Cost of Capital Practices in Bd

Report On: Cost of capital and Bangladesh perspective Prepared for: Shabbir Ahmed Professor Department of Finance University of Dhaka Course Name: Financial Management (F-206) Prepared by: Group No: 1 UNIVERSITY OF DHAKA TRANSMITTAL LETTER To Shabbir Ahmed Professor Department of Finance University of Dhaka Subject: Submission of Term Paper on “Cost of capital and Bangladesh Perspective” Dear Sir, With profound reference towards the dignity of yours, we are very happy that we have been able to submit the report on the course named “Financial Management (F-206)” as a part of our academic activities.

Here is the report on “Cost of capital and Bangladesh Perspective “ The topic that you have given us is really an important & interesting fact for us with the textual studies acquiring practical orientation about international Trade. WE THANK YOU FOR CHOOSING US FOR WORKING ON THIS TOPIC. Sincerely yours, Sumaiya Hafsa(15 – 176) On behalf of the group Luminous Department of Finance University of Dhaka Dated: 29th pril,2011 ACKNOWLEDGEMENT

It is our refreshment stand to thank Shabbir Ahmed, the adhering Professor of the Department of Finance, in University of Dhaka for rendering us her expertise knowledge and giving us the opportunity of practical exposure through this report. In this regard, we would also like to thank ourselves as our good teamwork and successful team spirit. Without cooperation and the support from each other, it would not be possible to prepare such a resourceful report. Practical knowledge is deep-seated for the application of conjectural intelligence.

Bearing this in mind, the course teacher introduced a program for the students of the course “Financial Management (F-206)” to prepare a report as a compulsory course requirement. As we are students of business school, so it’s very much important for us to have deep knowledge about the different aspects of International trade. Under this course we have gathered brief idea about international trade and finance. And by doing this report we used our theoretical knowledge in a practical situation. There are always some differences between theories and practical. This report bridges the gaps between them.

So, lastly we would again like to express our heartfelt thanks to our honorable teacher for providing us the opportunity to apply classroom learning in a practical situation. Contents ACKNOWLEDGEMENT4 Cost of equity6 Cost of equity formula:7 Cost of Debt8 Weighted average cost of capital8 Capital structure9 Cost of capital Bangladesh perspective10 Cost of capital The overall percentage cost of the funds used to finance a firm’s assets. Cost of capital is a composite cost of the individual sources of funds including common stock, debt, preferred stock, and retained earnings.

The overall cost of capital depends on the cost of each source and the proportion that source represents of all capital used by the firm. The goal of an individual or business is to limit investment to assets that provide a return that is higher than the cost of the capital that was used to finance those assets. The cost of capital is the rate of return that providers of capital demand to compensate them for both the time value of their money, and risk. The cost of capital is specific to each particular type of capital a company uses.

At the highest level these are the cost of equity and the cost of debt, but each class of shares, each class of debt securities, and each loan will have its own cost. It is possible to combine these to produce a single number for a companies cost of capital, the WACC. The cost of capital of a security is used to value securities, as the cost of capital is the appropriate discount rate to apply to the future cash flows that security will pay. For this reason, models that estimate the cost of capital, such as CAPM and arbitrage pricing theory, are regarded as valuation models.

Conversely, the cost of capital of a security can be calculated from the market price and expected future cash flows. This approach makes sense, when, for example, calculating a WACC Cost of equity In finance, the cost of equity is the return (often expressed as a rate of return) a firm theoretically pays to its equity investors such as shareholders to obtain their capital. Firms need to acquire capital from others to operate and grow. Individuals and organizations who are willing to provide their funds to others naturally desire to be rewarded.

Just as landlords seek rents on their property, capital providers seek returns on their funds. Firms obtain capital from two kinds of sources: lenders and equity investors. From the perspective of capital providers, lenders seek to be rewarded with interest and equity investors seek dividends or appreciation in the value of their investment (capital gain) or both. From a firm’s perspective, they must pay for the capital it obtains from others, which is called its cost of capital. Such costs are separated into a firm’s cost of debt and cost of equity and attributed to these two kinds of capital sources.

While a firm’s present cost of debt is relatively easy to determine from observation of interest rates in the capital markets, its current cost of equity is unobservable and must be estimated. Finance theory and practice offers various models for estimating a particular firm’s cost of equity such as the Capital Asset Pricing Model. Another method is derived from the Gordon Model. Moreover, a firm’s overall cost of capital, which consists of the two types of capital costs, can be estimated using the weighted average cost of capital model.

