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Public Version

NATS - Cost of Capital for CP2November 2004


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19 November 2004

Dear Sirs

Report prepared by PricewaterhouseCoopers LLP (PwC) in connection withadvising the Civil Aviation Authority (CAA) on the cost of capital in the context of the NATS review.

This report (Report) has been prepared for the CAA (you or the Company) inconnection with cost of capital in the context of the forthcoming NATS price review. Ithas been produced in accordance with our letter of engagement dated 29 July 2004 andattached terms and conditions. It reports our recommendations and findings in the areaof cost of capital.

PwC accepts no duty of care to any third party for this Report. Accordingly regardlessof the form of action, whether in contract, tort or otherwise, and to the extent permitted

by applicable law, PwC accepts no liability of any kind to any third party and disclaimsall responsibility for the consequences of any third party acting or refraining to act in

reliance on the Report.The information used by PwC in preparing this Report has been obtained from a varietyof sources as indicated within the Report. While our work has involved analysis of financial information, it has not included an audit in accordance with generallyaccepted auditing standards. Accordingly we assume no responsibility and make norepresentations with respect to the accuracy or completeness of any information

provided to us by and on your behalf.

By its very nature, cost of capital work cannot be regarded as an exact science and theconclusions arrived at in many cases will of necessity be subjective and dependent onthe exercise of individual judgement. Although the advice we give and our conclusionsare in our opinion reasonable and defensible, others might wish to disagree with our

views.

Yours faithfully

PricewaterhouseCoopers LLP

Economics Regulation Group

Group Directors OfficeCivil Aviation AuthorityCAA House45-59 KingswayLondon WC2B 6TE

For the attention of Mr Harry Bush

PricewaterhouseCoopers LLP1 Embankment Place

London WC2N 6RHTelephone +44 (0) 20 7583 5000Fax +44 (0) 20 7804 4993

PricewaterhouseCoopers LLP is a limited liability partnership registered in England with registered number OC303525 . The registered office of PricewaterhouseCoopers LLP is 1 Embankment Place, London WC2N 6RH. PricewaterhouseCoopers LLP is authorised and regulated by the Financial ServicesAuthority for designated investment business.


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Table of Contents Section Page

Executive Summary 1 - 3

Weighted Average Cost of Capital (WACC) 4 - 5

Formulation of the WACC 6 - 7

CAPM and the alternative cost of equity methodologies 8 - 10

Cost of Debt Methodologies 11 - 12

Cost of Equity Inputs 13 - 36

Cost of Debt Inputs 37 - 45

Gearing 46 - 49

Taxation 50 - 51

Summary and Conclusions 52 - 53

Appendices 54 - 62


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Executive Summary

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Executive Summary

Executive summary

We have been asked by the Civil Aviation Authority (CAA) to examine the appropriate cost of capital to apply to NATS in the context of the forthcoming NERL and Oceanic price review (CP2)

Our estimated range for NATS pre-tax, real WACC (to be applied to both NERL and Oceanic) is 4.9% to 7.4%.

Our analysis suggests a central estimate for NATS' pre-tax, real cost of capital of 6.1%, although, there is considerable imprecision in estimating a precisefigure within this range. We would expect the CAA to select a figure close to our central estimate, although the CAA may choose to take a different view of any of the underlying cost of capital assumptions.

Key areas of discussion in this document are:

The most appropriate formulation for the cost of capital

The significant movement in the real risk-free rate since the first price control review (CP1)

The basis for measuring beta: which are NATS comparators and from when should beta estimates be taken The level of the Equity Market Risk Premium (EMRP)

Whether there are arguments for adding a small companies risk premium to NATS cost of capital

How to measure gearing, given the reduction in NATS debt levels

NATS actual cost of debt and current borrowing costs in the market

The basis of converting post-tax cost of capital figures into pre-tax equivalents.

The following page shows the WACC we have calculated on both a pre-and post-tax basis and in real and nominal terms.

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Executive Summary

Comparison of Assumptions

1 Implied asset beta based on PwC unlevering approach 2

Gearing calculation using NPV-weighted average methodology (see page 47).

Assumptions CAA for CP1 (January 2001)

Low Central High

Real risk-free rate 2.5% 3.5% - 3.8%

Nominal risk-free rate 4.9% -

Asset beta 0.50 0.55 0.60 0.55 1

Debt / Equity Ratio (D/E) 156% 100%

Target Gearing (D/D+E) 61% 50%

Equity beta 1.28 1.41 1.54 1.10

EMRP 3.0% 4.5% 6.0% 3.5% - 5.0%

Nominal, Cost of Equity (%) 8.7% 11.2% 14.1% -

Real, Cost of Equity 6.3% 8.8% 11.7% 7.35% - 10.8%

Debt margin 1.2% 1.2% - 1.8%

Nominal, Cost of Debt (%) 6.1% 6.1% 6.1%

Real, Cost of debt 3.7% 3.7% 3.7% 4.7% - 5.6%

Nominal, Post-tax WACC (%) 6.0% 7.0% 8.1% -

Tax Wedge x 1.2 x 1.2

Nominal, Pre-tax WACC (%) 7.2% 8.4% 9.8% -

Real, Post-tax WACC (%) 4.1% 5.0% 6.2%

Real, Pre-tax WACC (%) 4.9% 6.1% 7.4% 7.0% - 8.7%

Figure adopted - 7.75%

PwC for CP2

2

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Weighted Average Cost of Capital (WACC)

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Weighted Average Cost of Capital (WACC)

Weighted Average Cost of Capital

The cost of capital represents the required return a company should earn on invested capital in order to provide sufficient returns to the investors who financethe business.

