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CHAPTER 15 THE MANAGEMENT OF CAPITAL

Goal of This Chapter: The purpose of this chapter is to discover why capital particularly equity capital is so important for financial institutions, to learn how managers and regulators assess the adequacy of an institutions capital position, and to explain the ways that management can raise new capital. Key Topics in This Chapter ! ! ! ! ! ! The Many Tasks of Capital Capital and Risk Exposures Types of Capital In Use Capital as the Centerpiece of Regulation Basel I and Basel II Planning to Meet Capital Needs Chapter Outline I. Introduction: What Is Capital? II. The Many Tasks Capital Performs A. Cushion Against Risk of Failure B. Provides Funds Needed to Begin Operations C. Promotes Public Confidence D. Provides Funds for Future Growth and New Services E. Regulator of Growth F. Capital Plays a Role in Mergers G. Limits How Much Risk Exposure Banks and Competing Firms Can Accept H. Protects the Governments Deposit Insurance System III. Capital and Risk A. Key Risks in Banking and Financial Institutions Management 1. Credit Risk 2. Liquidity Risk 3. Interest Rate Risk 4. Operating Risk 5. Exchange Risk 6. Crime Risk B. Defenses against Risk 1. Quality Management 2. Diversification a. Portfolio b. Geographic 3. Deposit Insurance 4. Owners' Capital IV. Types of Capital in Use A. Common stock B. Preferred stock
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C. Surplus D. Undivided profits E. Equity reserves F. Subordinated debentures G. Minority interest in consolidated subsidiaries H. Equity commitment notes Relative Importance of the Different Sources of Capital V. One of the Great Issues in the History of Banking: How Much Capital Is Really Needed? A. Regulatory Approach to Evaluating Capital Needs 1. Reasons for Capital Regulation 2. Research Evidence VI. The Basle Agreement on International Capital Standards: An Historic Contract among Leading Nations A. Basel I 1. Tier 1 (core) Capital 2. Tier 2 (supplemental) Capital 3. Calculating Risk-Weighted Assets under Basel I 4. Calculating the Capital-to-Risk-Weighted Assets Ratio Under Basel I B. Capital Requirements Attached to Derivatives 1. Bank Capital Standards and Market Risk 2. Value at Risk (VaR) Models Responding to Market Risk 3. Limitations and Challenges of VaR and Internal Modeling C. Basel II: A New Capital Accord Unfolding 1. Why Basel II Appears to Be Needed 2. Pillars of Basel II 3. Internal Risk Assessment 4. Operational Risk 5. Basel II and Credit Risk Models 6. A Dual (Large-Bank, Small-Bank) Set of Rules 7. Problems Accompanying the Implementation of Basel II VII. Changing Capital Standards Inside the United States A. FDIC Improvement Act B. Prompt Corrective Action 1. Well capitalized 2. Adequately capitalized 3. Undercapitalized 4. Significantly undercapitalized 5. Critically undercapitalized VIII. Planning to Meet Capital Needs A. Raising Capital Internally 1. Dividend Policy 2. How Fast Must Internally Generated Funds Grow? B. Raising Capital Externally 1. Selling Common Stock 2. Selling Preferred Stock 3. Issuing Debt Capital 4. Selling Assets and Leasing Facilities 5. Swapping Stock for Debt Securities 6. Choosing the Best Alternative for Raising Outside Capital IX. Summary of the Chapter
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Concept Checks 15-1. What does the term capital mean as it applies to financial institutions?

Funds contributed to a financial institution primarily by its owners, consisting mainly of stock, reserves, and retained earnings, plus any long-term debt issued that qualifies under regulations. 15-2. What crucial roles does capital play in the management and viability of financial firm?

Capital provides the long-term, permanent funding that is needed to construct facilities and provide a base for the future expansion of assets. Capital also absorbs operating losses until management has a chance to correct the institution's problems. From a regulatory perspective capital limits the growth of risky assets. 15-3. What are the links between capital and risk exposure among financial-service providers?

