This exercise expands on Section 16.6.5.4 to develop a theoretical basis for the charge for Tier 2 required capital. Let Tier1RC = Total Tier 1 required capital Tier2RC = Total Tier 2 required capital ROE = The company’s desired return on equity WACC = The company’s weighted average cost of capital, reflecting its ROE, after-tax yield on debt, and capital structure Tier2IntRate = The after-tax interest rate earned on assets backing Tier 2 required capital Life Insurance Products and Finance CorpExp = Corporate expenses not allocated to business units. In order to allocate only relevant costs, these expenses could be limited to those related to raising and managing corporate capital.
Tier2ChargePct = The percentage of Tier 2 required capital charged to each business unit for the use of Tier 2 required capital.
Assume the following:
1. Tier1RC earns a return equal to ROE.
2. Tier2RC earns a return equal to Tier2IntRate + Tier2ChargePct.
3. Tier1RC + Tier2RC together earn an overall return equal to WACC, plus an additional amount equal to CorpExp.
The last assumption implies that we will choose a value for Tier2ChargePct that will allow the company to earn its WACC, after first covering corporate expenses.
Use these assumptions to develop a formula for Tier2ChargePct in terms of WACC, Tier2IntRate, CorpExp, ROE, Tier1RC, and Tier2RC.