Firms are generally financed through a mixture of debt and equity, which have different characteristics. Since the costs of debt and equity capital aredifferent, the overall measure of the cost of capital of a firm is the weighted average cost of capital (WACC), which is calculated as follows:

WACC = Ke * E/(D+E) + Kd *(1-T) * D/(D+E)

where:

Ke is the post-corporate tax cost of equity;

Kd is the pre-corporate tax cost of debt;

E is the value of equity;

D is the value of debt; and

T is the tax rate.

This is the standard post-corporate tax WACC, which can be estimated in nominal or real terms to match nominal or real cash-flows. It includes the (1-T)term on the cost of debt to represent the tax shield in debt interest payments.

The post-corporate tax WACC can be converted to a pre-corporate tax WACC using the formula set out below:

WACC pre-tax = WACC post-tax /(1-T)

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Formulation of the WACC

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Formulation of the WACC

WACC - Regulatory Precedent

Real or nominal WACC(September 1993 to June 2004)

76%

20%

4% Real

Nominal

Unknown

Pre- or Post- tax WACC(September 1993 to June 2004)

89%

7%4% Pre-tax

Post-tax

Unknown

The PwC database of global regulatory precedent contains detailedinformation on how regulators have calculated the cost of capital in the

past, and also the assumptions that they have made in estimatingindividual inputs.

Chart 1 shows that since September 1993 in 76% of cases the WACC has

been calculated in real terms. Almost all of those that were in nominalterms were calculated by Oftel, now Ofcom..

Chart 1

Chart 2

Chart 2 also shows that in 89% of cases the WACC has been calculated ona pre-tax basis.

The CAA have historically always followed a real, pre-tax approach tocalculating the WACC.

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CAPM and the alternative cost of equity methodologies

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CAPM and the alternative cost of equity methodologies

Estimating the cost of equity capital (contd)

The risk premium above the risk-free rate is the product of two variables:

a general equity market risk premium (EMRP). This is the additional return required by investors for investing in equities of average risk; and

beta ( ), being a measure of the relative non-diversifiable risk of a particular investment, derived by looking at the correlation of its returns with the

returns on the market as a whole.

A company whose returns are perfectly correlated with the market, has a beta equal to one. If a particular company has higher than average non-diversifiablerisk, its returns move more than the market, and the companys beta is greater than one. A company with a higher beta is more risky than the average equityinvestment and investors bearing this risk must be compensated in order to attract investment.

We have adopted the CAPM as it is the most widely used and accepted of thetechniques for estimating the cost of equity.

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Cost of Debt Methodologies

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Cost of Debt Methodologies

Estimating the cost of debt

The cost of debt is the return required by debt providers for lending to a business. It is typically calculated as follows:

Kd = Rf + DM

where:Kd is the pre-tax cost of debt;

Rf is the risk-free rate; and DM is the corporate debt margin.

The corporate debt margin is the additional return over the risk-free rate required by investors to hold debt rather than risk-free assets. The debt marginreflects the perceived credit quality of the borrower and the likelihood of default. This is partly influenced by the financial condition of the business as well asmore subjective factors such as the quality of a firms management.

If a company issues tradable debt then the market cost of debt can be measured directly. Alternatively, if the company has no tradable debt but there aregood comparators in the market that have issued traded debt, the debt margin can be estimated by benchmarking against the debt costs of these comparators.Debt costs can also be deduced from credit ratings, and if these are not available it may be possible to derive a synthetic rating based on interest cover 1,

because this is the main determinant of credit ratings.

1 Interest cover is usually calculated as earnings before interest and tax divided by net interest.

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Cost of Equity Inputs

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Risk-free rate

To determine the risk-free rate in practice, the redemption yield on safe and liquid financial instruments that have negligible default risk is considered. Therelevant instrument in the case of NATS is a UK Government bond.

The UK yield curve is currently very flat, although it is usually upward sloping. This means that yields for longer term instruments are generally greater thanyields for shorter instruments. Based on the spot UK benchmark yield curve, shown overleaf, the nominal risk-free rate is currently somewhere between 4.6%and 4.9% depending on the maturity of bonds selected. The real risk-free rate, measured by the yield on the UK index-linked benchmark bonds (also shown

overleaf), ranged from 1.6% to 2.0% at the time of our calculations. This evidence will need to be updated through the consultation process to reflectmovements in market rates.

The choice of risk-free rate usually depends on the maturity of the cash flows modelled in the financial projections. This approach avoids an inflation mismatch between the inflation assumptions in the economic modelling and the inflation assumptions in the cost of capital. Under this approach, for a five year price capmodel it would therefore be appropriate to use the five year risk-free rate.

An alternative approach would be to match the maturity of the risk-free rate to the average asset life of the assets in the business the real time horizon over which NATS is investing.

Most regulators in the past have veered towards a 5 to10 year maturity range. The CAA previously used a maturity range of 5 to 15 years in the April 2000 price control review.

Our suggestion is to adopt a 10 year risk-free rate.

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UK risk-free rate

UK Risk-Free Rate

0.0

1.0

2.0

3.0

4.0

5.0

6.0

3 m onth 6 m onth 1 year 2 year 3 year 4 year 5 year 6 year 7 year 8 year 9 year 10 year 15 year 20 year 30 year

Maturity

Y i e l d ( % )

UK Nom inal Benchm ark UK Index-linked Benchm ark

5 year

4.9%

1.9%

10 year

4.9%

1.9%

Source: Bloomberg and PwC Analysis

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Risk-free rate regulatory precedent

Source: PwC analysis

Our regulatory database shows that since September 1993, regulators in the UK have assumed a real risk-free rate ranging from 2.5% (Ofgem, December 1999)to 3.65% (MMC, CAA, Oftel, September 1993 to April 2000). The general decline in the real risk-free rate used by the regulators illustrated in the diagram

below is primarily a function of lower UK real interest rates.

