Overseas-Chinese Banking Corporation Limited (OCBC)

Table of Contents

Introduction. 4
Weighted Average Cost of Capital (WACC) 5
Cost of Equity. 6
Cost of Debt 6
Calculation of WACC.. 6
Results and Analysis. 8
Gearing Ratios. 9
Calculations of Gearing Ratios. 9
Gearing Ratio. 9
Debt-to-Equity Ratio. 10
Times Interest Earned Ratio. 10
Long-term Debt to Equity Ratio. 10
Debt Ratio. 11
Equity Ratio. 11
Results and Interpretations. 11
Capital Asset Pricing Model 13
CAPM Results and Interpretations. 14
Conclusion. 16
Recommendation. 18
References. 20
Appendix. 22
 
Introduction
Overseas-Chinese Banking Corporation Limited (OCBC) is a Singapore-based financial service company (Reuters, 2018). Currently, the group Chief Executive Officer is Nag Tsien. He also doubles as the Executive Non-Independent Director. The bank is a publicly listed financial service, and it has a market capitalization of $47, 683 million (Reuters, 2018). OCBC has a network of over 610 branches and representative offices in 18 countries and regions that include Singapore, Malaysia, Indonesia, China, parts of the Asia Pacific, and internationally (Bloomberg, 2018). Some of the services provided in its global consumer/ private banking segment include savings and fixed deposits, consumer loans, checking accounts, car loans, personal loans, and mortgages. It also has the global corporate/ investment banking segment, which offers project financing, overdrafts, trade financing, deposit accounts, syndicate loans among others. Its global treasury and market segment provides money market operations, foreign exchange activities, and fixed income and derivatives trading (Bloomberg, 2018). OCBC insurance segment provides life and general insurance service and fund management services. It also has other segments such as the OCBC Wing Hang segment and the property and investment holding activities (Bloomberg, 2018). Its successful operations has made OCBC be the second largest banking group in Singapore by total assets, and it has a rating of Aa1 from Moody’s due to its financial strength and stability (OCBC Group, 2018).
Weighted Average Cost of Capital (WACC)
The weighted average cost of capital (WACC) refers to the calculation of the cost of a company’s capital (Render, Stair, Hanna, & Hale, 2014). In WACC, each source of capital is appropriately weighted to determine the overall cost of the capital invested in the business. Usually, a business capital originated from common stock, preferred stock, bonds, and long-term debt, all of which have different costs. Usually, an increase in WACC leads to a decrease in the valuation of a business and an increase in risk. Noteworthy, a high WACC implies that the business capital is mainly from expensive sources of finance.
The calculation of WACC is done by summing up the product of the cost of each capital component and its weight (Render, Stair, Hanna, & Hale, 2014). WACC can be expressed using the following formula:
WACC = (E/V) (Re) + (D/V) (Rd) (1-Tc)
Where:
Re= Cost of equity
Rd= Cost of debt
E= Market value of the firm’s equity
D= Market value of the company’s debt
V= E+D, the total value of the firm’s financing.
E/V= Percentage of equity financing
D/V= Percentage of debt financing
Tc= Total corporate tax (Render, Stair, Hanna, & Hale, 2014).

Cost of Equity

In most cases, businesses use common stock or preferred stock as their main sources of equity. Additionally, they also generate more equity from their retained earnings. Since retained earnings are money that could have been paid to shareholders as dividends, they also have a cost, the opportunity cost. Normally, the Capital Asset Pricing Model (CAPM) is used to estimate the cost of equity (Horngren, Datar, & Rajan, 2011). In CAPM, the cost of equity is calculated as follows:
Cost of Equity = Risk-free rate + Beta (Market Rate of Return – Risk-Free Rate)
The risk-free rate is the rate of return offered on government treasury bills.
The market rate of return is the rate of return of a broad stock market index, such as the Wilshire 5000 (Horngren, Sundem, Schatzberg, & Burgstahler, 2013).
Beta (risk) of the market is always 1.0. If the business risk is more than the market’s, its beta is always greater than 1.0. Beta is less than 1.0 if the company’s risk is less than market’s (Peavler, 2016).

Cost of Debt

The cost of debt is the pre-tax cost of the firm’s bonds and long-term borrowings. Since payment of debt always leads to a deduction on interest paid, which is a benefit to the company, there is usually a tax shied (1-corporate tax rate) when calculating the cost of debt (Datar & Rajan, 2017).

