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That cable television is not courting bankruptcy is obvious from a perusal of these estimates for a typical 10, 000 subscriber system. The empirical details and analytical techniques which compel such a conclusion are contained in the five principal sections of this paper which follow and in a comprehensive statistical appendix.

Section B details the important parameters involved in calculating the rate of return on cable-system investment. Section C reviews the NCTA report's crucial assumptions, suggesting more reasonable alternatives in several instances. Section D reviews the terms obtained by system owners in recent mergers, deriving from these price estimates imputed expected future growth of revenues and profits. Section E contains the results of our calculations, including an examination of the effects of alternative copyright fee schedules. Finally, Section F is a full statement of our conclusions. The Appendix of the report, a separate volume, contains the voluminous computer printouts which define the detailed calculations of the results obtained.

B. KEY VARIABLES IN CALCULATING CABLE SYSTEM PROFITABILITY

This section describes the calculations performed in determining cable system profitability and introduces the most important variables that affect these calculations.

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Critical to Mitchell's study and our calculations is the internal rate of return--a fundamental measure of the profitability of capital investments. The internal rate of return on any investment project is that discount rate which equates total future discounted revenues to total discounted future costs. Since the discounted value of any revenue or expense item is directly proportional to its absolute magnitude and inversely proportional to its temporal distance from the present, both the timing and the magnitude of revenue or expenditure items play a critical role in the final calculations. This is not an idle point, as we shall see, for Mitchell has made some very important implicit assumptions about the timing of both revenues and costs.

The precise method for calculating the value of the rate of return is easily described. If we call p (t) the average revenue per subscriber at time t and S (t) the average number of subscribers at time t, the present value of all future revenues is:

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Defining operating costs in each period as OC (t) and capital outlays as
K(t), we may express the present value of all future outlays as:

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Combining these two formulas gives us the equation to be solved for r once all revenue and cost data are entered:

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As the formula for calculating the internal rate of return implies, revenues per subscriber, p(t), must be computed for all future time periods. These revenues are obtained from subscribers' monthly fees, the charge for second or third connections within the subscribing home, installation fees, advertising revenues, and revenues from leasing channels to independent suppliers of entertainment fare. Data on monthly fees currently realized by cable systems are easily obtained, but the future pattern of these fees is not so easily ascertained since changes in the monthly fee must typically be approved by municipal licensing authorities. In addition, there are only indirect data on the extent of "secondary" fees from households electing to connect more than one receiver to the cable.

More speculative is the magnitude and rate of development of "ancillary revenues"--from such sources as advertising, pay-cable, and other services provided in addition to retransmissions. Most of these sources are only beginning to develop at present, but most participants in the industry expect these revenues to grow substantially in the near future.

Mitchell's approach to estimating the future pattern of revenues per subscriber is quite simple. He assumes that the monthly fee is $5 and that 20 percent of all subscribers elect to connect a second set at $1 per month. Advertising revenues are projected at $2.20 per subscriber per year. All of these estimates are projected to grow at an annual rate of zero percent per annum. Other ancillary revenues are ignored,

The most important single variable in calculating the rate of return is the projected penetration of cable subscribers (i. e., the ratio of subscriber homes to total potential homes in the franchise area), Penetration, in turn, is the product of two phenomena: the attractiveness of the cable offering relative to off-the-air alternatives and the temporal rate at which households recognize this difference and actually subscribe. Thus, we must predict the ultimate "mature" value of cable penetration and the rate at which maturity is achieved.

There are a number of approaches to predicting the ultimate penetration of mature cable systems. The first is simply to view the recent experience of the industry and to extrapolate subscriber penetration for the next ten or fifteen years. This approach is weak because it is difficult to predict penetration in the top 100 markets since system growth in these areas in the recent past has been seriously impeded by FCC policy. Recent experience outside the top 100 markets cannot be utilized to predict consumer acceptance within these markets where signal quantity and quality is likely to be much better.

A second technique for predicting cable penetration is the use of published studies of demand relationships which have been estimated from existing data. These demand relationships can be fitted to the data for a variety of markets--including the number of imported signals allowed by the FCC, projections of price and income, and various other variables-to yield predictions of future mature subscriber penetration for each. This

10 is precisely Mitchell's approach, for he uses a recent study by R. E. Park of the Rand Corporation as his only basis for predicting cable penetration. We shall examine the appropriateness of Mitchell's choice in the next section by fitting Park's demand equation and an earlier relationship estimated by Comanor and Mitchell to data drawn from a random sample of cable systems. 10R. E. Park, Prospects for Cable in the 100 Largest Television Markets, The Bell System of

Economics and Management Science, Vol. 3, No. 1, Spring 1972.

A final possibility for predicting mature cable penetration is to utilize the projections provided by the system operators themselves. Fortunately, such projections have been provided on a confidential basis

11 to the NCTA by large multiple system owners. We shall consider this alternative in the next tion after testing the existing statistical demand models against new data.

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Operating costs are defined as those annual, recurring, noncapital expenditures required to provide cable service to subscribers. Unfortunately, precise data on these costs are not normally available from the nation's operating systems. Most systems do not report financial statistics to the public since their securities are not publicly traded. Moreover, systems operating under the new FCC regulations have not had sufficient experience in complying with these rules to provide good estimates of their contribution to operating costs. And, summaries of their financial reports to the FCC have not as yet been made public.

Because of these difficulities, most analysts of cable system profitability are forced to rely upon Comanor-Mitchell data--collected during an NCTA study--for estimates of operating costs. We shall be forced to do the same, despite the criticism which has been leveled at their estimates for being too high!2 we are especially interested in examining the influence of system size upon operating costs per subscriber, and we shall stress the importance of calculating rates of return for only those systems within the range of efficient scale of operation. Very small, inefficient systems must be excluded from any analysis of profitability of "typical" cable systems.

1 Don Andersson, op. cit. 12For example, see John J. McGowan, Roger Noll, and Merton J. Peck's technical memorandum

prepared for the Sloan Commission, 1971.

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