Problems for Commercial Bank Management

Lecture 2 Financial Statements

2.1. Suppose that a bank holds cash in its vault of $1.4 million, short-term
government securities of $12.4 million, privately issued money market instruments of
$5.2 million, deposits at the Federal Reserve banks of $20.1 million, cash items in the
process of collection of $0.6 million, and deposits placed with other banks of $16.4
million. How much in primary reserves does this bank hold? In secondary reserves?

PR = 36.5
SR = 17.6

2.2. Suppose a bank has an allowance for loan losses of $1.25 million at the
beginning of the year, charges current income for a $250,000 provision for loan
losses, charges off worthless loans of $150,000, and recovers $50,000 on loans
previously charged off. What will be the balance in the allowance for loan losses at
year-end?

Ending balance = 1.25 + 0.25 – 0.15 + 0.05 = 1.4

2.3. Jasper National Bank has just submitted its Report of Condition to the
FDIC. Please fill in the missing items from its statement shown below (all
figures in millions of dollars):

Report of Condition
Total assets $2,500
Cash and due from Depository
Institutions 87
Securities 233
Federal Funds Sold and Reverse
Repurch. 45
Gross Loans and Leases 1900
1 Loan Loss Allowance 200
Net Loans and Leases 1700
Trading Account Assets 20
Bank Premises and Fixed Assets 25
Other Real Estate Owned 15
Goodwill and Other Intangibles 200
All Other Assets 175
Total Liabilities and Capital 2,500

Total Liabilities 2260

Total Deposits 1600
Federal Funds Purchased and
Repurchase Agreements. 80
Trading Liabilities 10
Other Borrowed Funds 50
Subordinated Debt 480
All Other Liabilities 40
Total Equity Capital 240

Perpetual Preferred Stock 2

Common Stock 24
Surplus 144
Undivided Profit 70

2.4. Along with the Report of Condition submitted above, Jasper has also prepared a
Report of Income for the FDIC. Please fill in the missing items from its statement
shown below (all figures in millions of dollars):

Report of Income

Total Interest Income $120

Total Interest Expense 80
Net Interest Income 40
Provision for Loan and Lease Losses 4
Total Noninterest Income 58
Fiduciary Activities 8
Service Charges on Deposit Accounts 6
Trading Account Gains and Fees 14
Additional Noninterest Income 30
Total Noninterest Expense 77
Salaries and Benefits 47
 Premises and Equipment Expense 10
Additional Noninterest Expense 20
Pretax Net Operating Income 17
Securities Gains (Losses) 1
Applicable Income Taxes 5
Income Before Extraordinary Income 13
Extraordinary Gains – Net 2
Net Income 15

2.5. If you know the following figures:

Total Interest Income $140Provision for Loan Loss $5

Total Interest Expenses 100Income Taxes 5
Increases in bank’s undivided
Total Noninterest Income 15 profits 6
Total Noninterest Expenses 35

Please calculate these items:

Net Interest Income = 40
Net Noninterest Income = -20
Pretax net operating income = 15
Net Income After Taxes = 10
Total Operating Revenues = 155
Total Operating Expenses = 140
Dividends paid to Common Stockholders = 4

2.6. The Mountain High Bank has Gross Loans of $750 million with an ALL
account of $45 million. Two years ago the bank made a loan for $10 million to finance
the Mountain View Hotel. Two million in principal was repaid before the borrowers
defaulted on the loan. The Loan Committee at Mountain High Bank believes the hotel
will sell at auction for $7 million and they want to charge off the remainder
immediately.
a. Net loans?
b. After charge-off, Gross Loans, ALL and Net Loans?
c. If the Mountain View Hotel sells at auction for $8 million, how with the affect the
pertinent balance sheet accounts?

a. Net loans = 750 – 45 = 705

b. Gross loans = 750 – 8 = 742
All = 45 – 1 = 44
Net loans = 742 – 44 = 698
c. Gross loans = 742
All = 45
Net loans = 697

