Cost of capital

[Siddharth]

Hi,
Could anyone please explain what exactly is cost of capital and how it's being calculated?

 

[Sayantani]

Hi Siddharth,
I will try to answer this if I may and Mark can correct if I am wrong at any place.
Reserves are generally backed by safe assets like government bonds earning a low rate of return. While the shareholders require a higher rate of return which will be present in the RDR reflecting the riskiness of the business. If reserves grow at 2% but RDR reflects a return of 8% then 6% is the cost of capital. The cost will increase if the reserves are higher.
To understand it in another way, think that the shareholders would also want their profits earlier but generally what happens is if reserves grow at 2% and then discounted back at 8% then the profit value decreases for the shareholder or there is deferral in the emergence of profit. So the reserves are getting tied up to earn a lower rate of return rather than being able to earn a higher shareholders rate of return. This is the concept behind the cost of capital.

 

[Siddharth]

Okay, so as per your example can Cost of Capital be also considered as risk premium since reserves are growing at risk free rate and risk discount rate is the sum of risk free rate and risk premium.

 

[Mark Willder]

Hi Siddharth,
I will try to answer this if I may and Mark can correct if I am wrong at any place.
Reserves are generally backed by safe assets like government bonds earning a low rate of return. While the shareholders require a higher rate of return which will be present in the RDR reflecting the riskiness of the business. If reserves grow at 2% but RDR reflects a return of 8% then 6% is the cost of capital. The cost will increase if the reserves are higher.
To understand it in another way, think that the shareholders would also want their profits earlier but generally what happens is if reserves grow at 2% and then discounted back at 8% then the profit value decreases for the shareholder or there is deferral in the emergence of profit. So the reserves are getting tied up to earn a lower rate of return rather than being able to earn a higher shareholders rate of return. This is the concept behind the cost of capital.

Hi Sayantani

Thanks for posting. Yes, your explanation looks spot on.

Best wishes

Mark

 

[Mark Willder]

Okay, so as per your example can Cost of Capital be also considered as risk premium since reserves are growing at risk free rate and risk discount rate is the sum of risk free rate and risk premium.

Hi Siddharth

I would stick to the explanation that Sayantani gave in the exam as that is what the examiners will be expecting to see.

Your alternative explanation would be the same if the insurer was investing entirely in the risk free asset.

Best wishes

Mark