
of equity using total risk or value at risk. For most companies, the cost of equity ranking
is CETR > CEDRj > CESR (j = µ, 0, f). In some cases CEDRj > CEVAR and, in other cases, the
ranking is reversed. The differences between these risk measures can be very large. For
example, Telefonica de Argentina has a CESR of 7.08% per year while CETR and CEDR0 are
14.92% and 14.25% per year respectively. This suggests that an investor in Telefonica
de Argentina stock would be expecting to earn 7.08% per year if the cost of equity was
calculated using systematic risk. By comparison, this investor would expect to earn
14.92% per year if the cost of equity was calculated using a total risk measure. In other
words, there is a substantial difference in risk-adjusted expected returns. The cost of
equity sample averages for the telecommunications companies are 6.56% for systematic
risk, 12.00% for total risk, 10.49% for downside risk (CEDRµ) and 11.09% for value at risk.
These cost of equity measures are much higher than the corresponding values for the
U.S. stock market as a whole. The cost of equity calculated using downside beta measures
are almost always greater than the cost of equity calculated using systematic risk. On
average, the cost of equity calculated using downside beta 1 (beta 2) is 21% (36%) larger
than the average cost of equity calculated using systematic risk.


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Risk and Investment in the Global Telecommunications Industry 53


Table 6. Cost of equity

CEDR¬
Company CESR CETR CEVAR CEDRf CEDR0 CEDB1 CE DB2 CE REGf CE REG0 AVERAGE




APT Satellite Holdings Ltd. 8.23 19.38 16.68 13.55 10.65 13.77 10.50 12.15 11.03 15.23 13.12

Asia Satellite Telecom 7.72 11.79 11.02 10.84 8.46 10.48 9.27 10.59 8.03 10.92 9.91

BCE Inc. 4.95 8.22 7.97 7.52 5.76 6.38 5.34 6.71 5.28 5.73 6.39

BT Group PLC 5.93 9.15 8.80 8.97 7.63 9.23 7.47 8.94 7.23 9.08 8.24

Cable & Wireless 7.38 12.23 11.37 12.13 10.34 13.59 9.74 10.32 9.54 13.59 11.02

China Mobile Ltd 8.32 12.89 11.90 10.51 7.84 9.45 7.56 11.16 7.63 9.77 9.70

Deutsche Telekom AG 6.79 11.48 10.76 10.47 8.25 10.18 7.71 9.29 7.80 10.39 9.31

France Telecom 8.02 15.80 14.14 14.03 10.34 13.73 11.75 9.67 9.18 12.87 11.95

Indonesian Satellite Corp 6.32 15.90 14.21 12.03 8.90 11.21 10.25 8.45 8.49 11.36 10.71

Nippon Telegraph & Telephone 4.79 8.93 8.60 7.72 7.31 8.37 5.39 6.17 7.70 9.36 7.43

Nokia OYJ 8.94 13.07 12.04 12.25 8.33 10.55 7.99 11.21 7.24 9.65 10.13

Philippine Long Distance 5.84 10.31 9.79 9.13 8.39 10.22 7.28 7.61 8.52 11.11 8.82

Portugal Telecom 4.97 9.14 8.79 8.59 7.20 8.55 6.99 7.40 6.86 8.19 7.67

SK Telecom 7.87 15.44 13.87 11.59 7.94 9.58 6.96 10.58 7.82 9.99 10.16

TDC A/S 5.61 10.19 9.69 9.31 7.52 9.15 9.05 7.69 7.05 8.44 8.37

Telecom Argentina 7.80 16.33 14.52 14.78 11.73 15.80 9.67 10.29 10.92 15.91 12.77

Telecom Italia 4.36 8.08 7.86 7.20 6.18 6.82 5.08 6.08 6.18 6.66 6.45

Telefonica de Argentina 7.08 14.92 13.48 13.07 10.82 14.25 9.02 9.46 10.43 14.87 11.74

