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Revisiting Cost of Capital in Commercial Banks

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CHAPTER 1: INTRODUCTION 2 Background Capital Structure decision remains one of the corporate strategies to corporate managers because it affects firm’s value. This research is conducted within the commercial banks. In many research journals and articles the cost of capital is the expected rate of return of capital in investor’s investment. Weighted average cost of capital is considered as required rate of return in the company. Component of cost of capital are; long-term debt, preferred stock, and common stock. Each must have minimum return.

We analyze from previous research articles that the banks should not focus on historical cost but on new cost, because in order to invest and rise, new cost of capital is used to make decisions.

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Level of interest rates, tax rates are two of the factors that affects cost of capital in the commercial banks. Interest rates apply on debt and equity. It is the most important factor for investors. Cost of debt affects by the level of interest rates and also the cost of equity. As described in many articles, if interest rates increases the cost of debt increases, which increases the cost of capital.

So, the raising of capital delayed till interest rate become favorable. This shows how the interest rate can be a source effective measure of the cost of capital. Similarly, if the tax rates increases, the cost of debt decreases, which decrease the cost of capital as it affects the after tax cost. The cost of capital directly and totally linked with capital structure. Capital structure influence the value of the banks, firm, company potentially by reflects the financing strategy. And capital structure should consider tax strategies.

We found from different articles that the most important capital structure decisions are when the expected tax rates goes higher. The basic function of capital structure is to minimize the cost of capital and risk. Interest is tax deductable. The deductibility of interest payments provides influence for value. Higher the tax rate, the greater impact of deductibility of interest potentially on the after-tax cost of debt. These are the proved facts that are evaluated in previous researches. According to this research we are trying to find what role these factors play in commercial bank’s capital structure.

It is necessary for top management of any business institutions to ascertain the banks or firms relevant cost of capital. From the banks’ perspective, the cost of each source of capital reflects the level of return because it is affected by certain factors like tax rates, interest rates, dividends etc. as the time period changes, the level of return also changes. In its simplest form, the capital structure decision is the selection by firm management of debt-to-equity ratio for the firm. Cost of Capital is perhaps the most fundamental and widely used concepts in financial economies.

Managers of banks or corporation and also regulators employ the weighted average cost of capital for investment decisions. The WACC and the tax rates are endogenous to the firm’s debt policy. The interest rates affect the cost of debt as increasing debt increasing interest payments. We also derive the sources of capital structure that which source is better for the commercial banks and how the interest rates, tax rates brings variation in the cost of debt and the dividends and growth rates affects the cost of equity that totally affect the weighted average cost of capital.

Our methodology allows us to value the government tax rates and interest rates that affect cost of debt. We specify numerically the affects of the variations in the factor like interest rates, tax rates and dividends, thus providing useful conceptual framework for the tax and interest policy debates that influence cost of capital of debt and equity. Finally we come to analyze that cost of debt increase or decrease by variation in the interest rates and tax rates and that help in the estimation of WACC that show that whenever the WACC decreases, it results in an increase in the profit that is useful for any organization or commercial banks. . Problem statement (Revisiting the cost of capital in the commercial bank) The problem statement of this research proposal includes re-examine the cost of capital in commercial banking sector of Pakistan and also to evaluate the direct and indirect association of the factors that affects weighted average cost of capital and how this variation (increase or decrease) can affect the profit and also the capital structure -debt and equity- of the commercial banks. 2. Research objectives While doing research planning, we analyze that the cost of capital considers the factors affecting decision making.

The following object of the research comes into play: ? We will find out the factors which creates the variation (increase or decrease) on cost of capital and their effect on the capital structure decision making. ? To analyze the after effects of these factors on capital structure. ? To examine up to how much extent they are controllable or not from bank’s perspective. 3. Significance The importance of this research paper is that, the relation between the different determinants of the costs of capital creates different impact on the different commercial banks by affecting capital structure of that commercial bank.

We know that as the weighted average cost of capital decreases, it increases the profit n the Commercial Banks. Risk associated with cost of capital and capital structure taking needs to b looked at differently in the case of the commercial banking institutes. This research sheds new light on how the cost of capital computed in the case of commercial banks. Also the relationship between the cost of capital and capital structure is investigated. This research has another importance as banking system has a vital role to play in the economic development of a nation. A healthy economy requires a sound banking system.

This research states that how banks applies different techniques that enhance their performance and also affect the decision making of the Mangers regarding their capital. In this research, the main finding of the paper suggests that the commercial bank should focus on reducing the cost of capital that maximizes the profit. According to our findings, it is concluded that each banks has its policies of financing. Each bank takes decision of selecting capital structure for minimizing their cost, risk factor differently that occupies good financial position in market.

Factors that have impact on cost of capital as well as on capital structure are tax rates, interest rates, dividends payout, risk of default and other like market fluctuation, corporate governance. This research plays a vital role by showing the significant contribution of Commercial Banks while equating debt to equity ratio. It also shows the understanding of the performance of Banks by evaluating weighted average cost of capital. The main findings of the paper suggest that private commercial banks should focus on reducing the cost of capital which can magnify the returns to their stockholders.

Finally this research paper would also help the students in academics in understanding the relation between the factors and the cost of capital and also their after affects that create impact on the weighted average cost of capital. 4. Limitation Time constraint of this semester is the issue for this study as we have limited time in this semester as compared to the actual time required for the research. By being in banks we will acquire interviews approximately 15 -30 minutes with questionnaire because of the time given by the Mangers of Finance Division.

