W12_TRI_ Exploring Cost of Fund against Gold Value

1.      Problem recognition, definition and evaluation

Cost of Fund (CoF), known as the band of investment, is widely used for asset valuation purpose [1]. Generally, CoF is derived from WACC (Weighted Average Cost of Capital) that is measured by weighting company debt and equity costs with each portion of debt and equity in capital structure. The equity cost in many Indonesian companies is set in certain level, while the debt cost follows lending interest. Practically in project cost, CoF is viewed as additional price to be marked up to base cost. Therefore, CoF has to be included in cost estimation particularly for medium-long term projects.

Bank as primarily financial intermediation institution in Indonesia uses some components in deriving lending rate. Four main components are reflected in an interest rate of financing institution: cost of funds (deposit rate), loan loss expenses, operating expenses, and profits [2]. Deposit rate will follow BI rate updated quarterly by Bank Indonesia as main policy tool in order to maintain macroeconomic stability according to inflation targeting framework [3], thus BI rate is also well known as Indonesia risk free rate. Therefore, BI always considers macroeconomic factors, such as Inflation and exchange rate in setting BI rate.

However, lending rate does not always have strong correlation with inflation as shown in Figure 1. In addition, exchange rate stability is not sufficient condition for the reduction of cost of capital in emerging markets as Indonesia [4].

Figure 1. Indonesia Inflation and Average Lending Rate (source: author)

2.      Development of the feasible alternative

Gold that has more reliable and sustainable PP compared to USD is then used as benchmark value for Indonesia corporate lending rate applied for Indonesian Rupiah (IDR) as lending rate currency. Figure 2 presents that there is a correlation between PP USD over Gold (1,000 USD in gold equivalency) and lending rate by using data 2000-2011. This could be explained that more gold used for safety purposes of wealth which make the gold price going up and PP USD over Gold going down, then it will affect to market becomes over liquidity, thus decreasing lending rate is incurred.

Figure 2. Indonesia Lending Rate and PP USD (source: author)

3.      Development of the outcome

As described that Indonesia lending rate has a correlation with gold price, then the correlation will be analyzed using regression models provided in Microsoft Excel.

4.      Criteria of Selection

Regression model will select the best fit model based on r-squared value. Table 1 presents some regression models to represent the observed data. Figure 3 displays lending rate and PP USD regression using polynomial 5th order formula with r-squared 0.8617.

Table 1. Lending Rate-Gold Price Regression Models (source: author)

Figure 3. Trend Line of Lending Rate against PP USD over Gold (source: author)

5.      Analysis

Polynomial 6th order model is not used since the backward curve for PP USD less than 0.5 oz Gold /1,000 USD indicates extremely increase in lending rate. That increase will have low possibility to happen, since in fact over 25 years (1986-2011) as shown in Figure 2, average Indonesia lending rate is between 10 – 25 % per annum.

Although Polynomial 5th order has r-squared only 0.8617, the 5th order model still has relatively high r-squared compared to others. The backward curve results fairly constant lending rate around 12%. Furthermore, it also shows that there are other factors beyond PP gold that affect lending rate.  

6.      Selection of alternative

As result of that, The equation chosen from regression analysis is a Poly 5th order displayed in Equation 1, in which Y is lending rate (%) and X is PP USD over gold (Oz Gold/1,000 USD). This will be used as a new risk-free formula based on gold value that has proved as the most reliable and sustainable currency in the world.

y = -0.9741x⁵ + 8.6296x⁴ - 26.648x³ + 34.023x² - 14.49x + 13.392

Equation 1 Lending Rate-PP USD over Gold Regression Formula (source: author)

7.      Performance monitoring and post-evaluation of results

Relying CPI as solely reference in lending rate estimation is not valid as shown in Figure 1, since in fact, the CPI released from the Government doesn’t reflect the real inflation incurred in the market. Hence this creates a need to use an alternative reference with stable and reliable value as baseline, namely Gold.

 The further research regarding this gold-lending rate model should be conducted to build a better model of gold-lending rate as a new risk free rate model. Because in project cost, lending rate is viewed as additional price to be marked up to base cost, thus it has to be included in cost estimation particularly for medium-long term projects

References:

1.       Window on State Government. Manual for Discounting Oil and Gas Income. (2012, Sep 24).Retrieved from: http://www.window.state.tx.us/taxinfo/proptax/ogman/

2.       Rosenberg, Richard, Adrian Gonzalez, and Sushma Narain. (2009, Feb). The New Moneylenders: Are the Poor Being Exploited by High Microcredit Interest Rates? Retrieved from: http://worldbank.org /

3.       Hendarsyah, Nanang. (2010, Nov). Challenges and Policy Options in Managing Portfolio Investment Flows: Bank Indonesia’s recent Experiences. Retrieved from: http://www.bi.go.id /

4.       Rios, Antonio Diez de los. (2004, Jan). Exchange Rate Regimes, Globalisation and The Cost of Capital in Emerging Markets. Retrieved from: www.cemfi.es