I find the Miccolis discussion of cost of capital almost indecipherable as
well. Sturgis may be wrong, but at least he is clear about what he is
calculating. I think statement 1 assumes that the surplus must be invested
in riskfree (or nearly so) instruments as well, so why does the investor
need to capitalize income on these funds at any rate of return higher than
that - after all, he could have just "invested in the reserves" and put the
supporting equity into T-bills himself. Statements 2 and 3 are poor
attempts to clarify statement 1. Statements 4 and 5 are the next link in
the chain of logic: if the whole enchilada of future business must be
capitalized at the required (internal) rate of return on buyer's equity,
and the income on surplus funds is capitalized at the riskfree rate, then
in order to preserve the average ROE, the value of future business (gross
of the cost of capital at the riskfree rate) must be discounted at a rate
higher than the buyer's required (internal) ROE.
I hope that helps. I realize we're all "competing" for every extra point
on this exam, but at some point my humanity steps in for those of us who
struggle to memorize poorly written syllabus material in order to answer
poorly written questions in an insufficient amount of time. Of course,
this is all to prove that, given adequate amounts of time and clear
statements of client needs, we can look answers up in a book and help them.
Good luck,
John