blog #3: Deutsche Bank's issue on its capital structure.

In this week's lecture and seminar, I learned about the capital structure theory, and mainly about the Weighed Average Cost of Capital (WACC). So it is related to the previous week's lessons about cost of capital. I have learned about WACC back in high school but I definitely have learnt more about it in this week's classes. Other than that, I also have learnt about the theories of capital structure such as the trade-off models and pecking order models, debts and equity, how debts have lower risk than equity and so on.

In the recent news, I have found out that Deutsche Bank (German Bank) has more debts than equity. According to YCharts (2015), the debt to equity ratio was 3.00, as of 31st of December, 2015. Deutsche Bank's debt to equity ratios have always been high. It automatically means the bank have been taking high risks. It also implicated that by 31st of December 2015, Deutsche Bank held debts of three times more claim on assets than equity holders. Deutsche Bank had unhealthy capital structure because they have high level of debts and low level of equity. They really have negative signs of investment quality. If I were an investor, I don't think I would invest in Deutsche Bank.

According to NotQuant (2016), as of April 2014, Deutsche Bank was forced to raise an additional 1.5 billion of Tier 1 capital to support its capital structure. In May 2014, Deutsche Bank announced that they were selling stocks that worth 8 billion euros, which was up to 30% discount of the price. It truly shocked the media. I am thinking they were trying to raise liquidity. In March 2015, Deutsche Bank has failed the banking industry's "stress test" and is given warning on its capital structure. It is as expected because their debt to equity level has never been low, which really is disappointing to know.

Early this year, according to Financial Times (2016), Deutsche Bank's bond fell further and the 1.75 billion euro bond is trading below 76 cents on euro (see image below). Also, the 1.5 billion bond fell to 81.5 cents on the dollar. It wasn't a good start of the year for Deutsche Bank. The losses made their capital structure look even worse. The bank's CoCo bond of 1.75 billion had lost about 19% of its value (Financial Times, 2016). It was really bad news. This can result in investors not getting paid on their coupon payments. According to Bloomberg (2016), the investors were also worried that the capital and funds can decrease the value of its stock and bond even further.

Image source: Financial Times( 2016b)

Even their Returns on Invested Capital (ROIC) is lower than their Weighted Average Cost of Capital (WACC). The amount of Deutsche Bank's WACC and ROIC can be seen from Guru Focus (image below). It demonstrates that the WACC was 5% in average during last year and the ROIC was mostly negative in the past year. This shows rather bad sign and calls for a need to readjust their capital structure, to find the "optimum" amount of WACC in order to maximize wealth of shareholders. Companies should focus on lowering their WACC as low as possible to get higher returns.

Deutsche Bank's Ratios

Image source: Focus Guru

Can Deutsche Bank repay their debts (by having such low ROIC and high WACC) and make adjustments on their capital structure? This is one serious issue for investors and for the bank itself. In my opinion, I think they could, but not for long. There is still help for Deutsche Bank if they could come up with an action to the existing issue, such as, choosing or finding the optimal financing mix/ capital structure. I think they have incurred too much debt which leads to risks of bankruptcy.

There has always been a debate on whether optimal capital structure exists (M&M theory vs traditional theory). I respect both of the points but honestly, I think it does exist and it is quite logical to have not too much gearing (because the company can suffer from all the costs like bankruptcy costs, agency costs and taxes) BUT also not to have too little gearing (as it can decrease the WACC). Anyway, I also think capital structure matters to EVERY companies, big and small.

References:

YCharts, 2015 https://ycharts.com/companies/DB/debt_equity_ratio

Bloomberg, 2016 http://www.bloomberg.com/news/articles/2016-02-08/deutsche-bank-says-it-has-at1-payment-capacity-of-1-1-billion

Financial Times, 2016a http://www.ft.com/fastft/2016/02/08/deutsche-coco-bonds-plumbing-new-lows/?ftcamp=engage/capi/widget/client/openft/b2b

Financial Times, 2016b http://ftalphaville.ft.com/2016/02/09/2152719/the-coco-that-popped/?ftcamp=engage/capi/widget/client/openft/b2b

NotQuant, 2016 http://notquant.com/is-deutsche-bank-the-next-lehman/

http://www.gurufocus.com/financials/DB