According to finance theory, as a firm’s risk increases (decreases) its cost of capital increases (decreases). This theory is linked to observation of human behavior and logic: capital providers expect reward for offering their funds to others. Such providers are usually rational and prudent preferring safety over risk. They naturally require an extra reward as an incentive to place their capital in a riskier investment instead of a safer one. If an investment’s risk increases, capital providers demand higher returns or they will place their capital elsewhere. Knowing a firm’s cost of capital is needed in order to make better decisions.

Managers make capital budgeting decisions while capital providers make decisions about lending and investment. Such decisions can be made after quantitative analysis that typically uses a firm’s cost of capital as a model input. Cost of equity formula: Cost of equity = Risk free rate of return + Premium expected for risk Cost of equity = Risk free rate of return + Beta x (market rate of return- risk free rate of return) Where Beta= sensitivity to movements in the relevant market: Where: Es The expected return for a security Rf The expected risk-free return in that market (government bond yield) ? The sensitivity to market risk for the security RM The historical return of the stock market/ equity market (RM-Rf) The risk premium of market assets over risk free assets. The risk free rate is taken from the lowest yielding bonds in the particular market, such as government bonds. Cost of Debt The effective rate that a company pays on its current debt. This can be measured in either before- or after-tax returns; however, because interest expense is deductible, the after-tax cost is seen most often. This is one part of the company’s capital structure, which also includes the cost of equity.

A company will use various bonds, loans and other forms of debt, so this measure is useful for giving an idea as to the overall rate being paid by the company to use debt financing. The measure can also give investors an idea as to the riskiness of the company compared to others, because riskier companies generally have a higher cost of debt. To get the after-tax rate, you simply multiply the before-tax rate by one minus the marginal tax rate (before-tax rate x (1-marginal tax)). If a company’s only debt were a single bond in which it paid 5%, the before-tax cost of debt would simply be 5%.

If, however, the company’s marginal tax rate were 40%, the company’s after-tax cost of debt would be only 3% (5% x (1-40%)). Weighted average cost of capital The Weighted Average Cost of Capital (WACC) is used in finance to measure a firm’s cost of capital. The total capital for a firm is the value of its equity (for a firm without outstanding warrants and options, this is the same as the company’s market capitalization) plus the cost of its debt (the cost of debt should be continually updated as the cost of debt changes as a result of interest rate changes).

Notice that the “equity” in the debt to equity ratio is the market value of all equity, not the shareholders’ equity on the balance sheet. To calculate the firm’s weighted cost of capital, we must first calculate the costs of the individual financing sources: Cost of Debt Cost of Preference Capital Cost of Equity Capital Capital structure Because of tax advantages on debt issuance, it will be cheaper to issue debt rather than new equity (this is only true for profitable firms, tax breaks are available only to profitable firms). At some point, however, the cost of issuing new debt will be greater than the cost of issuing new equity.

This is because adding debt increases the default risk – and thus the interest rate that the company must pay in order to borrow money. By utilizing too much debt in its capital structure, this increased default risk can also drive up the costs for other sources (such as retained earnings and preferred stock) as well. Management must identify the “optimal mix” of financing – the capital structure where the cost of capital is minimized so that the firm’s value can be maximized. So in a summary, For an investment to be worthwhile, the expected return on capital must be greater than the cost of capital.

The cost of capital is the rate of return that capital could be expected to earn in an alternative investment of equivalent risk. If a project is of similar risk to a company’s average business activities it is reasonable to use the company’s average cost of capital as a basis for the evaluation. A company’s securities typically include both debt and equity, one must therefore calculate both the cost of debt and the cost of equity to determine a company’s cost of capital. However, a rate of return larger than the cost of capital is usually required.

The cost of debt is relatively simple to calculate, as it is composed of the rate of interest paid. In practice, the interest-rate paid by the company can be modeled as the risk-free rate plus a risk component (risk premium), which itself incorporates a probable rate of default (and amount of recovery given default). For companies with similar risk or credit ratings, the interest rate is largely exogenous (not linked to the company’s activities). The cost of equity is more challenging to calculate as equity does not pay a set return to its investors.

Similar to the cost of debt, the cost of equity is broadly defined as the risk-weighted projected return required by investors, where the return is largely unknown. The cost of equity is therefore inferred by comparing the investment to other investments (comparable) with similar risk profiles to determine the “market” cost of equity. It is commonly equated using the CAPM formula (below), although articles such as Stulz 1995 question the validity of using a local CAPM versus an international CAPM- also considering whether markets are fully integrated or segmented (if fully integrated, there would be no need for a local CAPM).