0

1

2

3

4

5

6

7

Oct-92 Apr-94 Oct-95 Apr-97 Oct-98 Apr-00 Oct-01 Apr-03 Oct-04

R e a

l R i s k - f r e e r a

t e ( % )

( m i d - p o i n

t )

MMC / CC

CAAOftelOfgemOfwatORR10yr Index Linked yields

Points that refer to CAA

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Risk-free rate suggested approach

The question of whether to use current market rates or allow for some historic averaging is a question of regulatory principle and risk attribution, and a desire toavoid the fluctuations in observed yields because of short term market volatility.

Regulators have not tended to follow the decline in the real risk-free rate as quickly as the market and the real risk-free rate is still very low by historicalstandards.

The Smithers report 1 suggested the use of a 2.5% real risk-free figure, based on longer term averages and evidence of mean reversion of the real risk-free rate.

As a consequence we have adopted the following figures in our calculations:

Nominal 10 year rate of 4.9%

Real 10 year rate of 2.5%

Our suggestion is to use the longer term average real risk free rate of 2.5%.

1A study into certain aspects of the cost of capital for regulated utilities in the UK, Stephen Wright, Robin Mason and David Miles, 13 February 2003

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Equity market risk premium (EMRP)

The equity market risk premium (EMRP) is a key assumption in the cost of equity. It is the return equity investors expect over and above the risk-free rate tocompensate for the additional risk associated with investing in equities instead of investing in risk-free assets.

Arithmetically it is expressed as:

EMRP = (Rm - Rf)

where

> Rm = the expected return on a fully diversified (market) portfolio of equities.

> Rf = the risk-free rate, estimated as the expected return on Government bonds.

The EMRP is a very difficult variable to estimate, and is highly contentious.

These are many different views and several different approaches. Well-respected estimates provide a very wide range for the equity risk premium of 2% to 9%.

In principle, the EMRP is an ex-ante (forward-looking) rather than an ex-post (historic) concept. However, both historic and forward-looking approaches arecommonly used to arrive at an estimate.

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EMRP - historic methods

Historic measures vary according to the time period selected - as can be seen from the table below. This table is based on US data provided by IbbotsonAssociates and Grabowski and King.

Source: Ibbotson Associates and Grabowski and King, 1998

A Barclays Equity-Gilts study gives similar results for the UK. Using Barclays data since 1919 (so roughly comparable with the 72 year results above), thearithmetic average is around 7-8%, and the geometric average is around 5-6%.

A commentary on the differences between geometric and arithmetic averages can be found in Appendix 2.

US EMRP (relative to government bonds)

Period Geometric average Arithmetic average

20 years (since 1978) 7.8% 8.5%

30 years (since 1968) 4.0% 5.2%

40 years (since 1958) 5.2% 6.3%

50 years (since 1948) 6.9% 8.1%

60 years (since 1938) 7.0% 8.2%

72 years (since 1926) 5.8% 7.8%

200 years (since 1798) 3.8% 5.2%

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Historic EMRP - Triumph of the Optimists - US, UK and global analysis The most recent and comprehensive scholarship on the EMRP is provided by three London Business School Professors Elroy

Dimson, Paul Marsh and Mike Staunton in the Triumph of the Optimists publication.

This dataset is subtly different from the traditional Ibbotson (US) and Barclays (UK) work, in that adjustments are made to thereturns achieved by investors to correct for the fact that we observe the returns of firms that survive and do not necessarily capturethe (negative) returns associated with firms that have failed. This adjustment for so-called survivor bias has the effect of reducingoverall measured premia, because actual achieved returns (once failure has been captured) are lower.

US, UK and global risk premia using the Triumph of the Optimists dataset (1900-2000) are set out below.

Arithmetic mean Geometric mean

US

Equities versus bills 7.7% 5.8%

Equities versus bonds 7.0% 5.0%

UK




Global


Source: Triumph of the Optimists (2002), page 306, 301 and 311

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EMRP - forward looking methods

Forward looking techniques typically estimate the EMRP from surveys of investor expectations, either directly or in conjunction with the Dividend DiscountModel (DDM) developed by Gordon in the early 1960s.

Forward looking surveys typically yield EMRPs in the range of 2% - 6%.

The main difficulty with the survey approach is that it is impossible to survey all participants in the equity market and it can be subjective.

Forward looking approaches tend to give lower results than historic calculations. Although some commentators suggest the EMRP may have risen recently dueto stock market falls, terrorist attacks etc, there is not a great deal of hard evidence for this.

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EMRP regulatory precedent Regulators in the UK have historically used an EMRP ranging from 3.4% (MMC, September 1993) to 5.0% (Oftel, January 1995 to October 2001).


0

1

2

3

4

5

6

Jan-93 Jun-94 Oct-95 Mar-97 Jul-98 Dec-99 Apr-01 Sep-02 Jan-04 May-05

E M

R P ( % )

( m i d - p o i n t

)

MMC / CCCAAOftelOfgemOfwatORR Ofcom


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EMRP suggested approach Whilst we have a slight preference for the Dimson, Marsh and Staunton (DMS) historic figures based on arithmetic averages, we do not believe it is appropriate

to ignore forward looking evidence or historic DMS evidence based on geometric calculations. It needs to be recognised that the EMRP is really a forwardlooking concept rather than a backward looking one, and measuring the EMRP based on equity returns in 1900 when the market was very different from whatit is today is not entirely satisfactory. Also, we believe that investor behaviour is such that the arithmetic mean calculation is most sympathetic to the manner inwhich investors evaluate equity risk, but this is a judgement and there is no single right or wrong approach.

