Public Version

NATS - Cost of Capital for CP2

November 2004

Economics Regulation Group Group Directors Office Civil Aviation Authority CAA House 45-59 Kingsway
London WC2B 6TE

PricewaterhouseCoopers LLP 1 Embankment Place London WC2N 6RH Telephone +44 (0) 20 7583 5000 Fax +44 (0) 20 7804 4993

For the attention of Mr Harry Bush 19 November 2004 Dear Sirs Report prepared by PricewaterhouseCoopers LLP (PwC) in connection with advising 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) in connection with cost of capital in the context of the forthcoming NATS price review. It has been produced in accordance with our letter of engagement dated 29 July 2004 and attached terms and conditions. It reports our recommendations and findings in the area of cost of capital. PwC accepts no duty of care to any third party for this Report. Accordingly regardless of 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 disclaims all 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 variety of sources as indicated within the Report. While our work has involved analysis of financial information, it has not included an audit in accordance with generally accepted auditing standards. Accordingly we assume no responsibility and make no representations 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 the conclusions arrived at in many cases will of necessity be subjective and dependent on the exercise of individual judgement. Although the advice we give and our conclusions are in our opinion reasonable and defensible, others might wish to disagree with our views. Yours faithfully

PricewaterhouseCoopers LLP

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 Services Authority for designated investment business.

Table of Contents
Section
Executive Summary Weighted Average Cost of Capital (WACC) Formulation of the WACC CAPM and the alternative cost of equity methodologies Cost of Debt Methodologies Cost of Equity Inputs Cost of Debt Inputs Gearing Taxation Summary and Conclusions Appendices

Page
1-3 4-5 6-7 8 - 10 11 - 12 13 - 36 37 - 45 46 - 49 50 - 51 52 - 53 54 - 62

Executive Summary

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 precise figure 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.

Executive Summary

Comparison of Assumptions
Assumptions Low Real risk-free rate Nominal risk-free rate Asset beta Debt / Equity Ratio (D/E) Target Gearing (D/D+E) Equity beta EMRP Nominal, Cost of Equity (%) Real, Cost of Equity Debt margin Nominal, Cost of Debt (%) Real, Cost of debt Nominal, Post-tax WACC (%) Tax Wedge Nominal, Pre-tax WACC (%) Real, Post-tax WACC (%) Real, Pre-tax WACC (%) 7.2% 4.1% 4.9% 6.1% 3.7% 6.0% 1.28 3.0% 8.7% 6.3% 0.50 PwC for CP2 Central 2.5% 4.9% 0.55 156% 61% 1.41 4.5% 11.2% 8.8% 1.2% 6.1% 3.7% 7.0% x 1.2 8.4% 5.0% 6.1% 9.8% 6.2% 7.4% 7.0% - 8.7% Figure adopted - 7.75%
1 2
2

CAA for CP1 (January 2001) High 3.5% - 3.8% 0.60 0.55 1 100% 50% 1.54 6.0% 14.1% 11.7% 1.10 3.5% - 5.0% 7.35% - 10.8% 1.2% - 1.8% 6.1% 3.7% 8.1% 4.7% - 5.6% x 1.2 -

Implied asset beta based on PwC unlevering approach Gearing calculation using NPV-weighted average methodology (see page 47).

Weighted Average Cost of Capital (WACC)

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 finance the business. Firms are generally financed through a mixture of debt and equity, which have different characteristics. Since the costs of debt and equity capital are different, 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: WACCpre-tax = WACCpost-tax/(1-T)

Formulation of the WACC

Formulation of the WACC

WACC - Regulatory Precedent

The PwC database of global regulatory precedent contains detailed information on how regulators have calculated the cost of capital in the past, and also the assumptions that they have made in estimating individual 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 nominal terms were calculated by Oftel, now Ofcom.. Chart 1 Chart 2

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

4% 7% Pre-tax Post-tax Unknown

Real or nominal WACC (September 1993 to June 2004)

4% Real Nominal 20% Unknown

89%

76%

Chart 2 also shows that in 89% of cases the WACC has been calculated on a pre-tax basis. The CAA have historically always followed a real, pre-tax approach to calculating the WACC.

