Cost of Capital: Applications and Examples, + Website, 5th Edition

APPENDIX 32A

Cost of Capital in Transfer Pricing Example¹

As discussed in Chapter 32, the Risk Study portion of the Duff & Phelps Risk Premium Report can be an effective tool to help quantify the relative risks of the functions and the appropriate return. The Risk Study reports observed rates of return based on three risk measures:

1. Profitability (operating profit margin or operating profit/revenue)
2. Volatility of operating profit margin
3. Volatility of return on equity (net income/book value of equity)

You can allocate overall profit margin to the functions and allocate overall rate of return based on the relative volatility of profit margins, for example.

For example, assume Millie Wear Products were to transfer its product trade names to an intellectual property holding company (Millie Trade Name Holding) and pay that holding company a royalty based on product sales. What is the appropriate rate of return for this royalty? Is the overall cost of capital for Millie Wear Products the appropriate rate of return? Again, the business of Millie Wear Products is a portfolio of business functions, and the overall cost of capital for Millie Wear Products represents the market's composite analysis of the risks of all of its products and functions.

While Millie Trade Name Holding is bearing a risk that future product sales will vary and likewise its cash flows, it is not bearing the risks of investment and the risks of variability of costs (assuming that the transferred product trade names ...