Dr Michael Power, Investec Asset Management

Why is the Cost of Capital so high in South Africa?

What is SA Inc. doing about it?

What is SA Inc’s Cost of Capital?

• SA Inc: for an ungeared company, 15%15% (Risk free rate of 9.5% + Equity Risk Premium of 5.5%)

Compared to:

• UK Inc: for an ungeared company, 8%8% (RFR of 4% + ERP of 4%)

• US Inc: for an ungeared company, 7.7%7.7% (RFR of 3.7% + ERP of 4%)

In other words, a South African company needs value added returns that are almost twice as high as British or American company to be profitable.

Why did Anglo American, Billiton, South African Breweries,

Old Mutual and Didata move their head listings to London?

So they could become more profitable

The Proof of the Pudding

Press Report covering Anglo American’s first earnings release following their move to London:

“Ogilvie Thompson said the group was pleased with its London listing, which had lowered its cost of capital…”

Press Report covering Anglo American’s first earnings release following their move to London:

“Ogilvie Thompson said the group was pleased with its London listing, which had lowered its cost of capital…”

23 March 2000

The Cost of Capital Defined

It is the blend of a corporation’s capital base, debt and equity, defined as the WEIGHTED AVERAGE COST OF CAPITAL or WACC

WACC = equity % of capital base (risk free rate + (beta x equity risk premium)) + debt % of capital base ((risk free rate + lending margin) x (1 - tax rate))

The modern multinational will spread itself between the world’s pools of capital so as to create the lowest risk adjusted blend of capital it can

Why is the WACC so important?

• It sets the proper hurdle rate to determine true ‘profit’

• A company whose auditors say it is ‘profitable’ and whose ‘profits’ are taxed by the Government may not be truly profitable!

• Returns to capital less Cost of Capital = Economic Value Added if positive, Economic Value Destroyed if negative

““It is critical that all operations It is critical that all operations earn returns in excess earn returns in excess of the cost of capital”of the cost of capital”

Roberto Goizueta,Roberto Goizueta,Former CEOFormer CEO

Why debt is usually cheaper than equity?

• Because of tax; the debt part of WACC is calculated as follows:

→ ((risk free rate + lending margin) x (1 - tax rate))

• But if a company’s gearing rises too high, the interest rate will almost certainly rise above the cost of equity as lenders’ concerns rise with gearing levels and they demand penal lending rates…

My focus here is on ‘more expensive’ equity not ‘less expensive’ debt

‘Abnormally’ geared

‘Normally’ geared

Interest

Rate

Gearing Levels

Cost of Equity

Cost of Debt

The Key Variables in a Cost of Capital

Common to both debt and equity

Risk free rate – RFR

Debt

Gearing

Tax Rate

Equity

Equity Risk Premium – ERP

Individual Stock beta – a measure of the stock’s volatility vs. its home market

The focus here is on the RFR and ERP

Risk Free Rate and Equity Risk Premium

What affects the RFR?

• Defined: A theoretical interest rate that would be returned on an investment which was completely free of risk. The 3-month Treasury Bill is a close approximation, since it is virtually risk-free.

►Country risk, including FX risk, political risk, investor appetite for sovereign risk

What affects the ERP?

• Defined: The extra return that the overall stock market or a particular stock must provide over the rate on Treasury Bills to compensate for market risk.

► Market history and outlook, market character

Mea Culpa. Have South Africa’s institutions ‘underinvested’ in Bonds?

• One reason why South Africa has such a high cost of capital is that it has such a high risk free rate

• This RFR is high partly because institutions have underinvested in Government paper

• Arguably a hang over from the era of prescribed assets

• Possibly due to a misplaced belief in the primacy of equities

• Also due to fear of being the first mover in the wrong year: Would investing institutions rather be wrong together than one look silly for doing the right thing in the one year when equities did outperform bonds?

An aside: Has the South African Government ended up paying far

more on its debt than it ‘should’ have over the past 15 years?