The ex-post ranges shown in the table below are based on the analysis provided by Dimson, Marsh and Staunton (relative to both bonds and bills). We ignorethe Ibbotson and Barclays capital work, because the DMS analysis is an improved version of both these sources as it adjusts for survivor bias whereas these

earlier surveys do not. The ex-ante ranges are based on the forward looking estimates from surveys of investor expectations.

EMRP Basis Minimum Maximum

Regulatory precedent 3.4% 5.0%

DMS, Ex-post arithmetic 5.6% 7.7%

DMS, Ex-post geometric 4.4% 5.8%

Ex-ante 2.0% 6.0%

Maximum Range 2.0% 7.7%

Suggested range 3.0% 6.0%

Determining an appropriate level for the EMRP is an unresolved and ongoing debate in finance. We believe that a range for the EMRP of 3% to6% is consistent with both recent surveys of historic information and ex-ante forecast figures derived directly from surveys of investor expectations.

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Beta

Asset beta

An asset beta is derived by adjusting the equity beta for the effect of financial risk by assuming that the business is financed solely with equity. It reflects theunderlying operational risk of a business at a pre-financing level.

A companys asset beta is not, therefore, directly observable and is calculated from the equity beta.

Asset betas are used to make comparisons of the underlying riskiness of businesses which have different levels of leverage.

There are two formulae that can be used to unlever equity betas. We use the formula shown below, which is sometimes referred to as the Miller formula or theHarris-Pringle formula:

The formula above assumes that firms typically target a constant debt equity ratio. An alternative unlevering formula which includes an additional (1-T) termassumes that debt is held constant at a certain level and will never vary. Therefore gearing will always vary as equity values fluctuate, but the value of debtdoes not. Alternative beta calculations using the alternative formula are provided in Appendix 3. The alternative formula (sometimes known as theModigliani-Miller formula) is shown below:

We use Bloomberg as our preferred provider of equity beta estimates, due to the ability to vary the estimation period, time of observation and benchmark equityindex. Our defaults is to estimate betas using five years of monthly observations.

E D

ae+= 1

+= E

DT

cae )1(1

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Equity beta - regulatory precedent

The equity betas that have been adopted by the UK regulators have ranged from 0.58 (MMC, June 1995) to 1.40 (Oftel, September 2001). This however is not agood indication of NATS equity beta, since it is based on companies from a wide range of sectors as well as gearing levels.


0.00

0.20

0.40

0.60

0.80

1.00

1.20

1.40

1.60


E q u

i t y b e t a

( m i d - p o

i n t )

MMC / CC

CAAOftelOfgemOfwatORR Ofcom


Heathrow, Gatwick, Stansted; andManchester Airport Price-cap 2003 - 2008

Heathrow - New assets only

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NATS beta analysis of comparators

As far as we are aware there are no comparable air traffic control business that have been floated with a track record sufficient to estimate beta. It is thereforenecessary to identify businesses that have similar risk characteristics to NATS.

Previously, BAA and Railtrack have been used as comparators by the CAA.

Our approach has been to:

Identify sectors that have a similar risk profile to NATS

Identify particular companies with a similar risk profile to NATS

Perform historical analysis to avoid placing undue weight on single point estimates

Our comparators are a large group of companies primarily involved in the utilities, airport and airline sectors, across Western Europe.

We take as wide an approach to this exercise as possible because measuring beta based on a single company observation can be unreliable given the statistical

error associated with beta measurement. In the analysis which follows we have used betas from Bloomberg that have been calculated using five years of monthly data, and incorporating a Bayesian

adjustment.

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Utility betas

The table below shows that the asset betas for utility companies across Europe range from minus 0.21 to 0.39, with an average of 0.30.

NATS main similarity to utility companies is that it is a regulated business. On the other hand, NATS key asset is its people, rather than any physical assetsuch as a network of pipes or wires. It is a more risky business than standard utilities, because the key driver of demand (air travel) is likely to have a higher income elasticity than essential services.

For these reasons, we would consider NATS asset beta to be greater than the utility average of 0.30.

Sector Company Country Equity No. of Monthly Market Cap. Total Debt 5 yr. Debt / AssetBeta Observations mils. mils. Equity Ratio Beta

Miller

Utility ComparatorsNational Grid Company UK 0.68 60 13,663.9 13,248.0 94.6% 0.35Railtrack Group plc UK 0.51 60 3,544.6 3,472.0 48.3% 0.34RWE AG Germany 0.69 60 15,226.5 29,677.2 134.4% 0.29

Scottish and Southern Energy UK 0.26 60 6,265.9 1,445.4 24.7% 0.21Severn Trent UK 0.42 60 2,794.0 2,864.4 103.9% 0.21E.ON AG Greece 0.55 60 26,751.1 14,973.2 56.1% 0.35Endesa SA Spain 0.92 60 10,431.2 11,232.9 134.8% 0.39Iberdrola SA Spain 0.52 60 9,953.3 7,038.3 78.5% 0.29Scottish Power Plc UK 0.43 60 7,258.0 5,133.9 75.6% 0.24United Utilities plc UK 0.47 60 3,977.8 4,469.7 111.0% 0.22Suez Lyonnaise Des Eaux SA France 0.93 60 10,587.4 17,915.4 146.1% 0.38

Median / Average 1 0.58 94.6% 0.30

Min 0.26 25% 0.21Max 0.93 146% 0.39

Excluded 2 AWG Plc UK 0.89 60 906.1 3,946.0 455.8% 0.16

1 Median is used for the 5 year debt / equity ratio and simple arithmetic average is used for the asset beta.

2 Comparators with less than 30 data points, or a debt / equity ratio of greater than 400%, have been excluded from all averages.

