Frictional cost of capital

[Sponge]

what is the frictional cost of capital

 

[Lindsay Smitherman]

Hi

It is the erosion of value of capital that is locked into a company and so cannot be used immediately by shareholders for other purposes. The capital hence generates lower returns than it otherwise would - the difference results in that capital having lower value to the shareholders than if it was not locked-in.

Specific frictional costs mentioned in the Core Reading are tax (eg from a shareholder’s perspective a life company may not be the most tax-efficient place to have capital locked in), investment management expenses and agency costs (management not necessarily running the business in a way which optimises returns to shareholders).

 

[Sponge]

Thank

Hi

It is the erosion of value of capital that is locked into a company and so cannot be used immediately by shareholders for other purposes. The capital hence generates lower returns than it otherwise would - the difference results in that capital having lower value to the shareholders than if it was not locked-in.

Specific frictional costs mentioned in the Core Reading are tax (eg from a shareholder’s perspective a life company may not be the most tax-efficient place to have capital locked in), investment management expenses and agency costs (management not necessarily running the business in a way which optimises returns to shareholders).

Thank you. I saw it being mentioned in the Sept 15 paper and it was referencing investment return against the risk discount rate

 

[Lindsay Smitherman]

Yes - this is the difference between the return that the shareholders want to earn (the risk discount rate) but can't because the capital is locked-in, and the investment return that the locked-in capital is constrained to sit there and earn. As the former is likely to be higher than the latter, this creates a 'cost of capital'.

 

[Sponge]

Yes - this is the difference between the return that the shareholders want to earn (the risk discount rate) but can't because the capital is locked-in, and the investment return that the locked-in capital is constrained to sit there and earn. As the former is likely to be higher than the latter, this creates a 'cost of capital'.

Thank you