CAPM and Super Profits

I love hearing all the hyperbolae from mining companies about how they’re going to pack up their open-cut iron ore mines and move them to down-town Tokyo. However, articles pointing out that mining companies are generally opposed to mining taxes doesn’t really contain enough novel information for me to classify it as ‘news’.

To someone with a finance background, it intuitively doesn't make sense that something called a "super profits tax" will apply to all profits over the government bond rate. There is a relatively simple reason for this; the government bond rate is the rate at which the Federal Government can borrow funds. Financial institutions don’t like risk, and the Federal Government is the lowest risk borrower around because if they do get hard up for cash, they can just print more money.

In my experience, most people with an undergraduate finance degree still don't know what the Capital Asset Pricing Model (CAPM) is. They will have heard of it and they will nod their heads when someone mentions it. However, unless they work in corporate finance, have taken a corporate finance course in the past year or spent more time at the uni library than in the uni pub (not many people I know), they're generally just faking it.

The CAPM (pronounced "cap-em") basically just says that says people don't like risk and the more risk a project has, the less they like it. Not liking it doesn't mean you won't invest in something - it just means you need to expect to earn a higher return on your money for you to invest.

So, how do you quantify “not liking risk”? First, ask "what would you earn on something that had no risk?". Second, ask "how much extra do I need to earn to make up for the risk?".

The answer to the first question is “the government bond rate”. As mentioned earlier, being able to print money is a pretty neat trick when you’re trying to convince someone you can repay them. First problem solved.

The answer to the second bit is a two step process; first ask "how much more than the government bond rate can I earn on the share market?" then multiply the by a factor that compared the risk of a project to the market average. The long term historical average return on the share market is typically around 6% above the bond rate. The risk of the project is a factor that ranges from around 0.5 to 2. The mining industry is pretty risky; there are big capital costs and it’s common to go out and dig a big hole in the middle of nowhere only to discover you’re unearthed a massive resource of worthless dirt. If I assume a mining project is given a risk factor of 2 times a "standard company". This suggests that a "fair" rate of return that the company would want to expect to undertake the project is the risk free rate (assume 6%) plus the risk factor (2) times the risk premium (6%) 6% + 2*6% = 18%.

So how does 6%, or thereabouts, qualify as a "super profit"?

Assuming you don't pay any tax on your first 6% of profits, then you pay 40% for returns above that, earning a (100% equity) return of 18% would mean you pay 0% tax on 6%, then 40% tax on the remaining 12%; a total tax rate of 27%. You wouldn’t exceed the corporate tax rate of 30% until you earned a return of 24% or more.