Estimating the required rate of return on debt using credit ratings

People's United Bank

The market value of People's United Financial (NASDAQ: PBCT) is $11.94 (current stock price) * 358.06 million shares outstanding = $4.275 billion. The book value of the debt is $19.802 billion. This gives People's United a total worth of $24.077 billion, weighted as 17.75% equity and 82.25% debt. The beta for the equity is 0.27. The risk free rate is 0.352% (Yahoo! Finance, 2011) and the traditional 7% market risk premium can be used. Using CAPM this gives a cost of equity of The cost of debt must also be calculated in order to determine the weighted average cost of capital of People's United. Being a retail financial institution, the vast majority of People's United's liabilities (90.5%) come in the form of deposits. Some of these pay no interest, and others pay out in savings, interest-bearing checking and money market accounts. Total interest expense for 2010 was $129.8 million on deposits of $17.933 billion, a rate of 0.72%. This is the cost of debt for People's United. The tax rate, estimated from the 2010 income statement, is 32.5%. The WACC formula (Investopedia, 2011) is as follows:

We (Ce) + Wd (Cd)(1-t)

(.1775)(2.242) + (.8225)(0.72)(1-.325)

0.398 + .399 = .7977 or 0.7977%

If People's United uses this WACC in its capital budgeting process, it is making a couple of key assumptions. The first is that the project being undertaken has the same risk as the company overall. The current WACC reflects, roughly, the risk level of the company's current operations. The project being analyzed, however, may have an entirely different risk profile.

Another assumption that People's United would be making is that the cost of debt in particular is valid. Financial institutions have unique balance sheets compared to other companies. The bank may or may not be able to raise more capital by increasing deposits -- the market is highly competitive and tapping this resource is not the same as tapping capital markets. The cost of debt in the capital markets is going to be higher for People's United, as the cost of debt calculated is barely higher than the risk-free rate for a one-year Treasury. The rates reflect more what the market is for retail bank accounts than what the market is for regional bank debt.

The fact that People's United is a bank makes using this WACC particularly problematic for that reason. Retail banks do not access debt markets the same as other companies do. As a result, if People's United wants to raise a substantial amount of capital it may need to rely on equity financing. In addition, the nature of the project can vary significantly in risk level, in part because of the regulatory environment and the fact that its traditional businesses have a low level of risk but new business ventures could have a high level of risk.

At this point, People's United does not appear to have different divisions that would have significantly different risk levels. The bank operates as a regional retail bank. In that context, some products might have different risk levels but the bank can price its products to match those risk levels. Only if the bank became engaged in other industries would it be likely that the use of different risk levels would be appropriate.