Capital functions as a cushion to absorb losses until management can correct the problems generating those losses. Institutions face many different kinds of risk: (1) crime risk, (2) interest-rate risk, (3) credit risk, (4) liquidity risk, (5) exchange risk and (6) operational risk. Capital represents the ultimate line of defense against these risks when all other defenses fail. 15-4. What forms of capital are in use today? What are the key differences between the different types of capital? The principal forms of bank capital include common and preferred stock, surplus, undivided profits, equity reserves, subordinated notes and debentures, minority interest in consolidated subsidiaries, and equity commitment notes. Common stock represents the par value paid by owners, while surplus is the amount paid over par value for the stock when it is first sold. Preferred stock is a special type of ownership where dividends are fixed and stockholders generally do not have a vote on major activities undertaken by the firm. Retained earnings or undivided profits are the accumulated earnings of the firm kept to reinvest back in the company. Subordinated notes and debentures are long term debt instruments that don not represent ownership claims. Equity reserves represents the funds set aside for contingencies, such as legal action against the institution, reserve for dividend expected to be paid but not yet declared or shrinking fund to retire stock or debt in the future. Minority interests in consolidated subsidiaries are one in which financial firms holds ownership shares in other businesses. Equity commitment notes are one in which debt securities are repaid from the sale of stock. 15-5. Measured by volume and percentage of total capital, what are the most important and least important forms of capital held by U.S.-insured banks? Why do you think this is so? The most important form of capital is surplus, followed by retained earnings, subordinated notes and debentures, and common and preferred stock. Common stock represents what owners contribute originally when they buy the stock to begin with. Retained earnings represent the growth in earnings that accumulate in the firm over time. What the owners contribute to the firm and the wealth that accumulates over time are the true cushion against loss that capital represents. 15-6. How do small banks differ from large banks in the composition of their capital accounts and in the total volume of capital they hold relative to their assets? Why do you think these differences exist? Small banks rely mainly on surplus value of their stock and retained earnings (undivided profits) and very
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little on long-term debt (subordinated notes and debentures), whereas large banks rely on surplus value of stock, retained earnings and long term debt. Small banks have a difficult time to place their equity and debt securities in the market and thus, rely more heavily on internal capital (i.e. retained earnings). Nevertheless, it is generally the smallest banks that maintain the thickest cushion of capital relative to their asset size. 15-7 What is the rationale for having the government set capital standards for financial institutions as opposed to letting the private marketplace set those standards? The government's interest in capital stems from its efforts to stabilize the financial system and avoid drains on the federal insurance system. Capital requirements have long been subject to government regulation, though bankers frequently argue that the market, rather than regulators, should determine how much capital a financial institution should hold. The fear among regulators, however, is that financial institutions would hold too little capital to avoid excessive numbers of failures and that the private market cannot adequately assess their need for capital. 15-8. What evidence does recent research provide on the role of the private marketplace in determining capital standards? The results of recent studies are varied, but most find that the private marketplace is more important than government regulation in determining the amount and type of capital financial institutions must hold. However, Recently government regulation appears to have become nearly as important as the private marketplace by tightening capital regulations and imposing minimum capital requirements, especially in the wake of the great credit crisis of 2008. 15-9. According to recent research, does capital prevent a financial institution from failing?

If capital is large enough to absorb operating losses it can prevent failure for a time, at least until the capital is all used up. However, there is no solid, undisputed evidence of a significant relationship between the size of the capital-to-asset ratio and the incidence of failure. 15-10. What are the most popular financial ratios regulators use to assess the adequacy of bank capital today? The prime capital-adequacy ratios are total capital to assets, equity capital to assets, total capital to risk assets, and primary or core capital and supplementary or secondary capital to total assets and to riskadjusted assets. 15-11. What is the difference between core (or tier 1) capital and supplemental (or tier 2) capital? Core capital is the permanent capital of a bank, consisting mainly of common stock, surplus, undivided profits (retained earnings), qualifying noncumulative perpetual preferred stock, minority interest in the equity accounts of consolidated subsidiaries, and selected identifiable intangible assets less goodwill, equity reserves and other intangible assets. Supplemental capital is secondary forms of bank capital, which includes the allowance (reserves) for loan and lease losses, subordinated debt capital instruments, mandatory convertible debt, intermediate-term preferred stock, cumulative perpetual preferred stock with unpaid dividends, and equity notes and other long-term capital instruments that combine both debt and equity features.