Calculation of WACC

WACC = (E/V) (Re) + (D/V) (Rd) (1-Tc)
WACC= Cost of Equity+ Cost of Debt
Calculated cost of equity
Cost of Equity= Risk-free rate + Beta (Market Rate of Return – Risk-Free Rate)
Risk-free rate= 1.34% (Money Authority of Singapore, 2018). Derived from the latest treasury bills rate.
Beta= 1.05 (Reuters, 2018) (Appendix 6)
Market Rate of Return= 11.99% (3 month index) (Market Watch, 2018). A 3 months period is appropriate since it factors the immediate industry changes.
Calculated cost of equity= 1.34%+ 1.05(11.99%-1.34%)
Calculated cost of equity= 12.5225%
My calculated cost of equity (12.5225%) is close to the one established by Bloomberg (Appendix 1) of 11%. Therefore, I used Bloomberg’s figures for this task. Noteworthy, the data from Bloomberg has considered the unique business environment in the Asia Pacific market and other international regions where OCBC operates and was thus more appropriate for this analysis.
Value of Equity
The book value of equity as at the end of third quarter (2017) was S$40,900. The market value of ordinary shareholder equity in the third quarter was S$46,754.90. The preferred equity was S$1,000. Since the business is a publicly traded company, the market value weights were used to determine the WACC.
Working on WACC
WACC = (E/V) (Re) + (D/V) (Rd) (1-Tc)
WACC= Cost of Equity+ Cost of Debt
Weights for each source of capital
Ordinary shareholders equity= 50.9%
Preference shareholders= 1.1%
Debt= 48% (Bloomberg, 2017) (Appendix 1)
WACC= (50.9%*11.00%) + (1.1%11.00%) + (48.00%*1.5%) (1-17%) = 6.3176% (Appendix 1).
Note: The corporate tax rate of Singapore is 17% for local companies (Singapore Company Incorporation, 2018).

Results and Analysis

The analysis of the WACC is important for both investors and the company. At a minimum, the WACC indicates the minimal rate of return that a business must make for it to be profitable. Therefore, the WACC acts an important tool for investors for guiding them on their investment decisions. Normally, a business that has a high WACC is less attractive since it must pay high costs to its lenders of capital before its shareholders can reap any benefit. Similarly, one with a low WACC is more attractive due to its low cost of capital. The analysis shows that the cost of equity is 5.72% {Cost of Equity= (50.9%*11.00%) + (1.1*11.00%)} and the cost of debt is 0.5976% {Cost of Debt= (48.00%*1.5%) (1-17%)}, which results in a total WACC of 6.3176%. Since the WACC is 6.3176%, OCBC should invest in projects that have a rate that is higher than 6.3176% for it to make profits.
From the analysis, it is clear that the cost of debt (0.5976%) is cheaper than the cost of equity (5.72%). Since the lower cost of debt is attributed to its low-interest rate and not its small share of its contribution to the business’ capital, OCBC should finance its operations mostly using debt instead of equity. However, OCBC should be careful when using debt finances to minimize its risk exposure due to changes in the cost of credit. In light of this, OCBC should negotiate for debt that is set at a fixed interest rate instead of one that is fluctuating, which can unexpectedly increase and result in high cost of debt. By using debt financing, the company would be able to give more value to its shareholders since it is a cheaper cost of financing. Importantly, debt financing can help the business to reduce its operating costs, in turn, enabling it to increase its profitability.

Gearing Ratios

Gearing ratios measure the proportion of the company’s liabilities to its equity. Consequently, they indicate a company’s financial risk due to debt. A high gearing ratio occurs when the company’s debt is more than its equity, whereas a low gearing ratio is when a business’ debt is less than its equity (Horngren, Datar, & Rajan, 2011). A high gearing ratio indicates that a firm is relying on debt to finance most of its operations. Therefore, any slowdown in business can make the firm unable to repay its debts. A low gearing ratio shows that a business shareholders directly finance their operations. Therefore, low gearing ratios indicate conservative financial management (Horngren, Datar, & Rajan, 2011).

Calculations of Gearing Ratios

Gearing Ratio

Gearing ratio= Long-term liabilities/ Capital employed
Long-term liabilities = loans (due more than one year) + preference shares + mortgages
Long-term liabilities= 1000+ debt issued (32,436) = 33,436
Capital employed = Share capital + retained earnings + long-term liabilities
Capital employed= 15,154+ 21,984+ 32,436= 69,574
Gearing ratio= 33,436/69,574= 0.48058. (48.058%)
The company has a normal gearing ratio since its ratio lies between 25% and 50%.