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C f E i I


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Airline betas

The asset beta range for the airline industry is wider than that for the utilities. It ranges from 0.28 to 1.16. The average for the group is 0.63.

NATS is in the same industry as airlines, but is unlikely to be as exposed to the same quantum of systematic risk faced by airlines.

Sector Company Country Equity No. of Monthly Market Cap. Total Debt 5 yr. Debt / AssetBeta Observations mils. mils. Equity Ratio Beta

Miller

Airline ComparatorsAlitalia SpA Italy 0.91 60 572.7 1,332.7 143.8% 0.37British Airways UK 2.01 60 2,225.4 5,559.0 308.5% 0.49Lufthansa AG Germany 1.02 60 2,772.1 2,423.5 81.0% 0.56Finnair Finland 0.5 60 293.5 158.4 78.4% 0.28Groupe Air France CHEC France 1.42 60 2,104.4 2,939.6 140.5% 0.59Easyjet plc UK 1.29 44 570.4 110.3 11.0% 1.16

Iberia Lineas Aereas de Espana SA Spain 1.4 39 1,287.6 352.4 43.5% 0.98Turk Hava Yollari Anonim Ortakligi (THY) Turkey 1.17 60 0.5 0.5 42.2% 0.82Ryanair UK 0.86 60 3,070.1 935.1 19.6% 0.72Swissair Group Switzerland 1.03 30 1,948.8 7,500.0 193.1% 0.35

Median / Average 1 1.16 79.7% 0.63Min 0.50 11% 0.28Max 2.01 309% 1.16

Excluded2

Austrian Airlines Austria 1.54 60 249.4 1,304.3 815.6% 0.17KLM Royal Dutch Netherlands 1.24 60 499.4 2,966.4 826.9% 0.13

1 Median is used for the 5 year debt / equity ratio and simple arithmetic average is used for the asset beta.

2 Comparators with less than 30 data points, or a debt / equity ratio of greater than 400%, have been excluded from all averages.

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Beta key individual comparators

For our key individual comparators we have carried out a full historical analysis. Betas show significant variability over time, so it is important to consider the period when the comparator in question was most alike NATS.

Appendix 3 shows historical asset betas for BAA, Railtrack Group and BT Group, using monthly, weekly and daily regressions.

Current asset beta estimates for the three key individual comparators are provided below:

Company Country Equity No. of Monthly Market Cap. Total Debt 5 yr. Debt / AssetBeta Observations mils. mils. Equity Ratio Beta

Miller

BAA plc UK 0.64 60 5,893.4 3,701.0 51.6% 0.42BT Group plc UK 1.57 60 15,714.4 13,532.0 92.4% 0.82

Railtrack Group plc1

UK 0.51 60 3,544.6 3,472.0 48.3% 0.34Median / Average 0.91 52% 0.53Min 0.51 48% 0.34Max 1.57 92% 0.82

2

Railtrack market capitalisation and total debt figures are as at March 2001. This is the latest date that it was available on Bloomberg.

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Asset beta - Summary

1. Sectors

0.62 0.63

Utilities Airports Airlines

2. Companies

0.34 0.42 0.82

Railtrack BAA BT

3. Averages

0.52 0.53

Sector Company

0.3

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Asset beta suggested approach

NATS is a fully regulated business, as are the majority of our utility comparators. It also shares certain properties and risks in common with airports andairlines, but also other network service providers, such as Railtrack and BT.

A key difference between NATS and its airport comparators is that, following the Composite Solution, NATS is exposed to broadly 50% of the risk in trafficvolumes it previously faced. This tends to suggest a lower asset beta than for airports.

We have also considered the difference in the operating gearing between NATS relative to more capital intensive regulated business such as electricity and

water utilities, and the effect that this may have on the asset beta. For example, NATS ratio of operating costs to assets is approximately 40% whereas for theutilities it is less than 10%. Railtrack on the other hand has an operating gearing similar to NATS although its asset beta is closer to that of utilities. It istherefore difficult to show how to adjust for differences in operating gearing between NATS and the comparators. This point however further demonstrates thedifference between the utilities and NATS business and another reason why NATS beta should be above the utilities asset beta.

Assessing an appropriate asset beta for NATS is not an exact science. Based on the evidence we have adopted a range from 0.5 to 0.6.

We have made Bayesian adjustments to our betas. This adjustment is typically made to take account of estimation errors when observing beta estimate, whenusing a small number of comparators.

Our cost of capital calculations employ a range for the asset beta of 0.5 to 0.6.

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Small company risk premium (SCP)

Small company risk premia relate to the findings of Fama and French who suggested that the CAPM may be mis-specified with respect to size (they alsofound a mis-specification with respect to high book to market ratios).

The Fama French work has been criticised, particularly for the fact that there is very little economic reasoning as to why smaller companies should be morerisky in portfolio terms than large companies. As Fama Frenchs conclusions are largely drawn from empirical findings, not all academics accept the validity of a small company premium.

However the majority of practitioners do, in actual fact, apply a size premium. This can be applied as an adjustment to the cost of capital dependent on therelative size of the company in question.

