Commission Decision 2013/126/EU

law://eu/dec/2013/126@2026-11-13

Contents

THE EUROPEAN COMMISSION,Having regard to the Treaty on the Functioning of the European Union, and in particular the first subparagraph of Article 108(2) thereof,Having regard to the Agreement on the European Economic Area, and in particular Article 62(1)(a) thereof,Having called on interested parties to submit their comments pursuant to the provisions cited above^note and having regard to their comments,Whereas:

HAS ADOPTED THIS DECISION:

Article 1 #

The initial share capital and the subsequent share capital increases amounting to EUR 94459719, land allocated to Ciudad de la Luz amounting to EUR 9800040, the participating loans amounting to EUR 115 million, the convertible loan stock issued since 2008 totalling EUR 45829840 granted unlawfully to Spain by Ciudad de la Luz SA prior to 31 December 2010, and any incentive granted to film producers under the condition that filming takes place at Ciudad de la Luz, in breach of Article 108(3) of the Treaty, constitute State aid incompatible with the internal market.

Article 2 #

1.Spain shall recover the incompatible aid granted under Article 1 from the beneficiary.

2.The sums to be recovered shall bear interest from the date on which they were put at the disposal of the beneficiary until their actual recovery.

3.The interest shall be calculated on a compound basis in accordance with Chapter V of Council Regulation (EC) No 794/2004^note.

4.Spain shall cancel all outstanding payments of the aid referred to in Article 1 with effect from the date of adoption of this Decision.

Article 3 #

1.Recovery of the aid referred to in Article 1 shall be immediate and effective.

2.Spain shall ensure that this Decision is implemented within four months following the date of notification thereof.

Article 4 #

1.Within two months following notification of this Decision, Spain shall submit the following information:

(a)the total amount (principal and interest) to be recovered from the beneficiary;

(b)a detailed description of the measures already taken and planned to comply with this Decision;

(c)documents demonstrating that the beneficiary has been ordered to repay the aid.

2.Spain shall keep the Commission informed of the progress of the national measures taken to implement this Decision until recovery of the aid referred to in Article 1 has been completed. It shall immediately submit, at the request of the Commission, information on the measures already taken and planned to comply with this Decision. It shall also provide detailed information concerning the amounts of aid and interest already recovered from the beneficiary.

Article 5 #

This Decision is addressed to the Kingdom of Spain.

Annex I

Ciudad de la Luz (CDL) — Approach for the calculation of an appropriate cost of capital in capital budgeting decisions — July 2009

Objective

The objective of this report is to establish whether the investment in the project creating the company Ciudad De la Luz (CDL) can be qualified as State aid. According to the market economy investor principle, the investment undertaken is considered to be State aid if the expected compensation to be received by the State is lower than what a private investor would have requested under the circumstances of that particular project.

A private equity investor^note would have been willing to invest in the CDL project if the expected internal rate of return^note was higher than or equal to the opportunity cost of equity capital^note (i.e. the return that he could have obtained in a similar project).

In the analysis which follows, we calibrate the Capital Asset Pricing Model (CAPM) to obtain the cost of equity capital. This is the relevant measure that determines whether a private investor would have undertaken the CDL project.

The resulting parameter range is then compared to the ex-post performance of a representative sample of CDL’s competitors. This is the approach adopted by LECG in its submission, namely to use ex-post performance to establish a benchmark for the opportunity cost of capital for this type of projects. As will be seen below, the measure of ex-post performance chosen by LECG is not the correct one to establish a benchmark. More importantly, any ex-post performance metric is an imperfect proxy for ex-ante required returns.

We find that the opportunity cost of capital for this project should be around 14,91 %. Hence, a private investor would require an internal rate of return of more than 14,91 %. According to the business plan proposed by CDL in 2004 (which is the most recent financial information on which the present project is based), the internal rate of return for the investment in CDL was 5,74 %^note.

Consequently, a private investor would not have invested in the CDL project since its internal rate of return is lower than the opportunity cost of capital.

The Cost of Equity CapitalThe appendix provides the general definition of the weighted average cost of capital (WACC), which includes both equity and debt.

—the time value of money;

—K_e the cost of equity capital, expressed in %;

—the risk associated with investing in CDL.

—R_f is the risk-free rate, expressed in %;

—(R_m – R_f) is the market risk premium, expressed in %;

—β is the ‘Beta’, a measure of the systematic (non-diversifiable) risk associated with CDL’s stock, which reflects both the business and financial risk.

The cost of equity capital is the minimum required rate of return CDL must offer to its shareholders to compensate them for:

It is important to stress that the relevant rate of return is an expected future return, not a historical return. The cost of equity capital reflects the opportunity cost of investment for shareholders in companies or projects with the same (or similar) business and financial risk as the one under consideration.

In what follows, we apply a widely accepted method of estimating the cost of equity capital, namely the Capital Asset Pricing Model (CAPM):

Ke = Rf + βRm – Rf

Where:

For the risk-free rate, market practice suggests taking the long-term (typically 10-year) government bond rate in the country of operations.

For the market risk premium, one should take the historical market risk premium over a reasonably long time period. It is common market practice to take the difference between the historical return on a diversified equity index in the country of operations, and the risk-free rate.

Application to Ciudad De La Luz

The average annual return on 10 year government bonds in Spain was 4,1 % in 2004^note.

