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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 measures 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.

9 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 track record will face higher costs of capital and will require somehwat higher rates of return to justify their construction.

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

RESULTS--AN EXAMPLE

We are now prepared to analyze the financial results for typical systems in the several market situations discussed earlier.

For

each system, the computer simulates the complete revenue and cost experience to be expected, using the parameters supplied by the analyst. The detailed cost and revenue schedules have been built into the Comanor-Mitchell computer program, modified to include the changes in FCC rules, penetration and costs discussed earlier and in the appendix of this study.

As an example, consider the abstract of the computer output reproduced in Table 3 Part A indicates that this example is

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representative of a 25,000 subscriber system located near the middle of a top 50 market. Density is assumed to be 200 homes per mile, and family income $12,200. Annual subscriber rates are $62.40, correspond

ing to $5.00 per month plus a small additional amount for second sets. Since this is a central urban location, 20% of the cable

miles are underground, and standard local origination equipment has been budgeted. Revenue from advertising on the cablecasting channel has been estimated at $2.20 per subscriber annually. The table of signals carried shows that 3 VHF networks plus one viewingtest network are available off-the-air. In addition there is one UHF independent and a VHF educational station. In addition to these broadcast signals, the cable system imports two independents and

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