Debt-to-Equity Ratio

This ratio shows the percentage of the company’s assets that are financed through debt (Horngren, Datar, & Rajan, 2011). Accordingly, it shows the credit risk in the business due to debt financing.
Debt to equity ratio= (Long-term debt + Short-term debt + Bank overdrafts) ÷ Shareholders’ equity
Total equity S$40,900 million
Total debt= S$ 48,089 million
Debt-to-equity ratio= 48,089/40,900 = 1.17577
OCBC has a high debt-to-equity ratio of 1.17577, which shows that the bank finances its operations mainly using debt. Further, this ratio indicates that the company’s management is aggressive in exploiting any viable business opportunities they discover.

Times Interest Earned Ratio

Earnings before interest and taxes ÷ Interest payable
Earnings before interest and taxes= S$3830
Interest payable= S$171
Times Interest Earned Ratio= 3830/171= 22.3977
OCBC has a time interest earned ratio of 22.3977. This ratio shows that the bank can comfortably repay the interests from its borrowings.

Long-term Debt to Equity Ratio

Long-term Debt to Equity Ratio= Long-term liabilities/ equity
Long-term liabilities= 32,436
Equity= 40,900
Long-term debt to equity ratio= 32,436/40,900= 0.79306
OCBC’s long-term debt to equity ratio is 0.79306. Since the debt-to-equity ratio of the company is 1.17577, it can be deduced that OCBC mainly finances its operations using long-term debt.

Debt Ratio

Debt ratio= total liabilities (Including deposits and life assurance fund liabilities)/ total assets
Debt ratio= 397,613/ 438,513= 0.9067

Equity Ratio

Equity ratio= total equity/total assets
Equity ratio= 40,900/438,513= 0.09327

Results and Interpretations

The analysis shows that the business has an average gearing ratio, which is 48.058%. The analysis also shows that OCBC mostly relies on both short-term and long-term borrowings for its operations. As such, OCBC is averagely geared, since its gearing ratio lies between 25% and 50%. A highly geared business always has a ratio of more than 50%, while one with less than 25% has low gearing. Despite the risks posed by a company having too much debt, it is important to note that long-term debt is not necessarily dangerous for the business. The main advantage of long-term debt over short-term liabilities is that it is always cheaper and it does not dilutes shareholders interest in the company (Horngren, Datar, & Rajan, 2011). Therefore, the appropriate gearing levels mostly depend on the business prospects of a company. Furthermore, the long-term capital structure of a firm is always in the control of the management and shareholders. As a result, the gearing ratio can always be adjusted to appropriate levels depending on the performance of the business. Ways of reducing a business gearing include the following:

  1. Focusing on cost minimization
  2. Repaying long-term liabilities
  3. Retaining profits instead of issuing dividends
  4. Issuing more shares.
  5. Converting loans into equity. (Datar & Rajan, 2017).

In the same vein, a company can increase its gearing by:

  1. Focusing on growth by expanding its investments instead of maximizing on short-term profits.
  2. Converting short-term liabilities to long-term debt
  3. Buying back ordinary shares.
  4. Increasing its payment of dividends
  5. Issuing of preference shares and debentures (Datar & Rajan, 2017).

OCBC debt-to-equity ratio is 1.17577. This ratio shows that the business mostly relies on debt to finance its operations. Further, the gearing ratio indicates that OCBC’s management is moderately aggressive when exploiting business opportunities. OCBC has a high time interest earned ratio of 22.3977. This ratio indicates that the bank can comfortably repay the interest expense on its borrowing. In particular, this ratio shows that the company’s earnings are more than its interest expense. The long-term debt to equity ratio for OCBC is 0.79306. This ratio indicates that OCBC mainly relies on long-term liabilities to finance its operations. OCBC debt-ratio is 0.9067, which shows that the company’s assets can comfortably pay its liabilities. Its equity ratio is 0.09327, which indicates that OCBC relies mostly on debt for its operations.
 
 
 