The information given by the managers is also limited because it difficult for them to provide all necessary information as they are bound by the policies of the commercial bank. 1. 6 Report Structure Chapter 1 represents the introduction of research topic its background, problem statement, objectives of research that set, significance of this research and limitations. This chapter gives brief information about the topic pervious information, the scope of research and its benefits, the target of the research. And also provides the basic information that already conducted by different authors researchers.

Chapter 2 deals with the literature review and conceptual framework. In this portion you will find the different views of different researchers related to this research topic cost of capital in commercial banks including capital structure importance its link with cost of capital, and factors that affect cost of capital. This portion also gives the direction and relevant information which is very helpful in proceedings the research. Conceptual framework helps in determining the relationships of factors with WACC.

Chapter 3 provides the detail of methodology that is adapted to proceedings the research. This portion gives explanation of research type, method, sample size, instruments that is used in finding and collecting the data. Chapter 4 gives the analysis of data that is collected through the questionnaire, interviews and calculating the WACC of commercial banks that chosen with assumptions, and research findings that proves the hypotheses that is set. Chapter 5 includes the conclusion of research findings and literature review findings.

Also gives the recommendations. Finally Appendix attach to our research that contain Questionnaire. CHAPTER 2: LITERATURE REVIEW AND CONCEPTUAL FRAMEWORK 1 Literature Review 2 Capital structure (Khadka 2005) has analyses in his research that the firms meet their operational needs by raising their funds and this can be done through the capital structure that involves the two major sources of debt and equity. There should be an appropriate balance between debt and equity as it has effects on the risk and return of the shareholders of the company.

If there are reasonable proportions of debt and equity in the capital structure of the firm, it maximizes the shareholders wealth while minimizing the cost of capital and that could be considered as the optimal capital structure. (John J. Pringle, Jun. , 1974) Since banks are private economic units, it is reasonable to suppose that shareholder interests will influence, if not control, managerial decisions. Capital is an important managerial decision variable and that it plays an important role in the financial management of the individual bank. Groth 1997) said that the selection of capital structure affects the cost of capital. Carefully selection of capital structure is more important. Banks and companies consider more conservative capital structure with sensitivity to cyclical effects of economy. It involves in dividing not in sharing. If payments of dividend are not deductible and if interest is tax deductible on debt then capital structure is important. Barton and Gordon (1987) Financing and capital structure choices are among the several key decisions made by firm managers.

Yet the study of these questions has been generally neglected by strategy researchers. Several scholars have noted that the issues involved are concerned with fundamental choices ‘which should support and be consistent with the long- term strategy of the firm. Balakrishnan and Fox (1993) said that by selecting suitable financing, a ‘firm’s ability to manage its relationship with lenders thus becomes a key source of competitive advantage. Capital is a critical resource for all firms, the supply of which is uncertain. This uncertainty enables the suppliers of finance to exert ontrol over the firm. Stearns (1986) and Mizruchi (1993) estimate the cost of equity capital use a dividend discount model (DDM) methodology and earnings estimates. They find that the cost of equity capital for large U. S publicly traded companies ranged between 10% and 12% during 1979-1995, depending on the assumptions used with the DDM approach. Interestingly, Myers and Borucki (1994) obtain the same range of estimates for the cost of equity capital of a limited sample of U. S. utility companies using a DDM-type method.

Bruner (1998) and Weaver(2001) surveying large corporation and confirm about WACC methodologies. Both authors find that there is a significant difference exists in estimating the equity capital component of the firm. Some uses CAPM while other uses different methods. 4 Cost of capital Cost of capital is the minimum required rate of return by investors in firm’s securities. It occupies an important role in the theory of financial management and in the investment decision making as it provides criteria for allocation of the capital that what a firm pays for its capital like debt, preferred stock and equity.

Cost of Capital is related with the level of risk associate with existing and new assets and investments. (Khadka 2005) Modigliani and Miller (1958) proved that firms cost of capital is independent of capital structure as it has no effect on the capital structure. The traditional belief of Modigliani and Miller (1963) is that the cost of capital can affect capital structure as in this belief they said that the personal taxes may include that brings variation in the cost of capital and hence affects the capital structure of the company. Khadka 2005) states that there is an empirical relationship between the cost of capital with capital structure, the size of the firm, growth of the firm, dividend payout ratio and liquidity of underdeveloped economy like Nepal but the major focus was the relationship of the leverage with the cost of capital where he conclude that negative beta shows that there is a negative relationship of cost of capital with the leverage as cost of capital decreases with the use of the leverage and this is done by the tax deductibility of the interest charges in the Nepalese firms.

Cost of capital is the expected rate of return of capital in investor’s investment. On debt, the amount of interest is paid is called cost of debt. Whereas cost of equity is equivalent to the risk free rate of interest plus risk premium for business risk. (Groth 1997). 5 Factors that affects cost of capital Groth (1997) further said that risk is one of the factors that affect the cost of capital which determines the expected risk of cash flow in the asset side of the bank. Business risk is that when bank and companies cash flow are not able to meet its operating expenses.

Risk is linked to economic changes. And it would be at risk to business risk when change in economy occurs and when financing is done by totally with equity. Cost of equity influenced by business risk. Equity holder’s risk has not accepted by the creditors and preferred stock holder if present. If increase in business risk occurs then it decreases the financial risk and the optimal D/E ratio, and increases the cash flow uncertainty of asset side. Financial risk is that when bank and companies cash flow are not able to meet its financial obligations. If firm finances through debt, then it has financial risk.

