CENTRAL BANK OF SRI LANKA

The Cost of Equity for Sri Lankan Private Banks: a CAPM Based Approach

Research Paper

By

K. P. M. Perera (1902)

Central Bank of Sri Lanka

i

This research paper is submitted in fulfillment of requirement to obtain the scholarship for post graduate studies abroad offered by

the Central Bank of Sri Lanka for its Staff Officers.

ii

Acknowledgement

This research paper was made possible through the help and support of everyone, including:

superiors & colleagues, family, friends, and in essence, all sentient beings, Please allow me to

dedicate my acknowledgment of gratitude toward the following significant advisors and

contributors:

First and foremost, I would like to thank Dr. Chandranath Amamrasekara & Dr. Roshan Perera

for their support and encouragement. They kindly read my proposal and offered invaluable

detailed advice on objectives, contents and the methodology to be used in presenting the paper.

Secondly, I should thank Mr. Nimal Gunawardena, Director, Internal Audit for his invaluable

advice during my stay at the department encouraging me for higher studies as well as all other

Directors and Deputy Directors who encouraged me.

Thirdly, I would like to thank all my collegues at Management Audit Department who

encouraged me, especially Ms. Chamila Rupasinghe, Ms. Thilini Jayasinghe amd Mr. Mahesh

Kumara of the Management Audit Department who read my paper and provided valuable

insights. Further, I should thank all my collegues at the Ministry of Defence & Urban

Development for encouraging me in finishing this paper early.

Finally, I sincerely thank my family and friends, who were supportive in making this study a

success. The production of this research paper would not be possible without all of them.

iii

Abstract

This paper is an empirical study of the cost of equity of Sri Lankan Private Banks listed in the

Colombo Stock exchange. A Single Factor Capital Assets Pricing Model (CAPM) was used to

examine the overall equity return of Sri Lankan Private Banks. Model which uses regression

analysis, has been tested for serial correlation and heteroscedasticity. Using pre-tested stationary

variables for the whole market based on monthly observations of averaged market returns and

risk free interest rate from 2003 to 2012, we find that: (i) equity market risk premium and risk

free interest rate explains over 80% of bank equity risk premium (ii) bank risk premium is

negative from 2007 to 2012 on 5 year monthly rolling regression (iii) Cost of equity of private

sector banks had declined from 3.28% to 0.62% from 2007 to 2012 (iv) cost of equity of banks is

very much less than cost of interest (v) Therefore, raising equity capital is cheaper for banks

instead of debt capital. It was observed that Sri Lankan market results are not consistent with

results of studies of either King (2009) or Thiripalraju et al (2011) on foreign markets.

iv

List of Annexures

1. Table 01 – List of Banks used for the study (Page 22)

2. Table 02 – Results of the Unit Root test (Page 22)

3. Table 03 – Results of the Heteroscedasticity test (Page 22)

4. Table 04 – Results of the study (Page 23)

v

Table of Contents

Chapter One………………………………………………………………………………. 06

Chapter Two………………………………………...…………………………………….. 08

Chapter Three…………………………………………………………………………….. 11

Chapter Four…...………………………………………………………………………….15

Chapter Five……………………………………………………………………………….17

Chapter Six……………………………………………………………………………… 19

List of References…………………………………………………………………………. 21

Annexures………………………………………………………………………………….22

vi

Chapter One

Overview of the Study

1.1 Introduction

The best cushion a company has to absorb losses is the equity. That means, more the equity, less

the risk for creditors. However, based on the risk and return tradeoff theory more equity might

turn into higher cost. The cost of equity could be higher than long term debt due to several

factors such as tax deductible nature of interest and high risk premium for equity due to higher

risk. Therefore, analyzing the cost of equity in any company or industry is very important in

deciding the optimal capital mix in the long term.

1.2 What is Cost of Equity?

As per Damodaran cost of equity is “the rate of return investors require on an equity investment

in a firm”. This is the required rate of return (RRR) in the portfolio theory in finance on any

investment. The return of any investment is measured on market value of the investment as

historical data such as book value does not reflect the reality. As such, cost of equity should also

be measured on the market value.

1.3 Methods of Estimating Cost of Equity

There are several methods in measuring the cost of equity. One method is the accounting ROE.

