Finance Assignment: Evaluation of Business Scenarios

Question

Task

Prepare a detailed finance assignment addressing the following questions:

Question 1

1. Suppose the management of ABC Bank Limited decides that it needs to expand its fee-income- generating services. Among the services the bank is considering adding to its service menu is investment banking activities and the brokering of mutual funds, stocks, and bonds.
   1. Please list two potential advantages that might come to ABC Bank as a result of adding these services to its menu.
   2. Discuss two potential disadvantages the bank might encounter from selling these fee- generating services.
2. MTF Pharma plans a $120 million IPO with an offer price of $6.00 per share, underwritten at $4.00. The company’s legal fees, ASIC registration fees, and other administrative costs total $320 000. The company’s share price increases by 10 percent on the first day. Please calculate the followings:
   1. Total amount due to the underwriter
   2. Total underpricing amount
   3. Company’s total costs of issuing the securities
3. JYO Limited issues an IPO, which will be sold on a best-effort basis. The company's investment bank TTR Bank demands a spread of 15 percent of the offer price, which is set at $32 per share. Ten million shares are issued. However, TTR was overly optimistic and eventually is able to sell the shares for only $28 per share.

Requirements:

1. Calculate total proceeds for TTR Bank
2. Calculate total proceeds for JYO Limited

Question 2

1. Why might a lending institution want to protect itself from adverse movements in interest rates? Explain.
2. Is the following statement true or false? Briefly support your arguments. “The primary means of protection against the risk of insolvency and failure is a bank’s capital.”
3. ASD Bank uses the Moody’s Analytics Portfolio Manager model to evaluate the risk–return characteristics of the loans in its portfolio. ASD has two loans with the following characteristics:

Loan given to VCD Corporation (with an amount of $3 million) earns 1 percent per year in fees, and the loan is priced at a 4 percent spread over the cost of funds for the bank. For collateral considerations, the loss to the bank if the borrower defaults will be 20 percent of the loan’s face value. The expected probability of default is 3 percent.

Loan given to RRT Corporation (with an amount of $7 million) earns 2 percent per year in fees, and the loan is priced at a 5 percent spread over the cost of funds for the bank. For collateral considerations, the loss to the bank if the borrower defaults will be 15 percent of the loan’s face value. The expected probability of default is 2 percent.

The default risk correlation between VCD and RRT is -0.15.

Requirements:

1. Calculate the percentage return on the loan portfolio
2. Calculate the percentage risk of the loan portfolio

Question 3
The balance sheet for VBN Bank Limited is presented below ($ millions):

Notes to the balance sheet:

The interbank cash rate is 8.5 percent, the floating loan rate is (BBR + 4 percent), and currently BBR is 11 percent. Fixed-rate loans have five-year maturities, are priced at par, and pay 12 percent annual interest. The principal is repaid at maturity. Core deposits are fixed rate for two years at 8 percent paid annually. The principal is repaid at maturity. Euro CDs currently yield 9 percent.

1. What is the duration of the fixed-rate loan portfolio of VBN?
2. If the duration of the floating-rate loans and interbank lending is 0.36 year, what is the duration of VBN’s assets?
3. What is the duration of the core deposits if they are priced at par?
4. If the duration of the euro CDs and interbank borrowings is 0.401 year, what is the duration of VBN’s liabilities?
5. What is VBN’s leverage adjusted duration gap?
6. What is the impact on the market value of equity if the relative change in all interest rates is a decrease of 0.5 percent?
7. What variables are available to VBN to immunise the bank? How much would each variable need to change to get DGAP equal to zero?

Question 4

1. Why were U.S. commercial banks forbidden to offer investment banking services for several decades? How did this affect the ability of U.S. banks to compete for underwriting business?
2. UPO Bank has the following balance sheet (in millions of dollars) with the risk weights in parentheses.

In addition, UPO Bank has $40 million in performance-related standby letters of credit (SLCs) with credit conversion factor of 50%.

1. What is the total minimum capital required under Basel III? Consider capital conservation buffer and assume that APRA suggests no countercyclical capital buffer.
2. Does UPO Bank have enough capital to meet the regulatory capital requirements? Calculate Tier 1 CAR, Common Equity Tier 1 CAR, and Total CAR and compare them with Basel III requirements. Consider capital conservation buffer and assume that APRA suggests no countercyclical capital buffer.
3. What additional Common Equity Tier 1 capital does UPO need to meet the minimum capital adequacy requirement? Consider capital conservation buffer and assume that APRA suggests no countercyclical capital buffer.

Question 5

1. What different regions around the globe today appear to offer the greatest opportunities for expansion for international banks? Why do you think this is so? Explain.
2. QWE Bank Limited originates a pool of 250 mortgages, each with 30-year maturity and averaging $250,000 with an annual mortgage coupon rate of 6 percent. The mortgage backed security insurance fee is 50 basis points and QWE Bank’s servicing fee is 20 basis points.

