Banks Optimal Capital Structure will reduce short term loan interest rates

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yasaswi gomes 30 November 2020

Cost-Plus loan pricing method and interesting facts about it:

The Debt and Equity along with costs of capital do play a crucial role in fixing short term 1-2 years interest rates.

Total Debt		40,00,000
Kd		10%
Total Equity		60,00,000
Ke		19%
WACC		4%	+	11%	=	15%
Servicing costs		1%
Risk premium		2%
Loans given out (Assets)		1,00,00,000
Profit margin		11%	(Ke * E/A)
Profit		11,40,000	(Ke * E)
Bank Working Capital		20,000
Profit margin excluding Working Capital		14%	(Ke * E/ A-WC)

Cost Plus loan price=		WACC + Service Cost+ Risk Premium + Profit Margin Excluding working capital
Interest	=	33%

Now if we change the debt structure:

Total Debt		60,00,000
Kd		10%
Total Equity		40,00,000
Ke		19%
WACC		6%	+	8%	=	14%
Servicing costs		1%
Risk premium		2%
Loans given out (Assets)		1,00,00,000
Profit margin		8%	(Ke * E/A)
Profit		7,60,000	(Ke * E)
Bank Working Capital		20,000
Profit margin excluding Working Capital		9.50%	(Ke * E/ A-WC)

Cost Plus loan price=		WACC + Service Cost+ Risk Premium + Profit Margin Excluding working capital
Interest charged	=	26%

Note: Consider WACC as Marginal WACC under this current situation.

Attached File : 2750458 20201130192114 new microsoft excel worksheet.xlsx

Aditi Kaur (Practising CA) 01 December 2020

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ayusmita (Tax consultant) 30 November 2020

Elaborate in simply way

yasaswi gomes 30 November 2020

Ok!! The capital Structure philosophy is true. The optimal capital Structure will minimise costs of funding and this will reduce interest rates. The first one has lower debt proportions and higher equity, hence a company has to earn additional money to payback the lenders and shareholders. So the bank will charge more interest rates. In the next model, capital Structure changed and required rate of return to pay back customers is reduced, this will allow the loans to be given at lower rates.