NATS is not a listed company and so it is difficult to be precise about its potential market value. It is a monopoly provider of services in its market and incurred by large publicly quoted shareholders in addition to the government and employee shareholdings. In these circumstances it is not clear that a small companies premium is relevant and we have not adopted a SCP in our base case calculations.

We have not adopted a SCP in NATS WACC calculation.

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Cost of Debt Inputs

37

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Basis for cost of debt calculation

NATS cost of debt can be based on either the market cost of debt i.e. benchmarking debt costs against companies with similar risk profile and/or creditrating, or it can be based on NATS actual cost of debt.

Regulators typically use the market cost of debt as this is considered as the efficient cost of debt for the company and therefore is least likely to lead toinefficient funding costs. However, some regulators have made allowances for embedded debt, where funds have been borrowed at fixed rates higher than a current level.

There are two main reasons why a market based approach may not be appropriate when assessing NATS cost of debt for CP2:

NATS has higher gearing than other regulated companies; if the actual and market debt rates are significantly different, NATS is more likely toface financial difficulties.

NATS financing structure was associated with the Composite Solution and management have inherited the resultant funding arrangements.

As a result we have sought to use NATS actual cost of debt, provided that we can be reassured that the cost of debt is not at an unacceptable level inrelation to current market rates.

We have calculated NATS cost of debt in nominal terms. From this we have assessed the debt premium over the risk-free rate to apply to cost of capital calculations in real terms.

The cost of debt is calculated as a weighted average of the cost of the debt instruments used over the period under consideration (CP2). The basis of thiscalculation is as follows:

Where the debt instruments already exist, the actual cost of that instrument is used. This reflects the unique conditions faced by NATS at thetime of the Composite Solution which are likely to mean NATS was unable to raise finance at a cost consistent with its credit rating at that

point in time.

Where it is assumed new instruments will be put in place over CP2, the likely market rate for a company of NATS credit quality has been used The cost of debt estimate is calculated excluding any adjustments for the:

Acquisition Facility swap break costs; and

RPI swap.

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Cost of Debt Inputs


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Basis for cost of debt calculation (contd)

The relevant debt instruments over CP2 are summarised below:

Debt instrument usedFrom

(year of CP2)To

(year of CP2) Interest rate assumption

New Bank Facility 1 Yr. 2.5 Yr. 5 Market rate for A- credit (5.47%) see Prevailing Cost of Debt slide

Fixed Rate Bond (Bond 1) Yr. 1 Yr. 5 NATS projections/actual costs

Capex Facility Yr. 1 Yr. 2.5 NATS projections/actual costs

Working Capital Facility Yr. 1 Yr. 5 NATS projections/actual costs

NERL Loan Notes Yr. 1 Yr. 5 NATS projections/actual costs

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Swap break costs

Background

Interest rate swaps relating to the Acquisition Facility were put in place at the time of the PPP (re-profiled at time of Composite Solution).

The Acquisition Facility was fully refinanced in 2003 with the issue of a fixed-rate bond requiring these swaps to be cancelled. Due to the prevailing interestrates at the time these swaps were executed, NATS incurred 56.6m in break costs.

Treatment

For the purposes of this analysis, the swap break costs have not been expressed as an uplift to the cost of capital. This is because the analysis seeks todetermine a forward-looking cost of debt, based upon the current financing in place, but without any adjustments for historic financing costs.

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Cost of Debt Inputs


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RPI swap

Background

NATS put in place an RPI swap at the time of the fixed rate bond issue in 2003. It receives fixed-rate interest payments, but pays index-linked interest payments on the swapped amount.

As is typical with index-linked debt when compared with fixed rate debt, debt service is back-ended i.e. relatively low initially but increasing in later periods.

According to NATS financial projections (in the financial model) a net cash inflow under this swap is anticipated over CP2. This is consistent with theindex-linked profiled described above.

Treatment

For the purposes of estimating the cost of debt the impact of the RPI swap is excluded because:

The RPI swap agreement was a matter of management choice. The incentives for efficient financing are reduced if the CAA includes the impactof all of NATS individual financing instruments in its regulatory determination.

As part of this exercise we have sought to use NATS actual cost of debt as this reflects the unique conditions faced by NATS at the time of theComposite Solution. This analysis assumes that the RPI swap was not a central requirement of either the Composite Solution or the subsequentrefinancing through the capital markets but rather a management decision taken to enter into a financial arrangement to achieve, inter alia,reduced exposure to inflation risk.

The inclusion of the RPI swap in the cost of debt calculation during CP2 would decrease the cost of debt; however due to the length and profileof the RPI swap its inclusion in the cost of debt calculation during future control periods would likely increase the cost of debt. Therefore, itsinclusion in the cost of debt during CP2 would tie future policy makers into the same treatment over future control periods and potentiallyincrease regulatory risk to the company.

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Cost of Debt Inputs


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NERLs weighted average cost of debt (contd)

5.90%

6.00%

6.10%

6.20%

6.30%

M a r - 0

6

J u n - 0

6

S e p - 0

6

D e c - 0

6

M a r - 0

7

J u n - 0

7

S e p - 0

7

D e c - 0

7

M a r - 0

8

J u n - 0

8

S e p - 0

8

D e c - 0

8

M a r - 0

9

J u n - 0

9

S e p - 0

9

D e c - 0

9

M a r - 1

0

J u n - 1

0

S e p - 1

0

Date

%

Excluding sw ap break,

Excluding RPI sw ap

.

