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The Actuarial Professionmaking financial sense of the future
Finance & Investment Conference 2003The Caledonian Hilton Hotel, Edinburgh
The Cost of Capital for Financial Firms
Jon Exley and Andrew SmithApplications of Financial TheoryWorking Party
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Key Questions
• Pricing (prospective) question:
• what rate of return is required on assets / liabilities
• to create value for shareholders?
• to justify retaining or growing a business unit?• Performance measurement (retrospective) question:
• which business units created value?
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Presentation Overview
• Classical cost of capital methods
• ROE, ROC, WACC• What is equity?• Taxes and frictional costs• Financial distress • Implications for pricing, capital structure, accounting
and regulation
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Two Schools of Thought
Pricing and Performance Measurement
EconomicCapital
ContingentClaims
This presentation is about the contingent claims approach
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The Actuarial Professionmaking financial sense of the future
The Cost of Capital for Financial Firms
Part I: Classical Theory
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Simplified Company Balance Sheet
Assets Liabilities
Assets = € 500consisting ofPlantInventory Debt = € 400
Borrow at 6%
Equity = € 100
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The Pricing Question
• What is the required return on the assets?
• profit before interest cost
• divided by initial asset value• Classical answer: WACC
• Use for discounting new projects
• And as a target ROE (return on equity)
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Cost of Capital in First Year
Assets Liabilities
Assets = € 500consisting of- Plant- Inventory Debt = € 400
Borrow at 6%
Equity = € 100
required return 10%(eg from CAPM)cost of equity € 10
borrow at 6%cost of debt = € 24
total cost of capital= € 10 + € 24= € 34
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Weighted Average Cost of Capital
WACC = Equity
Assets* Required equity return
Debt
Assets* Borrowing rate+
= 0.2 * 10% + 0.8 * 6%
= 6.8%
= € 34
€ 500
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Summary: Rates of Return So Far
5%
6%
7%
8%
9%
10%
risk-free
market equityreturn
cost ofborrowing
cost ofequity
WACC(weighted
average cost of capital)
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Banking and Insurance
• Industrial model translates readily to banking
• assets (loans) to be priced
• given the cost of financing (equity, debt and deposits)• Insurance more challenging
• debt = policyholder liabilities
• pricing problem relates to liabilities, not assets
• Cost of Equity more useful than WACC
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The Actuarial Professionmaking financial sense of the future
The Cost of Capital for Financial Firms
Part II: What is equity?
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What is equity?
• Balance sheet equity = € 100
• but only € 60 required to meet solvency regulations
• and only € 40 “economic capital” needed if regulations were risk-based
• Market capitalisation = € 150
• € 100 equity plus € 50 franchise value
• shareholder requires return on total investment• So does the 10% cost of equity apply to € 40, € 50, €60, €
100 or € 150?
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Profit Target: Impact on Valuation
corp
orat
e va
luat
ion
supp
orte
d
equity for setting profit target
zero economiccapital
net assets
market capitalisation
regulatorycapital
bookequity
equity+ franchise
A business that earns its cost of book equity should trade at book
value
… but higher profits are required to support an
existing value in
excess of book
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Do these statements make sense?