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15-12. A bank reports the following items on its latest balance sheet: allowance for loan and lease losses, $42 million; undivided profits, $81 million; subordinated debt capital, $3 million; common stock and surplus, $27 million; equity notes, $2 million; minority interest in subsidiaries, $4 million; mandatory convertible debt, $5 million; identifiable intangible assets, $3 million; and noncumulative perpetual preferred stock, $5 million. How much does the bank hold in Tier 1 capital? In Tier 2 capital? Does the bank have too much Tier 2 capital? The Tier 1 capital items include: Common stock and surplus Undivided profits Noncumulative perpetual preferred stock Identifiable intangible assets Minority interest in subsidiaries Total Tier 1 capital $27 mill. 81 5 3 4 $120 mill. The Tier 2 capital items include: Allowance for loan and lease losses Subordinated debt capital Mandatory convertible debt Equity notes $42 mill. 3 5 2

Total Tier 2 capital

$52 mill.

The bank does not have too much Tier 2 capital. Tier 2 capital can be up to 100 percent of the amount of Tier 1 capital and still count toward meeting capital requirements. 15-13. What changes in the regulation of bank capital were brought into being by the Basel Agreement? What is Basel I? Basel II? U.S. banks, along with international banks from other industrialized nations, must hold a ratio of core capital or Tier 1 (permanent) capital to risk-weighted assets of 4 percent and an additional 4 percent in supplementary or secondary capital, under the terms of the Basel Agreement on international capital standards. Basel I refers to the capital standards that are in effect today. Basel II is a new capital requirement accord that is supposed to address the weaknesses of Basel I. It is scheduled to be phased in starting in 2008. 15-14. First National Bank reports the following items on its balance sheet: cash, $200 million; U.S. government securities, $150 million; residential real-estate loans, $300 million; and corporate loans, $350 million. Its off-balance-sheet items include standby credit letters, $20 million and long-term credit commitments to corporations, $160 million. What are First National's total risk-weighted assets? If the bank reports Tier I capital of $30 million and Tier 2 capital of $20 million, does it have a capital deficiency? We first convert the off-balance-sheet items to their credit-equivalent amounts: Off-Balance-Sheet Items: Standby credit letters $20 mill. * 1.00 = $20 mill. Long-term commitments to corporations $160 mill. * 0.50 = 80 mill. Then we risk-weight all assets: Risk-Weighted Assets Cash $200 mill. * 0 = U.S. Government Securities: $0 mill.

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$150 mill. * 0 = Standby Credit Letters: $20 mill. * 0.20 = Residential Real Estate Loans: $300 * 0.50 = Corporate Loans: $350 * 1.00 = Long-Term Credit Commitments: $80 * 1.00 = Total Risk-Weighted Assets = The bank has total capital of: Tier 1 capital = $30 mill. Tier 2 capital = $20 mill. $50 mill. The bank's capital to risk-weighted asset ratio is: $50 mill. = 0.086 or 8.6% $584 mill.

