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?

Primary reserves holds the bank

Cash in its vault $1.4 m
Deposits at the Federal Reserve banks $20.1 m
Cash items in the process of collection $0.6 m
Deposits placed with other banks $16.4 m

Total Primary reserves $38.5 m

Secondary reserves holds the bank

Short-term government securities $12.4 m

Privately issued money market instruments $5.2 m

Total Secondary reserves $17.6 m

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?

The balance in the allowance for loan loss (ALL) account at year end will be:
Beginning ALL= $1.25 million
Plus: Annual Provision
for Loan Losses= +0.25
Recoveries on
Loans Previously= +0.05
Charged Off
Minus: Charge
Offs of Worthless= -0.15
Loans
Ending ALL= $1.40 million

1
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
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 $140 Provision for Loan Loss $5

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

3
Total Noninterest Expenses 35

Please calculate these items:

Net Interest Income = 140 – 100 = 40
Net Noninterest Income = 15 – 35 = 20
Pre-tax net operating income = 40 – 20 – 5 (PLL) = 15
Net Income After Taxes = 15 – 5 (IncTax) = 10
Total Operating Revenues = 140 + 15 = 155
Total Operating Expenses = 100 + 35 + 5 (PLL) = 140
Dividends paid to Common Stockholders = 10 (NetIncAfterTax) – 6 = 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 ?
Net Loans = Gross Loans –ALL = $750 - $45 = $705

b. After charge-off, Gross Loans, ALL and Net Loans?

Gross Loans = $750 - $1 = $749 The gross loans now reflect the
realizable value.

ALL = $45 - $1 = $44 *The amount of the loan that is bad

Net Loans = $749 -$44 = $705

c. If the Mountain View Hotel sells at auction for $8 million, how with
the affect the pertinent balance sheet accounts?
Gross Loans = $750 - $8 = $742

ALL = $45 ALL is restored to original amount

Net Loans = $742 -$45 = $697

4
2.7. You were informed that a bank’s latest income and expense statement
contained the following figures (in $ millions):

Net Interest Income $700

($300
Net Noninterest Income )
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

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

TII = 2TIE and Net Interest Income = TII –TIE = $700 so:
2TIE –TIE = $700 TIE = $700 and TII = 2($700) = $1,400

Total Noninterest Income (TNI) and Total Noninterest Expense(TNE):

TNI = .75TNE and Net Noninterest Income = TNI – TNE = -$300 so:
.75TNE – TNE = -$300 - .25TNE = $300
TNE = $1200 and TNI = .75($1200) = $900

Provision for Loan Losses

PLL = .02*Total Interest Income = .02*($1,400) = $28

5
Taxes

Pre-Tax Net Operating Income = Net Interest Income + Net Noninterest

Income –PLL
Pre-Tax Net Operating Income = $700 + -$300 - $28 = $372
Taxes = .3* (Pre-Tax Net Operating Income + Security
Gains)= .3*(372+10) = $114.60

Dividends

Net Income = Pre-Tax Net Operating Income + Security Gains- Taxes

Net Income = $372 +$10- $114.60 = $267.4
Increase in Undivided Profit = Net Income– Dividends
Dividends = Net Income – Increase in Undivided Profit

Dividends= $267.4 - $200 = $67.4

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?

Unit Price Charged Per Month = $4.87 + $1.21 + 0.10 x ($4.87 + $1.21) = $6.69

6
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?

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 Septembe 550
r
April 150 October 600

7
 May 225 Novembe 625
r
June 300 Decembe 300
r

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

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?

3.5% = 100
[ (1+
Interest Earnings 365/365
$3267 . 12
) −1
]
[ $2500 x 90 days +$3000 x 180 days+$4500 x 95 days ]
Average Balance = 365 days

= $3267.12

Interest = 3267.12 x 3.5% = 114,35

8
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)?

