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Rethinking the implications of “real options” theory for the U.S. local telephone industry

  • Richard N. Clarke
Part of the Topics in Regulatory Economics and Policy book series (TREP, volume 34)

Abstract

Real options theories are an important advance in analyzing the value of various business arrangements. Because incumbent exchange carriers’ business arrangements with their new competitors are at the center of regulators’ efforts to demonopolize the U.S. local telephone industry pursuant to the Telecommunications Act, it is natural that these new arrangements should be inspected to determine whether they correctly reflect the import of real options’ costs. Investors and regulators have recognized these considerations, and to the extent that certain real options models do not reach the same conclusion, it is because they have not been parameterized to reflect accurately the market conditions facing the U.S. local telephone industry.

Keywords

Real Option Federal Communication Commission Energy Information Administration Real Option Theory Real Option Model 
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Notes

  1. 2.
    The first rigorous development of the mathematical theory of financial option values was provided in Black, F. and M. Scholes. 1993. “The Pricing of Options and Corporate Liabilities,” Journal of Political Economy, No. 81, pp. 637–659.CrossRefGoogle Scholar
  2. 3.
    Major contributions to real options theory include: Dixit, A. and R. Pindyck. 1994. Investment Under Uncertainty, Princeton University Press. McDonald, R. and D. Siegel. “Investment and the Valuation of Firms When There is an Option to Shut Down,” International Economic Review, Vol. 28, No. 2, pp. 331–349; Pindyck, R. “Irreversible Investment, Capacity Choice and the Value of the Firm, American Economic Review, Vol. 78, No. 5, pp. 969–985. Hubbard, R.G. “Investment Under Uncertainty: Keeping One’s Options Open,” Journal of Economic Literature, Vol. 32, pp. 1816–1832, provides a useful summary.Google Scholar
  3. 4.
    See, for example, Jerry Hausman, “The Effect of Sunk Costs in Telecommunications Regulation,” in this volume, which states, “A … calculation which ignores the sunk cost feature of telecommunications network investments would thus be off by a factor of two.”Google Scholar
  4. 6.
    Hausman, op. cit.Google Scholar
  5. 7.
    See, Direct Case of the General Services Administration (“GSA calculates the weighted cost of capital as 9.27 percent”), filed January 19, 1999 in Federal Communications Commission CC Docket No. 98-166; or Responsive Submission of AT&T Corp. with its accompanying Affidavit of Bradford Cornell and John I. Hirshleifer (“applying established financial economics principles to the market data on the publicly-traded firms that operate local telephone networks yields a weighted average cost of capital range of no higher than 8.5% to 9.5%”), filed March 16, 1999 in the same proceeding.Google Scholar
  6. 9.
    See, for example the Comments of GTE (“there is no basis to alter the current prescribed authorized rate of return of 11.25%”), filed January 19, 1999 in Federal Communications Commission CC Docket No. 98–166; or the Comments of Bell Atlantic (“the Commission should not adjust the prescribed rate of return”) filed in the same proceeding.Google Scholar
  7. 14.
    As an example, in the early 1990s, NYNEX claimed that only its midtown and downtown Manhattan exchanges were profitable, and that its other New York City exchanges generally “lost” money. But when Teleport then offered to purchase any of these “unprofitable” exchanges at their net book value, NYNEX refused to sell. See “The Local Call Goes Up for Grabs,” New York Times, December 29, 1991, Section 3, p. 1.Google Scholar
  8. 15.
    See “In the matter of U S West Tariff F.C.C. Nos. 3 and 5,” FCC Common Carrier Bureau Order on Transmittal 629, September 28, 1995.Google Scholar
  9. 16.
    In addition to gains from waiting to invest, there may be other advantages in managerial flexibility that incorporate real options value. See L. Trigeorgis. 1996. Real Options: Managerial Flexibility and Strategy in Resource Allocation, MIT Press.Google Scholar

Copyright information

© Kluwer Academic Publishers 1999

Authors and Affiliations

  • Richard N. Clarke
    • 1
  1. 1.AT&TUSA

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