Requirements:

1. What is the monthly mortgage payment?
2. What are the expected monthly cash flows to securitized bondholders?
3. What is the present value of the pass-through security bonds? (Assume that the risk adjusted market annual rate of return is 6 percent compounded monthly)
4. What are QWE Bank’s expected monthly cash flows?

Answer

Finance Assignment Answer 1
4. Suppose the management of ABC Bank Limited decides that it needs to expand its fee-income- generating services. Among the services the bank is considering adding to its service menu is investment banking activities and the brokering of mutual funds, stocks, and bonds.

i. Please list two potential advantages that might come to ABC Bank as a result of adding these services to its menu.

a) Fee generating services like Investment banking activities and brokering of stocks are not affected by interest rate fluctuation like traditional activities hence bank do not have to hedge against these risks.

b) Investment bank activities and brokering of stocks and bonds are of multi billion transaction and banks usually charge 2-3% as the brokerage which transforms to huge sum of money dealing with B2B customers and two or more activities again work as a hedge in case of other activities fail

ii. Discuss two potential disadvantages the bank might encounter from selling these fee- generating services. [2 marks]

a) The potential law suits, huge investment and highly skilled employees are required during the course of these activities.

b) These activities are very volatile and not a continuous income generating process for ABC bank limited.

5. MTF Pharma plans a $120 million IPO with an offer price of $6.00 per share, underwritten at $4.00. The company’s legal fees, ASIC registration fees, and other administrative costs total $320 000. The company’s share price increases by 10 percent on the first day. Please calculate the followings:

i. Total amount due to the underwriter [1 mark]

Total shares issued = $120,000,000/$6

=20 million shares

Underwriting spread = 20,000,000* (6-4)

= $2*20,000,000

=$40,000,000

Total amount due = $40,000,000 + $320,000

= $40,320,000

ii. Total underpricing amount [2 marks]

Share price at end of first day = 1.1*$6=$6.6

Total under-pricing amount = ($6.6-$6)*20 million

= $12,000,000

iii. Company’s total costs of issuing the securities [1 mark]

Cost of underwriting + cost of under pricing

=$40,320,000 + $12,000,000

=$52,320,000

6. JYO Limited issues an IPO, which will be sold on a best-effort basis. The company's investment bank TTR Bank demands a spread of 15 percent of the offer price, which is set at $32 per share. Ten million shares are issued. However, TTR was overly optimistic and eventually is able to sell the shares for only $28 per share.

Requirements:

i. Calculate total proceeds for TTR Bank [1 mark]

Gross proceed from the IPO = $32*10,000,000

= $320,000,000

Underwriting spread = $320,000,000* 15 percent

= $48,000,000 proceed to underwriter

ii. Calculate total proceeds for JYO Limited [1 mark]

Proceeds to JYO Limited = ($28*10,000,000-$48,000,000)

= $232,000,000

Answer 2
4. Why might a lending institution want to protect itself from adverse movements in interest rates?Explain. [3 marks]

Commercial banks income generating source is net interest rate margins. i.e. the difference between the lending rate and borrowing rate. Lending and borrowing are the bank’s main business. And bank generate profits from lending at higher rate and borrowing at lower rates.

The reasons banks want to protect adverse movements in interest rates are.

1. Assets liability match. In case interest rates are too low. People will take their money out and borrowers will come at great pace. In case it is too high lenders will come and borrowers will disappear.
2. Also, all the loans given at floating rate of interest will cause loss of income to the bank until they decrease the borrowing rates.
3. Banks has created its long term assets in such a way to fulfil its long term liabilities and any mismatch will cause bank to lose its net worth

5. Is the following statement true or false? Briefly support your arguments. [2 marks]
“The primary means of protection against the risk of insolvency and failure is a bank’s capital.”

• TO support enough losses and unidentified extraordinary losses bank’s capital is required. Therefore, after collapse of 2008 basell 3 norms were created.
• Bank’s capital also protect bank from default of unsecured bond holders, depositors which may turn into NPAs .
• Bank’s also take insurance against the deposits made and the premium for those is given from the net profit which becomes bank’s capital.
• Tier I, Tier II and tier III capital requirements are made to ensure that banks capital do not fall below certain requirements and they do not collapse

6. ASD Bank uses the Moody’s Analytics Portfolio Manager model to evaluate the risk–return characteristics of the loans in its portfolio. ASD has two loans with the following characteristics:

Loan given to VCD Corporation (with an amount of $3 million) earns 1 percent per year in fees, and the loan is priced at a 4 percent spread over the cost of funds for the bank. For collateral considerations, the loss to the bank if the borrower defaults will be 20 percent of the loan’s face value. The expected probability of default is 3 percent.