Since the accounting ROE does not take into account the market changes in value of equity this

is not acceptable in academic research. Reported earnings divided by market capitalization is

another method and has been used by researchers in determining the cost of equity. However, a

more market based approach would provide a realistic picture of the cost of equity. Dividend

discount model introduced by Gordon in 1956 is another approach which has been widely used

in calculating the cost of equity. In this approach all future cash flows arising from equity are

discounted to get the present value of the stock and therefore cost of equity is the discount rate

which equalizes the market value of equity with present value. However, the most popular and

realistic approach might be Capital Assets Pricing Model (CAPM) as it incorporates the market

risk as well as individual company risk in calculating cost of equity of a company. From 2006

vii

onwards Federal Reserve System in USA has been using only CAPM approach in calculating the

average cost of equity of the bank in charging commercial banks for services provided. (King

M.R. 2009). More descriptive analysis of CAPM will be discussed under methodology.

viii

Chapter Two

Research Problem and Literature Survey

2.1 Introduction

Banking business entails borrowing at a lower rate and disbursing loans and advances at a higher

rate. They act as financial intermediaries of a country where they collect excess funds from

surplus units and loan to deficit units. Therefore, banks do a yeoman service to the growth of the

country. However, a banks’ balance sheet generally has liabilities with shorter maturities and

assets with longer maturities. This is called the maturity mismatch. Therefore, the industry is run

on the trust of depositors with the assumption that at any given point in time only a fraction of

the total depositors will withdraw the deposits. As a result, banking sector is said to be a very

fragile sector in any country.

2.2 The Background of the Research

In promoting financial system stability of the country, analyzing risk and return trade off of

equity of banks is of vital importance for policy makers in formulating capital regulations for

local banks as well as will help in applying the globally developed standards in the local arena.

Further, comparison of these rates and their patterns with other countries could reveal the

structural & conceptual similarities & dissimilarities of cross-border equity markets as well as

reactions of investors of bank equity to any dramatic changes in the financial markets.

2.3 Research Problem

In view of foregoing and the lack of local literature on the area, following research problems was

derived.

“What is the cost of equity of private sector banks in Sri Lanka in the last decade? Are

there any observable patterns in the behavioral trend of the estimated cost of equity?”

ix

2.4 Sample

The monthly stock market data for banks from January 2003 to December 2012 based on

availability, was used in estimations. All eight private banks who had listed stock during the

period of 2003 to 2012 were included in the study. Please refer, Table 01 of annexures for the

list of banks.

2.5 Prior Studies

Zimmer & McCauley (1991) estimated cost of equity of 34 international banks from six

countries over 1984-90 using the bank-level return on equity (ROE). This considers the ratio of

banks reported earnings to market capitalization. This ROE was averaged over time and across

banks from each country to arrive at a country specific ROE. They observed that real cost of

equity of UK, US & Canadian banks are higher compared to their counterparts in Swiss,

Germany & Japan. The authors recognized that though a backward looking accounting measure

is not ideal it has the advantage of being observable.

A Dividend Discount Model (DDM) had been used by Maccario et al (2002) to measure the cost

of equity of non-US banks in 12 countries from 1993-2001 period. They have used the earnings

yield with the assumptions that analyst forecast are the best estimate of next years’ earnings,

earning grow at the economic growth level and dividend payout ratio is constant. However, the

weakness of this approach is that banks with higher earnings will face a higher cost of equity.

They have concluded that banks in Canada, Holland and Sweden face higher cost of capital

compared to banks in Germany and Japan. Easton (2009) has highlighted the shortcomings of

past earnings based approach through empirical evidence, though, the approach has its own

merits.

2.7 Green et al (2003) described methods used by Federal Reserve Bank to charge for its

services from other banks. The cost of equity is necessarily an input for the calculation of Private

Sector Adjustment Factor for this. Up until 2002 an earnings based approach was used to

calculate the cost of equity. However, from 2002 to 2005 an average of earnings based figure,

discounted cash flows & CAPM based cost of equity was used. Barnes & Lopez (2006) has

concluded that recent research suggests that the Federal Reserve’s decision to set the COE

x

estimate equal to that of the overall equity market (that is, to set their beta equal to one) is

reasonable.

King (2009) has estimated cost of equity for banks in six countries over 1990-2009 using CAPM.

