Cost of Capital

THE COST OF CAPITAL FOR FINANCIAL FIRMS By C. J. Exley and A. D. Smith

[Presented to the Institute of Actuaries, 23 January 2006]

abstract

Most businesses have assets financed by capital providers. The cost of capital is a measure of the returns required by those capital providers. Its main use is to set a target for the profits, which must be achieved on the firm’s assets in order to satisfy equity and bond holders. This paper describes the classical theory of the cost of capital, and then applies it to the special case of banking and insurance firms. We develop implications for product pricing, performance measurement and capital structure optimisation.

keywords

Cost of Capital; Capital Asset Pricing Model; Franchise Value; Market Consistent Valuation; Embedded Value; Franchise Insurance Premium; Frictional Costs; Taxation; Performance Measurement

contact addresses

C. Jon Exley, Barclays Capital, 5 The North Colonnade, Canary Wharf, London E14 4BB, U.K. E-mail: Jon.Exley@barclayscapital.com Andrew D. Smith, Deloitte & Touche LLP, Stonecutter Court, 1 Stonecutter Street, London EC4A 4TR, U.K. E-mail: andrewdsmith8@deloitte.co.uk Charlie [Munger] and I have not the faintest idea what our cost of capital is and we think the whole concept is fairly crazy, frankly Warren Buffett, May 2003

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Introduction

1.1 Why does the Cost of Capital Matter? 1.1.1 Some people think that capital incurs a cost just by being there. A business must meet capital costs in addition to other expenses of doing business. Others talk confidently about the cost of capital, as if they have already measured it, comprehensively taken account of all accounting effects, risks, regulations, taxes and other complications, survived a rigorous audit process, and now use cost of capital as a guiding principle for running every aspect of their lives. The rest of us sit in meetings feeling left out, making a mental note to research the ingenious secret. If that sounds familiar, then...