I dare not recognise capital gains in my
balance sheet, because shareholders would
increase my profit targets
When I reduce the capital required for my business, this saves on
cost of capital and creates value for
shareholders
I added value last year because the business achieved a return on equity in excess of its
cost of equity
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Least Satisfaction:Link from metrics to market value
-5%
0%
5%
10%
15%
20%
89 90 91 92 93 94 95 96 97 98 99 0 1
P/C insuranceAll companiesLifeCommercial Banks
0
200
400
600
800
1000
1200
1988 1990 1992 1994 1996 1998 2000 2002
P/C Insurance
All companies
Life insuance
Banks
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Reconciling ROE to TSR – The role of franchise value
This yearactual
Next yeartarget
100
50
ma
rke
t cap
italis
atio
n
equity
107
52
6
ma
rke
t cap
italis
atio
n
dividend
target total return 10%
target franchise growth 4%
implied 13% target ROE
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Franchise Values (Dec 2000)
0%
20%
40%
60%
80%
100%
Sk
and
ia
Gen
eral
i
Pru
den
tial
LT
SB
HS
BC
L&
G
All
ian
z
AX
A
Ab
bey
Nat
ion
al
RB
OS
HB
OS
Iris
h L
ife
His
cox
RS
A
Franchise
Net Assets
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Aegon: Equity and Franchise
0
10
20
30
40
50
60
70
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
Franchise
Equity
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The Actuarial Professionmaking financial sense of the future
The Cost of Capital for Financial Firms
Part III: Taxes and Agency Costs
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Tax and Agency Costs
• Tax: rate τ1 on profit
• Agency costs
• Arising from principal / agent conflicts
• Related to management control over resources
• Proportional to Equity capital or Profit
• Rate τ2 on equity, rate τ3 on profit
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Impact of Tax and Agency Costs
Industrial and Banks Insurance
• Tax and agency costs
reduce the return on equity
available to shareholders
• To justify shareholder
investment, a firm must
pass these costs on to
customers
• Higher returns on assets
required (eg higher
mortgage interest rates)
• Tax and agency costs
reduce the return on equity
available to shareholders
• To justify shareholder
investment, a firm must
pass these costs on to
customers
• Lower cost of debt required
(eg lower liability discount
rate in premium basis)
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The Actuarial Professionmaking financial sense of the future
The Cost of Capital for Financial Firms
Part IV: Financial Distress Costs
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Modelling Financial Distress
statutory net assets at year endsh
are
hold
er v
alu
e
franchise value at risk
limited liabilityput option
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Impact of Financial Distress
• Franchise value disappears• Shareholders get nothing• Debtholders and administrators share the assets
• we assume administrators get the lot• Debtholders anticipate this credit risk
• and therefore do not lend at the risk free rate
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10
12
14
16
18
20
0 10 20 30 40 50
equity
fran
chis
e
Capital Optimisation
default option
franchise valueat risk
optimalcapitalisation
tax/agency costs too high
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treating tax, agency costs, default, existing / new business split
what the market sees(share price × shares in issue)
what the accountantrecognises:
investments (?estate)in-force liabilities
value of new businesscapital raising / holding
/ distribution costsagency costsown credit risk
Defining net assets necessarily involves accounting decisions.
There is no unique “economic” view that abstracts from these decisions
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The Actuarial Professionmaking financial sense of the future
The Cost of Capital for Financial Firms
Part V: Pricing
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How the Answer Looks
95
96
97
98
99
100
101
102
103
104
105
Discount atrisk-free rate
CAPM liabs Expenses ontechnical
assets
Cost ofCapital
Tax DefaultOption
PlannedMargin
FranchiseInsurance
Pre
miu
m p
er
£1
00
Lia
bil
ity
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Comparison: New vs Old
Premium =
+ PV Mean claims
+ Market risk load
+ Credit risk load
+ Operational risk load
+ Event risk load
+ Other risk load
Premium =
+ Mean claims (PV risk free)
+ Systematic risk load
+ Agency cost of capital
+ Tax
- Default option
+ Margin for profit
+ Franchise protection
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Questions for Discussion
• Is there any meaningful “economic” capital value that
• differs from market capitalisation
• transcends accounting and regulatory distortions• Do you accept that shareholders require a return on their
franchise value
• Market price should drive profit margins
• EVA measures overstate new value created?• Are actuaries adequately prepared to understand the strengths
and weaknesses of banking techniques when applied to insurance firms?
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The Actuarial Professionmaking financial sense of the future
Finance & Investment Conference 2003The Caledonian Hilton Hotel, Edinburgh
The Cost of Capital for Financial Firms
Jon Exley and Andrew SmithApplications of Financial TheoryWorking Party