As per him the cost of equity estimates declined steadily across all countries from 1990 to 2005

but rose from 2006 onwards. He summarizes the reasons for fall in the cost of equity as decrease

in risk-free rate over the period and a decline in the sensitivity of bank stock returns to market

risk in all countries except Japan.

Thiripalraju & Acharya (2011) used CAPM approach to estimate cost of equity of 19 Indian

banks from 2004-2009. They further estimated sector-wise cost of equity (public sector banks,

new private sector banks & old private sector banks) based on individual bank estimates. They

concluded that cost of equity increased for all banks in the study period though declined

marginally in 2009. As per them the major contribution for rise of equity came from increase in

risk free rate and marginally by rising CAPM beta.

As per Fama & French (1997) estimates of the cost of equity for industries are imprecise.

Standard errors are more than 3.0% per year are typical for both the CAPM and the three factor

model of Fama & French. These large standard errors are the result of the uncertainty about true

factor risk premiums and imprecise estimates of the loadings of the industries on the risk factor.

As per them estimates of the cost of equity for firms and projects am surely even more imprecise.

Baker & Wulger (2013) confirm that the equity of better-capitalized banks have both lower

systematic risk (beta) and lower idiosyncratic risk (firm specific risk) based on a sample of more

than 4000 banks and 70 years of data.

xi

Chapter Three

Methodology

3.1 Introduction

The cost of equity is generally defined as the expected return of purchasing the common stock of

a firm. Therefore, it is vital for asset valuations. This study being focused on private sector banks

present in the Colombo Stock Exchange, will be of importance to regulators at the Central Bank.

For example, the changes with regard to capital requirements coming up with the adaptation of

new BASEL requirements could have a direct impact on the cost of equity of banks. The

management of the banks as well as regulators could have an idea of the possible costs faced by

them based on these estimates.

3.2 Capital Assets Pricing Model

The Capital Asset Pricing Model introduced by Sharpe, Treynor, Lintner & Mossin

independently is one of the commonly used models to arrive at the RRR of a financial asset. It

basically consists of three variables. They are the risk free rate, expected market return or market

risk premium and the firm or industry specific beta.

3.3 Risk Free Rate

Risk free rate is the alternative an investor of a financial asset has, had he not invested in the

specific market. Generally, short term government bill rate is considered as an acceptable proxy

for risk free rate since they are default free in nature.

3.4 Market Return

Market return is the equity market return in the economy. This consists of two parts. That is

return due to capital appreciation and returns due to dividends. Returns due to capital

appreciation are the ASPI returns. Returns due to dividends do occur only a few times a year and

are generally factored in the market price as cumdiv. This can be supported by the Fama’s

efficient market hypothesis that all information of the value of the stock is factored in the market

xii

price since they are publicly available. As a result the stock price variances reflect the total return

of the stock. The market risk premium is the average return of the market minus risk free return.

3.5 Firm or Industry Specific Return

Firm specific return or the industry specific return depends on the return of the market.

Variability or volatility of the market returns is referred to as systemic risk. Firm specific risk is

the degree of volatility of the specific return in comparison with market volatility. This measures

the riskiness of the individual firm compared to the market. Estimating this sensitivity factor is

the core of this study. As a result company risk premium is the dependent variable and the

market risk premium is the independent variable.

3.6 Variable and Model Building

Three variables described above are constructed into form the following model.

Rit = Rft + β (Rmt - Rft ) + Eit………………………………………………………………………………………………....(1)

where, Rit = the return on the stock i on day t, Rft = the risk free rate, βi = the systematic risk of

stock I, Rmt = the return on the market on day t, εit = the error term in the model

The model can be rearranged as follows, based on the excess returns for the stock and the excess

returns of the market.

Rit - Rft = β (Rmt - Rft) + Eit

The model can be built in to a regression model as,

Rit - Rft = αi + β (Rmt - Rft) + Eit …………………………………………………………………………………………….(2)

Where αi refers to intercept which should not be statistically different from zero. The CAPM

beta (market risk factor) is the slope coefficient of the model. If β is less than 1 then firm or

industry return is less volatile compared to market and therefore, risk premium is less. If β is

higher than 1 it means individual asset return is more volatile than the market and therefore,

expected risk premium of investing in the stock is higher.

xiii

3.7 Prior Observations on CAPM Based Approach

As per King (2009) researchers have found that CAPM beta estimates for individual stocks are

volatile and imprecise, and the residuals across firms may exhibit common sources of variation

due to omitted variables.