CAPM and the alternative cost of equity methodologies

CAPM and the alternative cost of equity methodologies

Estimating the cost of equity capital

We have adopted the Capital Asset Pricing Model (CAPM) as the basis for the calculation of NATS cost of equity. The CAPM is the most widely used and accepted of the techniques for estimating the cost of equity and is adopted by most national regulators. (See Appendix 1 for a summary of the alternative approaches). The formula for the model is set out below: Ke = Rf + *EMRP where: Ke is the post-tax cost of equity; Rf is the risk-free rate; is the equity beta; EMRP is the equity risk premium (Rm Rf); and Rm is the market return.

CAPM theory suggests that investors can eliminate the specific risks associated with an investment by holding a sufficiently diversified portfolio. The remaining risk is known as systematic or beta risk. This cannot be removed by diversification since it is common and systematic to all investments, albeit to a greater or lesser extent.

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-diversifiable risk, 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 equity investment 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 the techniques for estimating the cost of equity.

10

Cost of Debt Methodologies

11

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 margin reflects 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 as more 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 are good 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 cover1, because this is the main determinant of credit ratings.

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

12

Cost of Equity Inputs

13

Cost of Equity Inputs

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. The relevant 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 than yields 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 reflect movements 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 cap model 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.

14

Cost of Equity Inputs

UK risk-free rate

U K R isk -F ree R ate

6.0

U K N om inal B enchm ark

U K Index-link ed B enchm ark

4.9%

5.0

4.9%

4.0 Yield (%)

5 year
10 year

3.0

2.0
1.9%
1.9 %

1.0

0.0 3 m onth 6 m onth 1 year 2 year 3 year 4 year 5 year 6 year M aturity 7 year 8 year 9 year 10 year 15 year 20 year 30 year

Source: Bloomberg and PwC Analysis

15

Cost of Equity Inputs

Risk-free rate regulatory precedent

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.
7
MMC / CC CAA Oftel Ofgem Ofwat ORR 10yr Index Linked yields

5 Real Risk-free rate (%) (mid-point)

1
Points that refer to CAA

0 Oct-92
Source: PwC analysis

Apr-94

Oct-95

Apr-97

Oct-98

Apr-00

Oct-01

Apr-03

Oct-04

16

Cost of Equity Inputs

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 to avoid 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 historical standards. The Smithers report1 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%.

A 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

17

Cost of Equity Inputs

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 to compensate 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 are commonly used to arrive at an estimate.

18

Cost of Equity Inputs

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 Ibbotson Associates and Grabowski and King.

US EMRP (relative to government bonds) Period 20 years (since 1978) 30 years (since 1968) 40 years (since 1958) 50 years (since 1948) 60 years (since 1938) 72 years (since 1926) 200 years (since 1798) Geometric average 7.8% 4.0% 5.2% 6.9% 7.0% 5.8% 3.8% Arithmetic average 8.5% 5.2% 6.3% 8.1% 8.2% 7.8% 5.2%

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), the arithmetic 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.

19

Cost of Equity Inputs

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 the returns achieved by investors to correct for the fact that we observe the returns of firms that survive and do not necessarily capture the (negative) returns associated with firms that have failed. This adjustment for so-called survivor bias has the effect of reducing overall 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 US Equities versus bills Equities versus bonds UK Equities versus bills Equities versus bonds Global Equities versus bills Equities versus bonds 6.2% 5.6% 4.9% 4.6% 6.5% 5.6% 4.8% 4.4% 7.7% 7.0% 5.8% 5.0% Geometric mean

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

20

Cost of Equity Inputs

EMRP - forward looking methods

Forward looking techniques typically estimate the EMRP from surveys of investor expectations, either directly or in conjunction with the Dividend Discount Model (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 due to stock market falls, terrorist attacks etc, there is not a great deal of hard evidence for this.

22

Cost of Equity Inputs

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).

4 EMRP (%) (mid-point)

3 MMC / CC CAA Oftel Ofgem Ofwat ORR Ofcom Jul-98 Dec-99 Apr-01 Sep-02 Jan-04 May-05

1 Points that refer to CAA 0 Jan-93

Jun-94

Oct-95

Mar-97

Source: PwC analysis

23

Cost of Equity Inputs

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 forward looking concept rather than a backward looking one, and measuring the EMRP based on equity returns in 1900 when the market was very different from what it 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 in which 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 ignore the 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 Regulatory precedent DMS, Ex-post arithmetic DMS, Ex-post geometric Ex-ante Maximum Range Suggested range

Minimum 3.4% 5.6% 4.4% 2.0% 2.0% 3.0%

Maximum 5.0% 7.7% 5.8% 6.0% 7.7% 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% to 6% is consistent with both recent surveys of historic information and ex-ante forecast figures derived directly from surveys of investor expectations.

