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JERRY DUVALLFEDERAL COMMUNICATIONS COMMISSION

Investing in Telecommunications Infrastructure under Uncertainty and

Irreversibility: Communications Satellites as a Case Study

PHOENIXC E N T E R

Presented BeforeThe Phoenix Center Fourth Annual State Educational Retreat

Sponsored by

The Phoenix Center for Advanced Legal & Economic Policy Studies

At

Pointe Hilton Tapatio Cliffs ResortPhoenix, ArizonaOctober 18, 2007

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Preliminary Remarks

The views expressed are those of the speaker and do not necessarily reflect the views of the Federal Communications Commission or its staff.

The purpose of the presentation is to: (1) examine how profit-oriented business firms, such as

communications satellite carriers, make profitable decisions respecting sunk-cost, telecommunications capital assets made under uncertainty; and

(2) the possible influence of public policy on both the timing and quantity of investment in such telecommunications infrastructure.

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The Investment Decision Without Sunk Costs

Rt = cash flow or net revenue (gross revenue less expenses) at time t

r = discount rate (e.g., weighted average cost of capital)t = time index measured in periods (e.g., years)n = expected life of the investment project (e.g., n years)C0 = total capital outlay for the investment project at the

beginning of the project (i.e., t = 0)

n

tt

t Cr

RNPV1

0)1(

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The Investment Decision Without Sunk Costs

1.1 Net Present Value (NPV) and Capital Budgeting Definition of NPV of an Investment Project NPV Decision Rule Investment in a Communications Satellite Key Assumptions in Computing NPV and the

Application of the NPV Decision Rule Reversibility Investment as a “Once-and-for-all” Opportunity

Optimal Investment: The Neoclassical Theory of Investment Derivation of the Firm’s Demand for Desired Capital

Stock Determination of the Firm’s Equilibrium Capital Stock

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NPV Decision Rule

NPV Value DecisionNPV > 0 InvestNPV < 0 Don’t InvestNPV = 0 Indifferent

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Present Value of Forecast Satellite Net Lease Revenues:Total investment = C0 = $300; WACC = r = 8.5%; Life = n = 5 years.

(1) (2) (3) (4)

YearForecast Net

Lease Revenues ($

Millions)(1.085)t

[1/2]

1/(1.085)t

[(1) x (3)]PV of

Forecast Net Lease

Revenues ($Millions)

1 60 1.085000 0.921659 55.3002 64 1.177225 0.849455 54.3653 70 1.277289 0.782908 54.8044 73 1.385859 0.721574 52.6755 69 1.503657 0.665045 45.888

336 263.032$263.032 - $300 = -$36.968

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Key Assumptions in NPV Analysis

Reversibility Investment in capital assets can be easily sold to other

users Investment is not sunk

Investment as a “Once-and-for-all” Opportunity If the firm declines to invest in a project, it cannot

reconsider the decision

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Optimal InvestmentJorgenson (1963); Hall and Jorgenson (1967)

Firm’s Demand for Desired Capital Stock Neoclassical Economics Embeds NPV Rule Maximize Present Value of the Firm’s Infinitely Long

Flow of Net Revenues

qIsLpQR

where p = unit price of the Q units sold by the firm; s is the uniform wage rate paid to L units of labor; q is the price of I units of capital goods.

(1)

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Dynamic Optimization Problem

Maximize present discounted value of net revenues over an infinite time horizon

)()()()](),([)(

..)]([max 0

tKtItKtLtKQtQ

tsdttReV rt

where Constraint (3) is the production function and Constraint (4) holds that the rate of growth of the firms capital stock is just equal to investment less replacement where is the rate of economic depreciation.

(2)

(3)

(4)

10Solution to the Dynamic Constrained Optimization Problem

ps

LQ

pqtqrq

KQ )/)((

Profit maximizing quantity of labor is determined where the marginal product of labor equals the wage rate (s/p).

Profit maximizing quantity of capital (equilibrium desired capital stock) is determined where the marginal product of capital equals the price of capital, q, multiplied by the user cost of capital, then divided by the unit price of output. The user cost of capital is the implicit rental price for one unit of capital per unit of time.

(5)

(6)

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Equilibrium Capital Stock

)/)(( qtqrqKQp

The profit maximizing firm increases the size of the its capital stock to the point where the value of the marginal increment of its capital stock (pMPK) equals the user cost of capital (uc).

