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.
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.
I really wish Mr. Bartholomeusz would stop dissembling and just once reveal all the facts in one reasoned and balanced piece of journalism.
Despite, the complexity of the financial sector the difference between WACC and the Risk free Rate is not that difficult to comprehend – despite his arrogance I think the Treasurer, the Finance Minister and the Treasury really have got their collective head around it.
I think Mr. Bartholomeusz has himself misunderstood what this tax does. He said the bond rate won’t compensate companies or their investors from the risks of mining projects which run over decades and numerous commodity cycles. But hello? No-one is suggesting it will
The prposed tax is 40% on the profits above the risk free rate (or bond rate). That means that capital does not have to take large risk for what is effectively a risk free return, they take a punt on – risk free plus 60%. That is, 60% of a very very large number; that being the profits in excess 5-6%. It may not be as good as the money-for-jam they had before from what is effectively finding and pulling rocks out of the ground, but, for God’s sake, there may well be a very good argument that profit-taking is an insatiable beast which as a society we should be wary not overfeed.
So, stop banging on about who knows more about the black art of finance and address the facts –
Of course, Mr. Bartholomeusz must have missed the bit in Journalism 101 about digging a bit deeper, uncovering facts and stress-testing opposing opinions.
How could anyone possibly take this story seriously with that line at the bottom about effective nationalisation of industry. It simply cannot be construed by any rational person as anything other than a knee jerk ideologically based reaction. If you want to peddle your prejudices behind a wall of facts try and stop them showing.
@Kit
In the case of the mining industry, that is complete rubbish. For your homework I suggest you write out Mr Bartholomeusz’ penultimate sentence a hundred times.
Oh, and the routine trivialising of the mining industry by one side of this debate – “effectively finding and pulling rocks out of the ground” – is getting pretty tired. Those who’ve actually tried it know there’s nothing easy about either of those things, and in fact they’re quite difficult to do well, i.e. competitively. Find another line.
Mark, for homework write out my reponse above 10 times and then accurately comment on its content.
Point taken on the ‘rocks in the ground’ taunt, but no-one seems to want to compare the risks of mining with the risks of, for instance, R&D in manufacturing ventures – of course all business is risky and mining might be on the riskier side but I think history has shown that miners are doing OK and my only point is i’m sure they’ll continue to Ok because we alll still need to burn those damn rocks they’re pulling out.
@Kit “history has shown that miners are doing OK”
I’d say that’s exactly wrong. For every profitable miner extant today, there would be ten mine/exploration firms whose very names are all but forgotten, except maybe by those investors who saw their capital disappear with them. This is the flip side of the “very very large” profit reward/risk equation.