CHAPTER 15

Week 11 – Class Exercise (Qs)

1 Richman Savings Association has forecast the following performance ratios for the year
ahead. How fast can Richman allow its assets to grow without reducing its ratio of equity capital
to total assets, assuming its performance holds reasonably steady over the period?

Profit margin of net income over operating revenue 16.00%

Asset utilization (operating revenue ÷ assets) 8.25%
Equity multiplier 10x
Net earnings retention ratio 60.00%

Internal capital growth rate = Profit margin of net income over operating revenue × Asset
utilization × Equity multiplier × Net earnings retention ratio

Answer:
Internal capital growth rate = Profit margin of net income over operating revenue × Asset
utilization × Equity multiplier × Net earnings retention ratio
= 0.16 × 0.0825 × 10 × 0.60= 0.0792 or 7.92 percent

Its assets cannot grow any faster than 7.92 percent over the period without reducing its ratio of
equity capital to total assets.

2.. 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 firms 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 Net Income ÷ Total Net Income ÷ Total

Assets Equity Capital (or ROE)
(or ROA)
First National Bank of 1.25% 15%
Hopkins
Safety National Bank 1.2% 13%
Ilsher State Bank 0.9% 11%
Mercantile Bank and Trust 0.25% 3%
Company
Lakeside National Trust −0.5% −7%

The basic relationship needed in this problem is:

Net income after tax

ROE =
Equity capital

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 Net income after tax
Equity capital =
ROE

And,

Net income after taxes

ROA=
Total Assets
Net income after taxes
Total Assets =
ROA

Hence, the capital-to-asset ratio can be calculated as follows:

ROA
Capital-to-asset ratio =
ROE

Therefore, the ratio of total capital to total assets for the banks named in the problem must be:

Net Income ÷
Net Income ÷ Total Equity
Total Assets Capital (or
Name of Bank (or ROA) ROE) ROA ÷ ROE
First National 1.25% 15%
Bank of Hopkins 8.33%
Safety National Bank 1.2% 13% 9.23%
Ilsher State Bank 0.9% 11% 8.18%
Mercantile Bank and 0.25% 3%
Trust Company 8.33%
Lakeside National Trust −0.5% −7% 7.14%

Answer:

If an institution’s ratio of equity capital to total assets drops to 2 percent or less, a depository
institution is considered “critically undercapitalized”. In this case, 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. It implies that
the negative earnings may be eroding the capital position of this bank.

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3. 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 thrift’s 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 revenues are 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)

(a) (b)
Sale of Sale of 9% (c)
Common Stock Preferred Stock Sale of 10%
at $25 per share at $12 per share Capital Notes

Estimated operating revenues $180,000,000 $180,000,000 $180,000,000

Estimated operating expenses $151,000,000 $151,000,000 $151,000,000

Net revenues $29,000,000 $29,000,000 $29,000,000

Interest expense on capital notes - - $800,000

Before-tax income $29,000,000 $29,000,000 $28,200,000

Estimated income taxes $9,860,000 $9,860,000 $9,588,000

After-tax income $19,140,000 $19,140,000 $18,612,000

Preferred stock dividends - $720,000 -

Net income for common stockholders $19,140,000 $18,420,000 $18,612,000

Shares of common stock outstanding 5,720,000 5,400,000 5,400,000

Earnings per share of common stock $3.35 $3.41 $3.45

In this case, _____sale of debt _____would generate the highest EPS for the bank's shareholders.

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(B) Because of the dilution effect of issuing stock, if operating revenues rise to $225 million, the
situation will be as shown below:

(a) (b)
Sale of Sale of 9% (c)
Common Stock Preferred Stock Sale of 10%
at $25 per share at $12 per share Capital Notes

Operating revenues $225,000,000 $225,000,000 $225,000,000

Operating expenses $182,500,000 $182,500,000 $182,500,000

Net revenues $42,500,000 $42,500,000 $42,500,000

Interest on capital notes - - $800,000

Before-tax income $42,500,000 $42,500,000 $41,700,000

Estimated income taxes $14,450,000 $14,450,000 $14,178,000

After-tax income $28,050,000 $28,050,000 $27,522,000

Preferred stock dividends - 720,000 -

Net income for common

stockholders $28,050,000 $27,330,000 $27,522,000

Shares of common stock

outstanding 5,720,000 5,400,000 5,400,000

Earnings per share of

common stock $4.90 $5.06 $5.1

Again ________Common Stock ________can also be considered this time as it also generates a
slightly less earnings per share.

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(C) If operating revenues drop to $110 million, then the situation will be as shown below:

(a) (b)
Sale of Sale of 9% (c)
Common Stock Preferred Stock Sale of 10%
at $25 per share at $12 per share Capital Notes

Operating revenues $110,000,000 $110,000,000 $110,000,000

Operating expenses $102,000,000 $102,000,000 $102,000,000
Net revenues $8,000,000 $8,000,000 $8,000,000
Interest on capital notes - - $800,000

Before-tax income $8,000,000 $8,000,000 $7,200,000

Estimated income taxes $2,720,000 $2,720,000 $2,448,000

After-tax income $5,280,000 $5,280,000 $4,752,000

Preferred stock dividends - 720,000 -

Net income for common

Stockholders $5,280,000 $4,560,000 $4,752,000

Shares of common Stock

outstanding 5,720,000 5,400,000 5,400,000

Earnings per share of

common stock $0.92 $0.84 $0.88

In this case, to raise the required sum of $8 million, issuing __ preferred stock____. 

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