R_f = 4,1 %

According to Fernández (2004)^note, the historical market risk premium over government bonds in Spain (during the period 1991-2003, which corresponds approximately to the period prior to our investment) is between 6,8 % and 9,3 % (the difference lies in the method to calculate the average — arithmetic versus geometric). We consider the lower bound of this interval for our estimation of the market risk premium.

Rm – Rf = 6,8 %

Finally, for the estimate of beta, we use publicly available information pertaining to companies that have been identified as direct competitors to CDL by the Spanish authorities.

In 2001, KBC Securities provided a report containing the necessary information to calculate the net present value of a 10-year investment in the Carrere Group. Note that both the date and the investment’s maturity roughly coincide with the case at hand. The discount rate used in the KBC report was 12 %, while the reported beta stood at 1,8. Taking into account that the financial risk profile of Carrere is different from that of CDL (Carrere’s capital structure includes debt), we have to adjust this beta and compute the unlevered beta in order to isolate the business risk profile. The formula to obtain the unlevered beta is given by:

BetaUnlevered = BetaLevered/1 + 1 – T D/E

where T is the applicable tax rate. The tax rate for France, where Carrere is established, is around 33 %, and the debt to equity ratio data can be found in the original KBC report. At the time of the share issue, the debt to equity ratio stood at 10 %. This magnitude has been confirmed with Bloomberg data.

Using these parameter values, we obtain the following value for the unlevered beta:

Beta_Unlevered = 1,68

A similar assessment was made in Germany in 2008 by Der Spezialist fur Finanzaktien for Studio Babelsberg, another firm identified as a direct competitor to CDL by Spanish authorities. That report assumed a cost of equity of 12 %, and a beta of 1,5. At the time the report was published, Studio Babelsberg was a debt-free company, meaning that its capital structure was identical to CDL’s; hence there is no need to adjust the beta in this case.

This direct evidence obtained from detailed reports pertaining to two direct competitors indicates that the beta applicable to CDL is (at least) in the 1,5-1,68 range. In addition, the investment in CDL is likely to involve a higher degree of idiosyncratic risk for the reasons already expounded by the Commission. In other words, CDL’s beta is probably higher than that of its competitors.

In what follows, we take the arithmetic average between these two figures and assign it to CDL (despite the fact that the idiosyncratic risk associated with CDL is probably higher). It should be noted that these figures were provided by financial analysts who carried an in-depth analysis of Carrere and Studio Babelsberg.

Thus, the lower bound of the expected return on equity for a private investor would be:

Ke = 4,1 + 1,59 * 6,8 = 14,91 %

Obtaining this number is useful, as it implies that a value for the WACC substantially below 14,91 % can be dismissed out of hand.

Pitfalls in the Methodology of LECG

The estimation made by the LECG study, leading to a discount factor of 5,15 %, is methodologically flawed. LECG claimed that the right proxy for the weighted average cost of capital (WACC) is the realised Return on Assets (ROA) of one, or possibly two, competitors (Pinewood and Babelsberg).

First of all, the accounting returns, such as ROA, should in general not be considered as a correct measure for an investor’s expected average return for at least three reasons^note. Accounting returns are calculated on an annual basis, whereas a rational investor will consider the return over the entire life time of the project. Secondly, accounting information is historical information about the company and therefore better adapted to evaluate ex post performance of the firm than ex ante expected performance on the investments. Finally, investors are not really interested in accounting earnings but rather in monetary gains, i.e. the cash flows they receive from their investment.

Furthermore, LECG should have compared the WACC measure with the ROCE (Return on Capital Employed), and not with ROA. The WACC measure refers to the total capital, i.e. equity and financial debt. However, in the liabilities side of a typical balance sheet, you find not only equity and financial debt but also current liabilities, i.e. payables to suppliers. Therefore, total assets are equal to or higher than total capital and for a given return, ROA is lower than or equal to ROCE^note. Hence, it is the ROCE that should be compared with the WACC and not the ROA. A project realises positive value if and only if the realised return on capital employed is equal to or greater than the WACC.

Competitors data

Before turning to market data, we would emphasise again that the relevant benchmark is the ex-ante cost of equity capital. Ex-post observed returns are only an imperfect proxy for ex-ante expectations, as ex-post realised returns are not necessarily equal to ex-ante required returns. If investors are interested in the past performance of an industry, they should look at the ROCE, an ex-post return relatively neutral to the capital structure of different firms, since it includes both debt and equity. As the level of leverage in a company increases, the return on equity for shareholders increases, as compared to the ROCE.

In what follows, we analyse data on the ROCE of a representative group of competitors from various sources and observe that results are not out of line with our calibration exercise.

1. Amadeus data

Amadeus is a comprehensive, pan-European database containing financial information on over 11 million public and private companies in 41 European countries provided by Bureau van Dijk (BvD) Electronic Publishing. BvD is one of the world’s leading providers of firm level balance sheet data, with Europe being most extensively covered.

The median is the number separating the higher half of a sample from the lower half. If the observed values are arranged in either ascending or descending order, the median is the value in the middle.

The arithmetic mean (average) is the sum of all the observations divided by the number of observations.

For many distributions, the median and mean coincide. Empirically, the two may differ substantially if, despite large sample size, the observed distribution is skewed (e.g. because it contains a number of outliers, i.e. extreme observations).