Loan given to RRT Corporation (with an amount of $7 million) earns 2 percent per year in fees, and the loan is priced at a 5 percent spread over the cost of funds for the bank. For collateral considerations, the loss to the bank if the borrower defaults will be 15 percent of the loan’s face value. The expected probability of default is 2 percent.

The default risk correlation between VCD and RRT is -0.15.

Requirements:

i. Calculate the percentage return on the loan portfolio [2 marks]

Expected return from loan given to VCD = (.01+.04)-(0.03*.2)= 0.044

Expected return from loan given to RRT = (.02+.05)-(.02*15)= .067

Weight of the VCD loan in total portfolio = $3/$10= 30% Weight of the RRT loan in total portfolio = $7/$10= 70%

Expected return=w1*r1+w2*r2

w1 = weight of VCD

w2 = weight of RRT

r1 and r2 are expected returns of the same

percentage return= 0.3*.044 + 0.7*.067

= .06 or 6%

ii. Calculate the percentage risk of the loan portfolio [3 marks]

• LGD VCD = loss given default of VCD = Expected loss * probability of default* loan amount
  = .20*.03*$3 milion=$18,000
• ?Vcd= 0.030.97
• Risk for VCD Loan = LGD* ?Vcd
  = $18,000* 0.17
  =$3060
• LGD RRT = loss given default of RRT = Expected loss * probability of default* loan amount
  = 0.15*.02*$7 million
  = $21,000
• ?RRT= 0.020.98
  =0.14
• Risk for RRT Loan = LGD* ?RRT
  = $21,000*0.14
  =$2940
  Risk of the portfolio
  = Risk of VCD2+Risk of RRT2+2*?*Risk of VCD*Risk of RRT
  ?= -0.15
  = $4081
  Expressed as a percentage = $4081/10,000,000*100
  =4.08%

Question 3
The balance sheet for VBN Bank Limited is presented below ($ millions):

Notes to the balance sheet:

The interbank cash rate is 8.5 percent, the floating loan rate is (BBR + 4 percent), and currently BBR is 11 percent. Fixed-rate loans have five-year maturities, are priced at par, and pay 12 percent annual interest. The principal is repaid at maturity. Core deposits are fixed rate for two years at 8 percent paid annually. The principal is repaid at maturity. Euro CDs currently yield 9 percent.

8. What is the duration of the fixed-rate loan portfolio of VBN? [3 marks]

 

Duration = PV of CF * t/ PV of cash flow

= $262.33/65

=4.03 years

9. If the duration of the floating-rate loans and interbank lending is 0.36 year, what is the duration of VBN’s assets? [1 mark]

Duration of assets = (0+.36*20+.36*105+4.03*65)/220

=1.39 years

10. What is the duration of the core deposits if they are priced at par? [1 mark]

Duration = PV of CF * t/ PV of cash flow

= 38.48/20

=1.92 years

11. If the duration of the euro CDs and interbank borrowings is 0.401 year, what is the duration of VBN’s liabilities? [1 mark]

Duration of liabilities = (1.92*20+.401*50+.401*130)/220

=0.50 years

12. What is VBN’s leverage adjusted duration gap? [1 mark]

Leverage adjusted duration gap = duration of assets – 200/220* duration of liabilities

= 1.39- (200/220)*.50

= 0.93 years

13. What is the impact on the market value of equity if the relative change in all interest rates is a decrease of 0.5 percent? [1 mark]
Positive duration gap means a decrease in interest rate will lead to increase in equity.

Change in equity = (-)0.93 * (-)0.005 * Total equity

= 0.93*.005* 220,000,000

=$1,023,000

Market value of equity = $20,000,000 + $ 1,023,000

= $21,023,000

14. What variables are available to VBN to immunise the bank? How much would each variable need to change to get DGAP equal to zero? [2 marks]

Immunise the bank means to match the duration of assets and liabilities

Variable available to VBN to set duration gap to 0 are.

1. Reduce the duration of assets by 0.45 years ( 0.5*200/220). To do this reduce the fixed income assets or increase the floating rate loan
2. Increase the duration of liabilities to match that of assets. To do that increase the core deposits or reduce the interbank borrowings.

Answer 4
3. Why were U.S. commercial banks forbidden to offer investment banking services for several decades? How did this affect the ability of U.S. banks to compete for underwriting business? [4 marks]

Commercial banks were not allowed to offer investment banking services for the following reasons.

1. They would force a client to but securities as collateral and to increase the sales along with the loan process.
2. Small banks would not have the resources to beat the profit and economies of scale if they were allowed investment banking activities.
3. There would be huge parity between the interest rates between the investment banks and small commercial banks.
4. Due to increase in risk due to investment activities they would always be the danger of bank collapse.

Due to this US banks were not able to capture the market, profitability and economies of scale and lost the US customers to other investment banks.