Capital Asset Pricing Model

The Capital Asset Pricing Model (CAPM) is used to calculate the minimal required rate of return on any investments. To establish the minimum required rate of return, the CAPM model obtains the total risk in any investment. At optimal levels, the expected return is always equal to the cost of equity. CAPM is calculated using the following formula:
Expected Return/Cost of Equity = Risk-free rate + Beta (Market Rate of Return – Risk-Free Rate)
E(Ra) = Rf + β((Rm)- Rf)
Where:
E(Ra)= Expected returns in the market
Rf= Risk-free rate
β = Beta
Rm= Market rate of return
(Rm-Rf)= Market risk premium
The risk-free rate (Rf) refers to the rate of return that an individual can earn without exposing himself/herself to risks. Normally, the risk-free rate of return is determined by considering the proxy of the risk-free rate, the time when the rate is issued, and the maturity period of the “risk-free” investment. One of the common risk-free rates is the one given by the government on its treasury bills. Treasury bill rates are considered as being risk-free since governments rarely default on their financial obligations.
Beta measures the stock’s volatility relative to the market performance. In practice, the market beta is always 1.0, while that of individual stocks depends on how much they deviate from that of the market. Accordingly, beta shows the risk levels of each stock relative to that of the market. Stocks that have a risk that is higher than the market’s have a beta of more than 1.0, while those with lesser risk have a beta of less than 1.0. Since companies that have a high beta are riskier relative to the rest of the market, they also have a higher cost of capital.
The market rate of return (Rm) shows the average returns that individuals make in the market. Ordinarily, this rate is always higher than the risk-free rate so that it can incentivize investors to participate in the market. The market risk premium is the difference between the market rate of return and the risk-free rate (Rm-Rf). Accordingly, it shows the required average returns in the market needed to make investors accept investing. Since investing in each company exposes a person to different risk levels, a firm’s market premium is multiplied by beta (risk of each stock) to establish the minimum return premium needed to make an investor purchase its stocks. Noteworthy, investors have different risk tolerance, which also determine their investment patterns. As such, some people may be willing to invest in stocks with low but stable returns whereas others may want to invest in high return but risky investments.

CAPM Results and Interpretations

Expected Return = Risk-free rate + Beta (Market Rate of Return – Risk-Free Rate)
Risk-free rate= 1.34% (Money Authority of Singapore, 2018). Derived from the latest treasury bills rate.
Beta= 1.05 (Reuters, 2018)
Market Rate of Return= 11.99% (3 month index) (Market Watch, 2018) (Appendix 4). A 3 months period is appropriate since it factors the immediate industry changes.
Expected return = 1.34%+ 1.05(11.99%-1.34%)
Expected return = 12.5225%
Under the CAPM concept, an investor should invest in projects that have a higher return than his/her expected minimum return. From the calculations of OCBC 9 months financial performance, the company’s expected return is 12.5225%. It is important to note that the industry beta is 1.51 and the sector’s beta is 1.47 (Appendix 6). Since a high beta indicates higher risks, due to greater deviation of the stock from the market trend, other businesses in the finance industry or the banking sector can have higher returns, albeit with higher risks. Additionally, the high risks in these businesses also result in them having a high weighted average cost of capital.
The eligible capital in the business is S$34,250 Million (Appendix 3). Since the expected return for the business is 12.5225%, investors should evaluate if the company was able to at least earn S$3,216.72 million for its first nine months of the year 2017 to know the viability of their investments. If the OCBC made more than S$3,216.72 million, then they should invest in it. Otherwise, they should consider other better-performing companies.
Expected income to have been made in 2017 (9 months) = Eligible Capital* Expected rate of return* Investment period
Expected income to have been made in 2017 (9 months) = 12.5225% *9/12* S$34,250 Million
Expected income to have been made in 2017 (9 months) = S$ 3,216.72 million
Eligible Capital= S$34,250 (OCBC Group, 2018).
As at the end of the third quarter of 2017, OCBC had made S$2,877 million, which is less than the expected income of S$ 3,216.72 million (Appendix 2 and 3) (OCBC Group, 2018). Therefore, an investor should not invest in OCBC.
Industry expected return:
Expected return = 1.34%+ 1.51(11.99%-1.34%)
Expected return = 17.4215%
Sector expected returns:
Expected return = 1.34%+ 1.47(11.99%-1.34%)
Expected return = 16.9955%
It can be observed that the industry and sector expected rate of returns are more than those of OCBC. Since the beta values for both the industry and sector are more than those of OCBC, these other businesses have a higher risk. Impliedly, these figures show that OCBC’s management is more conservative than that of other businesses in the financial industry or banking sector. Accordingly, it mostly invests in low-risk projects, which ordinarily have low returns (Wild, Shaw, & Chiappetta, 2012). If an investor is risk averse, he/she should invest in OCBC since its returns are more certain, and its risk levels are low. Otherwise, he should invest in projects that have higher returns and risks. However, if the individual is a risk taker, he/she should invest in other businesses in the finance industry or banking sector, which are more aggressive than OCBC so that he/she can reap higher returns.

