Perhaps someone should organise a basic corporate finance tutorial for the Rudd cabinet. And perhaps a quick primer on the psychology of markets and corporations.
Last week there were reports from attendees at an investment bank seminar with Wayne Swan that the Treasurer didn’t appear to understand the difference between the risk-free rate and a company’s cost of capital. Apparently, according to the attendees, he thought they were the same.
One might have thought that, surely, they were mistaken. They must have misheard him.
The risk-free rate, presently about 5.7%, is the 10-year bond rate. It reflects the cost of federal government borrowings, with the risk to the buyer of the bonds reduced by the government’s taxing powers. A company’s cost of capital is the weighted average cost of both its debt (priced with a risk premium against the risk-free rate) and its equity, which carries its own risk premium.
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A company’s weighted average cost of capital (WACC) will vary from company to company, depending on the mix of debt and equity in its balance sheet, perceptions of its specific levels of risk and of its prospects. Resource companies, because of the volatility of commodity prices and demand, tend to be very conservative — BHP is funded about 15% by net debt and 85 per cent by far more expensive equity.
Last night, on the ABC’s Q&A program, the finance minister, Lindsay Tanner — generally regarded as the most financially literate person in the government — was asked by host Tony Jones who decided what a “super profit” was.
He started by comparing the proposed resource super profits tax (RSPT) with the petroleum resources rent tax, which he said, correctly, had a five percentage point “factor” on top of the bond rate before the super tax cuts in.
“This one (the RSPT) doesn’t but there’s one other key difference. There’s swings and roundabouts here and that is that this tax proposal is also rebating losses.
“So, in other words, we are saying to the miners not only will we take 40% of your — above a basic cost of capital (my emphasis) — profit, we will also rebate you 40% on losses and that will be transferable,” he said.
So another economic minister apparently doesn’t appreciate the vast distinction between a risk free rate and a WACC. Given that in the case of a resource company its WACC would be in the mid-teens, if not higher — and they need a project to generate a margin above their WACC if it isn’t going to destroy shareholder value — perhaps it’s not surprising that the Rudd government doesn’t appear to believe the sector’s cries of anguish.
The government, of course, is happy to spend $43 billion of taxpayer funds on the national broadband network for a prospective return, based on very optimistic assumptions, of about six per cent, with Tanner and Conroy arguing at the unveiling of the NBN implementation study that because the projected return was above the bond rate that meant the NBN was financially viable.
As Melbourne Business School’s Paul Kerin pointed out forcefully in The Australian last week the risk-free rate reflects the risk of the government defaulting on its borrowings, not the riskiness of a particular project or the return required to compensate for the risk.
The government’s own agencies — including Tanner’s finance department — say that analysis of public sector projects should use private sector discount rates for analogous projects.
Thus the risk-free rate is no guide to financial viability, let alone super-profitability.
The concept of symmetry that underpins the RSPT — that in return for grabbing 58% of the profits of the established projects the government will expose itself to 40% of the losses of failed projects — is just as flawed, while Ken Henry’s view that taxing the most profitable mines to encourage more marginal productions is simply weird.
Is there a miner out there who will regard the prospect of “only” losing 60% of their capital as an incentive to invest?
The resource sector is by nature optimistic. Even the smallest of mining companies dream of finding the big deposit. They — and, more particularly, their financiers — aren’t after marginal projects that could be wiped out the moment (which may be arriving) the Chinese economy hiccups, even if the taxpayer is going to be exposed to 40% of the downside.
The big miners, such as BHP Billiton or Rio Tinto and Xstrata, can’t, of course, shift the Pilbara or Queensland’ coal fields, but they can’t be forced to commit new capital to them. Canada, with an effective tax rate of 23 per cent, has already said it would be happy to have their capital. Brazil, with rates that range between 27 per cent and 38 per cent, won’t complain if they invest there.
If the RSPT were genuinely a tax on super or windfall profitability — closer in structure and detail to the PRRT and without the elements that effectively socialise and nationalise the profits of our biggest and lowest-cost mines — the resource sector would accept it.
That would, of course, require an understanding of the risks involved in committing billions of dollars to projects that will run over decades and numerous commodity cycles — and the returns the companies and their investors require to compensate them for those risks. The bond rate won’t do it.