Real Men prefer the equity highwire over cash…

50

150

250

350

450

550

650

750

850

950

89 90 91 92 93 94 95 96 97 98 99 00 01 02

All Share

Cash

Source: JPMorgan

South African Equities vs Cash since 1989

Returns (Pre-tax, August 1989 = 100)

2003: Cash: +12.8%, Equities: +16.1%

…but Gentlemen still prefer bonds!

Returns (Pre-tax, August 1989 = 100)

50

150

250

350

450

550

650

750

850

950

89 90 91 92 93 94 95 96 97 98 99 00 01 02

All Bond

All Share

Cash

South African Bonds vs Equities vs Cash since 1989

2003: Cash: +12.8%, Equities: +16.1%, Bonds: +18.1%

Bonds in the five ‘bad’ years when equities ‘won’:Not so bad, except in 1994

Year Bonds Equities CPI Bonds less CPI

1989 23% 55% 15.3% 7.7%

1991 14% 31% 16.2% -2.2%

1993 40% 54% 9.5% 30.5%

1994 -18% 23% 9.9% -27.9%

1999 33% 61% 2.2% 30.8%

In 3 out of 5 ‘bad’ years, bond returns beat inflation

Bonds vs. Equities vs. Inflation since 1989

Year Inflation Equities Bonds

1989 -2003 +261% +697% +1009%

Compound Average

6.6% 13.8% 16.7%

Real growth through investing in securities is easy to achieve in South Africa.

But ‘easiest’ to achieve by not taking equity risk!

• Does South Africa have a structural negative equity risk premium?

– Since 1994, equities have outperformed bonds in only 1999. Indeed, even cashcash has outperformed equities in this period: +14.1% p.a. vs. +13.1% p.a. to end of February 2004

• What on earth is a negative equity risk premium? Does such a measure as an “equity risk discount”“equity risk discount” exist?

All this begs the two questions…

South Africa’s Unbalanced See-Saw

Overweight

Equities

Underweight

Bonds

Bond yield ‘too high’;Cost of capital – 15%+15%+ – built on ‘too high’ arisk free rate

1. By overinvesting in equities, South Africa’s investors ironically make it more difficult to outperform in equities.

2. This is because a ‘too’ high a cost of capital makes it more difficult

for corporations to add real value to their capital.

JPMorgan’s look at SA Inc’s true profitability

Currency to the rescue

Is SA Inc on its way to becoming unprofitable again?

What are companies doing about SA’s high cost of captial?

What have the big boys done? Making the Great Trek to London

Conventional Wisdom uprooted

1. Cost of Capital is determined by the locale of the assets

2. Moving your place of listing has no effect on your cost of capital

– “By moving its head listing to London, Anglo had no effect on its cost of capital”

Wrong! Cost of Capital is a price, a price for a ‘share’ of a package of risk, a share in a company

That price – as are all prices – is determined by the interaction of the supply of risk (provided by the company) and the demand for risk (made by investors)

Moving to London virtually halved Anglo American’s cost of capital from about 17% to about 9%

An investment returning value added equivalent to a 14% return on capital turned from being unprofitable to profitable merely by Anglo moving to London.

The Two Sides of the Price of Risk:Corporate Supply and Institutional Demand

The Appetite for Equity

Risk

The Price of Equity Capital

The Appetite for Debt

Risk

The Price of Debt Capital

The Weighted Average Cost

of Capital

Risk supplyRisk demand

The Capital Market

The Supply of Debt Capital

The Supply of Equity Capital

The CompanyInstitutions CASHFLOWS

The Role the Company plays: The seller of cash flows, the buyer of capital

• A company owns those cash flows arising from its investments over future time periods

• A company finances its activities by blending debt with equity to create a capital base. The capital charge made against that base – calculated by using the WACC rate – is the hurdle rate for profitable capital employment.

• That hurdle rate is usually applied to prospective projects as a discount rate to determine their likely financial viability.