Conclusion

OCBC is a fairly stable bank in the financial industry. Although the company relies on debts to finance some of its operations, it can comfortably repay these obligations when they are due. The business has a low weighted average cost of capital (WACC), which is 6.3176%. Among the components of WACC, which are the cost of debt and cost of equity, it has been observed that the cost of equity is less than that of capital. In particular, capital has a cost of 5.72%, and liabilities have a cost of 0.5976%. Since the cost of liabilities is lower than that of equity, the business should finance its operations mainly using debt.
The gearing ratios of the company also indicate that the business does not heavily operate on credit. OCBC has a gearing ratio of 48.058%, which shows the bank is not heavily burdened with debts. In most businesses, the gearing ratio lies between 25% and 50%. Enterprises that are highly dependent on debt have a ratio that is more than 50%, while those whose management is extremely conservative, and thus avoid loans, have a ratio of less than 25% (Blocher, Stout, Juras, & Cokins, 2015). The debt-to-equity ratio of OCBC is 1.17572. This ratio indicates that the company’s liabilities are slightly more than its equity. However, the difference is minimal. OCBC’s long-term debt-to-equity ratio is 0.79306. This ratio shows that the business equity can be able to repay its long-term liabilities when they are due. Since the debt-to-equity ratio is 1.17572 and the long-term debt-to-equity ratio is 0.79306, it can be concluded that OCBC mainly relies on long-term liabilities to finance its operations. The debt ratio of OCBC is 0.9067. Therefore, the company’s assets can fully repay its debt, which implies that the bank is stable (Keat, Young, & Erfle, 2013).
Regarding the expected returns, OCBC is a fairly stable and safe investment. As such, it has a low expected return of 12.5225%, which is much lower than the 17.4215% expected return of the finance industry and the 16.9955% expected return of the banking sector. Usually, investments that are less risky always have low expected returns and similarly low weighted average cost of capital. OCBC’s bank’s management can increase its expected return by investing in more aggressive and high return projects, which are also riskier (Lanen, Anderson, & Maher, 2013). The expected nine months profits for the company at its current expected returns of 12.5225% is S$3,217.72 million; however, OCBC just made S$2,877 million as at the end of the third quarter. This lower than expected profits show that the business is underperforming, given its risk levels. Therefore, an investor should not invest in the bank because his/her risk exposure is more than the returns that he/she is getting.

Recommendation

OCBC capital structure has an almost equal proportion of liabilities to equity. The debt-to-equity ratio of the business is 1.17577. OCBC’s debt-to-equity ratio indicates that the bank’s liabilities are slightly higher than its equity, and thus it finances most of its operations using credit. Further, this information shows that the OCBC’s management is slightly aggressive in exploiting various business opportunities for the company.
Although the bank’s debts are more than its equity, this information should not cause any alarm among investors since its gearing levels are within the normal levels. OCBC’s gearing ratio is 48.058%, which is within the accepted range of 25% to 50% for normal companies. The moderately aggressive nature of the company’s management partly explains OCBC’s low expected returns when compared to those of the finance industry and the banking sector (Peavler, 2016). If OCBC’s management were more aggressive, it would have taken more credit, which would have made its gearing ratio to be more than 48.058%. OCBC’s debt-to-equity ratio is 1.17572, while its long-term debt-to-equity ratio is 0.79306. Accordingly, the bank finances most of its operations using long-term debt and not short-term financing. Since long-term debt is usually cheaper than short-term debt, the company should continue using this form of finance for its operations.
The weighted average cost of capital for the business is 6.3176%. The analysis of the WACC shows that the cost of equity is 5.72% {Cost of Equity= (50.9%*11.00%) + (1.1*11.00%)} and the cost of debt is 0.5976% {Cost of Debt= (48.00%*1.5%) (1-17%)}, which results in a total WACC of 6.3176%. Since shareholder’s equity costs more than credit financing, the business should use more credit for its operations than shareholders equity. The main advantage of this approach is that it will result in OCBC having cheaper WACC, which will result in greater shareholder value (Rothaermel, 2016). Additionally, it will ensure that shareholders stake in the company is not diluted due to the issuance of new shares. Further, this source of financing is always easy to access since it has fewer regulations and requirements than the floating of shares.
OCBC’s expected return is 12.5225% whereas that of the finance industry is 17.4215% and that of the banking sector is 16.955%. Noteworthy, the lower expected returns for OCBC’s than its industry and sector is partly attributed to the bank’s investment in low-risk and thus low return projects (Vanderbeck & Mitchell, 2015). Further, its management is slightly conservative, especially based on its gearing ratio, which is less than 50%. Since the OCBC’s profits for the nine months of 2017 were lower than its expected return levels of 12.5225%, an investor should not purchase the OCBC’s stock. In practice, a person who would be purchasing the company’s stock would be exposing himself/herself to an investment whose risks are more than the actual returns.
 

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