2.7. You were informed that a bank’s latest income and expense statement
contained the following figures (in $ millions):

Net Interest Income $700

Net Noninterest Income ($300)
Pretax net operating income $372
Security gains $10
Increases in bank’s Undivided
Profit $200

Suppose you also were told that the bank’s total interest income is twice as large as its
total interest expense and its noninterest income is three-fourths of its noninterest
expense. Imagine that its provision for loan losses equals 2 percent of its total interest
income, while its taxes generally amount to 30 percent of its net income before
income taxes. Calculate the following items for this bank’s income and expense
statement:

Total Interest Income (TII) and Total Interest Expense(TIE):

Total Noninterest Income (TNI) and Total Noninterest Expense(TNE):
Provision for Loan Losses
Taxes
Dividends

Lecture 3 Deposits

3.1. A bank determines from an analysis of its cost-accounting figures that for
each $500 minimum-balance checking account it sells account processing and other
operating costs will average $4.87 per month and overhead expenses will run an
average of $1.21 per month. The bank hopes to achieve a profit margin over these
particular costs of 10 percent of total monthly costs. What monthly fee should it
charge a customer who opens one of these checking accounts?

4.87 + 1.21 + 10%(4.87 + 1.21) = 6.69

3.2. Use the APY formula required by the Truth in Savings Act for the
following calculation. Suppose that a customer holds a savings deposit in a savings
bank for a year. The balance in the account stood at $2,000 for 180 days and $100 for
the remaining days in the year. If the Savings bank paid this depositor $8.50 in interest
earnings for the year, what APY did this customer receive?

Balance = (2000 x 180 + 100 x 185)/365 = 1036.99

APY = 8.5/1036.99 = 0,82%

3.3. Monica Lane maintains a savings deposit with Monarch Credit Union. This
past year Monica received $10.75 in interest earnings from her savings account. Her
savings deposit had the following average balance each month:

January $400 July $350

February 250 August 425
March 300 September 550
April 150 October 600
May 225 November 625
June 300 December 300

What was the annual percentage yield (APY) earned on Monica’s savings account?

Balance = (400x31 + 250x 28 +…)/365 = 373.56

APY = 10.75/373.56 = 2,88%

3.4. The National Bank of Mayville quotes an APY of 3.5 percent on a one-
year money market CD sold to one of the small businesses in town. The firm posted a
balance of $2,500 for the first 90 days of the year, $3,000 over the next 180 days, and
$4,500 for the remainder of the year. How much in total interest earnings did this
small business customer receive for the year?

Balance = (2500x90 + 3000x180 + 4500x95) = 3267,12

Interest = 3267.12 x 3.5% = 114,35

3.5. Gold Mine Pit Savings Association finds that it can attract the following
amounts of deposits if it offers new depositors and those rolling over their maturing
CDs the interest rates indicated below:

Expected Volume Rate of Interest

of New Deposits Offered Depositors
$10 million 3.00%
15 million 3.25
20 million 3.50
26 million 3.75
28 million 4.00

Management anticipates being able to invest any new deposits raised in loans yielding
6.25 percent. How far should this thrift institution go in raising its deposit interest rate
in order to maximize total profits (excluding interest costs)?

Expected Rate of
Volume of Interest Marginal
New Offered Additional Marginal Revenue Accum
Deposits Depositors Cost Cost Rate rate Diff Income Pro
10 3.00% 0.3000 3.00% 6.25% 0.0325 0.325 0.325
15 3.25% 0.4875 3.75% 6.25% 0.0250 0.125 0.450
20 3.50% 0.7000 4.25% 6.25% 0.0200 0.100 0.550
26 3.75% 0.9750 4.58% 6.25% 0.0167 0.100 0.650
28 4% 1.1200 7.25% 6.25% -0.0100 -0.020 0.630

Lecture 4

4.1. From the data given in the following table, please construct as many of the
financial ratios discussed in this chapter as you can and then indicate what dimension
of a business firm’s performance each ratio represents.