• Critically, this hurdle rate is the price of capital determined where:

i. the supply of risk i.e. those investment activities undertaken by the company

meets:

ii. the demand for risk i.e. what investors in debt and equity capital are willing to pay to buy access to those cashflows

Stage 1: Anglo with a head listing in Jo’burg

Priceof Equity

Quantity of Equity

Supply of Equity Risk channeled through the company

Demand for Equity Risk fromSouth African Investors

Z

Y

At fair value, SA investors would buy Y amount of risk at Price Z

Stage 2: Anglo moves head-listing to London

PriceOf Equity

Supply of Equity Risk channeled through the company

Demand for Equity Risk from South African Investors

Demand for Equity Risk from British Investors

A

B

Z

Y C

British investors have a higher tolerance of risk – so they pay B where SA investors would only pay Z and demand even more risk – C rather than Y – at that higher price B. At Price B, SA investors would demand only quantity D and so they sell Y-D in scrip, which flows from SA to the UK. In addition, the UK demands C-Y extra scrip!If only seeking Y capital in London, Anglo would only pay Z not B, a lower cost of capitalIf only seeking Y capital in London, Anglo would only pay Z not B, a lower cost of capital

D

Appetite settled from SA at B

Quantity of Equity

Extra appetitefrom London at B

Stage 3: Anglo’s move complete

PriceOf Equity

Supply of Equity Risk channeled through the company

Demand for Equity Risk from South African Investors

Demand for Equity Risk from British Investors

A

B

Z

Y C

Some existing South African investors with a greater willingness to Some existing South African investors with a greater willingness to pay more for risk would not have sold their Anglo shares in the London move.pay more for risk would not have sold their Anglo shares in the London move.

D Quantity of Equity

Combined Demand for Equity Risk from British and South African Investors

One-off capital gain

for SA

Q: What if Anglo had issued no new scrip upon moving to London? (It did, as did Billiton, Old Mutual, SAB & Didata!)A: The price ‘should’ have risen very sharply!

Priceof Equity

Supply of Risk channeled through the company Demand for Risk from

South African Investors

Demand for Risk fromBritish Investors

N

Z

Y

Because of the kinked supply curve at Y/Z, the price would have risen from Z to M, to be met by the transfer of scrip Y-N from the SA register to the London register.

Appetite settled from SA register

M

Quantity of Equity

Segregated pools of capital mean

separate demand curves

Why would London have a higher risk tolerance?

Suggested Answer: Segregated pools of capital – each with their own particular supply of risk opportunities as well as appetites for those risk opportunities – have their own specific tolerances for risk.

What would increase that risk tolerance?1. On the supplysupply side, BREADTH: The wider the variety of supplied risk opportunities – i.e. the broader the range of investible risk options open to investors – the greater the capacity for diversification and so the higher the tolerance involved in an individual risk opportunity (either in terms of price or quantity or even both)2. On the demanddemand side, DEPTH: The bigger the level of demand for risk – i.e. the greater the aggregate amount of capital available for investment – the deeper the appetite for risk

JSE

LSE

Broader

DeeperLondon has a broader, deeper appetite for risk than Jo’burg

“But if the assets don’t move, how can simply moving the head listing increase the valuation?”

• True, there is no change to the quantum of supply of risk in the form of future cash flows from the assets

• What changes is the nature of demandnature of demand for those cash flows

• If the new place of listing has a higher tolerance of risk and so a lower cost of capital, the discount rate by which the cashflows are discounted is reduced. This means the valuation rises.

JSE LSE

Anglo American’s

cashflows

Discount rate 15%Discount rate 9%

Anglo is more valuable to the LSE than it is to the JSE

The Two Tier Market at the JSE:Domestic vs. “Foreign”

March/April 2003: World Markets came down more than SA did

and currency strength exacerbated convergence; blew out again in May

The London Premium

-

5.00

10.00

15.00

20.00

25.00

1999/0

7/2

5

1999/1

1/2

5

2000/0

3/2

5

2000/0

7/2

5

2000/1

1/2

5

2001/0

3/2

5

2001/0

7/2

5

2001/1

1/2

5

2002/0

3/2

5

2002/0

7/2

5

2002/1

1/2

5

2003/0

3/2

5

2003/0

7/2

5

2003/1

1/2

5

The London Premium

-

5.00

10.00

15.00

20.00

25.00

1999/0

7/2

5

1999/1

1/2

5

2000/0

3/2

5

2000/0

7/2

5

2000/1

1/2

5

2001/0

3/2

5

2001/0

7/2

5

2001/1

1/2

5

2002/0

3/2

5

2002/0

7/2

5

2002/1

1/2

5

2003/0

3/2

5

2003/0

7/2

5

2003/1

1/2

5

What are the consequences of this insight?