Expecte Rate Total Margina Margina Margina Exp. Total

d Offered Interest l l Cost l Diff. In Profits
Inflows on New Cost Interest Rate Revenue Marg. Earned
Funds Cost Rate Rev and
Cost
$10 3.0% 0.3000 0.3000 3.000% 6.25% +3.250% $0.325
0
15 3.25 0.4875 0.1875 3.750 6.25 +2.500 $0.450
0
20 3.50 0.7 0.2125 4.250 6.25 +2.00 $0.550
0
26 3.75 0.975 0.275 4.583 6.25 +1.667 $0.650
0
28 4.00 1.12 0.145 7.250 6.25 -1.00 $0.630
0

Gold Mine Pit Savings Association should raise its deposit rate to 3.75%,
attracting $26 million in new deposits; because up to that point the marginal
revenue rate is greater than the marginal cost rate and total profits are also
rising. At 4.0%, the marginal cost rate is greater than the marginal revenue rate
and total profits have fallen from a high of $0.65 million back down to $0.63
million.

9
Lecture 4

4.1 A lender's cost accounting system reveals that its losses on real estate
loans average 0.45 percent of loan volume and its operating expenses from
making these loans average 1.85 percent of loan volume. If the gross yield on
real estate loans is currently 8.80 percent, what is this lender's net yield on these
loans?

Net Yield on Real Estate Loans = 8.80% - 0.45% - 1.85% = 6.50%

4.2 Suppose a business borrower projects that it will experience net profits of
$2.1 million, compared to $2.7 million the previous year and will record
depreciation and other noncash expenses amounted of $0.7 million this year
versus $0.6 million last year. What is this firm’s projected cash flow for this
year? Is the firm’s cash flow rising or falling? What are the implications for a
lending institution thinking of loaning money to this firm? Suppose sales
revenue rises by $0.5 million, costs of goods sold decreases by $0.3 million,
while cash tax payments increase by $0.1 million and noncash expenses
decrease by $0.2 million. What happens to the firm’s cash flow? What would
the lender’s likely reaction to these events?

The firm's projected cash flow can be estimated by either of two methods discussed in the text:

Cash Flow Estimate B = $2.1 million + $0.7 million = $2.8 million

for the Current Year

The previous year the cash flows amounted to:

Cash Flow Estimate B = $2.7 million + $0.6 million = $3.3 million

For the Previous Year

Clearly the firm's cash flow is falling, which suggests that the lending institution needs to find out the
reasons for this decline before committing any of funds.

Sales Revenue +$.5

Costs of Goods Sold +$.3
Cash Tax Payments -$.1
Noncash Expenses -$.2
Total +$.5 increase in cash flows from these changes

These changes should make the lender happier because it means that cash flows are rising again.

10
4.3 The lending function of depository institutions is highly regulated, and
this chapter gives some examples of the structure of these regulations for
national banks. In this problem you are asked to apply those regulations to Tree
Rose National Bank (TRNB). Tea Rose has the following sources of funds:
$250 million in capital and surplus, $200 million in demand deposits, $775
million in time and savings deposits, and $200 million in subordinated debt.

a. What is the maximum dollar amount of real estate loans that TRNB
can grant?
TRNB can grant $775*70% = $542.5 million in real estate loans
b. What is the maximum dollar amount TRNB may lend to a
single customer?
TRNB may lend up to $200*15% = $30 million to a single customer.

4.4 Aspiration Corporation, seeking renewal of its $12 million credit line,
reports the data in the following table (in millions of dollar) to Hot Springs
National Bank’s loan department. Please calculate the firm’s cash flow as
defined earlier in this chapter. What trends do you observe, and what are their
implications for the decision to renew or not renew the firm’s line of credit?

Nex
t
20X 20X 20X 20X Yea
1 2 3 4 r
Costs of Goods
Sold $5.1 $5.5 $5.7 $6.0 $6.4
Selling and
Admin Exp. $8.0 $8.2 $8.3 $8.6 $8.9
Sales Revenue $7.9 $8.4 $8.8 $9.5 $9.9
Depreciation
and other
noncash $11. $11. $11. $11. $10.
expenses 2 2 1 0 9
Taxes Paid in
Cash $4.4 $4.6 $4.9 $4.1 $3.6

Cash Flow = Sales Revenues – Cost of Goods Sold – Selling and Admin – Taxes Paid in Cash + Non
Cash Expenses
20x1 $7.9 - $5.1 - $8.0 - $4.4 + $11.2 = $1.6 million
20x2 $8.4 - $5.5 - $8.2 – $4.6 + $11.2 = $1.3 million
20x3 $8.8 - $5.7 - $8.3 - $4.9 + $11.1 = $1.0 million
20x4 $9.5 - $6.0 - $8.6 - $4.1 + $11.0 = $1.8 million
Next $9.9 - $6.4 - $8.9 - $3.6 + $10.9 = $1.9 million

11
Year
While this firm had an initial decrease in cash flows, in the last year its cash flows have rebounded
significantly, suggesting that the firm would have less trouble making required loan payments. The
lender needs to be sure to check to see if the projections for next year seem reasonable. Borrowers
are sometimes over optimistic about future opportunities. However, if the projections are reasonable,
Hot Springs National Bank should consider renewing the loan.