The CAPM model is most commonly estimated based on the realized excess returns. The

assumption is that historical returns are a good proxy for expected returns and monthly excess

returns are approximately independently and normally distributed through time. After the

calculation of Beta values the cost of equity can be calculated based on equilibrium relationship

in equation (1) above and analyzed for any observable behavioral patterns.

King has used 5 year rolling regression over each monthly return for each bank and averaged it

to obtain portfolio beta for each rolling period. This is because; beta is a time varying factor.

However, since decisions are made based on time bound data this analysis calculated beta on five

year rolling regression only at the end of the year from 5th year onwards. (i.e.2007). Thiripalraju

& Acharya (2011) has used the same approach in calculating cost of equity of Indian Banks from

2004 to 2009. The base for each estimation was made limited to past 5 years data. The

assumption is that estimations based on forward looking market model may not be realistic if the

data is outdated.

3.8 Stationarity Testing

All variables were tested for their stationarity using unit root test.(Table 2-Annexures) The

Augmented Dickey Fuller Test and Philip Perron tests were used to determine the stationarity of

individual variables. It was found that both the variables of average bank return and the ASPI

returns (Market return) are stationary at level, I(0) . Risk free interest rate (1 year treasury bill

rate) was considered as a stationary variable, I(0). As a result market risk premium (ASPI returns

– risk free interest) and banking sector risk premium (average bank return – risk free interest)

were found to be stationary at I(0) under Phillip Perron Test. Based on the test result & nature of

variable (return rate) it can be presumed that variable is a stationary variable. (Please refer Table

01)

xiv

3.9 Testing for OLS Assumptions

After developing the model, OLS assumptions were tested for their validity. multicolinearity,

heteroscadasticity and the auto-correlation of the model are the most important assumptions.

Heteroscadasticity (variance of error terms are not constant) was tested using Breusch-Pagan test

using the following hypothesis (Table 3- Annexures). It was noted that model was free from

heteroscadasticity.

Ho = Model has heteroscadasticity

H1 = Ho is not true

P value 0.00<0.05, therefore, Ho is rejected. The model is free from heteroscadasticity.

3.14 Serial correlation (correlation of error terms) was tested using Durbin-Watson test.

Ho = Model has Serial Correlation

H1 = Ho is not true

No of observations = 120, No of independent variables =1

Value of Table Du=1.746 <2.06(DW statistic)<2.254

Therefore, model was found to be free from serial correlation

Testing for Multi-colinearity was not relevant since only one independent variable has been used

in the model.

3.10 Conclusion

In conclusion, model used satisfies all requirements expected of a model used in estimation of

future predictions.

ROE of government sector banks were not estimated, because it is a primary methodology of

estimating cost of capital which assumes returns equals cost. Further, results of ROE approach

are in anyway not comparable with cost of equity estimations derived using CAPM approach.

xv

Chapter Four

Empirical Results

4.1 Introduction

The table 3 to the annexures shows the extra-ordinary results of the research on investing in

equity in the Sri Lankan Equity Market. In all 5 years for which rolling average of ASPI returns

were calculated, the returns have been less than 3%. Comparatively, during the same period the

risk free rate (the 1 year treasury bill rates) has been a double digit number.

4.2 ASPI Returns

ASPI returns does not show a specific with a highest of 2.38% in 2010 and lowest of .79% in

2008. The average of the ASPI returns from 2003 to 2012 has been 1.92% whereas risk free rate

for the same period has been 11.26%. These drastic differences in the two returns could be

explained by the high demand by government for domestic debt during the peak of the global

financial crisis in 2007 & 2008. 1 year interest rate even exceeded 19% in that period.

4.3 Risk Free Rate, Market Risk Premium, Beta, Banking Risk Premium and Cost

of Equity

Cost of equity of a specific firm depends on three things. Those are market risk premium, risk

free interest rate and the firm specific beta.

The risk free rate has also behaved in the same trend with a 300 basis points increase in 2007

through 2009 and slight drops afterwards through 2012. As described earlier in 2009 risk free

rate reached its peak of 13.69% on 5 year rolling average and dropped slightly afterwards.