The data we present below is characterised by values for the mean that are higher that the median (positive skewness). Since the mean is sensitive to outliers, we focus on the median instead. Note that this choice leads to a finding of lower returns as compared to using the sample average.

Peer group analysis

If we consider a very broad sample comprising all NACE 921 (Motion picture and video activities), this yields more than 11000 observations for the period 1994-2008.

	Median
Return on capital employed (ROCE)	13,56 %

Pinewood-Shepperton, Carrere Group and Barrandov Studio belong to the narrower four-digit NACE code 9211 (Motion picture and video production). In addition to the NACE classifications, Amadeus provides a finer definition of peers by grouping firms within the same NACE code according to their size. Pinewood-Shepperton, Carrere Group and Barrandov Studio belong to the group of ‘very large companies’ in NACE 9211 (‘very large’ is not an absolute measure, but relative to other firms belonging to NACE 9211). The median^note for this peer group of 45 companies over the period 2000-2006, in the cases where data were available, is as follows:

	Median
ROCE	10,1 %

Studio Babelsberg is listed in Amadeus under the same NACE code as the previous three companies, but is considered only as ‘a large company’. The ‘large company’ peer group for NACE 9211 is formed by 133 companies. The median of the group over the same period (2000-2006) is:

	Median
ROCE	10,1 %

Cinecitta Studios is listed under the ‘advertising’ NACE code meaning that the peer group is inadequate for comparison purposes. CDL, too, has been assigned to a peer group with NACE code 7413 (Market research and public opinion pooling), in our opinion not relevant for our assessment.

2. ORBIS dataORBIS is a global database which has information on over 50 million companies worldwide (Bureau van Dijk Electronic Publishing).

—Pinewood Shepperton

—Studio Babelsberg

—Carrere Group

—Cinecitta

—Ealing Studios

—Barrandov

—Prime Focus

—Ray Corp

—Europacorp

In order to obtain information on firms mentioned in the submission provided by the Spanish authorities, it was necessary to turn to ORBIS. In ORBIS, information was available for the following companies:

The median over these companies and over the period 2002-2007 is:

	Median
ROCE	10,82 %

Since this group of companies is made-up of clearly identified competitors, there is no risk of including an ‘outlier’ that is not really active in the same segment as CDL (which may be the case for the peer groups that have been constructed in Amadeus). We therefore also report the average for that group over the 2000-2007 period.

	Average
ROCE	12,26 %

Conclusion

Our calibrated opportunity cost of capital for the investment in CDL stands at 14,91 %. If we accept at face value the 2004 business plan proposed by CDL and LECG’s analysis, the internal rate of return of this project is 5,74 %. However, we stress that the cash flows forecasted in the 2004 business plans appear as unduly optimistic, especially taking into account the actual losses incurred by the company during the period 2002-2004^note. Given the information at our disposal, we can conjecture that the expected cash flows presented in the 2004 business plan represented an upper bound.

As stated in the introduction, an investor would only invest in a project with an internal rate of return larger than the opportunity cost of capital. Consequently, an investor in CDL would have required a much higher internal rate of return (i.e. at least 14,91 %) in order to invest in this project. We can conclude that the investment made in CDL did not fulfil the market economy investor principle.

With a WACC = 14,91 %, and assuming that the 2004 cash flow forecasts represent an upper limit, we computed the NPV of the project as the sum of discounted cash flows. On the basis of the submission provided by the Spanish authorities, it emerges that the 199 million investment is the sum of the cash flows in the period 2005-2007. The cash flow of the last period includes the residual value, computed using the dividend discount model:

Vt = Dt1 + gr – g

Where D_t stands for the dividend to pay in year t, g is the dividend growth rate and r the discount rate.

This expression is highly sensitive to the parameters D_t and g. Obtaining accurate estimates for D_t and g is beyond the purpose of this note. For this reason, we use as a benchmark the values proposed by the Spanish authorities, namely D_t = 8651 (last period cash flow) and g = 2,553 % (the inflation rate). However, we apply our estimated discount rate of 14,91 %. On the basis of these parameter values, the project yields a negative net present value of- NPV = – 131,65 mil.

	2002	2003	2004	2005	2006	2007	2008
Cash flow	–884	–1792	–2601	–118177	–55813	–25088	4462
Discount	1 + WACC^2	1 + WACC	1	1/1 + WACC	1/1 + WACC^2	1/1 + WACC^3	1/1 + WACC^4
14,91 %	1,3204	1,1491	1,0000	0,8702	0,7573	0,6591	0,5735
DCF	–1167,26	–2059,19	–2601,00	–102843,09	–42268,78	–16534,56	2559,16

	2009	2010	2011	2012	2013	2014	NPV
Cash flow	5526	6561	6842	8057	8307	80447
Discount	1/1 + WACC^5	1/1 + WACC^6	1/1 + WACC^7	1/ + WACC^8	1/1 + /WACC^9	1/1 + WACC^10
14,91 %	0,4991	0,4344	0,3780	0,3290	0,2863	0,2491
DCF	2758,17	2849,86	2586,30	2650,40	2378,07	20041,62	–131,65

Comments on the last submission (25 March)

The 25 March submission lacks methodological rigour and makes some central claims that are at best unsubstantiated. It states that:

…‘To quantify this return and above all the risk premium that a private investor would require from a project, different models are used, the most common of which is the Capital Asset Pricing Model (CAPM). For example, if this model is applied to the case in hand, a private investor ‘would require’ a risk premium, not a return, of 3,75 % in 2000 and 2,07 % in 2004.’

and further presents the following table:

Table 1
	Market risk premium	Beta of Ciudad de la Luz	Risk premium required from Ciudad de la Luz
2000	9,49 %	0,395	3,75 %
2004	5,25 %	0,395	2,07 %

In other words, the submission claims that CDL’s Beta is ß = 0,395. This is an unsubstantiated conjecture that is not backed up with any hard and verifiable data. In addition, it is hard to reconcile it with common sense.