24

Cost of Equity Inputs

Beta
Equity beta
The degree of systematic risk associated with an investment can be measured from the correlation between movements in returns on that investment and returns on the market as a whole. The stronger the correlation, and the greater the amplitude of the movement in returns for the investment relative to the market as a whole, the higher the systematic risk associated with an investment. A companys beta measures this risk. Observed betas are known as equity betas, because they are derived directly from the equity markets. They are affected by: Cyclicality of revenues: stable low demand elasticity companies tend to have low betas; cyclical sectors tend to have higher betas. Operational leverage: the higher proportion of fixed costs the greater the impact upon returns from cyclical movements in revenue; and Financial leverage: the more debt finance that is adopted by a company, the greater the risk to equity providers, as their returns are geared up by the higher amount of fixed debt costs.

25

Cost of Equity Inputs

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 the underlying 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 the Harris-Pringle formula:

e = a 1+ D E

)
D E

The formula above assumes that firms typically target a constant debt equity ratio. An alternative unlevering formula which includes an additional (1-T) term assumes 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 debt does not. Alternative beta calculations using the alternative formula are provided in Appendix 3. The alternative formula (sometimes known as the Modigliani-Miller formula) is shown below:

e = a 1 + (1 Tc )

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 equity index. Our defaults is to estimate betas using five years of monthly observations.

26

Cost of Equity Inputs

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 a good indication of NATS equity beta, since it is based on companies from a wide range of sectors as well as gearing levels.
1.60 1.40 1.20 1.00 Equity beta (mid-point) 0.80 0.60 0.40 0.20
Points that refer to CAA
Heathrow, Gatwick, Stansted; and M anchester Airport Price-cap 2003 - 2008 Heathrow - New assets only

M M C / CC CAA Oftel Ofgem Ofwat ORR Ofcom

0.00 Jan-93

Jun-94

Oct-95

M ar-97

Jul-98

Dec-99

Apr-01

Sep-02

Jan-04

M ay-05

Source: PwC analysis

28

Cost of Equity Inputs

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 therefore necessary 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.

29

Cost of Equity Inputs

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 asset such 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.
Company Country Equity Beta No. of Monthly Observations Market Cap. mils. Total Debt mils. 5 yr. Debt / Equity Ratio Asset Beta Miller 0.35 0.34 0.29 0.21 0.21 0.35 0.39 0.29 0.24 0.22 0.38 0.30 0.21 0.39 0.16

Sector

Utility Comparators National Grid Company Railtrack Group plc RWE AG Scottish and Southern Energy Severn Trent E.ON AG Endesa SA Iberdrola SA Scottish Power Plc United Utilities plc Suez Lyonnaise Des Eaux SA Median / Average1 Min Max Excluded2 AWG Plc

UK UK Germany UK UK Greece Spain Spain UK UK France

0.68 0.51 0.69 0.26 0.42 0.55 0.92 0.52 0.43 0.47 0.93 0.58 0.26 0.93 0.89

60 60 60 60 60 60 60 60 60 60 60

13,663.9 3,544.6 15,226.5 6,265.9 2,794.0 26,751.1 10,431.2 9,953.3 7,258.0 3,977.8 10,587.4

13,248.0 3,472.0 29,677.2 1,445.4 2,864.4 14,973.2 11,232.9 7,038.3 5,133.9 4,469.7 17,915.4

94.6% 48.3% 134.4% 24.7% 103.9% 56.1% 134.8% 78.5% 75.6% 111.0% 146.1% 94.6% 25% 146% 455.8%

UK

60

906.1

3,946.0

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.

30

Cost of Equity Inputs

Airport betas
The asset beta for airports ranges from 0.42 to 0.89, and the average for the group is 0.62, which is slightly lower than airlines Airports derive their demand from air travel, but they may not bear the full brunt of the systematic market risk that airlines face.

Sector

Company

Country

Equity Beta

No. of Monthly Observations

Market Cap. mils.

Total Debt mils.