Avge: 6.13%

Step-down due to refinancing of Capex Facilitywith relatively cheaper New Bank 1 facility

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Cost of Debt Inputs


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Prevailing cost of debt market pricing of A- corporate debt

5.47% for

5 years

Source: Bloomberg

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Cost of Debt Inputs


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Cost of debt - Summary

The projected weighted average cost of debt is 6.13% in nominal terms. This equates to a 1.2% margin over the risk-free rate.

The cost of debt over CP2 is calculated as a weighted average of the actual debt instruments where applicable (ie existing debt), otherwise at the market rate(ie new debt).

The cost of debt calculation does not make any adjustments for the swap break costs and the RPI swap.

While the cost of debt at 6.13% is higher than the current cost of debt for an A- rated corporate, the estimate does reflect the actual cost to NATS of raisingdebt under the unique circumstances it faced at the time of the Composite Solution ie that it was unlikely NATS could finance itself at the market rate at that

point in time. Furthermore it is difficult to be exactly certain of what market rate NATS would pay and we suggest caution in applying market rates at a timewhen corporate debt premiums a close to historic lows.

For the above reasons, it would not be unreasonable to assume the actual cost of debt in calculating NATS WACC for the purpose of CP2.

We have adopted a debt margin of 1.2%.

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Gearing

46

Gearing


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Gearing

NATS gearing (expressed in terms of total debt as a proportion of the regulatory asset base) is projected to decline over time. A variable gearing introduces acomplexity into the cost of capital formulations as they traditionally rely upon a constant gearing assumption. There are therefore three options for takingaccount of variable gearing:

Use a cost of capital that varies year-on-year. This is not too difficult to model with model spreadsheet software, but is not as simple a methodology to present compared to using a single WACC figure.

Use the Adjusted Present Value (APV) method, which treats the business as if it were entirely unlevered and then separately evaluates the impact of debtfinance as a result of in-year cash flow modelling. Because it uses an unlevered cost of equity to discount the cash flows of the unlevered firm and aseparate discount rate to discount the tax shield identified from the in-year cash flow modelling, it does not therefore require a gearing assumption in thecost of capital. The APV method would require communication of an unfamiliar looking cost of capital framework.

Solve for the NPV-neutral constant gearing level, which equates the results of a year-on-year discounting approach to a constant WACC and can therefore be used in a way to allow comparisons to other regulatory precedents.

We have adopted the NPV-neutral approach. Using the financial model incorporating the CAAs CP2 proposals, NATS gearing is projected to move from67% to 55% over the course of CP2, with a NPV equivalent average gearing figure of 61%.

We have adopted a gearing figure of 61% in our calculations.

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Benchmark gearing

A prospective gearing figure of 61% would still be high compared to other regulated businesses. This does mean that the financial robustness assessment of theCP2 proposition is important. This will need to ensure that the business is able to withstand a downward shock to cash flow generation that is possible but notextreme.

Recent average gearing Gearing figure used in most recentregulatory determination

NERL 85% Composite Solution

33%

48%

BAA 34% 25%/45%

46%

50%

BT 20%-40%

Railtrack 50%

Water and Electricity 50%

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Gearing Regulatory Precedent

0

10

20

30

40

50

60

70


G e a r i n g

( m i d - p o i n t

)

MMC / CCCAAOfgemOfwatORR Ofcom

Oftel


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Taxation

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Taxation


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Taxation

Pre-tax WACC method

The CAA have historically elected to express the cost of capital on a pre-corporate tax basis. This requires an uplift to the standard post-corporate tax WACC.

A commonly applied formula for this uplift is presented below:

WACCpre-tax = WACCpost-tax * TW

Where TW is the tax-wedge and is equal to 1/(1-T).

This formula is simplistic and is unlikely to deliver theoretically correct answers. In the lead up to the 1994 water industry price review Ofwat tried to develop amore complex formula but eventually settled for expressing the WACC on a post-tax basis.

Within the uplift formula, regulators have the choice of using the statutory tax rate or the effective tax rate. The benefit of using the statutory tax rate is itssimplicity. However, using the statutory rate would be overly beneficial to NATS at the present time because its capital allowances exceed its regulatorydepreciation. In this situation the full uplift would over-recover for the tax NATS needs to pay. Using the effective tax rate in the uplift formula is a moreaccurate way of capturing NATS actual tax position, and because of the significant difference between capital allowances and regulatory depreciation, wehave used the effective tax rate in our calculations.

NATS effective tax rate under the CAA CP2 proposals ranges from 10% in 2007 to 26% in 2011. This is calculated on the basis of a fully equity financed NATS as the benefit of the interest tax shield is incorporated into the WACC formula.

The average effective tax rate is around 15%. When applied to the formula above this provides an uplift factor of close to 1.2, which was the figure suggested

by the CAA for CP1. We have therefore adopted the same figure in our calculations.

We have adopted a pre-tax uplift factor of x1.2 in our calculations.