0 4 150 350 80 $584

which exceeds the minimum requirement of 8 percent. Moreover, more than 4 percent of the 8.6 percent in capital is Tier 1 capital, so the bank satisfies the capital requirements. 15-15. How is the Basel Agreement likely to affect a bank's choices among assets it would like to acquire? Under the capital standards brought into being by the Basel Agreement, differing risk weights will apply to different kinds of bank assets. Each dollar of high-risk assets, such as corporate loans and home mortgages, requires a greater proportion of bank capital pledged behind it than a dollar of low-risk assets, such as government securities. Banks desiring to keep their capital costs as low as possible will move toward government securities and away from corporate loans and home mortgage loans. They will also change the types of off-balance sheet items they hold for the same reason. 15-16. What are the most significant differences between Basel I and Basel II? Explain the importance of the concepts of internal risk assessment, VaR, and market discipline Basel I used a one size fits all approach to determine a banks capital requirements. Basel II recognizes that different banks have different risk exposures and should be subject to different capital requirements. It also broadens the types of risk considered for determining capital requirements, including credit, market and operational risk. Internal risk assessment refers to an innovation in Basel II which allows banks to measure their own risk exposure. These measurements are subject to review by the regulators to ensure that they are reasonable. The VaR model is one of the models used to determine a banks risk exposure. It measures the price or market risk of a portfolio of assets whose value may decline due to adverse movements in the financial markets or interest rates. Market discipline refers to the market determining the banks risk exposure. In order to achieve that a bank would be required to issue subordinated debt. Since this debt is not guaranteed the buyers of these notes would be very vigilant about the issuing banks financial condition. 15-17. What steps should be part of any plan for meeting a long-range need for capital? The four key phases of planning to meet a bank's capital needs are as follows:
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1. Develop an overall financial plan. 2. Determine the amount of capital that is appropriate given the goals, planned service offerings, acceptable risk exposure, and state and federal regulations. 3. Determine how much capital can be generated internally through profits retained in the business. 4. Evaluate and choose that source of external capital best suited to the institutions needs and goals. 15-18. How does dividend policy affect the need for capital? The retention ratio is of great importance to management. A retention ratio set too low results in slower growth of internal capital, which may increase the failure risk and retard the expansion of earning assets. A retention ratio set too high can result in a cut in stockholders dividend income. Other factors held constant, such a cut would reduce the market value of stock issued by a financial institution. The optimal dividend policy is one that maximizes the value of the stockholders investment. 15-19. What is the ICGR, and why is it important to the management of a financial firm? The ICGR indicates how fast a firm can allow its assets to grow and still keep its capital-to-asset ratio fixed. The ICGR indicates how fast earnings must grow and what proportion must be retained in the business to insure a constant capital-to-asset ratio. 15-20. Suppose that a bank has a rate of return on equity capital of 12 percent and its retention ratio is 35 percent. How fast can this bank's assets grow without reducing its current ratio of capital to assets? Suppose that the bank's earnings (measured by ROE) drop unexpectedly to only two-thirds of the expected 12 percent figure. What would happen to the bank's ICGR? The relevant formula is: ICGR = ROE x Retention Ratio = 0.12 * 0.35 = 0.042 or 4.2 percent If ROE unexpectedly drops to only two-thirds of the expected 12 percent figure, the ICGR becomes: ICGR = [0.12 * 0.66] * 0.35 = 0.028 or 2.8 percent. 15-21. What are the principal sources of external capital for a financial institution? The principal sources of external capital are: selling common stock, selling preferred stock, issuing debt capital, selling assets, leasing certain fixed assets or swapping stock for debt securities. 15-22. What factors should management consider in choosing among the various sources of external capital? The choice of alternative that management should choose will depend primarily on the impact each source would have on returns to stockholders, usually measured by earnings per share (EPS). Other key factors to consider are the institutions risk exposure, the impact on control by existing stockholders, the state of the market for the assets or securities being sold, and regulations. Drawing upon common and preferred stock increases the borrowing capacity and provides permanent capital, but it can result in ownership and earnings dilution. Debt capital is generally cheaper to issue due
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to the leveraging effect, but creates greater risk of variability in shareholder returns and increased risk failure. Selling assets and leasing capital usually creates a substantial inflow of cash. Swapping Stock for Debt Securities strengthens its capital and saved the cost of future interest payments on the notes. Problems and Projects 15-1. The management at Thyme National Bank located in Key West, Florida, is calculating the key capital adequacy ratios for its third-quarter reports. At quarter-end the banks total assets are $92 million and its total risk-weighted assets including off-balance-sheet items are $85.5 million. Tier 1 capital items sum to $4.75 million, while Tier 2 capital items total $2.5 million. Calculate Thyme Nationals leverage ratio, total capital-to-total assets, core capital-to-total risk-weighted assets, and total capital- to-total riskweighted assets. Does Thyme National meet the Basel I requirement stipulated for a bank to qualify as adequately capitalized? In which of the five capital adequacy categories created by U.S. federal regulators for PCA purposes does Thyme National fall? Is Thyme National subject to any regulatory restrictions given its capital adequacy category? $92 million $85.5 million $4.75 million $2.5 million

Total assets Risk weighted assets including offbalance-sheet items Tier 1 capital Tier 2 capital

Leverage ratio: Tier 1 capital/Total asset = $4.75 million/$92 million = 0.0516 or 5.16 percent Total capital-to-total assets ratio: (Tier 1 capital + Tier 2 capital)/Total assets = ($4.75 million + $2.5 million)/$92 million = $7.25 million/$92 million = 0.0788 or 7.88 percent Core capital-to-total risk-weighted assets: = Tier 1 capital/ Risk weighted assets including off-balance-sheet items = $4.75 million/$85.5 million = 0.0555 or 5.56 percent Total capital-to-total risk-weighted assets: = (Tier 1 capital + Tier 2 capital)/ Risk weighted assets including off-balance-sheet items = ($4.75 million + $2.5 million)/$85.5 million = 0.0848 or 8.48 percent Yes, Thyme National Bank meet the Basel I requirement of having a minimum ratio of capital to risk weighted assets of at least 8 percent, a ratio of Tier 1 capital to risk-weighted assets of at least 4 percent, and a leverage ratio of at least 4 percent stipulated for a bank to qualify as adequately capitalized. Thyme National Bank falls in adequately capitalized category among the five capital adequacy categories created by U.S. federal regulators for PCA purpose. Thyme National Bank is subject to a regulatory restriction of not accepting broker-placed deposits without regulatory approval.