5 yr. Debt / Equity Ratio

Asset Beta Miller 0.81 0.42 0.89 0.51 0.46 0.65 0.62 0.42 0.89 0.19

Airport Comparators Aeroporti di Roma BAA plc Flughafen Wien AG Fraport AG Kobenhavns Luftavne TBI Median / Average1 Min Max Excluded2 Unique Zurich

Italy UK Austria Germany Denmark UK

0.81 0.64 0.89 0.73 0.78 1.01 0.81 0.64 1.01 1.11

44 60 60 37 60 60

1,044.6 5,893.4 634.2 1,534.4 933.2 374.5

2.1 3,701.0 509.8 501.1 158.8

0.2% 51.6% 0.0% 43.5% 71.0% 55.6% 47.5% 0.00 71% 480.0%

Switzerland

60

291.8

1,210.0

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.

31

Cost of Equity Inputs

Airline betas

Sector

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.
Company Country Equity Beta No. of Monthly Observations Market Cap. mils. Total Debt mils. 5 yr. Debt / Equity Ratio Asset Beta Miller 0.37 0.49 0.56 0.28 0.59 1.16 0.98 0.82 0.72 0.35 0.63 0.28 1.16 0.17 0.13

Airline Comparators Alitalia SpA British Airways Lufthansa AG Finnair Groupe Air France CHEC Easyjet plc Iberia Lineas Aereas de Espana SA Turk Hava Yollari Anonim Ortakligi (THY) Ryanair Swissair Group Median / Average1 Min Max Excluded2 Austrian Airlines KLM Royal Dutch

Italy UK Germany Finland France UK Spain Turkey UK Switzerland

0.91 2.01 1.02 0.5 1.42 1.29 1.4 1.17 0.86 1.03 1.16 0.50 2.01 1.54 1.24

60 60 60 60 60 44 39 60 60 30

572.7 2,225.4 2,772.1 293.5 2,104.4 570.4 1,287.6 0.5 3,070.1 1,948.8

1,332.7 5,559.0 2,423.5 158.4 2,939.6 110.3 352.4 0.5 935.1 7,500.0

143.8% 308.5% 81.0% 78.4% 140.5% 11.0% 43.5% 42.2% 19.6% 193.1% 79.7% 11% 309% 815.6% 826.9%

Austria Netherlands

60 60

249.4 499.4

1,304.3 2,966.4

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.

32

Cost of Equity Inputs

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 Beta

No. of Monthly Observations

Market Cap. mils.

Total Debt mils.

5 yr. Debt / Equity Ratio

Asset Beta Miller 0.42 0.82 0.34 0.53 0.34 0.82

BAA plc BT Group plc Railtrack Group plc1 Median / Average Min Max

UK UK UK

0.64 1.57 0.51 0.91 0.51 1.57

60 60 60

5,893.4 15,714.4 3,544.6

3,701.0 13,532.0 3,472.0

51.6% 92.4% 48.3% 52% 48% 92%

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

33

Cost of Equity Inputs

Asset beta - Summary

1. Sectors
0.3 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

34

Cost of Equity Inputs

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 and airlines, 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 traffic volumes 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 the utilities 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 is therefore difficult to show how to adjust for differences in operating gearing between NATS and the comparators. This point however further demonstrates the difference 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, when using a small number of comparators.

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

35

Cost of Equity Inputs

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 also found 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 more risky 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 the relative 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.

36

Cost of Debt Inputs

37

Cost of Debt Inputs

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 credit rating, 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 to inefficient 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 to face 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 in relation 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 this calculation 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 the time 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.

38

Cost of Debt Inputs

Basis for cost of debt calculation (contd)

The relevant debt instruments over CP2 are summarised below:

Debt instrument used New Bank Facility 1

From (year of CP2) Yr. 2.5

To (year of CP2) Yr. 5

Interest rate assumption Market rate for A- credit (5.47%) see Prevailing Cost of Debt slide NATS projections/actual costs NATS projections/actual costs NATS projections/actual costs NATS projections/actual costs

Fixed Rate Bond (Bond 1) Capex Facility Working Capital Facility NERL Loan Notes

Yr. 1 Yr. 1 Yr. 1 Yr. 1

Yr. 5 Yr. 2.5 Yr. 5 Yr. 5

40

Cost of Debt Inputs

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 interest rates 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 to determine a forward-looking cost of debt, based upon the current financing in place, but without any adjustments for historic financing costs.

41

Cost of Debt Inputs

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 the index-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 impact of 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 the Composite Solution. This analysis assumes that the RPI swap was not a central requirement of either the Composite Solution or the subsequent refinancing 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 profile of the RPI swap its inclusion in the cost of debt calculation during future control periods would likely increase the cost of debt. Therefore, its inclusion in the cost of debt during CP2 would tie future policy makers into the same treatment over future control periods and potentially increase regulatory risk to the company.