Below, we provide direct quotes from Brealey and Myers, the central reference in LECG’s submission.

‘…beta measures how sensitive a security is to market movements. Stocks with betas greater than 1,0 tend to amplify the overall movements of the market. Stocks with beta between 0 and 1,0 tend to move in the same direction as the market, but not as far. Of course, the market is the ‘portfolio of all stocks’, so the ‘average’ stock has a beta of 1,0.’ (Chapter Seven, pg. 174).

In other words, higher-beta stocks mean greater volatility and are therefore riskier.

Investment in CDL is at least as risky as investment in its established competitors whose betas are substantially above 1 (see evaluations made by KBC Securities and Spezialist für Finanzaktien).

Finally, in terms of the risk-free rate, it seems highly opportunistic to refer to the present temporary financial crisis in order to rebut the value chosen by the Commission, which corresponds to the risk-free rate in the period of the investment in CDL.

Annex II · [adapted from the document of March 2010]

Reply to the submission of 19 October 2009 prepared by LECG

(1)Alleged erroneous use of the CAPM model.While LECG accepts that a CAPM-based analysis is the correct avenue to pursue, it questions the parameter values that have been used by DG COMP. More precisely, LECG asserts that:

—the equity premium should have been lower

—the ‘betas’ should also have been lower

(2)The Commission should not have limited itself to Consultia IT’s business plan, but should also have used Arthur Andersen’s 2000 business plan to establish the relevant benchmark.

(3)The Commission did not use the appropriate financial ratios to estimate the expected profitability of the CDL project.

(4)Furthermore, the Commission did not take into account the expected revenues deriving from the development of hotels and office space.

The reply of the consulting company LECG to the Commission’s analysis focuses on four issues:

1. The parameters of the CAPM

1.1. Equity premium

LECG questions our choice of using historical data relating to the premiums, based on Fernández (2004), to estimate the market risk premium in Spain for the years 2000 and 2004. Instead, LECG suggests using the information found in a later paper by the same author^note.

As will be seen below, the LECG report quotes this paper very selectively.

The LECG report argues that the required equity premium should be used instead of the historical equity premium. However, Fernández (2009) states the following:

‘It is easy to conclude that there is not a generally accepted equity premium point estimate or a common method to estimate it. […]The recommendations regarding the equity premium, taken from 150 finance and valuation textbooks published between 1979 and 2009, range from 3 % to 10 %. Several books use different equity premiums in different pages and most books do not distinguish among the four different concepts that the phrase ‘equity premium’ designates: historical equity premium, expected equity premium, required equity premium and implied equity premium. […]129 of the books consider expected and required equity premium to be synonymous terms and 82 do not distinguish between expected and historical equity premium.’

Furthermore, as regards its concrete value, the LECG study proposes using an equity premium recently presented by Fernández (2009). Fernández suggests using a Required Equity Premium (REP) ranging from, 3,8 % to 4,3 %. There are at least two reasons for which this range is not valid for our purposes. First, it suffers from intrinsic limitations, since it is a subjective valuation by a single individual. It should be noted that Fernández also presents an average value obtained from 150 textbooks (see graph below). Secondly, and most importantly, the suggestion to use a value of 3,8 %-4,3 % is an estimation of the current equity premium, not the one prevailing in 2000 and 2004. The values of the parameters to plug in the CAPM should be contemporaneous to the date of the business decision (i.e. ex-ante and not ex-post). In other words, the relevant equity premium is the one that was prevailing in 2000 (or 2004), not 2009. With respect to that point, Fernández’s paper (2009) does provide consensus estimates of the REP in 2000 and 2004. In particular, the 2004 value of the REP is above 6 %, whereas its value for 2000 is around 7 %. Our estimation before this paper was made public was correct, and was in this range, i.e. 6,8 %.

‘The figure below shows the evolution of the Required Equity Premium (REP) moving average (last 5 years) used or recommended in 150 finance and valuation textbooks.’

Moving average 5 years

1.2. Beta

As far as the beta is concerned, the LECG report casts doubts on the use of estimations provided by private companies specialised in valuations. Below, we provide the links to the studies we refer to:

Carrere (the information we used can be found on p. 5 of the report below):http://www.carreregroup.com/fr/documents/financials/Etude_Financiere_13062001.pdf

Studio Babelsberg (see p. 10):http://www.studiobabelsberg.com/uploads/media/Studio_Babelsberg__14May08.pdf

In our view, this is precisely the place where a private investor would look for information to establish a beta ex-ante. These analysts have specific skills to assess ex-ante valuations.

The two studies provide betas for certain close competitors of Ciudad de la Luz.