Once cost of debt and cost of equity have been determined, their blend, the weighted-average cost of capital (WACC), can be calculated. This WACC can then be used as a discount rate for a project’s projected cash flows. Cost of capital Bangladesh perspective This has been carried out to evaluate the relationship between market performance and Cost of capital of selected private commercial banks in Bangladesh that are listed in Dhaka Stock Exchange.

The selected 24 banks are: Arab Bangladesh Bank Limited (ABBL), The City Bank Limited (CBL), International Finance Investment and Commerce Bank Limited (IFICBL), Islami Bank Bangladesh Limited (IBBL), National Bank Limited (NBL), Pubali Bank Limited (PBL), Rupali Bank Limited (RBL), Uttara Bank Limited (UBL), Eastern Bank Limited (EBL), Al-Arafah Islami Bank Limited (AABL), Prime Bank Limited (PMBL), Southeast Bank Limited (SBL), Dhaka Bank Limited (DBL), National Credit and Commerce Bank Limited (NCCBL), Social Investment Bank Limited (SIBL), Dutch- Bangla Bank Limited (DBBL), Mutual Trust Bank Limited (MTBL), Standard Bank Limited (STDBL), One Bank Limited (OBL), Bank Asia Limited (BAL), Mercantile Bank Limited (MBL), Export Import Bank of Bangladesh Limited (EXMBL), ICB Islamic Bank Limited (ICBL), Jamuna Bank Limited (JBL). These banks are selected on the basis of the availability of required data. The relevant data and information are collected from Dhaka Stock Exchange, Audited Annual Reports of different private commercial banks of Bangladesh, Bangladesh Bank, Securities and Exchange Commission and websites of relevant private commercial banks of Bangladesh.

This study employs after-tax cost of debt and cost of equity in order to estimate WACC for selected banks. The procedure of calculating after-tax cost of debt and cost of equity has been stated here in details. The cost of debt measures the cost of borrowing funds of the firm. In calculating the after-tax cost of debt of each bank for each year, the following estimation procedure has been used: After-tax cost of debt = pre-tax cost of debt (1 – tax rate) We have observed ‘cost of fund’ of each bank for each year as the pre-tax cost of debt. The relevant tax rate used to calculate the after-tax cost of debt is 45% since that is the rate at which all commercial banks are taxed in Bangladesh.

The cost of equity for each bank of each year has been calculated by using the general form of the CAPM. Required rate of return on equity = risk-free rate + Beta * market risk-premium Where, risk-free rate is generally estimated by observing the yields of the Treasury Bonds (T-bonds) as the default risk is negligible for T-bonds. The same procedure has been followed here. It should be noted that for 2006, the risk-free rate has been calculated by averaging the yields of the 5 year T-bonds and 10 year T-bonds. However, for 2007 and 2008 the yields of 15 year T-bonds and 20 year T-bonds have also been taken into consideration since the Bangladesh Bank has introduced the 15 year and 20 year bonds from 2007.

In computing the market risk-premium the data of DSE general index (Value Weighted Index) has been used as a proxy of the market portfolio. For each year, the average monthly return of the index has been calculated first, and then the average monthly returns have been converted into a yearly return. Finally, the realized market risk-premium for each year has been estimated by subtracting the risk-free rate of that year from the estimated return of the index. On the other hand, the standard procedure has been followed while estimating beta of each bank for each year which is to regress stock returns (Rj) against the market returns (Rm). A linear regression equation for estimating beta has been used as follows: Rj = a + b Rm

Where, a = intercept from the regression and b = slope of the regression which corresponds to the beta of the stock and measures the riskiness of the stock. In this paper the monthly stock returns have been regressed against the monthly index returns for calculating the beta of each bank for each year. Given all these estimations, the general form of the WACC equation has been used in calculating the WACC of each bank for each year. WACC = D / (D+E) * after tax cost of debt + E / (D+ E) * cost of equity …. (3) Where, D is the total book value of the debt the bank has employed in a particular year and E is total book value of the equity the bank has employed in a particular year.

For example, in case of Arab Bangladesh Bank Limited, the bank has total debt worth BDT 45,406,574,310 and total equity worth BDT 2,582,762,912 as of 31st December 2006. The after-tax cost of debt and the cost of equity have been estimated to be 0. 05522 and -0. 180580383, respectively. Therefore, the WACC for Arab Bangladesh Bank Limited has been estimated to be 0. 042529337 as of 31st December 2006. (Please see Table 1 for details) In order to examine the relationship between the WACC of each selected bank for a year and their respective yearly return on stocks, we have estimated monthly return of each bank first, as follows: Monthly return = (monthly closing price – monthly beginning price) / monthly beginning price