42

Cost of Debt Inputs

NERLs weighted average cost of debt (contd)

6.30%
Step-down due to refinancing of Capex Facility with relatively cheaper New Bank 1 facility

6.20%

Avge: 6.13%

6.10% Excluding sw ap break, Excluding RPI sw ap

6.00%

5.90% Mar-06 Dec-06 Mar-07 Jun-06 Dec-07 Mar-08 Jun-07 Dec-08 Mar-09 Jun-08 Dec-09 Mar-10 Jun-09 Sep-06 Sep-07 Sep-08 Sep-09 Jun-10
.

Date

43

Sep-10

Cost of Debt Inputs

Prevailing cost of debt

market pricing of A- corporate debt

5.47% for 5 years

Source: Bloomberg

44

Cost of Debt Inputs

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 raising debt 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 time when 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%.

45

Gearing

46

Gearing

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 a complexity into the cost of capital formulations as they traditionally rely upon a constant gearing assumption. There are therefore three options for taking account 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 debt finance 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 a separate discount rate to discount the tax shield identified from the in-year cash flow modelling, it does not therefore require a gearing assumption in the cost 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 from 67% 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.

47

Gearing

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 the CP2 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 not extreme.

Recent average gearing NERL 85% Composite Solution

Gearing figure used in most recent regulatory determination 50%

BT Railtrack

33% 48% 34% 46%

20%-40% 50% 25%/45% 50%

BAA Water and Electricity

48

Gearing

Gearing Regulatory Precedent

70 MMC / CC CAA Ofgem Ofwat ORR Ofcom Oftel

60

50

Gearing (mid-point)

40

30

20

10

0 Jan-93

Jun-94

Oct-95

Mar-97

Jul-98

Dec-99

Apr-01

Sep-02

Jan-04

May-05

Source: PwC analysis

49

Taxation

50

Taxation

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 a more 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 its simplicity. However, using the statutory rate would be overly beneficial to NATS at the present time because its capital allowances exceed its regulatory depreciation. 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 more accurate way of capturing NATS actual tax position, and because of the significant difference between capital allowances and regulatory depreciation, we have 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.

51

Summary and Conclusions

52

Summary and Conclusions

Base Case WACC

Assumptions Low Real risk-free rate Nominal risk-free rate Asset beta Debt / Equity Ratio (D/E) Target Gearing (D/D+E) Equity beta EMRP Nominal, Cost of Equity (%) Real, Cost of Equity Debt margin Nominal, Cost of Debt (%) Real, Cost of debt Nominal, Post-tax WACC (%) Tax Wedge Nominal, Pre-tax WACC (%) Real, Post-tax WACC (%) Real, Pre-tax WACC (%) 7.2% 4.1% 4.9% 6.1% 3.7% 6.0% 1.28 3.0% 8.7% 6.3% 0.50 PwC for CP2 Central 2.5% 4.9% 0.55 156% 61% 1.41 4.5% 11.2% 8.8% 1.2% 6.1% 3.7% 7.0% x 1.2 8.4% 5.0% 6.1% 9.8% 6.2% 7.4% 7.0% - 8.7% Figure adopted - 7.75%
1 2
2

CAA for CP1 (January 2001) High 3.5% - 3.8% 0.60 0.55 1 100% 50% 1.54 6.0% 14.1% 11.7% 1.10 3.5% - 5.0% 7.35% - 10.8% 1.2% - 1.8% 6.1% 3.7% 8.1% 4.7% - 5.6% x 1.2 -

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

53

Appendices

54

Appendices

Appendix 1: An evaluation of the CAPM and alternative methodologies for estimating the cost of equity capital
Different methods that can be used to estimate the cost of equity capital are shown below:
Methodology CAPM Explanation The intuition behind CAPM is that investors are only rewarded for being exposed to non-diversifiable risk (also known as systematic or market risk). Pros Widely used and applied in many applications, including valuations. Cons Empirical tests have found that beta may not be the only variable that has explanatory power, although it is also recognised that CAPM is difficult (if not impossible) to test (Roll critique). PwC view Should be used as primary methodology.

Dividend Growth Model

The Dividend Growth Model (DGM) is a simple forward-looking model that assumes that current share prices are equal to the present value of all future dividend payments, and thus infers the cost of equity.