4.5 Crockett Manufacturing and Service Company holds a sizeable inventory

of dryers and washing machines, which it hopes to sell retail dealers over the
next six months. These appliances have a total estimated market value currently
of $25 million. The firm also reports accounts receivable currently amounting
to $12,650,000. Under the guidelines for taking collateral discussed in this
chapter, what is the minimum size loan or credit line Crockett is likely to
receive from its principal lender? What is the maximum size loan or credit line
Crockett is likely to receive?

These figures suggest that the minimum size credit line available would be:
Minimum-Size Credit Line Available = 0.30 x $25,000,000 + 0. 40 x $12,650,000
= $7,500,000 + $5,060,000
= $12,560,000
Maximum-Size Credit Line Available = 0.80 x $25,000,000 + 0.90 x $12,650,000
= $20,000,000+ $11,385,000
= $31,385,000

4.6 Butell Manufacturing has an outstanding $11 million loan with Citicenter
Bank for the current year. As required in the loan agreement, Butell reports
selected data items to the bank each month. Based on the following
information, is there any indication of a developing problem loan? About what
dimensions of the firm’s performance should Citicenter Bank be concerned?

12
Butell has announced
within the past 30 days
that it is switching to
new methods for
calculating
depreciation of its fixed
assets and for valuing
inventories. The firm’s
board of directors is
planning to discuss at its
next meeting a proposal
to reduce stock
dividends in the coming
year.

13
Selected items reported
to the bank by the
company do indicate the
possible development of
a
problem loan situation.
For one thing, Butell's
cash account has fallen
sharply in the latest
month after several
months of a substantial
uptrend and the firm's
liquidity ratio of current
assets
to current liabilities has
declined significantly in
14
the last 3 months.
Decreases in the firm's
liquidity position may be
signaling declining sales
and/or difficulty in
maintaining enough
cash
to meet near-term
liabilities. Another
possible cause for
concern centers around
Butell's capital
structure as its ratio of
equity capital relative to
debt financing is falling,
indicating that creditors
15
(including Citicenter
Bank) are providing a
larger share of the firm's
capitalization. Thus,
each
creditor is becoming less
well secured. However,
these changes in
liquidity and capital
structure
may only reflect normal
seasonal pressures and
may not be real
problems for the bank,
especially

16
because other aspects
of Butell's recent
performance--its stock
price, earnings before
interest and
taxes, and ROA seem to
be improving.
Butell has announced
within the past 30 days
that it is switching to
new methods for
calculating
depreciation of its fixed
assets and for valuing
inventories. The firm’s
board of directors is
17
planning to discuss at its
next meeting a proposal
to reduce stock
dividends in the coming
year.
Selected items reported
to the bank by the
company do indicate the
possible development of
a
problem loan situation.
For one thing, Butell's
cash account has fallen
sharply in the latest
month after several
months of a substantial
18
uptrend and the firm's
liquidity ratio of current
assets
to current liabilities has
declined significantly in
the last 3 months.
Decreases in the firm's
liquidity position may be
signaling declining sales
and/or difficulty in
maintaining enough
cash
to meet near-term
liabilities. Another
possible cause for

19
concern centers around
Butell's capital
structure as its ratio of
equity capital relative to
debt financing is falling,
indicating that creditors
(including Citicenter
Bank) are providing a
larger share of the firm's
capitalization. Thus,
each
creditor is becoming less
well secured. However,
these changes in
liquidity and capital
structure
20
may only reflect normal
seasonal pressures and
may not be real
problems for the bank,
especially
because other aspects
of Butell's recent
performance--its stock
price, earnings before
interest and
taxes, and ROA seem to
be improving.
Butell has announced within the past 30 days that it is switching to new
methods for calculating
depreciation of its fixed assets and for valuing inventories. The firm’s board of
directors is
planning to discuss at its next meeting a proposal to reduce stock dividends in
the coming year.

