Question

Community Bank is faced with the decision of whether or not to open a new branch. The current market value of the bank is $2,500,000. According to company policy (and industry practice), the bank’s capital structure is highly leveraged. The present (and optimal) ratio of debt to total assets is 0.9. Community Bank’s debt is almost exclusively in the form of demand, savings, and time deposits. The average return on these deposits to the bank’s clients has been 5% over the past five years. However, recently interest rates have climbed sharply, and as a result Community Bank presently pays an average annual rate of 6.25 % on its accounts in order to remain competitive. In addition, the bank incurs a service cost of 2.75 % per account. Because federal “Regulation Q” puts a ceiling on the amount of interest paid by banks on their accounts, the banking industry at large has been experiencing disintermediation – a loss of clients to the open money market (Treasury bills, etc.), where interest rates are higher. Largely because of the interest-rate situation (which shows no sign of improving), Community Bank’s president has stipulated that the branch project will be financed with 90% debt. Its cost of RM500,000 will have to be raised by an issue of new equity. The bank’s cost of equity capital, ke, is 11%. Community Bank’s marginal tax rate is .48. Market analysis indicates that the new branch may be expected to return net cash flows according to the following schedule:

Year 0

1 2 3 4 5 to year 20

RM -500,000 25,000 35,000 45,000 45,000 50,000

(I) Should Community Bank open the new branch?.

(II) If the costs escalate to RM1.5 million, should Community bank open the new branch?

(III) If cost of equity capital increases to 18%, should Community bank open the new branch?

Answer 1

Answer to Part (I)

The decision to open new branch can be answered through NPV Technique

Net Present Value = Present value of all Inflows - Present Value of all outflows

if NPV is positive, New branch can be opened

For calculation of NPV, Discount factor = Cost of Equity = 11%

NPV table

Since NPV is Negative, It is not advisable to open New branch

For Part (II)

If cost Escalated to RM1.5 Million, Present Value of outflows increases which in turn increase the negative NPV. Hence, It is not advisable to open New branch.

Revised NPV table

For Part (III)

If cost of Capital Increases to 18%, which will reduce the PV of inflows. Hence, it is not advisable to open branch

Revised NPV table