Simple.

Relies on accurate growth forecasts. Forecasts may be biased and lead to highly volatile cost of equity estimates, if share prices are volatile.

Seldom used as the primary method of estimating the cost of capital but can be useful as a cross check.

Arbitrage Pricing Theory

The principle behind Arbitrage Pricing Theory (APT) is similar to CAPM: investors get incremental reward for incremental (non-diversifiable) risk.

Theory is sound and intuitively appealing.

APT is hardly ever used because of problems with data availability and remains more of a conceptual academic model than a practitioners tool. In practice, this model is not widely used in its pure form but practitioners may increase the cost of equity in a judgemental way to reflect greater perceived risk for a small company.

Data availability is too limited to undertake any meaningful analysis.

Fama-French 3 Factor Model

Some academic tests of CAPM have shown that there may be some misspecification with regard to: Size Book/market value ratio

Has achieved some empirical support.

Justifies making a small company adjustment to CAPM.

The Fama French 3 Factor Model attempts to compensate for the perceived misspecification as follows: Re = Rf + Bi x EMRP + Si x E(Size) + H x E (Book/Market) MCPM (and other stochastic option approaches) This model calculates cost of capital based upon volatilities from option prices in the market. Some intuitive appeal. Lacks academic endorsement. Very seldom used in general and not well understood. Impractical. Unlikely to be used although approach has some appeal in sectors such as biotechnology.

55

Appendices

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 which assumes 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 final value 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 =

(1.05 / 1) 1 = 2.5%

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.

56

Appendices

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:

Source Brealey & Myers Ibbotson2 McKinsey (1st & 2nd editions) 3 McKinsey (3rd edition) 4 Damodoran5
1

Arithmetic

Geometric

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)

57

Appendices

Appendix 3: BAA historical asset beta (Bloomberg)

BAA - Historical asset beta analysis (July 1999 to July 2004)
Monthly Adjusted Weekly Adjusted Daily Adjusted Monthly Unadjusted Weekly Unadjusted Daily Unadjusted

0.90 0.80 0.70 0.60 0.50 Asset beta 0.40 0.30 0.20 0.10 0.00 -0.10 -0.20
9 l-9 Ju 9 t-9 Oc n Ja 0 -0 0 r-0 Ap 0 l-0 Ju t-0 Oc 0 n Ja 1 -0

1 r-0 Ap

l Ju

1 -0

Oc

1 t-0

02 nJa

2 r- 0 Ap

2 l-0 Ju

Oc

2 t-0

n Ja

3 -0

3 r-0 Ap

3 l-0 Ju

t-0 Oc

n Ja

4 -0

4 r-0 Ap

l Ju

4 -0

58

Appendices

Appendix 3: RT Group historical asset beta (Bloomberg)

Railtrack - Historical asset beta analysis (July 1999 to November 2002)
0.80 0.70 0.60 0.50 0.40 0.30 0.20 0.10 0.00 -0.10 -0.20 Monthly Adjusted Weekly Adjusted Daily Adjusted Monthly Unadjusted Weekly Unadjusted Daily Unadjusted

Asset beta

ay -0 0

ay -0 1

ay -0 2

Ju l-9 9 Se p99

Ju l-0 0 Se p00

Ju l-0 1 Se p01

Ju l-0 2 Se p02

n00

n01

n02

00

01

99

ar -0 0

ar -0 1

ar -0 2

ov -

ov -

ov -

Ja

Ja

Ja

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

ov -

02

Appendices

Appendix 3: BT historical asset beta (Bloomberg)

BT - Historical asset beta analysis (July 1994 to July 2004)
Monthly Adjusted Weekly Adjusted Daily Unadjusted Monthly Unadjusted Weekly Unadjusted Daily Unadjusted

