Jerry Duvall Federal communications commission
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Transcript of Jerry Duvall Federal communications commission
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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
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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
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x x x x x x x x
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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
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Non-dominated Designs
Dominated Designs
C* 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