Tax rates and interest rates are also factors. Interest payment expected deductibility give opportunity for value. If the tax deductibility is realized by the company then stockholders get the expected benefit of the tax deduction. Jorgenson and Landau (1993) or Bond and Devereux (2003) analyses that the government’s choice of the corporate tax rate is an important factor with respect to the investment decision made by shareholders and it is well known that the existence of corporate taxes distort this investment decision away from the social optimum . John J. Pringle, Jun. (1974) said that the traditional function of risk-bearing, capital is important in adjusting the maturity structure of liabilities. Risk is a function of uncertainty regarding future events, e. g. , earnings, losses on loans and securities, fluctuations in deposits, conditions in the financial markets, etc. Cost of equity increases if the financial risk become high. The cost of equity and debt increases with the increase in debt. The deduction of tax and its benefit is an expected benefit, to allow deduction of interest; the pre-tax EBIT income must be large.

On after tax cost of debt, there is the greater the impact of interest deductibility, if the tax rate s higher. John R. Graham, (2003) analyze that the appropriate cost of capital in the presence of personal taxes does not depend directly on either the dividend payout rate or the tax on dividends. Equity shares have a market value lower than the difference between the reproduction cost of a firm’s assets and the market value of its debt obligations. Because of this capitalization, it need not be true that an economy without risk or uncertainty would have no equity financing.

Groth (1997) said that asymmetry of effects is that the expected return to stockholder will goes up, if in place of some equity; some debt is used. The good or bad leveraging effects are asymmetry if interest is tax deductable. The inability to realize the interest deduction result in an asymmetry effect on expected return to stockholder. Weighted average cost of capital become low with the cost of capital high, if the debt capital increase in proportion. Cost of equity increases with the cost of debt.

If the cost of components high the weighted average cost of capital increases and reason is that shareholder prefer to use of debt when expected value of tax benefit is attractive as compared to the added financial risk associated with the debt. The Demanded rate of increase in cost of debt and equity, effects on value of the expected increase in tax benefit of using more debt. Interest rate affects the cost of debt. It involves the risk components that have the probability of default on the debt. Meziane (2006) in his article said that a company pays interest which is treated as an expense for tax purpose and therefore it is tax deductable.

Company will be bankrupt, if default on payment of interest to bank present by company. Equity financing cannot create a tax advantage because dividends are paid after interest and tax. Interest is paid on debt before tax deduction, whereas, dividend is paid after tax benefit. So, the cost of equity is high then cost of debt. Debt financing becomes attractive when tax is deductable from interest. Banks use cost of capital for decisions, a weighted average interest on debt. Bank should select D/E ratio for which the cost of capital fluctuate with the degree of debt finance is minimized.

The D/E ratio is considered as one of the way of financing. (Alan J. Auerbach, aug. 1979). William F. Coffin and Sean Collin (2006) said that in the mid of 1990, a trend towards higher B/S debt in which low cost interest rate, lending level reduced by commercial banks and increase payback period for borrowers, a stable banking system. Cost of capital become low that could lower by the management in down market through viewing current corporate governance themes, taking action on giving management training with respect to capital market issues of today and advanced planning to identify the potential investors. Cost of capital and Corporate Governance Ramly and Rashid said corporate governance is also the factor that affects the cost of capital. CG directly affects the cost of equity, And indirectly with beta. This means poor performance of manager created through weak rights, thus increase cost of capital. Strong (weak) shareholders right associated with increase (decrease) cost of equity capital. CG generate liquidity problem in which investor high the sell price and decrease the buy price which can high the transaction cost and also affects the COEC.

Thus, the CG creates strong mechanism on COEC and provides positive shareholder value for firm. It has also reducing effects on cost of capital. Banks and other financial institutes have negative influence on CG. Hennart, (1994) Both classes of suppliers (debt holders and equity holders) have governance abilities. The level of governance ability varies between the two and the optimal selection of the type of financing depends on the nature of resources of the firm. Seth, (1990) financing choices have the potential to affect performance by changing the level of governance costs. Importance and difficulties of WACC Denis Boudreaux (1995) in his article uses the buildup model for the cost of equity capital by estimating cost of equity capital for capital budgeting analyses. He said that whenever there is a need to determine the value of the firm, the cost of capital must be estimated. He said that the cost of debt of closely held firm is much higher that the publicly traded organization because of the loans or debt borrowed by the closely held firms including the commercial banks.

He further said that the public traded firms have the low risk whereas a huge risk factor is involved in the closely held businesses. Experts have recognized that the exploitation of debt and equity can enhance the corporate value in 1940s. Later in the years, five concept developed on this area(1) early gearing leverage model; (2) the model of Modigliani and Miller (MM); (3) Capital Asset Pricing Model(CAPM); (4) Arbitrage Price Theory (APT); and (5) Gordon Model Shubbar and Alzafiri, (2008). Unless a firm can gain in excess of its cost of capital, it will not add value to its investor’s wealth.

Company’s cost of capital is expressed by the weighted average of the cost of individual sources of capital employed. Bruner et. al. , (1998). For a firm using common stock (equity) and bond (debt) financing, with re and rd as the cost of equity capital and the cost of debt capital, the WACC is expressed the following equation: WACC = r = wd rd (1 ? t) + we re Where, wd (weight (proportion) of debt) = (value of debt/value of debt and value of equity), we (weight (proportion) of equity) = (value of equity/value of debt and value of equity), wd + we = 1, and t = tax rate on corporate income.

The component costs, re and rd, as well as the weights are based on market values: re is frequently calculated as the risk free rate plus a risk premium, based on the capital asset pricing model, and rd reflects the market rates on the firm’s outstanding debt and on the rd of similar firms. The standard treatment includes (1? t) in the WACC calculation to reflect the deductibility of interest payments in the calculation of the corporate tax on the firm’s income statement: the interest cost of debt, by this procedure, is reduced.