Telefonica del Peru 6.70 11.33 10.64 10.27 9.70 12.30 10.05 10.84 9.89 13.44 10.52

Telefonica SA 6.17 9.34 8.96 8.35 6.94 8.14 6.83 8.52 6.63 7.80 7.77

Telefonos de Mexico 6.01 8.55 8.27 8.06 6.12 7.06 5.84 8.39 5.45 6.01 6.98

Telekomunidasi Indonesia 7.57 15.03 13.56 12.46 9.04 11.45 8.75 10.68 8.56 11.64 10.88

Vodafone 4.83 8.94 8.61 8.49 6.85 7.97 6.18 6.46 6.44 7.84 7.26

Nextel 9.95 17.56 15.41 15.88 10.96 14.67 11.38 13.47 9.67 14.51 13.35

AT&T 5.04 9.72 9.28 8.55 7.59 8.95 5.55 6.71 7.66 9.53 7.86

Verizon 3.41 8.39 8.13 6.92 6.14 6.56 3.95 3.78 6.44 6.79 6.05

Average 6.56 12.00 11.09 10.49 8.34 10.32 7.91 8.95 7.99 10.41 9.41

US Market 5.19 5.19 5.19 5.19 5.19 5.19 5.12 7.09 5.19 5.19 5.37




While systematic risk is a very well known and widely used measure of market risk, the
results in this chapter suggest that a prudent investor in global telecommunications
companies might also wish to calculate risk measures based on total risk, value at risk,
downside risk, and regret. Unfortunately there is no simple answer to the question,
“which is the appropriate risk measure to use?” nor is the use of downside risk without
its™ critics (Nawrocki, 1999). Different individuals have different attitudes and prefer-
ences towards risk (Bernstein, 1998). One possible approach would be to use the simple


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54 Henriques & Sadorsky


average value of the ten cost-of-equity calculations. The average value for each company
is presented in the last column of Table 6. These cost-of-equity average values range from
a low of 6.05 for Verizon to a high of 13.35 for Nextel. The South American and Indonesian
companies have fairly large values for the average cost of equity. Contrary to what one
might expect, the average cost of equity for telecommunications companies in develop-
ing countries is not always greater than the average cost of equity for telecommunica-
tions companies in developed countries. This is borne out by the high average cost-of-
equity values for Cable & Wireless, France Telecom and Nextel. In general, it is difficult
to find evidence of regional differences in the average cost of equity of telecommunica-
tions companies.
In order to more fully develop the usage of the cost-of-equity values (Table 6) and risk
measures (Table 3), we perform two simulation experiments to build distributions for each
company™s cost of equity. In the first simulation, we assume that for each company in
our sample, the cost of equity can be approximated by a normal distribution with a mean
and standard deviation calculated from that company™s ten cost-of-equity values. A
number of different distribution functions (exponential, extreme value, normal, logistic,
triangular, Weibull, uniform and Pareto) was fit to each company™s cost-of-equity values.
For each company, the normal distribution ranked high (usually in the top four) for
chosen fit. For each company, 5,000 simulations were performed and the minimum, mean,
maximum, 5% value, and 95% values recorded. The results are reported in Table 7.
These results show not only the average cost-of-equity value for each company, but also
show the 90% confidence interval. For example, the average cost-of-equity value for
Telecomm Argentina is 12.78%. There is one chance in 20 that the cost of equity will be
below 8.01%. There is one chance in 20 that the cost of equity will be above 17.53%. Thus
we are 90% certain that the true cost of equity will be in the 8.01% to 17.53% range.
Simulation two is more elaborate in that the uncertainty is modeled directly into the
components of equation (6). A triangular distribution function with parameters 0.5, 1.19
and 2.25 was assumed for the risk-free rate. A normal distribution with mean 4 and
standard deviation 1 was assumed for the market-risk premium. A normal distribution was
assumed for each company™s risk measures using company sample values for the mean
and standard deviation. For each company, 5,000 simulations were performed and the
minimum, mean, maximum, 5% value, and 95% values recorded. The results are shown in
Table 8.
The mean values recorded in Tables 7 and 8 are for each company, fairly similar. The 5%
and 95% values for each company vary between the two tables and in some cases the
90% confidence interval is larger in Table 8 than it is in Table 7. The results in Table 8
are more precise because the randomness was modeled directly into the components of
equation (6). Our suggestion is therefore to not rely on just one cost-of-equity value but
to calculate several different cost-of-equity values and then use simulation techniques
to build up a probability distribution for each company™s cost of equity. In this way, a
clearer picture of where a company™s cost of equity lies is developed. After all, two
different distributions can have the same mean values but have very different shapes.
For project evaluation and investing, for example, distributions that are skewed to the
right are much preferred to distributions that are skewed to the left.