(7)

ucpMPK (8)

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Equilibrium Capital Stock

K (Capital Stock)

uc0

uc1

0 K*0 K

*1

pMPK & uc ($)

uc0

uc1

pMPK

Figure 1. Determination of the Desired Capital Stock in Jorgenson’s Neoclassical Theory of Investment

A

B

13Investing with Uncertainty and Irreversibility

Real Options Paradigm Uncertainty over future profit streams Irreversibility, i.e., sunk cost nature of many

investments in durable assets Choice of timing, i.e., the opportunity to delay

The interaction of these three factors requires more stringent hurdles than basic NPV analysis

Timing is critical

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Real Options: Investing vs. Opportunity to Invest

The Opportunity to Invest The opportunity to invest is a call option

The Investment Decision The Exercise of that option

Definition: An option is defined as the right, without an associated symmetric obligation to buy (if a call) or sell (if a put) a specified asset (e.g., common stock) by paying a pre-specified price (the exercise or strike price) on or before a specified date (the expiration or maturity date).

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Real Options: Investing vs. Opportunity to Invest

When to exercise the option?

“. . . Because of the uncertainty, the option has a time premium or holding value: it should not be exercised as soon as it is ‘in the money,’ even though doing so has a positive NPV. The optimal exercise point comes only when the option is sufficiently ‘deep in the money,’ i.e., the NPV of exercise is large enough to offset the value of waiting for more information. This conclusion is probably the most widely known ‘result’ of the real options literature.

Dixit and Pindyck (2000)

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Example(Pindyck 1991)

Factory Cost = I1 unit per periodNo operating costP0 = $100P1 = q($150) + (1-q)

$50, and doesn’t change thereon

Assume: I = $800 q = 0.30 Interest rate = 10%

Invest Now?

Invest Later

300800100,18001.1100

0

ttNPV

3861.1425

1.1800

1.11505.0

0

ttNPV

No cost or revenues in Year 0. Investment made in Year 1 only if P1 = $150.

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Example

If “invest today” or “never invest”, the firm invests ($300 payoff)

If $800 reversible, then invest today and sell the asset in the second period if price falls to $50

Real Options Irreversibility Ability to Wait

Value of the Flexibility Option $386 - $300 = $86

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Multiple Options and Managerial Flexibility

DeferAbandonExpandSwitch

Correct [project] valuation thus requires an expanded NPV rule encompassing both sources of a real investment opportunity’s value, the passive NPV of expected cash flows, and a value component for the combined value of the flexibility represented by the project’s real options.

Trigeorgis (1993)

Expanded NPV = Passive NPV + Combined Option Value

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Real Options in the Satellite Industry

Economic Characteristics Investments are Lumpy, Large, and Sunk Flow of Net Revenue is Uncertain Given Long Life

(15 years)

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Alternative Designs

Traditional Satellite Design Estimate capacity requirements using market studies

and “best guesses” Number of subscribers Average Usage per subscriber

Design constellation of satellites to meet the fixed capacity Operations methods used to estimate a Pareto Front

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Pareto Front

Satellite System Capacity

(Channels)

0 KB K* KA

x x x

Pareto Front

Figure 2. Satellite Capacity Design and Lifecycle Costs

x x x

x x x

x x x

x x x

x x x x x

x

x x x

x x x

x x x

x x x

x x x

x x x x x

x x x x

x x x

x x x

x x x

x x x

Non-dominated Designs

Dominated Designs

C* x x x

x x x x x x x x

x x x x x x x x x x

x x x x x x

x x x x x x x x

x x x x x x x x

x x x x x x x x

x x x x x x x

Design to K*.

What if demand is KA?

What if demand is KB?

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Flexible Satellite Design

Staged Deployment Managerial Flexibility Reduced Risk of Capacity Excess or Shortfall

Track the Pareto Front

Satellite System Capacity

(Channels)

0 KB K* KA

x x x

Pareto Front

x x x

x x x

x x x

x x x

x x x x x

x

x x x

x x x

x x x

x x x

x x x

x x x x x

x x x x

x x x

x x x

x x x

x x x

Non-dominated Designs

Dominated Designs

C* x x x

x x x x x x x x

x x x x x x x x x x

x x x x x x

x x x x x x x x

x x x x x x x x

x x x x x x x x

x x x x x x x

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Flexible Design

May not track the Pareto Front exactly due to embedded technologies

Embedding flexibility may be difficult and costly

Demand is modeled as a stochastic process and integrated into the design process

Staged deployment is treated as a Real Option

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Public Policy

Encourage Investment in Satellite Systems Lower rates of interest Lower tax rates on business revenues (lowers user

cost of capital) pMPK = uc/(1 - t)

Lower taxes on personal income increases spending Increased public sector spending on satellites Clear and consistent policies to reduce uncertainty

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Public Policy

Discourage Investment in Satellite Systems Higher rates of interest Lack of Clarity and consistent in public policies Build-out or Milestone Rules Reductions in Public Sector spending on satellite

services