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15-2. Please indicate which items appearing on the following financial statements would be classified under the terms of the Basel Agreement as ( a ) Tier 1 capital or ( b ) Tier 2 capital.

Tier 1 Qualifying noncumulative Preferred stock Common stock Undivided profits Minority interest in the equity Accounts of consolidated subsidiaries

Tier 2 Allowance for loan and lease losses Intermediate term preferred stock Cumulative perpetual preferred Stock with unpaid dividends Subordinated debt capital Instrument with an original Maturity of at least 5 Years Equity notes Mandatory convertible debt

15-3. Under the terms of the Basel I Agreement, what risk weights apply to the following on-balancesheet and off-balance-sheet items?

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The items which would appear in the 0%, 20%, 50% and 100% risk weight categories are the following: 0% 20 % 50 % 100 % Cash Deposits held at other Residential real estate Commercial loans banks loans U.S. Treasury Federal agency Long term Standby credit letters securities securities commitments to make for commercial paper corporate loans GNMA mortgage Municipal general Currency derivative Investments in backed securities obligation bonds contracts subsidiaries Short term loan FNMA or FHLMC Interest-rate derivative Credit card loans commitments issued or guaranteed contracts securities Reserves on deposit at Standby letters of Municipal revenue Bank real estate the Federal Reserve credit for municipal bonds banks bonds Bankers acceptances 15-4. Using the following information for Bright Star National Bank, calculate that banks ratios of Tier 1-capital-to-risk-weighted assets and total-capital-to-risk-weighted assets under the terms of the Basel I Agreement. Does the bank have sufficient capital? On-Balance-Sheet Items (Assets) Cash $ 4.5 million Off-Balance-Sheet Items Standby letters of credit backing repayment of commercial paper Long term unused loan commitments to corporate customers Total off-balance-sheet items Tier 1 capital $ 17.5 million

U.S Treasury securities Deposit balances due from other banks Loans secured by first lines on residential property (1- to-4family dwellings) Loans to corporations Total assets

25.6 4.0 50.8

30.5 $ 48 million $7.5 million

105.3 $190.2 million

Tier 2 capital

$5.8 million

Bright Star National Bank's required level of capital under the new international capital standards would be determined from: Standby credit letter: $17.5 million * 1.00 = $17.5 million Long-term credit commitments: $30.5 million * 0.50 = 15.25 million 0% Risk-Weighting Category: Cash U.S. Treasury securities $ 4.5 million 25.6 million $ 30.1 * 0 = $0 million
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20% Risk Weighting Category: Balances due from other Banks Credit equivalent Amounts of Standby credits 50% Risk Weighting Category: Residential real estate loans 100% Risk Weighting Category: Loans to corporations Credit equivalents of long-term commitments Total Risk-Weighted Assets

$ 4.0 million 17.5 million*0.20 = $.8 million

$ 50.8 million x 0.50 = $25.4 million

$105.3 million $15.25 million $120.55 million * 1.0 = $120.55 million $164.25 million = 4.57% = 8.10%

The bank's capital ratio is: Tier 1 capital/Risk-Weighted Assets = $ 7.5 million $ 164.25 million Total capital/Risk-Weighted Assets = $ 13.3 million $ 164.25 million

It is just above the minimum Tier 1 capital requirement of 4 percent and total capital (Tier One + Tier Two) requirement of 8 percent. 15-5. Please calculate New River National Banks total risk weighted assets, based on the following items that the bank reported on its latest balance sheet. Does the bank appear to have a capital deficiency?