Pablo Fernández, the author extensively, but selectively, quoted in the LECG study, has written widely to show that historical betas (as the ones proposed by LECG) are next to meaningless.

In his paper ‘Are calculated betas worth for anything?’ (Working paper IESE Business School), Pablo Fernández (2008) presents strong arguments against the use of calculated beta in valuations:

‘We show that, in general, it is an enormous error to use the historical beta as a proxy for the expected beta. First, because it is almost impossible to calculate a meaningful beta as historical betas change dramatically from one day to the next; second, because very often we cannot say with a relevant statistical confidence that the beta of one company is smaller or bigger than the beta of another; third, because historical betas do not make much sense in many cases: high-risk companies very often have smaller historical betas than low-risk companies; fourth, because historical betas depend very much on which index we use to calculate them. […]^note’ (our emphasis)

The third argument above put forward by Fernández (2008) also serves to illustrate that the betas presented by LECG cannot be right. Indeed, Fernández makes the assertion that high-risk companies are high beta. This is very intuitive: the required return for a high-risk project (such as CDL) ought to be above the return of a diversified portfolio (e.g. the IBEX 35).

In another paper, focused on Spain (‘On the instability of betas: the case of Spain’, 2008, Working paper IESE Business School) Pablo Fernández shows again that it is a serious error to use betas calculated from historical data to compute the required return to equity.

‘It is a mistake for seven reasons:

1.because betas calculated from historical data change considerably from one day to the next.

2.because calculated betas depend very much on which stock index is used as the market reference.

3.because calculated betas depend very much on which historical period (5 years, 3 years,…) is used to calculate them.

4.because calculated betas depend on what returns (monthly, yearly,…) are used to calculate them.

5.because very often we do not know if the beta of one company is lower or higher than the beta of another.

6.because calculated betas have little correlation with stock returns.

7.because the correlation coefficients (and the R2) of the regressions used to calculate the betas are very small.’

The paper provides numerous examples to support all of the seven statements.

2. The relevant time frame

In our previous analysis, we used the year 2004 as a reference year for the calculation of the NPV, as this was the time when the entire investment of EUR 199,4 million had been committed. However, we can easily duplicate our analysis for the year 2000. The resulting WACC would be higher than in 2004^note, due both to a higher market risk premium (which according to the information gathered by Fernández should be around 7 % — see section 1.1) and to a higher risk-free rate (which stood at 5,53 % for Spain in 2000^note). Hence, an internal rate of return of 8,84 % would still be much lower than the cost of capital (more precisely: WACC = 5,53 % + 1,59 * 7 % = 16,66 %).

It is possible to go one step further and compute the NPV of the project in 2000. Bearing in mind all the caveats we stressed in our previous analysis (i.e., the use at face value of the cash flows and the parameters used for the calculation of the terminal value, except, of course, for the WACC) we obtain the following negative NPV:

	2000	2001	2002	2003	2004	2005	2006	NPV
Cash flow	–46479	–69719	9005	12616	6930	7710	68698
Discount	1	1/1 + WACC	1/1 + WACC^2	1/1 + WACC^3	1/1 + WACC^4	1/1 + WACC^5	1/1 + WACC^6
16,66 %	1	0,8572	0,7348	0,6298	0,5399	0,4628	0,3967
DCF	–46479	–59762,56	6616,67	7946,13	3741,50	3568,16	27252,87	–57116,22

3. Financial ratios

The LECG report agrees with our point of view that CAPM is the right instrument to assess the ex-ante cost of capital. Moreover, the report does not provide any argument to rebut the use of the ROCE as a proxy for the WACC. Therefore, it is not necessary to repeat the reasoning already set out in the previous note. However, it may still be worth recalling why the ROCE is the most appropriate ratio. Since the economic profitability of a company is measured ex-post by the difference between the return on capital employed and the cost of capital, then intuitively, if one were to construct a benchmark based on past data of competitors in order to determine the minimum return required by investors, then the appropriate proxy would be the average industry ROCE.

4. The extension of the investment to hotels and office spaces

The assertions in this point are based on new evidence, namely six land valuation reports. As a preliminary remark, we note that this evidence is produced ex-post, and therefore was not part of the information available to a potential investor at the time^note. Secondly, we note that the Arthur Andersen report only mentions the possibility of developing a hotel complex (in phase III) and certain office space (in phase IV). The report contains an estimate of costs for developing hotels and offices but none of the associated revenues; hence the information to assess the profitability of developing the land is missing. Indeed, no business plan is provided for the development of phases III and IV. In the Consultia IT business plan, the reference to the hotels is made only indirectly through the mention of an area of complementary services, while offices are not even mentioned. Furthermore, these activities are not considered at all in the section on the economic and financial forecasts. In other words, at no stage would the private investors have been presented with a business plan concerning the development of the land. As such, this implies that the ex-ante assessment of the project should solely be based on the business plan concerning the film studios; indeed, all the relevant evidence indicates that land development was not part of the original business plan. In fact, the LECG submission of April 2008 explicitly stated, in section 5 (The operational value of a hotel complex and commercial area in Ciudad de la Luz) that the details of the investment in the services complex (hotels and commercial area) were not analysed in either of the two business plans because (i) the above mentioned services would in any event be built after the studio and (ii) the profitability of the studio was high enough and therefore it was not necessary to analyse at that moment the additional cash flows Ciudad de la Luz might generate.

