Equity Debt and Cost of Capital for Banks

Note that we did not estimate a cost of capital for Deutsche Bank even though we have estimates of the costs of equity and debt for the firm. The reason is simple and goes to the heart of how firms view debt. For non-financial service firms, debt is a source of capital and is used to fund real projects - building a factory or making a movie. For banks, debt is raw material that is used to generate profits. Boiled down to its simplest elements, it is a bank's job to borrow money (debt) at a low rate and lend it out at a higher rate. It should come as no surprise that when banks (and their regulators) talk about capital, they mean equity capital.63

There is also a practical problem in computing the cost of capital for a bank. If we define debt as any fixed commitment where failure to meet the commitment can lead to loss of equity control, the deposits made by customers at bank branches would qualify and the debt ratio of a bank will very quickly converge on 100%. If we define it more narrowly, we still are faced with a problem of where to draw the line. A pragmatic compromise is to view only long term bonds issued by a bank as debt, but it is an artificial one. Deutsche Bank, for instance, had long-term debt in December 2003 was 82 billion Euros, common equity with a market value of 40.96 billion Euros and preferred stock with a market value of 4.1 billion Euros. Using the cost of equity of 8.76% (from illustration 4.11), the after-tax cost of debt of 3.13% from illustration 4.12 and the cost of preferred stock (6.36%) from illustration 4.13:

Cost of capital = 3.13% (82/127.06) + 8.47% (40.96/127.06) + 6.36%(4.1/127.06) = 5.05%

With Deutsche Bank, we will do almost all of our analyses using the cost of equity rather than the cost of capital.

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