Wednesday, 8 July 2015

A little bit of interesting finance.

Today has been budget day here in the UK.   George Osborne, Ozy for short, has produced his first true blue budget and most early comments is along the lines: 'it's not as bad as it might of been'.   It did, however, manage to nudge the Greeks of the head of the news but not much of interest happening there until their PM presents their proposals for a new bail-out package tomorrow.   But what caught my eye in the budget was the removal of the tax shield attaching to 'buy-to-let' mortgages first for high rate taxpayers from 2017 onwards and, ultimately, I am sure for standard rate tax-payers.  There are two important issues here:  the first is whether this presages the removal of the tax shield on all business loans for the unincorporated self-employed and second, what the unintended consequences might be.  My interest here is the 2nd point, and this is my reading of what will happen.  My observations are based upon the fact that Buy2Let mortgages are significantly more expensive than their equivalent in the personal property market.

I have long suspected that mortgage companies, like trades people working for land-lords. try to 'bump the price'.  They are aware that any expense is tax deductible and trade on the basis that at the margin the land-lord is prepared to pay correspondingly more.  So this is my guess:  as the tax shield comes off, mortgage companies will be under pressure bring their rates down as the distinction between the Buy2Let and conventional mortgage disappears. As a result their margins and their regulatory capital will be squeezed restricting the additional loans they can make.  Make no mistake the tax shield is not much benefit to the land-lord but has, in my view, been a a back-door subsidy to the mortgage companies who have leapt at this rather tasty corner of the mortgage market.  

If the market corrects fully I suspect the effect will be broadly neutral and this is the line of argument that M&M made in rebutting the so called tax-shield effect on the WACC.  OK, the tax shield is a benefit to the borrower - only if the lender lets them have it.  But in a world where lenders have the market power it's significance on the cost of capital is moot to say the least.


Dmitry Selivanov said...

Dear Prof. Ryan,

I was pleased to attend your brilliant lecture on the cost of capital in Dubai.
I have two comments on the Rolls-Royce case study which I found of great interest:

1. In the 3rd method applied to calculate the cost of capital using Stock Analyst Reports, the situation with dropping EPS and growing Dividend Yield over the 5-year discrete period cannot be sustainable in the long run. I think these data should be normalized first and then the resulting discount rate/ cost of capital can look ‘realistic’ for investors and financial professionals. Otherwise, it is difficult to substantiate that some analysts’ short-term projections are a reliable estimate of the company cost of capital that is used for long-term financial decisions.

2. The financial theory and IFRS say that cost of capital is an entity-specific figure. There could be nothing unusual if the calculated and ‘triangulated’ figure is about 8% vs. 11% adopted by the company accountants. What we tried in our 3 calculation methods is to emulate the rationale of some typically motivated minority investor in the stock market. However, the company insiders including its majority shareholders, for sure, have much more detailed information on the company performance, risks and growth prospects. So if 11% required rate of return is an ‘educated guess’ or consensus forecast of a big number of well-informed investors, well, it should not be disregarded.

I hope these suggestions make some sense and might address gaps in the case study.

Thanks very much,
Dmitry Selivanov

Professor Bob Ryan said...

Hi Dmitry - thanks for your kind words and it was a pleasure meeting you in Dubai. I quite agree with your first point that a declining growth in earnings and a growing rate of dividends cannot be sustained indefinitely. The working assumption in the model is that the terminal value at year 5 reverts to a growth rate consistent with the rate of reinvestment at that point. What I have done is to test the analysts forecasts using a small ensemble of models using different assumptions and the results are remarkably consistent. It would appear that the small sample of equity analysts reporting out there are using a similar rate. Quite fascinating! On the 2nd point, you are quite correct in that what is quoted in the report is a WACC which is an entity cost as opposed to an equity cost. I wouldn't expect the equity cost to be lower, however. You raised an interesting point about the possibility of majority investors and as far as I can see RR doesn't have any - indeed, there doesn't appear to be a grouping who would be able to significantly influence control. What I think is going on - and I think we agree on this - is that the company perceives a range of firm specific risks which it is attempting to accommodate in its hurdle rate. That's not unusual but not quite to the degree of difference between the fair market rate and the quoted rate. I have recently looked at half a dozen other companies that have a concentrated product portfolio and a strong R&D driver, 2-3 per cent discrepancy is not uncommon but RR is at the very high end and worryingly so. Anyway, many thanks for your participation and interest - there's a lot of very interesting research to be done in multiple modelling methods in finance. Too few doctoral students of the right calibre are out there unfortunately. All the very best, Bob