JERRY DUVALL FEDERAL COMMUNICATIONS COMMISSION Investing in Telecommunications Infrastructure under Uncertainty and Irreversibility: Communications Satellites as a Case StudyPHOENIX CENTER 1 Presented Before The Phoenix Center Fourth Annual State Educational Retreat Sponsored by The Phoenix Center for Advanced Legal & Economic Policy Studies At Pointe Hilton Tapatio Cliffs Resort Phoenix, Arizona October 18, 2007

Preliminary Remarks 2 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.

The Investment Decision Without Sunk Costs 3 R t = 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) C 0 = total capital outlay for the investment project at the beginning of the project (i.e., t = 0)

The Investment Decision Without Sunk Costs 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

NPV Decision Rule 5 NPV ValueDecision NPV > 0Invest NPV < 0Don’t Invest NPV = 0Indifferent

Present Value of Forecast Satellite Net Lease Revenues: Total investment = C 0 = $300; WACC = r = 8.5%; Life = n = 5 years. 6 (1)(2)(3)(4) Year Forecast Net Lease Revenues ($ Millions) (1.085) t [1/2] 1/(1.085) t [(1) x (3)] PV of Forecast Net Lease Revenues ($Millions)

Key Assumptions in NPV Analysis 7 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

Optimal Investment Jorgenson (1963); Hall and Jorgenson (1967) 8 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 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)

Dynamic Optimization Problem 9 Maximize present discounted value of net revenues over an infinite time horizon 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)

Solution to the Dynamic Constrained Optimization Problem 10 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)

Equilibrium Capital Stock 11 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 (pMP K ) equals the user cost of capital (uc). (7) (8)

Equilibrium Capital Stock 12

Investing with Uncertainty and Irreversibility 13 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

Real Options: Investing vs. Opportunity to Invest 14 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).

Real Options: Investing vs. Opportunity to Invest 15 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)

Example (Pindyck 1991) 16 Factory Cost = I 1 unit per period No operating cost P 0 = $100 P 1 = q($150) + (1-q)$50, and doesn’t change thereon Assume:  I = $800  q = 0.30  Interest rate = 10% Invest Now? Invest Later No cost or revenues in Year 0. Investment made in Year 1 only if P 1 = $150.

Example 17 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

Multiple Options and Managerial Flexibility 18 Defer Abandon Expand Switch 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

Real Options in the Satellite Industry 19 Economic Characteristics  Investments are Lumpy, Large, and Sunk  Flow of Net Revenue is Uncertain Given Long Life (  15 years)

Alternative Designs 20 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

Pareto Front 21 Design to K*. What if demand is K A ? What if demand is K B ?

Flexible Satellite Design 22 Staged Deployment  Managerial Flexibility  Reduced Risk of Capacity Excess or Shortfall Track the Pareto Front

Flexible Design 23 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

Public Policy 24 Encourage Investment in Satellite Systems  Lower rates of interest  Lower tax rates on business revenues (lowers user cost of capital)  pMP K = uc/(1 - t)  Lower taxes on personal income increases spending  Increased public sector spending on satellites  Clear and consistent policies to reduce uncertainty

Public Policy 25 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