The only pertinent information relevant for the assessment of the land is represented by the bids received by Ciudad de la Luz in 2005 for the construction and operation of hotels and a commercial area, which were presented in section 5 mentioned earlier. This represents an evaluation made by the market in a period contemporaneous with the investment decision, a period moreover characterised by the real estate boom. As will be explained in the next section, the Euroval valuations do not offer proper guidance regarding the value of the land plots.

For the purpose of calculating the NPV including this additional land development, it is possible to use the price set by the market (the fact that it is relatively low, as recognised by the Spanish, is indeed evidence that this property development did not seem to be very attractive for private investors).

The following table provides NPV calculations that include the property development on the basis of the bids that were actually made in 2005 (EUR 560000 per year, adjusted for inflation, as stated by LECG). As can be readily seen, the NPV remains negative.

	2002	2003	2004	2005	2006	2007	2008
Cash flow	–884	–1792	–2601	–118177	–55813	–25088	4462
IPC hotels				1,000	1,021	1,042	1,064
Hotels				560	572	584	596
Total	–884	–1792	–2601	–117617	–55241	–24504	5058
Discount	1 + WACC^2	1 + WACC	1	1/1 + WACC	1/1 + WACC^2	1/1 + WACC^3	1/1 + WACC^4
14,91 %	1,3204	1,1491	1,0000	0,8702	0,7573	0,6591	0,5735
DCF	–1167,26	–2059,19	–2601,00	–102355,76	–41835,77	–16149,82	2901,01

2009	2010	2011	2012	2013	2014	NPV
5526	6561	6842	8057	8307	80447
1,087	1,110	1,133	1,157	1,181	1,206
609	621	634	648	661	9401
6135	7182	7476	8705	8968	89848
1/1 + WACC^5	1/1 + WACC^6	1/1 + WACC^7	1/+ WACC^8	1/1+/WACC^9	1/1 + WACC^10
0,4991	0,4344	0,3780	0,3290	0,2863	0,2491
3061,91	3119,74	2826,09	2863,46	2567,38	22383,73	–126445,48

A series of land valuation reports were prepared by Euroval. These reports were commissioned by the Sociedad Proyectos Temáticos de la Comunidad Valenciana, the investor in Ciudad de la Luz (CDL). The reports purport to provide an objective valuation of the land that would be used for the construction of hotels and offices in the CDL complex. They provide a valuation for the years 2000, 2002, and 2009. For each of these years, two plots are valued: one destined for the development hotel complex, and the other for office blocks, making for a total of 6 valuation reports.

Since the reports broadly follow the same methodologies, some of our comments are generic; whenever reference is made to specific assertions, the corresponding report is identified.

This memo describes the limitations of the aforementioned reports and concludes that the valuations presented therein are untrustworthy. In addition, the memo notes that the valuation report is not compatible with some of the claims found in the documents previously provided by Spanish authorities. Last, the memo indicates the kind of evidence that could have been used to obtain an estimate of the value of the land.

4.1. The reports

As can be seen, Euroval has not signed nor stamped any of these reports, i.e. there is no evidence at all that the entity takes responsibility for the valuations.

The Spanish authorities state that the valuation reports on the land drawn up in 2000 and 2002 do not fulfil the requirements of Ministerial Order ECO 805/2003 regarding the valuation of buildings, ‘since their purpose is other than the scope of application of that Order’ (e.g. p. 3 of the report providing the 2000 valuation for office space). It is not explained why the aforementioned ministerial order should not apply. The aforementioned ministerial order is also mentioned in conjunction with Law 6/1998 on land valuation (p. 13 of the aforementioned report). It is argued that, since it is a retrospective valuation for the year 2000 made in 2002, ‘the acting technical team is free to apply the calculation adjustments and hypotheses it considers most appropriate for the objective pursued.’ However, the ‘adjustments’ and ‘hypotheses’ are not spelled out. Furthermore, it is not clear why existing law can not be applied, particularly with regard to the valuation of the land. Nor is a justification provided for not applying the laws that were in force at the time.

The report providing the current (2009) valuation of the plot destined for office blocks contains an even more surprising statement. It is claimed that the valuation methods applicable according to the current legislation in force can be adapted because: ‘since the purpose of the valuation is a non-monetary contribution at the date in question, the acting technical team is free to apply the calculation adjustments and hypotheses it deems most appropriate for the objective pursued.’ In other words, since the valuation will not lead to a monetary transaction, the valuation methods that have to be applied by law can be modified. To be more precise, since no real money/transaction is involved, the technical team admits that they consider that they can make adjustments that they deem opportune given the ‘objective pursued’.

It is therefore no wonder that Euroval has not officially endorsed any of the six reports.

4.1(a) Reports pertaining to the building of office space (NNT plot)

The reports should have also explained more clearly what the qualification of ‘tertiary use’ for the land entails.

The most glaring limitation of these reports is the way they establish benchmark prices for office space in the Ciudad de la Luz complex. On p. 18 of the 2000 report, nine transactions are listed, including the price paid per square meter. These transactions took place between December 1999 and September 2000, and the average price paid was of EUR 1111,7 per square meter. This is the value taken to represent the benchmark for office space in the Ciudad de la Luz complex.