Business Assets Annual Revenue and Expense Items

Cash account $60 Net sales $600
Accounts receivable 155 Cost of goods sold 445
Inventories 128 Wages and salaries 52
Fixed assets 286 Interest expense 28
Miscellaneous assets 96 Overhead expenses 29
725 Depreciation expenses 12
Liabilities and Equity Selling, administrative, 28
and other expenses
Short-term debt: 108 Before-tax net income 6
Accounts payable 117* Taxes owed 1
Notes payable 325* After-tax net income 5
Long-term debt (bonds) 15
Equity capital 160
725
*Annual principal payments on bonds and notes payable total $55. The firm’s
marginal tax rate is 35 percent.

The financial ratios that could be computed given the data in this problem are the
following:

A. Expense Control Ratios:

Cost of goods sold $445

= = 74.17 percent
Net sales $600

Wages and salaries $52

= = 8.67 percent
Net sales $600

Interest expense $28

= = 4.67 percent
Net sales $600

Overhead expenses $29

= = 4.83percent
Net sales $600

Depreciation expenses $12

= = 2.00 percent
Net sales $600

Selling, administrative, and other expenses expenses $28

= = 4.67 percent
Net sales $600

Taxes owed $1
= = 0.17 percent
Net sales $600

B. Operating Efficiency: Measure of a Business Firm’s Performance

Effectiveness
Annual cost of goods sold $445
= = 3.48x
Average inventory $128

Net sales $600

= = 2.10x
Net fixed assets $286

Net sales $600

= = 0.83x
Total assets $725

Net sales $600

= = 3.87x
Accounts and notes receivable $155

Accounts receivable $155

Average collection period = = = 93 days
Annual credit sales $600
)(
( 360 360 )
C. Marketability of the Customer’s Product or Service:

Net sales - Cost of goods sold $600 -$445

GPM = = = 25.83 percent
Net sales $600

Net income after taxes $5

NPM = = = 0.83 percent
Net sales $600

D. Coverage Ratios: Measuring the Adequacy of Earnings

Income before interest and taxes $34

Interest coverage = = =1.214x
Interest payments $28

Coverage of interest and principal payments =

Income before interest and taxes $34

= = = 0.411x
Principal repayments $55
Interest payments + $28 +
1- Firm's marginal tax rate (1-35 percent)

E. Liquidity indicators for business customers:

Current assets $343

Current ratio = = =1.52x
Current liabilities $225
 Current assets - Inventory $343-$128
Acid-test ratio = = = 0.96 x
Current liabilities $225

Net liquid assets = Current assets - Inventory - Current liabilities = $343-$128-$225 = -$10 million
Net working capital = Current assets - Current liabilities = $343 -$225 = $118 million

F. Profitability indicators for business customers:

Before-tax net income $6
= = 0.83percent
Total assets $725

After-tax net income $5

= = 0.69 percent
Total assets $725

Before-tax net income $6

= = 3.75 percent
Net worth $160

After-tax net income $5

= = 3.13percent
Net worth $160

G. The Financial leverage factor:

Total liabilities $565

Leverage ratio = = = 77.9 percent
Total assets $725

Long-term debt $325

Capitalization ratio = = = 65 percent
Total long-term liabilities and net worth $500

Total liabilities $565

Debt-to-sales ratio = = = 94.17 percent
Net sales $600

4.3 Pecon Corporation has placed a term loan request with its lender and
submitted the following balance sheet entries for the year just concluded and the pro
forma balance sheet expected by the end of the current year. Construct a pro forma
Statement of Cash Flows for the current year using the consecutive balance sheets and
some additional needed information. The forecast net income for the current year is
$225 million with $50 million being paid out in dividends. The depreciation expense
for the year will be $100 million and planned expansions will require the acquisition
of $300 million in fixed assets at the end of the current year. As you examine the pro
forma Statement of Cash Flows, do you detect any changes that might be of concern
either to the lender’s credit analyst, loan officer, or both?
Pecon Corporation
(all amounts in millions of dollars)

