Guide

Cost of Capital

Publication type:
Guide
Status:
Current
Issue date:
Corporate author:
The Treasury
Publication category:
Guidance
Copyright:
© Crown Copyright, Attribution 4.0 International (CC BY 4.0)
Last updated:

This Handbook is a guide for the staff of Treasury when estimating the cost of capital in relation to Crown entities or SOEs, or reviewing estimates undertaken by others.

Other readers may also find the Handbook useful when undertaking these estimates.

Formats and related files

Table of contents

  • Preface
  • 1 Introduction
  • 2 Estimating the Cost of Capital for Value Based Reporting
    • 2.1 The basic formula and its modifications
    • 2.2 Determining each variable of the formula
      • 2.2.1 Rf - The riskless rate
      • 2.2.2 T - Marginal personal tax rate oninterest income
      • 2.2.3 ø - Tax adjusted market risk premium
      • 2.2.4 ßa - Asset beta
      • 2.2.5 Other variables
    • 2.3 Calculating the capital charge
  • 3 Application to Capital Budgeting
  • 4 Application to Setting Output Prices in NoncontestableProduct Markets
    • 4.1 Nominal or real rates
    • 4.2 Treatment of interest costs
    • 4.3 The presumed tax scenario
  • 5 Application to Valuation
  • Appendix 1: Choosing an Appropriate Methodology
  • Appendix 2: Versions of the Private Sector Model and the Relevance of Leverage
  • Appendix 3: The Riskless Rate and the Market Risk Premium
  • Appendix 4: Beta
  • Appendix 5: Choosing an Appropriate Measure of the Asset Base
  • Appendix 6: Comparison with the Capital Charge Regime for Government Departments
  • References

Introduction#

This Handbook is to help staff of the Treasury to:

  • review other people's estimates of the cost of capital
  • prepare their own estimates of the cost of capital for Crown entities or SOEs.

The Handbook explains how to calculate the cost of capital for value based reporting, and then reviews how this calculation could change if the cost of capital was required for:

  • capital budgeting
  • setting output prices in non-contestable markets
  • valuation.

The Handbook is not a detailed treatise on alternative methods of calculating cost of capital; such discussion is in the appendices. Where individual judgement is necessary, the Handbook seeks a practical approach; again detailed discussion of such judgements is in the appendices.