4. UPO Bank has the following balance sheet (in millions of dollars) with the risk weights in parentheses.

In addition, UPO Bank has $40 million in performance-related standby letters of credit (SLCs) with credit conversion factor of 50%.

iv. What is the total minimum capital required under Basel III? Consider capital conservation buffer and assume that APRA suggests no countercyclical capital buffer. [2 marks]

Total risk adjusted assets = 0%*30+20%*35+50%*90+100%*220

= $272 million

Considering SLCs (50% conversion) = 50%*$40 = $20

Total risk adjusted assets = $272 + $ 20 = $292

To ensure minimum capital under Basel III with capital conversion buffer = $292* 10.5%

= $30.66 million

v. Does UPO Bank have enough capital to meet the regulatory capital requirements? Calculate Tier 1 CAR, Common Equity Tier 1 CAR, and Total CAR and compare them with Basel III requirements. Consider capital conservation buffer and assume that APRA suggests no countercyclical capital buffer. [3 marks]

No, UPO bank does not have enough capita to meet regulatory capital requirements.

It has total capital of (10+ 7 + 8) $25 million.

Tier 1 CAR = Tier 1 capital/ Risk weighted assets

= 10(equity)+ 25%(maximum allowed)*7( preference shares)/292

=0.04 or 4% minimum required = 6%(Basel III)

Common Equity Tier 1 = CET1/ risk weighted assets

= 10/292 = 0.34 or 3.4%. Minimum required = 4.5% + 2.5% (CC buffer) (Basel III)

Total CAR = (10 + 8 + 7)/292

= 8.51% minimum requirement = 10.5%

vi. What additional Common Equity Tier 1 capital does UPO need to meet the minimum capital adequacy requirement? Consider capital conservation buffer and assume that APRA suggests no countercyclical capital buffer. [1 mark]

Minimum CET1 required considering capital conversion buffer is 7%.

Hence 7% of $292 million is $20.44 million. Additional CET required = 20.44-10 = $10.44 Million

Question 5

3. What different regions around the globe today appear to offer the greatest opportunities for expansion for international banks? Why do you think this is so? Explain. [4 marks]

The emerging markets and developed market have almost equal contribution to world’s GDP and in the next decade emerging markets will surpass developed market GDP’s. The first step in the right direction would be to expand in emerging economies like African subcontinent and Asian subcontinent. The countries which have huge amount of imports and exports should be preferred. Countries like Indonesia and Singapore which are tax heavens is market pace for biggest trades. The business opportunities for banks include consumer financial services, bond markets, Forex transactions and business for small and medium enterprises.

Countries like India and china and Malaysia are the next big trade partners of USA, Euro zone and china and hence huge amount of forex transaction with relatively stable currency is good option to expand in these regions

Banks to generate more profits should look at places with less regulations and transaction hubs to save taxes for example Luxemburg. Emerging markets such as south Africa have lesser requirements on capital ratios also places like this has inflation of 5- 6 % from which bank can generate good net interest rate margins and cheap labour and hence can become more profitable.

4. QWE Bank Limited originates a pool of 250 mortgages, each with 30-year maturity and averaging $250,000 with an annual mortgage coupon rate of 6 percent. The mortgage backed security insurance fee is 50 basis points and QWE Bank’s servicing fee is 20 basis points.

Requirements:

v. What is the monthly mortgage payment? [1 mark]

Let M be the monthly mortgage payment.

Total pool(P) = 250*250,000 = $62,500,000

M = P [ i(1 + i)^n ] / [ (1 + i)^n – 1] r/ 12 = monthly interest rate= 0.5%= i

= 62,500,000*(0.005*1.005^360) / (1.005^360)-1

= $374,719

vi. What are the expected monthly cash flows to securitized bondholders? [2 marks]

Monthly rate of return to bond holder = 6%-(50bps+20bps) = 5.3%

Total pool(P) = 250*250,000 = $62,500,000

M = P [ i(1 + i)^n ] / [ (1 + i)^n – 1] r/ 12 = monthly interest rate= 0.44%= i

= 62,500,000*(0.0044*1.0044^360) / (1.0044^360)-1

= $346,289.56

vii. What is the present value of the pass-through security bonds? (Assume that the risk adjusted market annual rate of return is 6 percent compounded monthly) [2 marks]

PV = M(bond holders) * [ (1 + i)^n – 1]/ [ i(1 + i)^n ]i = yield = 6%/12 = 0.5%

= $346,289.56*((1.005^360) – 1)/(0.005*1.005^360)

= $57,758,194.76

viii. What are QWE Bank’s expected monthly cash flows? [1 mark]

Cash in from mortgage payment = $374,719

Cash out to Bond holders = $346,289.56

Net expected monthly cash flow = Cash in – cash out

= $374,719- $346,289.56

= $ 28,430