1. Although it would mean contradicting South African-derived valuation metrics, an asset is priced in the market where the marginal purchase/sale of its shares takes place

2. Companies rooted in deeper, broader capital pools can afford to pay up to buy assets listed in shallower, narrower capital pools: so Anglo can afford to pay more for Amplats, Anglogold & Kumba than we can

3. Where local assets are bid for by foreigners, South African institutions might be able to hold out for a higher exit price than we would accept were the acquiror local

4. That we now have a two-tier market: the dual-listeds march to the metric of an offshore (mainly London-based) drummer whereas the SA-only listeds march to our own rhythm.

How much is our market affected by this issue?

Non-SA Head-listings:

Index weight close to 40%• Anglo American• Richemont • BHPBilliton• SABMiller• Old Mutual • Liberty International• Investec UK• Didata

Companies with offshore controlling

shareholders: about 4% • Anglogold• Amplats• Kumba• ABI• Iscor• Western Areas

Companies with large offshore

registers: about 6%• Goldfields• Harmony• Implats• SAPPI

Nearly 50% of our benchmark is affected by this consideration, including

every Resource company with a benchmark weight over 0.2% except

SASOL, and almost 1/3 of the Industrial and the Financials weights. Of the Top

40 FTSE/JSEAfrica Index, the above list constitutes about 2/3.

Nearly 50% of our benchmark is affected by this consideration, including

every Resource company with a benchmark weight over 0.2% except

SASOL, and almost 1/3 of the Industrial and the Financials weights. Of the Top

40 FTSE/JSEAfrica Index, the above list constitutes about 2/3.

Why Anglo can pay more for Amplats than most South Africans can

Anglo American is slowly but surely buying out the minorities in Amplats

– it now owns over 72% of the company – at prices which the South

African investment community consider to be too high.

• Q: Who is “Right”?

A: BothBoth sides!

• Q: Why?

A: Because Anglo has a lower cost of capital than we do, say 9%

vs. our 15%. With Amplats’ current valuation currently discounting a 12%

cost of capital, the share isis expensive to us as the opportunity

cost of capital we must employ is 15%. But to Anglo American, Amplats

isis showing value as the opportunity cost of capital Anglo must employ is

only 9%. Anglo American can ‘grandfather’ its base cost of capital onto its

controlled assets wherever they are located.

How did SAB ‘buy’ a 7.5% cost of capital?By buying Miller!

Though SAB did not realise the full implications at the time of the acquisition,

buying Miller had the net effect of reducing their cost of capital by 2% from

9.5% to 7.5%. This was achieved through two methods:

1. The Ballast Argument: The average risk profile of SABM’s cashflows was reduced with

inclusion of US-based, US-Dollar earning (i.e. beta-reducing) Miller, thereby reducing the discount

rate used by SABM’s investors, particularly US-dollar based investors.

2. The Tolerance Argument: Via Miller, SABM accessed an investor base with a higher

tolerance of risk: • on the equity side, this comes from now having at least 37% of their investor base

in the US (23.5% of that being Altria); SABM has an ADR facility; • on the debt side this comes from borrowing cheaply in US dollar corporate bond markets:

their August 2003 $2bn bond issue (admittedly of varying maturities but all of at least 5 year)

was $600m at 4.25% and $1.1bn at 5.5% (an average cost of 5.06%), both secured against

Miller whereas SABM Plc – the head company! – was only able to borrowed its $300m at 6.625%.

The US loan cost 157 bps less than the UK loan!