From 2007 to 2009 the market risk premium has been negative which has reached the peak and

dropped after 2009. This is mainly described by the behavior of the risk free rate.

xvi

4From 2003 to 2012 the Banking Sector Beta has been 1.00 which shows that banking sector in

general, neither accepts more or less risk compared to overall equity market. However, during

the calculated period banking sector Beta has been on an increasing trend. From 0.87 in 2007 it

has increased to 1.1 in 2012. This shows the banking sector which was rather insensitive to

equity market changes have also become sensitive on a continuous scale. May be that resulted

from the financial crisis that took place in 2007 and financial turbulence that took place in the

local financial sector during the period.

Banking sector risk premium which is the product of the sector specific beta and market risk

premium is highest in negative terms in 2010 at -12% where beta is relatively high at 1.07 and

equity risk premium is also relatively high and negative at -11.28%. In negative terms it is lowest

in 2007 at -7.2% when market risk premium is relatively lower in negative terms at -8.3% and

beta is lowest at 0.87.

The cost of equity is steadily declining through 2007 to 2012 with highest being 3.28% in 2007

and lowest being 0.62% in 2012. This shows cost of equity of banks are coming down

continuously.

xvii

Chapter Five

Conclusion and Recommendations

5.1 Introduction

This chapter tries to draw conclusions out of the empirical results in the previous chapter.

Correct interpretation of results is the most important task in the latter part of any study. Further,

making recommendations out of the conclusions made is also of vital importance. In summary,

the essence of the study is in this chapter.

5.2 Study in a Summary

The study provides estimates of real cost of equity of Sri Lankan private banks on a single factor

CAPM model which has been used by the Federal Reserve System. Cost of equity declined

steadily from 2007 to 2012. The behavior of both the risk free rate, equity market risk premium

and continuously increasing banking sector beta all three factors contributed to this behavior.

Most notable fact is for all 6 years equity market risk premium was negative primarily due to

ASPI returns being considerably lower than risk free interest rate. This is contradictory to theory

that equity market encompasses higher risk which should be compensated with higher risk

premium. Lack of informed decision making by investors in underdeveloped equity markets

might be the reason for this contrast. Kings study(2009) on banking sector cost of equity in 6

countries from 1990 to 2009 as well as study of Thiripalraju et al. (2011) on cost of equity of

Indian Banks from 2004 to 2009 all yielded positive annual bank risk premiums.

5.2 Results in Summary

The cost of equity is steadily declining through 2007 to 2012 with highest being 3.28% in 2007

and lowest being 0.62% in 2012. This shows cost of equity of banks are coming down. As a

result even with tax benefits associated with long term debt, banks will find it cheaper to expand

its equity capital. Further, these figures are considerably lower compared to figures revealed by

above two studies on India, Canada, France, Japan, UK and USA though time periods are not

exactly overlapping.

xviii

5.3 Recommendations

Therefore, the banks can be recommended to expand their equity compared to long term debt

which would be beneficial for them in cushioning its deposits as well as cheaper in financial

terms.

xix

Chapter Six

Limitations of the Study

6.1 Introduction

Making aware of the readers of the limitations and weaknesses is of vital importance to any

research paper. It outlines the boundaries of the research in which validity of conclusions and

Recommendations would prevail.

6.2 Types of Limitations

The limitations of the study can be broadly divided under two headings. Those are the criticisms

put forward by academics on the theoretical basis of the model used and the practical limitations

of the study.

6.3 Prior Criticisms and Defences of the Model

The criticisms of the model have been highlighted by most of the researchers worked on the

subject. As cited by King, Fama & French (2004) group these shortcomings into two headings.

They are rational risk story and the behavioral story. Under the former, investors are rational and

forward looking and the financial markets are efficient. In this view the weakness of the model is

that investors think about only the mean and variance of the portfolio returns and other

dimensions of the risk have been ignored. The main empirical shortcoming as per King is that a

single market factor model is insufficient to capture the complexities in the cross section of the

realized returns. In the other view markets and the participants are said to be irrational and they

overreact to good and bad situations which swing asset prices out of the proportion of the

fundamentals. Therefore, systematic and predictable mispricing of assets occurs. However, Stein

(1996) has argued that whether expected return is rational or irrational they all form opportunity

cost of equity.