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Summary and Conclusions

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Summary and Conclusions


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Base Case WACC

1 Implied asset beta based on PwC unlevering approach 2 Gearing calculation using NPV-weighted average methodology (See page 45)

Assumptions CAA for CP1 (January 2001)

Low Central High

Real risk-free rate 2.5% 3.5% - 3.8%

Nominal risk-free rate 4.9% -

Asset beta 0.50 0.55 0.60 0.55 1

Debt / Equity Ratio (D/E) 156% 100%

Target Gearing (D/D+E) 61% 50%

Equity beta 1.28 1.41 1.54 1.10

EMRP 3.0% 4.5% 6.0% 3.5% - 5.0%

Nominal, Cost of Equity (%) 8.7% 11.2% 14.1% -

Real, Cost of Equity 6.3% 8.8% 11.7% 7.35% - 10.8%

Debt margin 1.2% 1.2% - 1.8%

Nominal, Cost of Debt (%) 6.1% 6.1% 6.1%

Real, Cost of debt 3.7% 3.7% 3.7% 4.7% - 5.6%

Nominal, Post-tax WACC (%) 6.0% 7.0% 8.1% -

Tax Wedge x 1.2 x 1.2

Nominal, Pre-tax WACC (%) 7.2% 8.4% 9.8% -

Real, Post-tax WACC (%) 4.1% 5.0% 6.2%

Real, Pre-tax WACC (%) 4.9% 6.1% 7.4% 7.0% - 8.7%

Figure adopted - 7.75%

PwC for CP2

2

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Appendices


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Appendix 2: Historic EMRP - Arithmetic v Geometric premium

It is possible to measure bond and equity returns using either an arithmetic mean or a geometric mean. This is demonstrated in the following example whichassumes a single pound investment in the stock market over a two year period.

Arithmetic Mean

Initial investment in stock market = 1

Year 1: stock market return = 20%, therefore investment is worth 1.20

Year 2: stock market return = -12.5%, therefore investment is worth 1.05

Arithmetic mean return = (20% + -12.5%)/2 = 3.75%

Geometric Mean

A geometric mean is calculated as the nth root of the overall return, where n is the number of periods examined, and the overall return is the ratio of the finalvalue to the starting value i.e. 1.05/1.00 in the example above. It represents the compound growth rate of the overall return over the total number of periods.

In the example above, there are two periods and so the geometric mean is:

Geometric mean =

Arithmetic means are always higher than geometric means. The difference will be at its greatest the greater the volatility of the periodic returns. This is because geometric means effectively compress period to period arithmetic volatility.

( ) %5.211/05.1 =

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Appendix 2: Historic EMRP - Arithmetic v Geometric premium

Which approach is most frequently adopted?

The table below provides a snapshot guide as to what leading proponents in this area suggest:

1. Brealey & Myers Principles of Corporate Finance; sixth edition (2000)

2. Ibbotson Associates, Ibbotson SBBI 2003 yearbook

3. McKinsey, Valuation - Measuring and managing the value of companies,1st & 2nd editions (1990 & 1994)

4. McKinsey, Valuation - Measuring and managing the value of companies, 3rd edition (2000)

5. Damodoran, Investment Valuation, second edition (2002)

Source Arithmetic Geometric

Brealey & Myers1

Ibbotson 2

McKinsey (1st & 2nd editions) 3

McKinsey (3rd edition) 4

Damodoran 5

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Appendix 3: BAA historical asset beta (Bloomberg)

BAA - Historical asset beta analysis (July 1999 to July 2004)

-0.20

-0.10

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

0.80

0.90

J u l - 9 9

O c t - 9

9 J a n

- 0 0 A p

r - 0 0

J u l - 0 0

O c t - 0

0 J a n

- 0 1 A p

r - 0 1

J u l - 0 1

O c t - 0

1 J a n

- 0 2 A p

r - 0 2

J u l - 0 2

O c t - 0

2 J a n

- 0 3 A p

r - 0 3

J u l - 0 3

O c t - 0

3 J a n

- 0 4 A p

r - 0 4

J u l - 0 4

A s s e t

b e t a

Monthly Adjusted Monthly UnadjustedWeekly Adjusted Weekly UnadjustedDaily Adjusted Daily Unadjusted

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Appendix 3: RT Group historical asset beta (Bloomberg)

Railtrack - Historical asset beta analysis (July 1999 to November 2002)

-0.20

-0.10

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

0.80

J u l - 9 9

S e p - 9 9

N o v - 9

9 J a n

- 0 0 M a

r - 0 0

M a y - 0

0 J u l

- 0 0 S e p

- 0 0 N o

v - 0 0

J a n - 0 1

M a r - 0

1 M a

y - 0 1

J u l - 0 1

S e p - 0 1

N o v - 0

1 J a n

- 0 2 M a

r - 0 2

M a y - 0

2 J u l

- 0 2 S e p

- 0 2 N o

v - 0 2

A s s e t

b e t a

Monthly Adjusted Monthly UnadjustedWeekly Adjusted Weekly UnadjustedDaily Adjusted Daily Unadjusted

Note: gap in asset beta is due to period over which RT Group was delisted (July 1995 to September 1995), before becoming finally delisted in December 2002.

59

Appendices

d h l b ( l b )


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Appendix 3: BT historical asset beta (Bloomberg)

BT - Historical asset beta analysis (July 1994 to July 2004)

0.00

0.20

0.40

0.60

0.80

1.00

1.20

1.40

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

A s s e t

b e t a

Monthly Adjusted Monthly UnadjustedWeekly Adjusted Weekly UnadjustedDaily Unadjusted Daily Unadjusted

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Appendices

A di 4 WACC R g l t P d t


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Appendix 4: WACC - Regulatory Precedent

The most recent UK regulatory precedents are presented below:

Source Case Date Pre-tax, real Post-tax,nominal

Mobile phone inquiry

Manchester Airport Price Cap, 2003 - 2008

Wholesale mobile voice call termination consultation

Review of financial terms of Channel 3 licences

Electricity distribution price control review

Ofwat The capital structure of water companies October 2002 4.66%

CAA NATS April 2001 7.75%

11.25%

CAA February 2002 7.5%

12.2%

11.9%

6.6%

February 2003

December 2003

June 2004

June 2004

Post-tax,real

CC

Oftel

Ofcom

Ofgem 4.6%

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reading 5 pcw and cost of capital

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