The Cazenove Case StudyAuctioning a business worldwide

“We were selling a business and approached a number of potential suitors to invite bids for the business. The suitors were from all over the world, including Western Europe, Scandinavia, the UK, Southern Europe, Central America and South Africa. All parties were given identical information and asked to submit indicative bids. What was interesting, and it may have been coincidence, was that the value of the bids correlated exactly with relevant countries’ costs of capital – i.e. The country with the lowest cost The country with the lowest cost of capital bid highest, and vice versaof capital bid highest, and vice versa. Needless to say, the South African bidder lost out.”

Julian Wentzel of Cazenove

“We were selling a business and approached a number of potential suitors to invite bids for the business. The suitors were from all over the world, including Western Europe, Scandinavia, the UK, Southern Europe, Central America and South Africa. All parties were given identical information and asked to submit indicative bids. What was interesting, and it may have been coincidence, was that the value of the bids correlated exactly with relevant countries’ costs of capital – i.e. The country with the lowest cost The country with the lowest cost of capital bid highest, and vice versaof capital bid highest, and vice versa. Needless to say, the South African bidder lost out.”

Julian Wentzel of Cazenove

Q.E.D The price was determined by the bidder’s home cost of capital.

The location of the assets was not all-determining in the price.

►Could SAB have afforded Miller from South Africa?

The Errunza-Miller StudyDecember 2000

“Market Segmentation and the Cost of Capital in International Equity Markets.”

Findings: Capital market theory suggests that the removal of barriers to capital flows reduces companies' cost of capital and investors' realized returns. The authors studied the issuance of 126 American Depositary Receipts as a form of company-specific capital market liberalization. They find a significant reduction – an average of 42% – in the cost of capital for companies that issue ADRs for the first time.

Journal of Financial and Quantitative Analysisvol. 35, no. 4, 577–600

“Market Segmentation and the Cost of Capital in International Equity Markets.”

Findings: Capital market theory suggests that the removal of barriers to capital flows reduces companies' cost of capital and investors' realized returns. The authors studied the issuance of 126 American Depositary Receipts as a form of company-specific capital market liberalization. They find a significant reduction – an average of 42% – in the cost of capital for companies that issue ADRs for the first time.

Journal of Financial and Quantitative Analysisvol. 35, no. 4, 577–600

It works for South Africans too!MTN in Nigeria

In the case of valuing MTN’s Nigerian assets, MTN is leveraging its lower SA cost of capital when charging out its capital to MTN Nigeria.

• In South Africa MTN’s cost of capital is currently 16%

• In Nigeria, a stand-alone investment would typically have a cost of capital of at least 25%

• MTN is currently adding a 4% country risk on to its Nigerian operations (which now account for 42% of EBITDA and 68% of its pre-Head office cost profits)

• The 20% MTN Nigeria cost of capital is at a 5% discount to the ‘normal’ rate that would be charged. Why? Because of the appetite for risk available in SA’s deeper, broader capital markets

In the case of valuing MTN’s Nigerian assets, MTN is leveraging its lower SA cost of capital when charging out its capital to MTN Nigeria.

• In South Africa MTN’s cost of capital is currently 16%

• In Nigeria, a stand-alone investment would typically have a cost of capital of at least 25%

• MTN is currently adding a 4% country risk on to its Nigerian operations (which now account for 42% of EBITDA and 68% of its pre-Head office cost profits)

• The 20% MTN Nigeria cost of capital is at a 5% discount to the ‘normal’ rate that would be charged. Why? Because of the appetite for risk available in SA’s deeper, broader capital markets

Conclusions

• South Africa’s cost of equity capital is high because its RFR is high

• Everything must be done to reduce that rate.

The SARB: Are real interest rates excessively high?

Banks: Are lending margins too high?

Institutions: Have asset allocation decisions over-favoured equities?

• Otherwise: Companies have little option but to move their head listings to e.g. London

The alternative to a lower hurdle rate is a higher level of return. How could this be achieved relatively ‘painlessly’ for South Africans?

Through a more competitive exchange rate!