big c, page-29

Hi HT

Happy Easter to yourself and family.

In the interest of learning I would like to delve into how you calculated the WACC for OZL. I agree that 9.88% is in the general area I would expect for OZL (and you are right the Cost of Equity component is somewhat subjective and has a large bearing on the overall resulting NPV). Because it is prone to subjectiveness any NPV derived from this valuation method should be considerably under the companies EV before it is taken as a buy signal.

The cost of debt component is usually easily extracted from the notes to the accounts. Its simply a matter of looking at the weightings of the various debt instruments used and placing a weighting on each and the relevant interest rates.

The way Cost of Equity has been explained to me before is as follows. It has two elements firstly the risk free rate of return which in today's market would be around 4% (ie what you could achieve as an investor in a term deposit account with a major bank). The second element is the ERP(Equity Risk Premium) which is essentially the premium an equity investor would demand for the risk over and above the RFR.

Stocks that have very high financial volatility or have been market disappointers would have a higher ERP -up to 800bp, while reliable high quality businesses would have lower ERP's for example WOW would be around 400bp.

Additionally small cap stocks could have upto another 200bp added to their ERP for being more prone to the general vissistitudes of commercial realities such as competition etc.

So for OZL I would assume a Cost of Equity as follows; (and this is subjective and open to debate).

400bp(Risk Free Rate) + 650bp (ERP) =10.5%

I feel this is about right taking into account the commodity nature of OZL's business but also being aware that it is a low cost producer and likely profitable throughout a full commodity cycle.

The other point to add to this discussion is that the Cost of Equity component of the WACC is usually always higher than the Cost of Debt. This is somewhat self explanantory in that a bond holder or banker has protection through rights over the assets of a business which is a luxury Equity investors never have.

So on this basis OZL's WACC would actually be lower by my reckoning if they utilised more debt on the balance sheet. I should preface this by saying that I am talking solely in reference to management determining their own WACC and setting policy for a rate of return above the WACC before any acquisition was persued etc. I am not saying OZL should take on more debt.

While all this is somewhat academic I think it is a very important thing for an investor to understand. It is certainly something I look for in any company I am prepared to invest in nowdays - that management and the board have shown an understanding of and formed a policy around capital allocation practises above the companies WACC.

This should also be understood in terms of Retained Earnings which should not be thought of as interest free capital as some managers do. Also I am in favor of seeing strike prices for options adjusted as the level of retained earnings held in the company increases. But this is another topic for another day.

I have to say that the new OZL seems to be showing some much better pedigry in how they allocate shareholder funds.

Happy to hear your thoughts on the above. Thanks HT for your ongoing excellent contribution to the HC threads in general.