The average monthly return of each bank for each year has been converted, finally, into the yearly return, which has been used as the estimated yearly return of each bank for each year. EMPIRICAL FINDINGS One of the key objectives of this study is to estimate Weighted Average Cost of Capital (WACC) for selected private commercial banks in Bangladesh as no prior empirical study so far has been conducted in this regard in case of Bangladesh. Table 1 reports the detailed calculations of the estimated WACC (following Eq. 3) for 24 commercial banks of Bangladesh that are listed in Dhaka Stock Exchange for the period between January 2006 and December 2008. Table 1: Estimated WACC (2006-2008)

After-tax Cost of Debt- (2006) Cost of Equity- (2006) WACC- (2006) After-tax Cost of Debt- (2007) Cost of Equity- (2007) WACC- (2007) After-tax Cost of Debt- (2008) Cost of Equity- (2008) WACC- (2008) ABBL0. 0552-0. 18060. 04250. 05801. 53860. 16310. 0610-0. 07700. 0500 CBL0. 0382-0. 06820. 03250. 04150. 54960. 07150. 03800. 05600. 0393 IFICBL0. 0349-0. 09050. 02920. 03621. 15190. 10930. 03370. 08490. 0372 IBBL0. 05140. 11320. 05550. 04980. 59670. 08190. 0526-0. 10020. 0433 NBL0. 03380. 03610. 03400. 05120. 82750. 11390. 05430. 08840. 0572 PBL0. 0408-0. 08780. 03080. 03950. 90000. 11080. 04800. 06150. 0492 RBL0. 0363-0. 32980. 03470. 0354-0. 11700. 05590. 426-0. 15600. 0623 UBL0. 0257-0. 03950. 02270. 02540. 52450. 10390. 02730. 13440. 0340 EBL0. 04540. 01590. 04270. 0437-0. 02680. 03700. 05120. 18420. 0627 AABL0. 05010. 00560. 04660. 06040. 02330. 05790. 05750. 05510. 0574 PMBL0. 0448-0. 03310. 03990. 04631. 34820. 13240. 04700. 00380. 0444 SBL0. 05190. 00350. 04740. 05171. 05910. 14790. 05310. 05070. 0529 DBL0. 06180. 01160. 05920. 06220. 47610. 08470. 06340. 09770. 0653 NCCBL0. 0578-0. 00780. 05350. 05970. 83030. 11340. 06400. 04800. 0629 SIBL0. 0491-0. 01030. 04620. 0487-1. 1219-0. 03070. 04540. 28070. 0602 DBBL0. 04840. 07730. 04950. 04640. 38030. 06220. 04210. 18860. 0499 MTBL0. 0568-0. 03370. 5020. 05030. 46520. 07670. 05600. 05250. 0558 STDBL0. 0629-0. 03920. 05220. 06410. 66940. 13710. 05970. 01960. 0557 OBL0. 0460-0. 00630. 04260. 04591. 01270. 11040. 0486-0. 00500. 0447 BAL0. 0455-0. 05680. 03890. 05250. 64990. 09350. 0541-0. 00890. 0502 MBL0. 04950. 00570. 04680. 04810. 09650. 05130. 05050. 03090. 0493 EXMBL0. 0504-0. 00520. 04630. 04990. 61140. 09400. 05240. 01220. 0494 ICBL0. 06140. 06160. 06140. 03120. 2141-0. 05550. 00170. 2589-0. 0365 JBL0. 0670-0. 06810. 05650. 06740. 55110. 09780. 06870. 00630. 0644 The summary statistics of the estimated WACC of private commercial banks from 2006 to 2008 has been reported below in Table 2.

It can be seen from the table that the average WACC of commercial banks for 2006, 2007 and 2008 are 4. 42%, 8. 42% and 4. 84% respectively. It is also evident that there is moredispersion relative to the mean in WACC in 2008 compared with the WACC in 2006. However, the relative dispersion in the WACC is highest in 2007 as the coefficient of variation (CV) suggests whereas it is lowest in 2006. The highest WACC estimated in 2006 is 6. 14% whereas the lowest is 2. 24%. These figures for 2007 and 2008 are 16. 3% and -5. 6%, and 6. 54% and -3. 65%, respectively. Conclusion: From the findings it is seen that the cost of capital is becoming a strong force in explaining the market returns of the banking stocks.

One of the key reasons behind this is that the capital markets of Bangladesh are becoming more and more vibrant and efficient. For example the market capitalization of the DSE has increased by many folds in the last three to five years and new players are entering the market everyday. Therefore if the cost of capital can be reduced the expected return can go up. It is pertinent to mention that a strange positive association exists between the cost of capital and returns of the stocks in 2007 which might be due to the state emergency that was in effect during that time for which the normal operation of the capital market of the country was adversely affected.