Off-balance-sheet items include

The risk-weighted assets of New River National Bank would be calculated as follows: Off-Balance-Sheet Items: Standby credit letters = $87 mill. * .2 = $17.4 million Long-term corporate credit commitments = $145 mill. * 0.50 = $72.5 mill.
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On-Balance-Sheet Items and Credit-Equivalent Off-Balance Sheet Items: Asset Items Cash U.S. government securities Domestic interbank deposits Standby credit letters Residential real estate loans Commercial loans Long-Term corporate credit commitments Total Risk-Weighted Assets New River's overall capital-to-assets ratio is: Total Capital Total Risk-Weighted Assets = $115 million $846.98 million = 0.1358 or 13.58 percent Risk-Weight $115 miIl. * 0 $250 mill. * 0 $130 mill. * 0.20 $17.4 mill. * 0.20 $450 mill. * 0.50 $520 mill. * 1.00 $72.5 mill. * 1.00 = = = = = = = = 0 0 26 mill. 3.48 mill. 225 mill. 520 mill. 72.5 mill. $846.98 mill.

Overall, it does not appear from the information given above that New River has a capital deficiency. 15.6 Suppose that New River National Bank, whose balance sheet is given in problem 5, reports the forms of capital shown in the following table as of the date of its latest financial statement. What is the total dollar volume of Tier 1 capital? Tier 2 capital? Calculate the Tier 1 capital-to-risk-weighted-assets ratio, total capital-to-risk-weighted-asset ratio, and the leverage ratio. According to the data given in problems 5 and 6, does New River have a capital deficiency? What is its PCA capital adequacy category?

New River National Bank has the following Tier 1 and Tier 2 Capital items and totals: Tier 1 Capital Common stock (par) Surplus Undivided profit Total Tier 1 capital Tier 1 Capital Total Risk-Weighted Assets Total Capital $10 million $15 million $45 million $70 million = Tier 2 Capital Allowance for loan loss Subordinated debt capital Intermediate term preferred stock Total Tier 2 capital = $25 million $15 million $5 million $45 million

$70 million $846.98 million $70 + $45 million

0.0826 or 8.26 percent

0.1358 or 13.58 percent


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Total Risk-Weighted Assets Leverage ratio: Tier 1 Capital Total average Assets =

$846.98 million $70 million $1465 million = $70 million/$1465 million 0.0478 or 4.78 percent

This bank has sufficient Tier 1 capital and since its Tier 2 capital amount is less than its Tier 1 capital amount it satisfies the requirements of Basel I. Also its PCA capital adequacy category is Adequately capitalized (it has a ratio of capital to risk-weighted assets of at least 8 percent, a ratio of Tier 1 (or core) capital to risk-weighted assets of at least 4 percent, and a leverage ratio (Tier 1 capital to average total assets) of at least 4 percent). 15-7. Colburn Savings Association has forecast the following performance ratios for the year ahead. How fast can Colburn allow its assets to grow without reducing its ratio of equity capital to total assets, assuming its performance holds reasonably steady over it planning period? Profit margin of net income over operating revenue Asset utilization (operating revenue/assets) Equity multiplier Net earnings retention Ratio 17.75% 8.25% 9.5x 45.00%

Internal Capital Growth Rate = Profit Margin * Asset Utilization * Equity Multiplier * Retention Ratio = 0.1775 * 0.0825 * 9.5 * 0.450 = 0.0626 or 6.26% Its assets cannot grow any faster than 6.26 percent in order to avoid reducing its ratio of equity capital to total assets. 15-8. Using the formulas developed in this chapter and in Chapter 6 and the information that follows, calculate the ratios of total capital to total assets for the banking firm listed below. What relationship among these banks return on assets, return on equity capital, and capital-to- assets ratios did you observe? What implications or recommendations would you draw for the management of each of these institutions? Name of Bank First National Bank of Hopkins Safety National Bank Ilsher State Bank Mercantile Bank and Trust Company Lakeside National Trust Net Income/Total Assets (or ROA) 1.4% 1.2% 0.9% 0.5% -0.5% Net Income/Total Equity Capital (or ROE) 15% 13% 11% 6% -7%

The basic relationship needed in this problem is ROE = Net Income After Taxes Equity Capital = Net Income After Taxes Total Assets * Total Assets Equity Capital

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= In which case: Total Assets Equity Capital