The Ciudad de la Luz complex is outside the city of Alicante and next to an industrial complex (polígono industrial). By contrast, the nine transactions mentioned above involve offices (average size: 115,26 square meters) located in the most prestigious business streets in Alicante. Using these transactions to establish a benchmark for the 66576,54 m² that would be built in Ciudad de la Luz simply does not make sense.

The report uses the Spanish Consumer Price Index (CPI — Indice de Precios al Consumo, IPC) to deflate current values. In particular, the IPC is used to deflate a current valuation of the land back to the year 2000 (p. 24). We note that, as its name indicates, the CPI/IPC does not encompass asset price inflation; the index is computed on the basis of a basket of consumer goods. Using the CPI/IPC to deflate land values and/or real estate values is far from being innocuous, for the reasons explained below.

As is well known, Spain experienced a housing boom that lasted more than 10 years (to a notable extent, its current macroeconomic woes are related to that bubble). As a consequence land prices increased much faster than the general CPI.

According to statistics gathered by the Ministry of Housing of the Spanish Government (Ministerio de Vivienda, http://www.mviv.es/es/), housing prices in the Alicante province increased by 122,2 % during the period spanning the first quarter of 2000 and the third quarter of 2009 (this time period has been chosen as it corresponds to the one used in the 2000 Euroval report: January 2000 to August 2009). A cursory glance at the time series indicates that house prices increased fastest at the start of the time period under consideration.

The same statistical source also provides data on land prices; unfortunately, the series only begins in 2004. The average price per square metre of urban land in the Alicante province stood at EUR 234,3/m² during the first quarter of 2004. The corresponding figure for municipalities of more than 50000 inhabitants in the province of Alicante stood at EUR 464,9m² during the first quarter of 2004.

Since the price of land that can be used for real development of urban land is closely correlated to housing prices, it is possible to obtain an approximation to the deflator for land prices during the period Q1 2000 – Q4 2003 by looking at house price inflation during the same period. According to the Spanish Housing Ministry, house prices in the Alicante province increased by 80,1 % over the period between the first quarter of 2000 and the third quarter of 2003.

Thus, irrespective of whether one takes the average land price for the entire province (EUR 234/m² in Q1 2004), or that for large municipalities (EUR 464,9/m² in Q1), applying a deflator of that order of magnitude (+/- 80 %) would result in a land price in Q1 2000 much lower than that reported in the Euroval report.

It is also worth mentioning that, regarding the evolution of prices, the reports contradict each other. As mentioned above, on p. 18 of the 2000 report, nine transactions are listed, including the price paid per square meter. These transactions took place between December 1999 and September 2000, and the average price paid was of EUR 1111,7 per square meter. This is the value taken to represent the benchmark for office space in the Ciudad de la Luz complex.

The 2009 report follows the same methodology. On p. 18, seven transactions that took place between April 2007 and December 2008 are listed. The average value is EUR 2736,22 per square meter. Thus, the 2009 report provides glaring evidence that real estate inflation was far above the 33,5 % used in the 2000 report. By comparing the two reports, we obtain inflation of 146,1 %. This is in line with the Ministry of Housing reports: between the first quarter of 2000 and the second quarter of 2008 (the period of most of the transactions reported in the 2009 report), housing prices in the Alicante province increased by 152,1 %.

The fact that the figures found in the 2009 report are deflated by 15 % to establish current prices does not change the overall picture in view of the magnitudes involved.

As a by the way, we would also reiterate that using prices for small offices in the centre of Alicante to establish a benchmark for the Ciudad de la Luz complex does not make sense.

Two further comments should be borne in mind. Firstly, during property boom periods, the price of land usually increases faster that final house prices. In any case, the house price index understates land price inflation. Secondly, the average land price for large municipalities is probably not representative of land prices in a location such as that of CDL. Indeed, most of the underlying data used to construct this average price stems from land located in cities or their immediate vicinity (e.g. suburban ‘urbanizaciones’); CDL is located outside the city in a location with little (if any) residential housing.

Lastly, house price inflation is illustrated by the material used to teach second-year undergraduates at Unversidad Carlos III de Madrid that can be found at: http://www.eco.uc3m.es/~ricmora/ee/, materiales, Tema I, slide 67, which we reproduce below. This graphical evidence further confirms that house prices have increased much faster than the CPI/ICP.

Original source: LA VIVIENDA EN ESPAÑA: DESGRAVACIONES, BURBUJAS Y OTRAS HISTORIAS, José García Montalvo.Gráfico 20. Crecimiento nominal de los precios de la vivienda e inflación.Fuente: Ministerio de Fomento e INE.P. viviendaInflación

In all the reports, the arguments used to show that the costs of land development are nil are rather thin, given that some additional costs would have to be borne.

Finally, in the case of the office complex (NNT) a difference of 35 % (2002) or more than 50 % (2000) between the values obtained from the two valuation methods (dynamic residual method and increase in CPI) is indicative of the highly speculative nature of the exercise.

4.1(b) Reports on the valuation of the plot destined for a hotel complex (NNH plot)

The 2000 and 2002 reports on the second plot (‘NNH’) suffer from the same limitations (e.g. use of an inadequate deflator, lack of justification for not applying valuation methods established in Spanish law, etc.). As mentioned above, none of these reports are signed or stamped.

Some additional comments are nevertheless in order. The 2000 and 2002 reports establish benchmark prices for hotel rooms with the help of average prices. However, the source is not provided, nor is it clear whether it refers to Alicante province (2002 report), or the Comunidad Valenciana (2000 report).