Assets Liabilities Liabilities

Asstes at Projected and Equity and Equity
the End of for the End at the End for the End
the Most of the of the most of the
Recent Curreny recent Current
Year Year Year Year
Cash $ 532 $ 624 Accounts payable $ 970 $ 1,279
Accounts receivable 1,018 1,210 Notes payable 2,733 2,950
Inventories 894 973 Taxes payable 327 216

Net fixed assets 2,740 2,940 Long-term debt obligations 872 931
Other assets 66 87 Common stock 85 85
Undivided profits 263 373
Total assets $ 5,250 $ 5,834 Total liabilities and equity capital $ 5,250 $ 5,834

4.4 As a loan officer for Sun Flower National Bank, you have been responsible
for the bank’s relationship with USF Corporation, a major producer of remote-control
devices for activating television sets, DVDs, and another audio-video equipment. USF
has just filed a request for renewal of its $10 million line of credit, which will cover
approximately nine months. USF also regularly uses several other services sold by the
bank. Applying customer profitability analysis (CPA) and using the most recent year
as a guide, you estimate that the expected revenues from this commercial loan
customer and the expected costs of serving this customer will consist of the following:
Expected Revenues Expected Costs
Interest income from the Interest paid on customer
requested loan (assuming an deposits (3.5%) —?
annualized loan rate of 4% Cost of other funds raised 180,000
for 9 months) —? Account activity costs 5,000
Loan commitment fee (1%) 100,000 Wire transfer costs 1,300
Deposit management fees 4,500 Loan processing costs 12,400
Wire transfer fees 3,500 Recordkeeping costs 4,500
Fees for agency services 4,500

The bank’s credit analysts estimated the customer probably will keep an
average deposit balance of $2,125,000 for the year the line is active. What is the
expected net rate of return from this proposed loan renewal if the customer actually
draws down the full amount of the requested line for nine months? What decision
should the bank make under the foregoing assumptions? If you decide to turn down
this request, under what assumptions regarding revenues, expenses, and customer
deposit balances would you be willing to make this loan?

4.5. In order to help fund a loan request of $10 million for one year from one of
its best customers, Lone Star Bank sold negotiable CDs to its business customers in
the amount of $6 million at a promised annual yield of 2.75 percent and borrowed $4
million in the Federal funds market from other banks at today’s prevailing interest rate
of 2.80 percent.

Credit investigation and recordkeeping costs to process this loan application

were an estimated $25,000. The Credit Analysis Division recommends a minimal 1
percent risk premium on this loan and a minimal profit margin of one-fourth of a
percentage point. The bank prefers using cost-plus loan pricing in these cases. What
loan rate should it charge?

Lone Star Bank has sold negotiable CDs in the amount of $6 million at a yield of 2.75
percent and purchased $4 million in Federal funds at a rate of 2.80 percent. The
weighted average cost of bank funds in this case would be:

We can find the interest cost of funding a $10 million loan as follows:

Sale of negotiable CDs cost $165,000 ($6,000,000 × 2.75 percent) to the bank.
Whereas, the funds borrowed from Federal funds cost $112,000 ($4,000,000 × 2.80
percent).

Hence, the total interest cost of $277,000 is to be borne by the bank. On a $10 million
loan, t average annual interest cost is 2.77 percent ($277,000 ÷ $10,000,000).

The bank incurs a noninterest cost 0.25 percent ($25,000 ÷ $10,000,000) to process
this loan application. The bank considers a risk premium one percent and a 0.25
percent minimal profit margin.

Based on the cost-plus loan pricing model:

Loan interest rate =

Marginal cost of raising loanable funds to lend to the borrower +
Nonfunds operating costs + Estimated margin to compensate for default risk +
Desired profit margin

Loan interest rate = 2.77 percent + 0.25 percent + 1 percent + 0.25 percent = 4.27 percent
Lecture 5

5.1 Mr. and Mrs. Napper are interested in funding their children's college
education by taking out a home equity loan in the amount of $24,000. Eldridge
National Bank is willing to extend a loan, using the Napper's home as collateral.
Their home has been appraised at $110,000, and Eldridge permits a customer to use
no more than 70 percent of the appraised value of the home as a borrowing base. The
Nappers still owe $60,000 on the first mortgage against their home. Is there enough
residual value left in the Nappers’ home to support their loan request? How could the
lender help them meet their credit needs?