Further, the method used relies on five year rolling regressions. Overlapping windows imply that

beta changes slowly, with increases in the co-variance of banking sector returns relative to the

market only showing up over time. Alternatively, the regressions could be run on 12 months of

xx

returns which would definitely be noisier due to reduced number of observations. However, they

do not overlap and any change in covariance will appear more quickly.

6.4 Suitability of the Application

In view of the above weaknesses and consideration application of five year rolling regression

may be the most suitable in the given circumstances.

xxi

List of References

King, M. R. (2009), “The cost of equity of global banks: a CAPM perspective from 1990

to 2009”, BIS quarterly Review, Sep 2009

Thiripalraju, M. & Acharya, R. (2011), “The cost of equity for Indian Banks: A CAPM

Approach”, Indian Institute of Capital Markets/Research, www.utiicm.com

Green, E. J., Lopez, J.A. & Wang, Z (2003), “Formulating the Imputed Cost of Equity

Capital for Priced Services at Federal Reserve Banks”, FRBNY Economic Policy Review /

September 2003, pp 55-81

Barnes M. L. & Lopez J. A. (2006), “Alternative measures of the Federal Rserve Banks’

cost of equity capital”. Journal of Banking and Finance, no 30, pp 1687-711

Damodaran, A.(2000). “Investment valuation: Tools and Techniques for Determining the

Value of Any Asset”, 2nd Ed. New York: John Wiley & Sons, Inc., pp 182

Fama, E. F. & French, K. R., (1997), “Industry cost of equity”, Journal of Financial

Economics 43 ( 1997) 153-193

Easton, P., (2007), “Estimating the Cost of Capital Implied by Market Prices and

Accounting Data∗”, Foundations and Trends in Accounting Vol. 2, No. 4 (2007) 241–

364

Baker, M. & Wulger, J. “Would Stricter Capital Requirements Raise the Cost of Capital?

Bank Capital Regulation and the Low Risk Anomaly”, http://people.stern.nyu.edu

McCauley, R. N. & Zimmer, S.A. (1991) “The cost of capital for securities firms in the

United States & Japan”, FRBNY Quarterly Review/ Autumn 1991

Zimmer, S.A & McCauley, R. N. (1991): “Bank cost of capital and international

competition”, FRBNY Quarterly Review/ Winter 1991, pp 33-59

MacCario, A., Sironi, A. & Zazzara, C. (2002), “Is Banks’ Cost of Equity Capital

Different Across Countries? Evidence from the G10 Countries Major Banks*”, Libera

Universita Internazionale degli Studi Sociali (LUISS) Guido Carli, Working paper, May.

xxii

Annexures

Table 01 – List of banks used for the study.

No. Bank Name

01 Commercial Bank

02 DFCC

03 Hatton National Bank

04 National Development Bank

05 Nations Trust Bank

06 Sampath Bank

07 Seylan Bank

08 Merchant Bank of Sri Lanka

Table 02 - Results of the Unit Root Test

Variable ADF (t statistic) P Perron (t statistic) I(0) or I(1)

Bank risk premium -2.896451 -9.090805 I(1)/I(0)

Market risk

premium

-2.604726 -7.929980 I(1)/I(0)

ASPI returns -9.470220 -9.602326 I(0)

Average bank

returns

-10.07972 -10.18152 I(0)

Table 3 – Results of Heteroscadasticity Test

Heteroskedasticity Test: Breusch-Pagan-Godfrey F-statistic 18.89475 Prob. F(1,118) 0.0000

Obs*R-squared 16.56287 Prob. Chi-Square(1) 0.0000

Scaled explained SS 61.44583 Prob. Chi-Square(1) 0.0000

xxiii

Table 4 –Results of the study

Year Risk Free

Rate

Bank risk

Premium

Cost of

equity

Equity risk premium

in the Market

Beta

2007 10.48 -7.2 3.28 -8.30 0.87

2008 12.65 -10.19 2.46 -11.85 0.86

2009 13.69 -11.80 1.89 -12.04 0.98

2010 13.60 -12.00 1.60 -11.22 1.07

2011 12.93 -11.96 0.97 -11.28 1.06

2012 12.03 -11.41 0.62 -10.37 1.1

2003-2012 11.26 -9.34 1.92 -9.34 1.00