Also, to avoid double counting the tax “advantage” of debt, the interest payments are not calculated in the prospective cash flows. This is the textbook treatment in calculating a firm’s cost of capital. (Miller2006) Evaluating a firm’s weighted average cost of capital has its importance to the managers who estimate investments projects for capital budgeting purposes or to the investor whose desire is to assess the overall riskiness and expected return from a company’s activities for valuation purposes. (Miller 2006).

Fama and French (1997, 1999) analyse that few difficulties arise because there is some uncertainty in evaluating a firm’s (or banks) cost of capital. This uncertainty is a sort of risk faced by the firm when projecting a project’s cash flow. Bruner, Eades, Harris, and Higgins, (1998) also analyze that there is wide variation in estimating WAAC by different methods. This is due to the manager’s differences in firms cost’s of equity capital that helps in investment decision making. 8 Conceptual Framework DV= DEPENDENT VARIABLE IV= INDEPENDENT VARIABLE MV=MODERATE VARIABLE 9 Conceptual Hypothesis

Ho: WACC increases with increase in interest rates and decreases with decrease in interest rates. H1: WACC increases with decrease in tax rates and decreases with increase in interest rates. H3: Cost of debt increases with increases in interest rate and decreases with decrease in interest rates. H4: Cost of debt increases with decrease in tax rates and decreases with increase in interest rates. CHAPTER 3: RESEARCH METHODOLOGY 10 Type of Research Research can be defined as the search for knowledge, or as any systematic investigation, with an open mind and facts, usually using a scientific method.

Our research is empirical research, which tests the feasibility of a solution using empirical evidence. This research comprises of both the qualitative and quantitative research method for the data analysis. Firstly we search for the secondary data in order to know and understand the analysis of the previous researcher that how they work and create different perspective for the Weighted Average Cost of Capital than we include the researches of the previous researcher in the literature review of this research in order to create relation and direction between the previous researches with our research. 1 Sampling Technique Sampling Technique used in our research is Random Sampling in which we chosen from a population for investigation. In this method we chose from managers in the Commercial Banks and estimates obtained from the random sample in order to solve our queries related to WACC. 12 Sample Size The Sample Size is comprises of 5 Commercial Banks of Karachi. More than the given sample size is not possible because of the time of this semester and also the little difficulty in finding the appointments with the Mangers of Finance Departments. 3 Instruments Questionnaire includes 12 question given to the Managers of the Commercial Banks in order to analyses the perception of the manager that how each individual differs in their perception for the factors that affects the weighted average cost of capital. Most of them include five point likert scales. Other than questionnaire, the balance sheet of 2009 of each bank is used to estimate the WACC for the year and evaluate how the factors like tax rates, interest rates affect WACC. 14 Data Collection

This research has been carried out to evaluate the correlation between the factors of cost of capital like tax rates, interest rates and the WACC that how these factors affect the WACC in the commercial banks. The selected five banks include: Allied Bank Limited (ABL), Habib Bank Limite(HBL), Muslim Commercial Bank(MCB), Alfalah Bank and Soneri Bank Limited. Descriptive Data Analysis is taken place in order to estimate WACC. This study employs after-tax cost of debt and 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.

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 the year 2009 by the following formula: After-tax cost of debt = pre-tax cost of debt (1 – tax rate) The cost of equity evaluated through the given formula: Cost of equity = Gordon growth model =(Do (1 + g))/ (market price per share)] + g) Finally the Weighted Average Cost of Capital calculated by WACC = (Weighted average cost of debt) + (weighted average cost of equity) CHAPTER 4: DATA ANALYSIS 15 QUESTIONNAIRE ANALYSIS Banks normally prefer financing through debt plus equity. 1% of the commercial banks use both (debt and equity) as their sources of finance while remaining 29% of the banks prefer debt for their investment. Only exploitation of equity is not preferred by any banks because through debt finances, the banks gain and improves profit. [pic] Equity sources liable bank to pay dividend, 71% of the banks says that the dividend payment increases the cost of capital while the other 14% said that it decrease the cost of capital and the remaining said that dividend payment has no such impact on the cost of capital. [pic] 5% of the commercial banks said that by using tax shield, cost of capital decreases as it decreases cost of debt and also impact interest rates. While 14% said that it has no such impact like some of Islamic bank like Meezan Bank. [pic] 71% of the sample size agreed that the Cost of capital has positive impact on the capital structure by using both sources of finance while 15% disagree and other 14% are highly disagree. That means most of the commercial banks are in the favor of Ho that the using both sources improves the profit of the commercial bank. [pic] 7% agrees and 28% strongly agrees that the risk factor of the default increases as there is an increases liabilities when bank finance through debt while only 10% of the sample size disagree to this fact but still they have profit by increasing their liabilities. [pic] Approximately 86% of the commercial banks agree from the fact that the fluctuation in the interest rate affects Cost of Capital and also the Capital Structure of their banks while other says that there is no as such impact of the interest rates but from secondary data we analyze that interest rate is the factor that affects the cost of capital and the capital structure. pic] 71% of the managers agrees that as low dividend payout affects the reputation of their bank, similarly high dividend payout and dividend growth also affect the capital structure decision whereas 29% of the managers said that high dividend has no such impact on the cost of capital and on investment decision. [pic] 100% of the sample size agrees that cost of capital highly impact the investment decision in the commercial bank that also affects capital structure decision making and increases the profit if the weighted average cost of capital is low. [pic] 5% of the sample size agrees that the cost of capital has a huge impact on the level of risk because the maximization of the profit in the commercial bank is truly based on cost of capital and its other factors. [pic] 57% of the sample size agree that the taxes bring variation in the cost of capital in commercial bank while the other denied that taxes has no such affects on cost of capital but many researches has proved that taxes highly affects the cost of capital. [pic] 100% of the managers agree that weighted average cost of capital reduces as there is reduction in the net financial debt.

