Capital structure, cost of funding and bank performance: a managerial compendium

Using discounted cash flow (DCF) models and the internal rate of return (IRR) criterion, the paper conceptualises: 1) equity financing's stand-alone effect on banks' overall cost of capital, following Modigliani and Miller's (MM) (1963) and Miles and Ezzell's (ME) (1980) debt policies; 2) capital requirements' effect on bank performance. First, the simulations indicate that: 1) overall, leverage negatively influences weighted average cost of capital (WACC); 2) at the pre-tax WACC level, the value irrelevance principle is satisfied under the ME financial policy when the rating based cost of debt is used; 3) under the ME financial policy and high levels of risky debt the cost of funding (post-tax WACC calculated using the bank specific cost of debt) increases more than proportionally as equity increases. Second, with IRR fixed on a determined allocation of risk capital, additional requirements cause an increase in banks' performance with a higher franchise value net of taxes.