ROA

Total Assets Equity Capital = ROA ROE

ROE ROA

and

Equity Capital Total Assets

Therefore the ratio of total capital to total assets for the banks named in the problem must be: First National Bank of Hopkins = 0.014/0.15 = 0.0933 or 9.33%. Safety National Bank = 0.012/0.13 = 0.0923 or 9.23% Ilsher State Bank = 0.009/0.11 = 0.0818 or 8.18% Mercantile Bank and Trust Company = 0.005/0.06 = 0.0833 or 8.33% Lakeside National Bank = -0.005/-0.07 = 0.0714 = 7.14% None of the banks appear to have a serious capital deficiency problem. However, the bank with the lowest capital to total assets ratio is also the one with a negative return on assets and return on equity. The negative earnings may be eroding the capital position of this bank. 15-9. Over the Hill Savings has been told by examiners that it needs to raise an additional $8 million in long-term capital. Its outstanding common equity shares total 5.4 million, each bearing a par value of $1. This thrift institution currently holds assets of nearly $2 billion, with $135 million in equity. During the coming year, the thrifts economist has forecast operating revenues of $180 million, of which operating expenses are $25 million plus 70% of operating revenues. Among the options for raising capital considered by management are (a) selling $8 million in common stock, or 320,000 shares at $25 per share; (b) selling $8 million in preferred stock bearing a 9 percent annual dividend yield at $12 per share; or (c) selling $8 million in 10-year capital notes with a 10 percent coupon rate. Which option would be of most benefit to the stockholders? (Assume a 34% tax rate) What happens if operating revenue more than expected ($225 million rather than $180 million)? What happens if there is a slower-than-expected volume of revenues (only $110 million instead of $180 million)? Please explain. (a) Sale of Common Stock at $25 per share Operating revenues Operating expenses Net revenues Interest on capital notes Before-tax income Estimated income taxes After-tax income $ $180,000,000 151,000,000 $ 29,000,000 ------------------$29,000,000 9,860,000 19,140,000 (b) Sale of 9% Preferred Stock at $12 per share $180,000,000 151,000,000 $ 29,000,000 ------------------$29,000,000 9,860,000 $ 19,140,000 (c) Sale of 10% Capital Notes $180,000,000 151,000,000 $ 29,000,000 800,000 $28,200,000 9,588,000 $ 18,612,000

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Preferred stock dividends Net income for common stockholders Shares of common stock outstanding Earnings per share of common stock

---------------------$ 19,140,000 5,720,000 $ 3.35 $

720,000 18,420,000 5,400,000 $3.41

--------------------$ 18,612,000 5,400,000 $3.45

In this case sale of the debt would yield the highest EPS for the bank's shareholders Because of the dilution effect of issuing stock. If operating revenue rose to $225 million the situation would be the following: (a) Sale of Common Stock at $25 per share Operating revenues Operating expenses Net revenues Interest on capital notes Before-tax income Estimated income taxes After-tax income Preferred stock dividends Net income for common stockholders Shares of common stock outstanding Earnings per share of common stock $ $225,000,000 182,500,000 $ 42,500,000 ------------------$42,500,000 14,450,000 28,050,000 (b) Sale of 9% Preferred Stock at $12 per share $225,000,000 182,500,000 $ 42,5000,000 ------------------$42,500,000 14,450,000 $ 28,050,000 720,000 $ 27,330,000 5,400,000 $5.06 (c) Sale of 10% Capital Notes $225,000,000 182,500,000 $ 42,500,000 800,000 $41,700,000 14,178,000 $ 27,522,000 --------------------$ 27,522,000 5,400,000 $5.1

---------------------$ 28,050,000 5,720,000 $4.90

And again the capital notes would be the best option, although the preferred stock comes closer this time. If operating revenues drop to $110 million, then the situation would be the following:
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CHAPTER 14

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(a) Sale of Common Stock at $25 per share Operating revenues Operating expenses Net revenues Interest on capital notes Before-tax income Estimated income taxes After-tax income Preferred stock dividends Net income for common Stockholders Shares of common Stock outstanding Earnings per share of common stock $ $110,000,000 102,000,000 $ 8,000,000 ------------------$8,000,000 2,720,000 5,280,000

(b) Sale of 9% Preferred Stock at $12 per share $110,000,000 102,000,000 $ 8,000,000 ------------------$8,000,000 2,720,000 $ 5,280,000 720,000 $ 4,560,000 5,400,000

(c) Sale of 10% Capital Notes $110,000,000 102,000,000 $ 8,000,000 800,000 $7,200,000 2,448,000 $ 4,752,000 --------------------$ 4,752,000 5,400,000

---------------------$ 5,280,000 5,720,000

$ 0.92

$0.84

$ 0.88

In this case issuing the common stock is the best alternative from the point of view of the common stockholders.

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