It can be explained by the fact that if the cost of debt remains same but there is variation in the weightage of the debt. The lower weightage reduces the WACC of the commercial bank. [pic] While the method used for the cost of equity varies in different banks. 15% uses the CAPM, 42% uses the Gordon Growth Model whereas the remaining percentage uses both the CPM and Gordon Growth Model method when they finances through the equity. [pic] 16 DESCRIPTIVE ANALYSIS 17 Allied Bank Limited WACC = (Weighted average cost of dbt) + (weighted average cost of equity)

WACC = (interest (1-tax)) + (Do (1 + g))/ (market price per share)] + g) COST OF EQUITY: |YEAR |2005 |2006 |2007 |2008 |2009 | |DIVIDEND/SHARE |2. 5 |2. 5 |3 |3. 5 |4 | |GROWTH |0% |0% |20% |16. 66% |(14. 28%) | Average growth=4. 476% Cost of equity = Gordon growth model =(Do (1 + g))/ (market price per share)] + g) Cost of equity =4(1+0. 4476)/59. 11+0. 04476 = 11. 54% | |g |Growth Rate |4. 476% | | |Do |Last Dividend |4 | | |MP |Market Price |59. 11 | | | | | | COST OF DEBT: Interest Rate = 9. 619% Tax rate = 32. 4% Weighted average cost of debt after tax = 0. 09619(1-0. 324)

Weighted average cost of debt after tax =6. 503 % WEIGHTED AVERAGE COST OF CAPITAL: | |AMOUNT |%AGE COMPONENT |COST |WACC | | |Thousand |(a) |(b) |(a*b) | | |(000) | | | | |DEBT |39,457,216 |0. 0055 |0. 650 |0. 00036 | |EQUITY |7,110,007,580 |0. 9945 |0. 1154 |0. 11476 | |TOTAL |7,149,464,796 | | |0. 11512 or 11. 51% | ANALYSIS In order to prove our research hypotheses, we find different relation between the interest rates, cost of debt and WACC; we assume different variation in the interest rates as it is the independent variable that affects the WACC hich is the dependent variable. In 2009, the interest rate of ABL was 9. 619%, we assume two different rates in which one is greater than 2009 rate i. e. 15% and other is less than 2009 interest rate i. e. 7. 00%. As the interest rates increases, it also increases the cost of debt that results in the increase in the weighted average cost of capital. Hence, hypotheses Ho and H3 of our research has proved by this analysis because as the interest rate decreases to 7. 00%, the cost of debt also declines which result in decreases in the WACC and vice versa. INTEREST |COD |WACC | |7. 00% |4. 73% |11. 50% | |9. 62% |6. 50% |11. 51% | |15. 00% |10. 14% |11. 52% | pic] For the relation between the taxes rates, cost of debt and WACC. We find different variations among them. Tax rates are the independent variable so they create different affects on WACC as it is dependent variable. In 2009, ABL has the tax rate of 32. 40%. Similarly we assume one tax rate greater than 32. 4% and another is less than 32. 4% in order to prove our hypothesis. From the following analysis, we come to know that as the tax rates increases, it decreases the cost of debt that results in the decrease in the weighted average cost of capital.

Hence, hypotheses H1 and H4 of our research have proved by this analysis. |TAX RATES |COD |WACC | |30% |6. 73% |11. 84% | |32. 40% |6. 50% |11. 51% | |35% |6. 25% |11. 50% | [pic] 8 Habib Bank Limited (HBL) WACC = (Weighted average cost of debt) + (weighted average cost of equity) WACC = (interest (1-tax)) + (Do (1 + g))/ (market price per share)] + g) COST OF EQUITY: |YEAR |2005 |2006 |2007 |2008 |2009 | |DIVIDEND/SHARE |1. 5 |1. 48 |1. 48 |3. 01 |0. 30 | |GROWTH |0 |-1. 333% |0 |103. 378% |-90. 033% | Average growth=2. 4024%

Cost of equity = Gordon growth model =(Do (1 + g))/ (market price per share)] + g) Cost of equity = 0. 03 (1+0. 024)/40. 9+0. 024 = 2. 475% | |g |Growth Rate |2. 4024% | | |Do |Last Dividend |0. 03 | | |MP |Market Price |40. 90 | | | | | | COST OF DEBT: Interest Rate = (LIBOR+1. 75) = 18. 65% Tax rate = 37. 2% Cost of debt after tax = 18. 65 (1 – 0. 3732) Cost of debt after tax = 11. 69% WEIGHTED AVERAGE COST OF CAPITAL: | |AMOUNT |%AGE COMPONENT |COST |WACC | | |Thousand |(a) |(b) |(a*b) | | |(000) | | | | |DEBT |33,536,837 |0. 786 |0. 169 |0. 0912 | |EQUITY |9,108,000 |0. 214 |0. 0246 |0. 0053 | |TOTAL |42644837 | | |0. 0965 or 9. 65% | ANALYSIS We find different relation between the interest rates, cost of debt and WACC in order to prove our research hypothesis. We assume different variation in the interest rates as it is the independent variable that affects the WACC which is the dependent variable.