Selected items reported to the bank by the company do indicate the possible
development of a

21
problem loan situation. For one thing, Butell's cash account has fallen sharply
in the latest
month after several months of a substantial uptrend and the firm's liquidity ratio
of current assets
to current liabilities has declined significantly in the last 3 months. Decreases in
the firm's
liquidity position may be signaling declining sales and/or difficulty in
maintaining enough cash
to meet near-term liabilities. Another possible cause for concern centers around
Butell's capital
structure as its ratio of equity capital relative to debt financing is falling,
indicating that creditors
(including Citicenter Bank) are providing a larger share of the firm's
capitalization. Thus, each
creditor is becoming less well secured. However, these changes in liquidity and
capital structure
may only reflect normal seasonal pressures and may not be real problems for
the bank, especially
because other aspects of Butell's recent performance--its stock price, earnings
before interest and
taxes, and ROA seem to be improving.

Chapter 16 - Lending Policies

and Procedures: Managing
Credit Risk
16-12
Perhaps of greater
moment is the decline of
sales revenue below

22
Butell's projections. As
of the
latest month sales
revenue reached $290
million versus a
projection of $298
million. Citicenter
Bank must determine
the causes of this sales
shortfall to see if the
firm is encountering
increasing resistance to
sales of its product lines.
However, even this
trend may not be cause
for
23
alarm because sales
may be so volatile in
Butell's industry that
few analysts put any
faith in sales
projections. The bank's
loan officer needs to
review the customer's
earlier sales projections
and
sales revenue to
determine if there is a
real cause for concern.
Butell has indicated a
recent switch in
inventory and
24
depreciation accounting
methods.
Citicenter's loan officer
would do well to inquire
into the reasons for
these changes because
they
may reflect an attempt
by the firm to offset
actual or potential
future losses in some
aspect of its
operations.
Perhaps of greater moment is the decline of sales revenue below Butell's
projections. As of the
latest month sales revenue reached $290 million versus a projection of $298
million. Citicenter
Bank must determine the causes of this sales shortfall to see if the firm is
encountering
increasing resistance to sales of its product lines. However, even this trend may
not be cause for

25
alarm because sales may be so volatile in Butell's industry that few analysts put
any faith in sales
projections. The bank's loan officer needs to review the customer's earlier sales
projections and
sales revenue to determine if there is a real cause for concern.

Butell has indicated a recent switch in inventory and depreciation accounting

methods.
Citicenter's loan officer would do well to inquire into the reasons for these
changes because they
may reflect an attempt by the firm to offset actual or potential future losses in
some aspect of its
operations.

Lecture 5

5.1 From the descriptions below please identify what type of business loan is
involved.
a. A temporary credit supports construction of homes, apartments, office
buildings, and other permanent structures.
b. A loan is made to an automobile dealer to support the shipment of new cars.
c. Credit extended on the basis of a business’s accounts receivable.
d. The term of an inventory loan is being set to match the length of time needed
to generate cash to repay the loan.
e. Credit extended up to one year to purchase raw materials and cover a
seasonal need for cash.
f. A security dealer requires credit to add new government bonds to his security
portfolio.
g. Credit granted for more than a year to support purchases of plant and
equipment.
h. A group of investors wishes to take over a firm using mainly debt financing.
i. A business firm receives a three-year line of credit against which it can
borrow, repay, and borrow again if necessary during the loan’s term.
j. Credit extended to support the construction of a toll road.
5.2 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 the
dimension of a business firm’s performance each ratio represents.

26
* Annual principal payments on bonds and notes payable total $55. The firm’s
marginal tax rate is 35 percent.

5.3 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?

27
5.4 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:

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

28
decide to turn down this request, under what assumptions regarding revenues,
expenses, and customer deposit balances would you be willing to make this
loan?

5.5 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 3.50
percent and borrowed $4 million in the Federal funds market from other banks
at today’s prevailing interest rate of 3.25 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 this case. What loan rate would it charge?

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?

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

29
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.

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?

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?

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?

Chapter 7

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7-1. 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

7-2. 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?

7-3. 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?

7-4. 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%

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7-5. 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?

7-6. 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?

7-7. 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 450 425 400
nonperforming)
Investments 200 195 200
Total deposits 450 425 400
Money market borrowings 150 125 100

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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?

7-8. 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?

7-12. 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?

7-14 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?

7-21. 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?

7-22. 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?

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