RAROC Model

Barb Williams and Rick Thomas, while attending an executive education course at a well-known business school, came across a case which involved calculating the cost of capital for Telus Corporation (Telus). Basic data such as the Balance Sheet, Income Statement, Data on Telus’ Common Stock, Market Index, and the Average Annual Returns in North American Capital Markets were provided. In order to calculate Telus’ cost of capital we need to calculate the company’s Cost of Equity, Cost of Debt, and Tax Rate along with their weighted cost and then apply these to the Weighted

We use Capital Asset Pricing Model (CAPM) approach to calculate the cost of equity. The formula of CAPM is re = rf + β × (E[RMkt] – rf).

Week 1 – Introduction – Financial Accounting (Review) Week 2 – Financial Markets and Net Present Value Week 3 – Present Value Concepts Week 4 – Bond Valuation and Term Structure Theory Week 5 – Valuation of Stocks Week 6 – Risk and Return – Problem Set #1 Due Week 7* – Midterm (Tuesday*) Week 8 - Portfolio Theory Week 9 – Capital Asset Pricing Model Week 10 – Arbitrage Pricing Theory Week 11 – Operation and Efficiency of Capital Markets Week 12 – Course Review – Problem Set #2 Due

Peoples had accumulated assets of $556m. These assets were funded by short term consumer deposits, consisting largely of 3-month fixed rate savings certificates. These savings certificates were highly affected by interest rate fluctuations. The long term loans provided to people generate interest earnings which are do not increase or decrease with the interest rate fluctuations. Therefore, there was a mismatch between the interest rates earned by the bank and the interest rates that it had to give

In November 2001, the costs of required rates of return on debt in the capital market are as follows:

Since the onset of the financial crisis 2008, the sovereign debt crisis in western economies and the new financial regulation with Basel III coming up, the financial industry faces the challenge of reinventing itself. The ring-fence for Commercial and Investment Banking, and new economic and regulatory capital requirements will determine the kinds of products banks will be able to distribute. It will have a huge impact in the Investment Banking business, which will suffer tough regulation and supervisory procedures. At the same time, credit risk models will be reviewed because they have failed to predict the crisis of 2008. The current financial and economic crisis doesn’t have any precedent in the past.

At first, WACC and CAPM was attempted to be used as a source of cost of capital. However, for WACC, there is no available proportion of debt and cost of debt for MW. For CAPM, no available data seems to support the acceptable

* We assume the cost of capital to be a stated annual rate to facilitate calculations;

• Interest rate risk: Evaluating management of interest rate risk including the ability to accurately identify and quantify interest rate risk in assets and liabilities under varying model

3) What is the weighted average cost of capital and why is it important to estimate it? Is the

Normally, each bank tries to attract competitors clients by lower financing, preferred rate and investment services. This market is in the stage who could offer the best product with fastest service at reasonable price however this also causes bank to experience lower margin or return on asset (ROA).

The company’s objective is to improve its competitive position in deep-discount brokerage. In order to achieve this objective, the company must grow its customer base, requiring an investment of $100 million to upgrade its technological capabilities as well as an increase of $155 million for its advertisement budget. In order to evaluate the company’s cost of capital, we used the Cost Asset Pricing Model. Since the company went public recently, it would not be an accurate assessment of the risk of

amount of loan is USD 423 million which is almost 3 times more than average syndicated loan issued by

L1 - Modigliani & Miller (1958) ‘The Cost of Capital, Corporation Finance and the Theory of Investment’

Note – The book “Financial management” suggests the balance amount of loan one owes must be equal to the present value of the remaining loan payment (Titman et all, 2014). The information regarding the calculation of loan and outstanding loan gave us a fair idea about how the loan financing occur. Another important aspect learned is how the principle and interest affect the amount of any loan. This knowledge also brought other factors into consideration such as refinancing mortgage loan cost. The refinancing cost involves distinct hidden costs such as appraisal fee, legal fee, origination fee, and application. Hence, if one plan to refinance the loan by getting attracted to lower interest rate. The refinance must put some extra money aside to pay the refinancing cost.