In 2009, the interest rate of HBL was 18. 65%, we assume two different rates in which one is greater than 2009 rate i. e. 20% and other is less than 2009 interest rate i. e. 12. 00%. As the interest rates increases, it also increases the cost of debt that results in the increase in the weighted average cost of capital, this can easily proved by given table and you can also find this relation through the given graph. Hence, hypotheses Ho and H3 of our research has proved by this analysis because as the interest rate decreases to 12%, the cost of debt also declines to from 11. 69% to 7. 2% and which result in decreases in the WACC from 9. 65% to 6. 44% and vice versa. |INTEREST |COD |WACC | |12% |7. 52% |6. 44% | |18. 65% |11. 69% |9. 65% | |20% |12. 536% |10. 38% | pic] Tax rates are the independent variable so they create different affects on WACC as it is dependent variable. In 2009, HBL has the tax rate of 32. 40% that having COD 6. 503% and a WACC of 11. 51%. Similarly we assume one tax rate greater than 32. 4% and another is less than 32. 4% in order to prove our hypothesis. From the following analysis, we come to know that as the tax rates increases, it decreases the cost of debt that results in the decrease in the weighted average cost of capital. Hence, hypotheses H1 and H4 of our research have proved by this analysis. Tax rates |COD |WACC | |30% |6. 73% |11. 84% | |32. 4% |6. 503% |11. 51% | |35% |6. 25% |11. 50% | [pic] 19 Muslim Commercial Bank (MCB)

WACC = (Weighted average cost of debt) + (weighted average cost of equity) WACC = (interest (1-tax)) + (Do (1 + g))/ (market price per share)] + g) COST OF EQUITY: |YEAR |2005 |2006 |2007 |2008 |2009 | |DIVIDEND/SHARE |4. 5 |5. 1 |5. 6 |6 |6. 8 | |GROWTH |0 |13. 33% |9. 8% |7. 14% |13. 33% | Average growth=8. 72%

Cost of equity = Gordon growth model = (Do (1 + g))/ (market price per share)] + g) Cost of equity=6. 8(1+0. 0872)/189. 79+0. 0872 =12. 62% | |g |Growth Rate |8. 72% | | |Do |Last Dividend |6. 8 | | |MP |Market Price |189. 79 | | | | | | COST OF DEBT: Interest Rate = 12. 75% Tax rate = 33. 07% Cost of debt after tax = 12. 275 (1 – 0. 3307) Cost of debt after tax = 8. 216% WEIGHTED AVERAGE COST OF CAPITAL: | |AMOUNT |%AGE COMPONENT |COST |WACC | | |Thousand (000) |(a) |(b) |(a*b) | |DEBT |44,662,088 |0. 0221 |0. 0822 |0. 0018 | |EQUITY |1,972,537,950 |0. 778 |0. 1262 |0. 1234 | |TOTAL |2,017,200,038 | | |0. 1252 or 12. 52% | ANALYSIS From many different previous researches, we find different relation between the interest rates, cost of debt and WACC. We assume different variation in the interest rates as it is the independent variable that affects the WACC which is the dependent variable. In 2009, the interest rate of MCB was 12. 28%, we assume two different rates in which one is greater than 2009 rate i. . 11. 6% and other is less than 2009 interest rate i. e. 14. 90% in order to find the after affects of these changes. Remaining other things constant, as the interest rates increases, it also increases the cost of debt that results in the increase in the weighted average cost of capital, this can easily proved by given table and you can also find this relation through the given graph. Hence, hypotheses Ho and H3 of our research has proved by this analysis because as the interest rate decreases to 11. 6%, the cost of debt also declines to from 8. 22% to 7. 6% and which result in decreases in the WACC from 12. 52% to 12. 51% and vice versa. |INTERSET RATES |COD |WACC | |11. 60% |7. 76% |12. 51% | |12. 28% |8. 22% |12. 52% | |14. 90% |9. 97% |12. 6% | [pic] For the relation between the tax rates, cost of debt and WACC. We find different variations among them. Tax rates are the independent variable so they create different affects on WACC as it is dependent variable. In 2009, MCB has the tax rate of 33. 07%. Similarly we assume one tax rate greater than 33. 07% and another is less than 33. 07% in order to prove our hypothesis. From the following analysis, we come to know that as the tax rates increases, it decreases the cost of debt that results in the decrease in the weighted average cost of capital.

Hence, hypotheses H1 and H4 of our research have proved by this analysis. |TAX RATES |COD |WACC | |30% |8. 59% |12. 53% | |33. 07% |8. 22% |12. 52% | |40% |7. 36% |12. 50% | pic] 20 Al-falah Bank Limited WACC = (Weighted average cost of debt) + (weighted average cost of equity) WACC = (interest (1-tax)) + (Do (1 + g))/ (market price per share)] + g) COST OF EQUITY: |YEAR |2005 |2006 |2007 |2008 |2009 | |DIVIDEND/SHARE |0. 5 |1. 25 |1 |2. 25 |2. 25 | |GROWTH |0 |150% |-20% |125% |0 | Average growth=51%

Cost of equity = Gordon growth model =(Do (1 + g))/ (market price per share)] + g) Cost of equity = 2. 25(1+0. 51)/26. 13+0. 51 = 64% | |g |Growth Rate |51% | | |Do |Last Dividend |2. 25 | | |MP |Market Price |26. 13 | | | | | | COST OF DEBT: Weighted average Interest Rate = 6. 406%.