1.40

1.20

1.00

Asset beta

0.80

0.60

0.40

0.20

0.00 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

60

Appendices

Appendix 3: Details of comparable companies betas (Miller & M-M unlevering formulae)
Sector Company Country Equity Beta N o. of M onthly O bservations M arket Cap. mils. Total D ebt mils. 5 yr. D ebt / Equity Ratio Asset Beta M iller 0.35 0.34 0.29 0.21 0.21 0.35 0.39 0.29 0.24 0.22 0.38 0.30 0.21 0.39 0.16 Asset Beta M -M 0.41 0.38 0.36 0.22 0.24 0.39 0.47 0.34 0.28 0.26 0.46 0.35 0.22 0.47 0.21 U tility Comparators N ational Grid Company Railtrack Group plc RW E AG Scottish and Southern Energy Severn Trent E.O N AG Endesa SA Iberdrola SA Scottish Pow er Plc U nited U tilities plc Suez Lyonnaise D es Eaux SA M edian / Average1 M in M ax Excluded 2 AW G Plc UK UK Germany UK UK Greece Spain Spain UK UK France 0.68 0.51 0.69 0.26 0.42 0.55 0.92 0.52 0.43 0.47 0.93 0.58 0.26 0.93 0.89 60 60 60 60 60 60 60 60 60 60 60 13,663.9 3,544.6 15,226.5 6,265.9 2,794.0 26,751.1 10,431.2 9,953.3 7,258.0 3,977.8 10,587.4 13,248.0 3,472.0 29,677.2 1,445.4 2,864.4 14,973.2 11,232.9 7,038.3 5,133.9 4,469.7 17,915.4 94.6% 48.3% 134.4% 24.7% 103.9% 56.1% 134.8% 78.5% 75.6% 111.0% 146.1% 94.6% 25% 146% 455.8%

UK

60

906.1

3,946.0

Airline Comparators Alitalia SpA British Airw ays Lufthansa AG Finnair Groupe Air France CH EC Easyjet plc Iberia Lineas Aereas de Espana SA Turk H ava Yollari Anonim O rtakligi (TH Y) Ryanair Sw issair Group M edian / Average1 M in M ax Excluded 2 Austrian Airlines KLM Royal D utch

Italy UK Germany Finland France UK Spain Turkey UK Sw itzerland

0.91 2.01 1.02 0.5 1.42 1.29 1.4 1.17 0.86 1.03 1.16 0.50 2.01 1.54 1.24

60 60 60 60 60 44 39 60 60 30

572.7 2,225.4 2,772.1 293.5 2,104.4 570.4 1,287.6 0.5 3,070.1 1,948.8

1,332.7 5,559.0 2,423.5 158.4 2,939.6 110.3 352.4 0.5 935.1 7,500.0

143.8% 308.5% 81.0% 78.4% 140.5% 11.0% 43.5% 42.2% 19.6% 193.1% 79.7% 11% 309% 815.6% 826.9%

0.37 0.49 0.56 0.28 0.59 1.16 0.98 0.82 0.72 0.35 0.63 0.28 1.16 0.17 0.13

0.45 0.64 0.65 0.32 0.72 1.20 1.07 0.90 0.76 0.44 0.71 0.32 1.20 0.23 0.18

Austria N etherlands

60 60

249.4 499.4

1,304.3 2,966.4

Airport Comparators Aeroporti di Roma BAA plc Flughafen W ien AG Fraport AG Kobenhavns Luftavne TBI M edian / Average1 M in M ax Excluded 2 U nique Zurich

Italy UK Austria Germany D enmark UK

0.81 0.64 0.89 0.73 0.78 1.01 0.81 0.64 1.01 1.11 0.85 0.26 2.01

44 60 60 37 60 60

1,044.6 5,893.4 634.2 1,534.4 933.2 374.5

2.1 3,701.0 509.8 501.1 158.8

0.2% 51.6% 0.0% 43.5% 71.0% 55.6% 47.5% 0.00 71% 480.0% 75.6% 0.2% 309%

0.81 0.42 0.89 0.51 0.46 0.65 0.62 0.42 0.89 0.19 0.49 0.21 1.16

0.81 0.47 0.89 0.56 0.52 0.73 0.66 0.47 0.89 0.25 0.55 0.22 1.20

Sw itzerland

60

291.8

1,210.0

M edian / Average M in M ax

61

Appendices

Appendix 4: WACC - Regulatory Precedent

The most recent UK regulatory precedents are presented below:

Source

Case

Date

Pre-tax, real

Post-tax, nominal

Post-tax, real

CC

Mobile phone inquiry

February 2003

11.25%

CAA

Manchester Airport Price Cap, 2003 - 2008

February 2002

7.5%

Oftel

Wholesale mobile voice call termination consultation

December 2003

12.2%

Ofcom

Review of financial terms of Channel 3 licences

June 2004

11.9%

Ofgem

Electricity distribution price control review

June 2004

6.6%

4.6%

Ofwat

The capital structure of water companies

October 2002

4.66%

CAA

NATS

April 2001

7.75%

62