The resulting average prices are EUR 44,95/night in the 2000 report, and EUR 47,65/night in the 2002 report. Although the source underpinning these values has not been provided, they are not out of line with previous figures.

By contrast, the 2009 report provides a list of 6 well located hotels, all of which are 4- or 5-star, to establish a benchmark price. The latter is established EUR 104/night. There is no explanation as to why the methodology to establish benchmark prices is different from the one used in the 2000 and 2002 reports.

More importantly, it is hard to understand why the focus is on 4-5-star hotels. Is there any indication that demand would exist for 4-5-star hotels outside Alicante, located next to a highway and a ‘poligono industrial’?

In the same line, it is quite telling that the only hotel close to the CDL complex has been omitted. The latter is an IBIS, whose prices range from EUR 49 per night for the summer of 2010 (http://www.ibishotel.com/gb/reservation/multirates.jshtml consulted on 24 February 2010). As further evidence, luxury apartments next to a golf course (and relatively close to CDL) charge EUR 80 per night in August 2010 (peak season, see http://www.hotelesoasis.com/WebOasis/EN/ficha_hotel/plantio_golf/descripcion.jsp, consulted on 24 February 2010).

The 2009 report for the NNH plot also contain some surprising statements. One is initially pleasantly surprised to find out that the method to undertake the valuation is in conformity with the law (p. 13 reads ‘The methodological references are the criteria laid down in Ministerial Order ECO 805/2003 on real estate valuation and Law 6/1998 of 13 April 1998 on land valuation, the aim of the valuation being to establish the value at the present date.’ However, on p. 25, one discovers that, after all, the valuation report has not complied with the requirements set out in the Ministerial Order: ‘In accordance with Article 61(1)(b) of Order ECO 805/2003 of March 2003 on rules for real estate valuation, we would point out that this Valuation Report does not formally comply with that Order since its purpose is other than the scope of application of the Order’ (‘por ser su finalidad distinta al objeto de aplicación de la misma’).

It is also interesting to note that there is a huge difference between the estimates per square meter for the two plots (NNH and NNT). While not denying that the projected uses (offices vs. hotels) may explain part of the difference, the gap is still striking. For hotels, the values range from EUR 144,12/m² (2000) to EUR 188,35/m² in 2009. For office space, the respective magnitudes range from EUR 491,64/m² (2000) to EUR 800/m² in 2009. What can explain the significant difference in the price evolution (inflation) of these two plots situated next to each other? How is it possible to account for this difference of over 300 %?

Should we conclude that this is due to the fact that the methodology used to value the plot destined for hotels is closer to the standards established by the law? Or should it be put down to the greater transparency of the price of a hotel night?

It is also claimed that variable costs represent 50 % of revenues (e.g. on pp 18-19 of the 2009 report). Where does the estimate of such large margins come from?

Building costs are estimated on the basis of a benchmark price module. For the 2000 and 2002 reports, the correct figures are chosen. However, for the 2009 report, the 2006 figure is used. Why is this?

4.2. Risk premiums

We also note that the reports recognise that investment in hotel facilities is riskier than investment in office space (e.g. on p. 12 and p. 26 of the 2000 report). At all times, the Spanish authorities have consistently envisaged the construction of a ‘hotel complex’.

Similarly, the report indicates that the discount rate (tipo de actualización) is given by the following formula (p. 16 of the 2000 report):

i = Risk-free rate + risk premium

On the same page, a table provides the minimum risk premiums to be applied. The relevant premiums are above the ex-ante expected return on investment in Ciudad de la Luz.

Lastly, the risk premium used in the calculations appearing on p. 21 of the 2000 report (10 %) is lower than the one appearing in the corresponding table on p. 16 (11 %).

4.3. Credible valuations

In order to obtain a credible valuation of the land, valuations for around 2000 of various plots of similar characteristics in terms of size and location (next to the Aguas Amargas industrial complex), and intended for ‘tertiary use’ and ‘hotel use’, should have been provided.

Annex A

Information about the amounts of aid received, to be recovered and already recovered
Identity of the beneficiary	Total amount of aid received under the scheme^note	Total amount of aid to be recovered^note(Principal)	Total amount already reimbursed^note
Principal	Interest

Appendix

—Equity capital (E)

—K_e the cost of equity capital, expressed in %;

—Financial capital/debt) (D)

—K_d the cost of financial capital (debt), expressed in %.

In order to finance a project, investors need to invest some capital. Such capital has a cost. This is the cost of capital.

Typically, there are 2 broad sources of capital:

The sum of equity capital and debt capital gives us the total capital (C), expressed in EUR. Each of these 2 sources of capital has a certain cost. We note:

The total cost of capital is therefore the weighted average cost of capital (WACC), taking into account the proportion of equity capital and the proportion of debt capital. We have therefore:

WACC = KeEC + KdDC

Note also that K_d and K_e are the expected cost of financial capital and of equity capital, and not the historical cost.

Taking into account the tax advantages of debt financing, and assuming T is the tax rate applicable to CDL, we have:

WACC = KeEC + KdDC1 – T

In the particular case of CDL, no mention of debt is made in the 2000 business plan. Since the project is fully financed with equity capital we have the following:

WACC = K_e

Connections

History · 2 versions

Key facts