Tax rate = 34. 84% Cost of debt after tax = 0. 06406 (1 – 0. 3484) Cost of debt after tax = 4. 174% WEIGHTED AVERAGE COST OF CAPITAL: | |AMOUNT |%AGE COMPONENT |COST |WACC | | |Thousand (000) |(a) |(b) |(a*b) | |DEBT |18,687,600 |0. 00138 |0. 0417 |0. 000057 | |EQUITY |13,491,562,500 |0. 986 |0. 64 |0. 639104 | |TOTAL |13,510,250,100 | | |0. 639 or 63. 9% | ANALYSIS Many different researches have concluded that different variation in the interest rates as it is the independent variable that affects the WACC which is the dependent variable. In 2009, the interest rate of Alfalah Bank was 6. 404%, we assume two different rates in which one is greater than 2009 rate i. e. 8. 6% and other is less than 2009 interest rate i. . 4. 6% in order to find the after affects of these changes. Remaining other things constant, as the interest rates increases, it also increases the cost of debt that results in the increase in the weighted average cost of capital, this can easily proved by given table and you can also find this relation through the given graph. Hence, hypotheses Ho and H3 of our research has proved by this analysis because as the interest rate decreases to 4. 6%, the cost of debt also declines to from 4. 174% to 2. 997% and which result in decreases in the WACC from 63. 914% to 63. 0% and vice versa. |INTEREST RATES |COD |WACC | |4. 6% |2. 997% |63. 90% | |6. 406%. |4. 174% |63. 914% | |8. 6% |5. 604% |63. 918% | [pic] For the relation between the taxes rates, cost of debt and WACC.

We find different variations among them. Tax rates are the independent variable so they create different affects on WACC as it is dependent variable. In 2009, Alfalah has the tax rate of 34. 84%. Similarly we assume one tax rate greater than 34. 84% and another is less than 34. 84% in order to prove our hypothesis. From the following analysis, we come to know that as the tax rates increases, it decreases the cost of debt that results in the decrease in the weighted average cost of capital. Hence, hypotheses H1 and H4 of our research have proved by this analysis as they are negatively correlated. TAX RATES |COD |WACC | |25% |4. 805% |63. 917% | |34. 84%. |4. 174% |63. 9% | |40% |3. 844% |63. 915% | [pic] 21 Soneri Bank Limited ANALYSIS

Soneri Banks has following interest rates and tax rates, which affect WACC in the same manner as it affects other commercial Banks. In 2009, it has interest rate of 12. 63% that has the cost of debt 8. 54% and the WACC is of 0. 37%. Variation in the interest rates brings following changes and hence proves our research. |INTEREST RATES |COD |WACC | |11. 60% |7. 84% |0. 35% | |12. 3% |8. 54% |0. 37% | |14. 60% |9. 87% |0. 43% | [pic] Tax rates posses the same affect. As tax rates increases, it has negative relation with the COD and WACC that proves the hypothesis H1 and H4 of our research as in 2009, the tax rate was 32. 34%, when it decrease, the COD increases which also increases WACC and again inversely proportional when Tax rate increase. TAX RATES |COD |WACC | |25% |9. 47% |0. 41% | |32. 34% |8. 54% |0. 37% | |40% |7. 57% |0. 33% | [pic] CHAPTER 5: CONCLUSION AND RECOMMENDATION 1. Conclusion

According to past related researches, there should be a suitable balance between debt and equity as it has effects on the risk and return of the shareholders of the bank. If there are reasonable proportions of debt and equity in the capital structure, it maximizes the shareholders wealth while minimizing the cost of capital and that could be considered as the optimal capital structure. Factors like Interest payment expected deductibility give prospect for value. If the tax deductibility is realized by the bank then stockholders get the expected benefit of the tax deduction.

If firm finances through debt, then it has financial risk. And if through equity, then it has business risk. The cost of capital can affect capital structure that the taxes bring variation in the cost of capital and hence affect the capital structure of the banks. Cost of equity increases if the financial risk become high. The cost of equity and debt increases with the increase in debt. On after tax cost of debt, there is the greater the impact of interest deductibility, if the tax rate s higher. Weighted average cost of capital become low with the cost of capital high, if the debt capital increase in proportion.

Cost of equity increases with the cost of debt. If the cost of components high the weighted average cost of capital increases and reason is that shareholder prefer to use of debt when expected value of tax benefit is attractive as compared to the added financial risk associated with the debt. The Demanded rate of increase in cost of debt and equity, effects on value of the expected increase in tax benefit of using more debt. Interest rate affects the cost of debt. It involves the risk components that have the probability of default on the debt.

In this research, the main finding of the paper suggests that the commercial bank should focus on reducing the cost of capital that maximizes the profit. According to our findings, it is concluded that each banks has its policies of financing. Each bank takes decision of selecting capital structure for minimizing their cost, risk factor differently that occupies good financial position in market. Factors that have impact on cost of capital as well as on capital structure are tax rates, interest rates, dividends payout, risk of default and other like market fluctuation, corporate governance.

These factors differently affect the cost of capital and capital structure of each commercial bank. Some banks agree that tax brings variation in the capital structure as the use of taxes decreases the cost of debt but some banks strongly disagree, like Islamic bank Meezan and Alfalah,. These Islamic banks have no such interest rate risk. Tax impacts on cost of capital increases cost of capital agrees by majority of commercial banks, and disagrees by some commercial banks. Dividend impacts on cost of capital increases cost of capital agrees by some banks, and disagrees by some banks.

Interest rate brings effects on increase in cost of capital as the interest rate increases the cost of debt also increases but some banks strongly disagreed. Other factors like market fluctuation also influence interest rate to increase. And sometimes sudden increase in interest rates influence market. Due to this, all factors differently impact on cost of capital variation (increase and decrease) and capital structure decision making. We have estimated Weighted Average Cost of Capital (WACC) of commercial banks in order to find the effects of cost of capital and their factors on profit and capital structure decision making.

We analyze from computing WACC with different assumptions that; • The interest rates increases (decreases), it also increases (decreases) the cost of debt that results in the increase (decreases) in the weighted average cost of capital. Hence, hypotheses Ho and H3 is verify. • The tax rates increases (decreases), it decreases (increases) the cost of debt that results in the decrease (increases) in the weighted average cost of capital. Hence, hypotheses H1 and H4 is verify. The cost of capital improves the profit and capital structure decision making in which other factors also takes part to maximize the profit in the commercial banks. . Recommendations Cost of capital plays a central role in valuation, portfolio selection, and capital budgeting. Therefore, measuring and validating the cost of capital has been the subject of much research. • For reducing cost of capital of bank, we recommend that proportion of debt plus equity financing is better although debt increases risk of default as most of the commercial banks prefer debt financing. Because, debt financing provides tax benefit under suitable market conditions and reduces WACC. • Through equity financing banks give dividend which increases their reputation in market.