The maximum credit line available to the Nappers under the bank's current home-
equity loan policy is:
($110,000 × 70%) - $60,000 = $17,000
This clearly is not a large enough borrowing base to cover the $24,000 loan requested.
Many banks make adjustments in the permissible loan amount if the customer has an
above-average level of income, other assets to pledge, relatively low mortgage debt
obligations, and an excellent credit rating. Thus, the Nappers may be able to qualify
for an additional $7,000 in loanable funds (perhaps by pledging other collateral) to
make up the $24,000 they need.

5.2 Ben James has just been informed by a finance company that he can access
a line of credit of no more than $75,000 based upon the equity value in his home.
James still owes $125,000 on a first mortgage against his home and $25,000 on a
second mortgage claim against the home, which was incurred last year to repair the
roof and driveway. If the appraised value of James’s residence is $300,000, what
percentage of the home's estimated market value is the lender using to determine
James’s maximum available line of credit?

5.3 Jamestown Savings Bank, in renewing its credit card customers finds that of
those customers scoring 40 points or less on its credit-scoring system, 35 percent (or a
total of 10,615 credit customers) turned out to be delinquent credits resulting in total
losses. This group of bad credit card loans averaged $6,800 in size per customer
account. Examining its successful credit accounts Jamestown finds that 12% of its
good customers (or a total of 3,640 customers) scored 40 points or less on the bank’s
scoring system. These low scoring but good accounts generated about $1,700 in
revenues each. If Jamestown’s credit card division follows the decision rule of
granting credit cards only to those customers scoring more than 40 points and future
credit accounts generate about the same average revenues and losses, about how much
can the bank expect to save in net losses.

Loss 10615 x 6800 = 72 182 000

Revenue = 3640 x 1700 = 6 188 000
Save = 65 994 000

5.4 The Lathrop family needs some extra funds to put their two children
through college starting this coming fall and to buy a new computer system for a part-
time home business. They are not sure of the current market value of their home,
though comparable 4-bedroom homes are selling for about $410,000 in the
neighborhood. The Monarch University Credit Union will loan 75 percent of the
property’s appraised value, but the Lathrops still owe $265,000 on their home
mortgage and home improvement loan combined. What maximum amount of credit is
available to this family should it elect to seek a home equity credit line?

5.5 The Crockett family has asked for a 30-year mortgage in the amount of
$325,000 to purchase a home. At a 7 percent loan rate, what is the required monthly
payment?

7%/12
360 p

PV = a x (1- (1+i)^-n)/i => a = 2162

5.6 The Watson family has been planning a vacation to Europe for the past two
years. Gratton Savings agrees to advance a loan of $7,200 to finance the trip provided
the Watsons pay the loan back in 12 equals monthly installments. Gratton will charge
an add-on loan rate of 6%. How much in interest will the Watsons pay under the add-
on loan rate method? What is the amount of each required monthly payment? What
is the effective loan rate in this case?

5.7 Jane Zahrley’s request for a four-year automobile loan for $33,000 has been
approved. Reston Center Bank will require equal monthly installment payments for
48 months. The bank tells Jane that she must pay a total of $5,500 in finance charges.
What is the loan’s APR?

38500 = 38500/48 x (1- (1+i)^-n)/i =>i => APR = 12 x i

5.8 Mary Cantrary is offered a $1,600 loan for a year to be paid back in equal
quarterly installments of $400 each. If Mary is offered the loan at 8 percent simple
interest, how much in total interest charges will she pay? Would Mary be better off
(in terms of lower interest cost) if she were offered the $1,600 at 6 percent simple
interest with only one principal payment when the loan reaches maturity? What
advantage would this second set of loan terms have over the first set of loan terms?

