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The answer depends primarily on how rapidly penetration would decline as prices were raised; in technical economic terms, on the elasticity of demand. If, for example, a 16.5% increase in price, from $5.00 per month to $5.83, results in a 16.5% decrease in penetration, say from 30% to 25% of homes passed, then the higher price has (approximately) 4/ no effect on total subscriber revenue--it is fully offset by reduced demand for service.

A basic result of economic theory states that consumers' demand for a service will be increasingly sensitive to its price as more and closer substitutes are available for that service. Thus households in areas with a diversity of broadcast signals, with generally clear reception and with a variety of entertainment alternatives ca be expected to decline service rapidly as prices rise. This availability of good substitutes for CATV describes most top 100 markets. The econometric work of R.E. Park confirms this degree of price elasticity of demand in such areas; in fact, the figures in the example above correspond almost exactly to Park's statistical findings. 5/6/

4/ Calculating the percentage changes, for convenience, in terms of the original price and penetration, results in a slight approximation. A more exact result is obtained using the average of the old and new price and penetration.

5/ Park, "Prospects for Cable...", p. 140.

6

For a discussion of the effect of demand elasticity on maximum rates permitted by a regulatory authority, see Comaner and Mitchell, "The Costs of Planning: The FCC and Cable Television

How, then would cable systems' profits be affected by a 16.5% copyright payment and a concommitant rise in subscriber rates? Revenues would be unchanged, while operating costs would increase sharply by the amount of the copyright payments. There would

be some small offsetting changes in other incremental costs, resulting from the saving achieved by not serving the subscribers who do not purchase service at the higher price. For typical systems, there are rather small costs of installing additional drop lines, additional maintenance and billing expenses and slightly higher taxes and dues related to numbers of subscribers.

In consequence, the net effect of allowing higher subscriber rates in conjunction with 16.5% copyright fee payments would be to reduce rates of return to nearly the same levels as would be achieved by holding subscriber rates unchanged with the same 16.5% copyright fees. In addition, penetration would be lower, providing a narrower base for future leased-channel services capable of generating additional payments from cable systems to program suppliers. We remind the reader that the discussion in the preceeding several paragraphs assumed a degree of upward price adjustment which has not been observed. In the remainder of this study we adhere to a fixed monthly price of $5.00 7/ for maximum cable broadcast service allowed by the FCC rules. 8/

7 Plus $1.00 for second television sets in 20% of households. 8/ One other reminder may be in order. Since we are considering all prices and costs in 1972 terms, increases in the monthly subscription rate at about the rate of increase of consumer prices generally will not contradict our observation that real subscription rates cannot be adjusted.

An analysis of the profitability of systems under the alternative

assumption of higher rates and consequently reduced penetration would yield approximately the same findings.

57-786 - 76 pt. 1 35

MEASUREMENT OF CABLE SYSTEM PROFITABILITY

To summarize the profitability of the typical cable systems of this study we will calculate the (pre-tax) financial rate of return on total capital invested in each system. The financial (or internal) rate of returng/is the single comprehensive measure of investment in a cable system. Unlike ratio measu easures for a particular year (e.g. net revenues divided by total capital) it correctly recognizes the opportunity cost of front-end financing, i.e. that several years are required before systems achieve full penetration, during which time invested funds are needed. Using the financial rate of return permits us to compare the profitability of funds invested in CATV systems with other types of investments, and thus the likelihood of cable systems being constructed. The rate of return required to induce investment in a cable system will depend on the proportion of total capital which can be obtained through debt instruments and the associated borrowing rates, and the minimum return demanded by equity investors. Because the cable industry more closely resembles a high-risk growth industry than a public utility, at least at the present time, both lenders and investors demand higher rates of return than for seasoned investments.

2 The internal rate of return is that discount rate which equates the present value of revenues and costs over the lifetime of the system. For further discussion, see Comanor and Mitchell, "Cable Television and the Impact of Regulation," p. 184.

For this study we have held both revenues and cost at 1970 price levels over the full life of the cable system. Financial measures are consequently in real (constant dollar) terms. The corresponding rate of return concept is the financial return which would occur if prices did not rise throughout the economy: whereas in an inflationary period, investors expect price increases and demand higher returns in money terms to compensate them for the otherwise reduced value of their funds when their investment is recovered. Thus if investors expect a 4% rate of inflation to continue indefinitely and will invest in enterprises comparable to cable television only when they return 15% on average, the required rate of return in constant prices would be 11%.

A detailed investment survey 10 of the CATV industry in late 1971 reports that mature cable companies with demonstrated earnings have found long-term credit expensive, and that institutional investors are looking for a 15% return as a combination of interest and equity appreciation. As a standard of minimum profitability necessary to generate investment in new cable systems, we will use a 10% constant-dollar financial rate of return on total capital. This is on the low side of recent financing experience of established CATV companies, and would therefore apply to new systems constructed by the larger multiple system owners today. New CATV firms lacking a

10/ Halle & Stieglitz, Inc., "The Cable Television Industry."

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