In short, payment of dividend gives market position. And it is also important because in terms of financial ratios, equity financing shows bank more strong as compared to debt or liabilities. • Adopt an optimal capital structure to improve shareholder value. Capital structure is part of a bank’s package of financial policies, which include dividend policy and amount of debt and equity claims issued which improves share holder wealth and reduces WACC. Conventional thinking in the area of finance has also assumed that a certain amount of debt in the capital structure is a good thing. Interest rates are high in Pakistan.

The following reforms looked-for from the Government of Pakistan (GOP): • Allow and encourage consideration of financial institutions to reduce disintegration in the financial sector. • Strengthen legal and judicial reform laws to allow financial institutions to foreclose on guarantee to reduce risk in the case of unpaid loans without going through lengthy court proceedings. CHAPTER 7: AREA OF FURTHER STUDIES After performing this research we have concluded that the researches on the Weighted Average Cost of Capital in Banks are less or there is no proper research that has taken place for the Commercial Banks.

There should be more researches on the factor that are affecting WACC in the commercial banks as its proper estimation maximizes profit. It is found with the help of weightage there is a huge impact on the cost of capital that may be a source of further studies for the commercial bank because proper weightage of debt and equity can improves or enhances the profit of commercial banks. The WACC affects the profit or Capital Structure decision making that has direct affect on the reputation of the commercial banks. CHAPTER 8: REFERENCES • Nadeem A.

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French, 1997, Industry costs of equity, Journal of Financial Economics 43, 153-193. • Fama, E. F. , and K. French, 1999, The corporate cost of capital and the return on corporate investment, Journal of Finance 54, 1939-1967. • John J. Pringle, the Capital Decision in Commercial Banks, the Journal of Finance, Vol. 29, No. 3 (Jun. , 1974), pp. 779-795 • Richard Lambert*, Christian Leuz, Robert E. Verrecchia “Accounting Information, Disclosure, and the Cost of Capital” September 2005, Revised, August 2006 • Barton, S. L. and P. J. Gordon (1987). ‘Corporate strategy: Useful perspective for the study of capital structure? Academy of Management Review, 12, pp. 67-75 • Balakrishnan, S. and I. Fox (1993). ‘Asset specificity, firm heterogeneity, and capital structure’, Strategic Management Journal, 14(1), pp. 3-16. • A. Seth (1990). ‘The impact of LBOs on strategic direction’, California Management Review, 32(1), pp. 30-43. • Groth John C. , “Capital structure: Perspectives. ” Management Decision 35:7 (1997): 552–561. • John C. Groth, Professor, Texas A University, USA “Capital Structure: Implications”, 1997. • Ross, Stephen A. , Randolph W. Westerfield, and Jeffrey Jaffe. Corporate Finance. 9th ed.

Boston, MA: McGraw-Hill, 2010. • Alan J. Auerbach, Wealth Maximization and the Cost of Capital, the Quarterly Journal of Economics, Vol. 93, No. 3 (Aug. , 1979), pp. 433 • John R. Graham, “Taxes and Corporate Finance: A Review”, the Review of Financial Studies, Vol. 16, No. 4 (Winter, 2003), pp. 1075-1129 • Meziane Lasfer, Professor, Cass Business School, UK “Optimizing the Capital Structure: Finding the Right Balance between Debt and Equity”. • William F. Coffin and Sean Collin, 2006, Techniques to lower the cost of capital in today’s volatile markets, CCG Investor Relations. Ali Murtaza, manager financial reporting and analysis, finance division, BANK ALFALAH LIMITED. • Amir Ahmed, risk manager, Asst. vice president, Risk Management Unit, MEEZAN BANK. • Aniel Victor, Asst. manager, Riak management, UBL FUNDS MANAGERS. • Syed Ali Shabar, Branch Manager, MCB BANK LIMITED. • Raza Abbas, Asst. vice president, Portfolio Management, HABIB BANK LIMITED. • Aamir Maysorewala, customer service manager, ALLIED BANK LIMITED. • Riazullah Khan, Assistant Vice President & Manager, SONERI BANK. APPENDIX A Questionnaire NAME_________________________

DESIGNATION_________________ BANK__________________________ BRANCH_______________________ 1. Debt and equity are the sources of finance, through which source your bank finances their investment? a) Debt b) Equity c) Both 2. What is the impact of dividend payment on cost of capital as using equity is source of finance that will liable bank to pay dividend? a) Increase cost of capital b) Decrease cost of capital c) No impact on cost of capital 3. Tax shield also has an important factor in cost of capital, how tax impact on cost of capital? a) Increase cost of capital b) Decrease cost of capital ) No impact on cost of capital 4. Cost of capital has positive impact by using both sources of finance. [pic] 5. When bank finance through debt, it increase liabilities that also increase the risk factor of default. [pic] 6. Fluctuation in the interest rate affects Cost of Capital and also the Capital Structure of your banks. [pic] 7. As low dividend payout will affect the reputation of your bank, is high dividend payout and dividend growth affect the capital structure decision? [pic] 8. Cost of capital occupies an important role in the financial management and in investment decision making in commercial banks. [pic] . Cost of capital affects the level of risk in commercial bank. [pic] 10. Taxes bring variation in the capital structure of commercial banks. [pic] 11. Reducti