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Risk and Investment in the Global Telecommunications Industry 55


Table 7. Cost of equity (simulation 1)

Co mpany M inim um M ean M aximum 5% 95%



APT Satellite H oldings Ltd. -0.59 13.12 24.42 7.94 18.29

A sia Satellite Telecom 4.35 9.91 14.73 7.69 12.14

B C E Inc. 1.95 6.39 10.77 4.55 8.22

BT G roup PLC 4.17 8.24 12.34 6.50 9.98

Cable & W ireless 4.22 11.02 17.99 7.98 14.05

China M obile Ltd 2.80 9.70 16.21 6.76 12.65

D eutsche T eleko m AG 3.98 9.31 14.77 6.85 11.77

France Telecom 2.99 11.95 21.89 7.96 15.94

Indonesian Satellite Corp -0.49 10.71 21.40 6.22 15.19

N ippon T elegraph & T elephone 1.81 7.43 12.67 5.04 9.82

N okia O Y J 2.91 10.13 16.92 7.01 13.25

Philippine Long D istance 3.24 8.82 14.85 6.30 11.33

Portugal Telecom 3.43 7.67 12.07 5.72 9.61

SK T elecom 0.77 10.16 19.75 5.81 14.52

T DC A/S 3.06 8.37 13.43 6.19 10.55

T elecom Argentina 2.13 12.78 24.19 8.01 17.53

T elecom Italia 2.57 6.45 10.46 4.65 8.25

T elefonica de Argentina -0.78 11.74 22.80 7.45 16.03

T elefonica del P eru 3.50 10.52 17.08 7.74 13.28

T elefonica SA 3.96 7.77 11.93 6.09 9.44

T elefonos de M exico 2.73 6.98 11.22 5.06 8.89

T elekomunidasi Indonesia 2.18 10.88 19.12 7.12 14.63

V odafone 2.58 7.26 12.08 5.21 9.31

N extel 3.94 13.35 24.45 9.12 17.58

AT &T 1.66 7.86 13.54 5.27 10.44

V erizon -0.68 6.05 12.46 3.29 8.80



Notes: For each company 5,000 simulations were calculated from a normal distribution
using that company™s cost of equity mean and standard deviation.


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56 Henriques & Sadorsky


Table 8. Cost of equity (simulation 2)
Company Minimum Mean Maximum 5% 95%



APT Satellite Holdings Ltd. -0.14 12.88 30.40 6.27 20.66

Asia Satellite Telecom 2.50 9.74 19.35 6.00 13.86

BCE Inc. 1.53 6.34 12.75 3.83 9.24

BT Group PLC 1.14 8.13 15.08 5.18 11.22

Cable & W ireless 1.18 10.86 22.50 6.52 15.69

China Mobile Ltd 1.93 9.52 21.90 5.36 14.32

Deutsche Telekom AG 2.20 9.19 19.68 5.51 13.43

France Telecom 1.96 11.82 25.80 6.74 17.91

Indonesian Satellite Corp 0.55 10.61 29.02 5.12 17.04

Nippon Telegraph & Telephone 1.67 7.40 15.67 4.50 10.70

Nokia OYJ 1.82 9.94 22.00 5.79 14.67

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