Lecture 6

6-1. A government bond is currently selling for $1,195

and pays $75 per year in interest for 14 years when it matures.
If the redemption value of this bond is $1,000, what is its
yield to maturity if purchased today for $1,195?

1195 = 75/(1+YTM) + … + 1075/(1+YTM)^14 Excel

YTM = 5.47

6-2. Suppose the government bond described in problem

1 above is held for five years and then the savings institution
acquiring the bond decides to sell it at a price of $940. Can
you figure out the average annual yield the savings institution
will have earned for its five-year investment in the bond?

6-3. U.S. Treasury bills are available for purchase this

week at the following prices (based upon $100 par value) and
with the indicated maturities:

a. $97.25, 182 days.

b. $95.75, 270 days.
c. $98.75, 91 days.

Calculate the bank discount rate (DR) on each bill if it is held

to maturity. What is the equivalent yield to maturity
(sometimes called the bond-equivalent or coupon-equivalent
yield) on each of these Treasury Bills?

6-4. Farmville Financial reports a net interest margin of

2.75 percent in its most recent financial report, with total
interest revenue of $95 million and total interest costs of $82
million. What volume of earning assets must the bank hold?
Suppose the bank’s interest revenues rise by 5 percent and its
interest costs and earnings assets increase by 9 percent. What
will happen to Farmville’s net interest margin?

Earning assets = (95-82)/0.0275 = 472.73

=(95x1.05 – 82x1.09)/(473x1.09) = 2.01%

6-5. If a credit union’s net interest margin, which was

2.50 percent, increases 10 percent and its total assets, which
stood originally at $575 million, rise by 20 percent, what
change will occur in the bank's net interest income?

6-6. The cumulative interest rate gap of Poquoson

Savings Bank increases 60 percent from an initial figure of
$25 million. If market interest rates rise by 25 percent from an
initial level of 3 percent, what changes will occur in this
thrift’s net interest income?

6-7. New Comers State Bank has recorded the following

financial data for the past three years (dollars in millions):
 Current Year Previous Year Two Years Ago
Interest revenues $82 $80 $78
Interest expenses 64 66 68
Loans (excluding nonperforming) 450 425 400
Investments 200 195 200
Total deposits 450 425 400
Money market borrowings 150 125 100

What has been happening to the bank’s net interest margin?

What do you think caused the changes you have observed? Do
you have any recommendations for New Comers’
management team?

6-8. First National Bank of Bannerville has posted

interest revenues of $63 million and interest costs from all of
its borrowings of $42 million. If this bank possesses $700
million in total earning assets, what is First National’s net
interest margin? Suppose the bank’s interest revenues and
interest costs double, while its earning assets increase by 50
percent. What will happen to its net interest margin?

6.9. Peoples’ Savings Bank has a cumulative gap for the

coming year of + $135 million, and interest rates are expected
to fall by two and a half percentage points. Can you calculate
the expected change in net interest income that this thrift
institution might experience? What change will occur in net
interest income if interest rates rise by one and a quarter
percentage points?

6.10 Suppose Carroll Bank and Trust reports interest-

sensitive assets of $570 million and interest-sensitive
liabilities of $685 million. What is the bank’s dollar interest-
sensitive gap? Its relative interest-sensitive gap and interest-
sensitivity ratio?

6.11. Suppose that a savings institution has an average

asset duration of 2.5 years and an average liability duration of
3.0 years. If the savings institution holds total assets of $560
million and total liabilities of $467 million, does it have a
significant leverage-adjusted duration gap? If interest rates
rise, what will happen to the value of its net worth?

6.12. Stilwater Bank and Trust Company has an average

asset duration of 3.25 years and an average liability duration
of 1.75 years. Its liabilities amount to $485 million, while its
assets total $512 million. Suppose that interest rates were 7
percent and then rise to 8 percent. What will happen to the
value of the Stilwater bank's net worth as a result of a decline
in interest rates?