Banks Optimal Capital Structure will reduce short term loan interest rates

yasaswi gomes (My grammar is 💯 good I)   (7290 Points)

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.