RDP 8807: The Cost of Capital: Some Issues Appendix II: Construction of the Cost of Capital Measure

Nigel Dews

August 1988

Appendix II: Construction of the Cost of Capital Measure

In Section 4 a weighted average measure of the cost of capital was outlined. This appendix provides further details of the construction of the measure. The methodology used was developed by Carmichael and Stebbing (1981). Appendix III provides the data.

From Section 4 the ex ante real cost of funds to the firm (h) is defined as:

where: b = ratio of debt to total funds employed by the firm.
      That is, b = B/(B + E)
      and B = market value of debt for a sample of 50–60 companies listed on the Sydney Stock Exchange.
      E = market value of equity for a sample of 50–60 companies listed on the Sydney Stock Exchange.
  τ = corporate income tax rate.
  i = gross nominal interest cost to the firm, per unit of debt obligation. In this case, assumed to equal the yield on industrial debentures with five or less years to maturity obtained from Melbourne Stock Exchange data.
  ê = ex ante real after-tax rate of return on equity. Derived using the methodology outlined in this paper and fully detailed in Carmichael and Stebbing (1981) Appendix 3.5, using GAUSS (NLSYS). Results were particularly sensitive to the assumed average expected rate of retirement of debt. For this reason, the rate applied was by 2.2 per cent per quarter, the same as that used by Carmichael and Stebbing (1981).
  Inline Equation = expected rate of change in prices. The measure of expected inflation used is the average change in the non-farm GDP deflator, over the previous four quarters (not including the current quarter) and is consistent with the approach taken by Atkinson and Chouraque (1985).