Bank II Class Activities/Chapter (15)

Concept check 15-12 A bank reports the following items on its latest balance sheet: allowance
for loan and lease losses, $42 million; undivided profits, $81 million; subordinated debt capital,
$3 million; common stock and surplus, $27 million; equity notes, $2 million; minority interest in
subsidiaries, $4 million; mandatory convertible debt, $5 million; identifiable intangible assets, $3
million; and noncumulative perpetual preferred stock, $5 million. How much does the bank hold
in Tier 1 capital? In Tier 2 capital? Does the bank have too much Tier 2 capital?

The Tier 1 capital items include: The Tier 2 capital items include:

Common stock and surplus $27 mill. Allowance for loan and $42 mill.
lease losses
Undivided profits 81 Subordinated debt capital 3
Noncumulative perpetual Mandatory convertible debt 5
preferred stock 5 Equity notes 2
Identifiable intangible assets 3
Minority interest in
subsidiaries 4
Total Tier 1 capital $120 mill. Total Tier 2 capital $52 mill.

The bank does not have too much Tier 2 capital. Tier 2 capital can be up to 100 percent of the
amount of Tier 1 capital and still count toward meeting capital requirements.

Problems:
15-2. Please indicate which items appearing on the following financial statements would be
classified under the terms of the Basel Agreement as ( a ) Tier 1 capital or ( b ) Tier 2 capital.
 Tier 1 Tier 2
Qualifying noncumulative Allowance for loan and lease losses
Preferred stock
Common stock Intermediate term preferred stock
Undivided profits Cumulative perpetual preferred
Stock with unpaid dividends
Minority interest in the equity Subordinated debt capital
Accounts of consolidated Instrument with an original
subsidiaries Maturity of at least 5 Years
Equity notes
Mandatory convertible debt

15.6 Suppose that New River National Bank, whose balance sheet is given in problem 5,
reports the forms of capital shown in the following table as of the date of its latest financial
statement. What is the total dollar volume of Tier 1 capital? Tier 2 capital? Calculate the Tier 1
capital-to-risk-weighted-assets ratio, total capital-to-risk-weighted-asset ratio, and the leverage
ratio. According to the data given in problems 5 and 6, does New River have a capital
deficiency? What is its PCA capital adequacy category?

New River National Bank has the following Tier 1 and Tier 2 Capital items and totals:

Tier 1 Capital Tier 2 Capital

Common stock (par) $10 million Allowance for loan loss $25 million
Surplus $15 million Subordinated debt capital $15 million
Undivided profit $45 million Intermediate term preferred stock $5 million
Total Tier 1 capital $70 million Total Tier 2 capital $45 million

This bank has sufficient Tier 1 capital and since its Tier 2 capital amount is less than its Tier 1
capital amount it satisfies the requirements of Basel I.
15-9. 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 revenue 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) (b) (c)

Sale of Sale of 9%
Common Stock Preferred Stock Sale of 10%
at $25 per share at $12 per share Capital Notes

Operating revenues $180,000,000 $180,000,000 $180,000,000

Operating expenses 151,000,000 151,000,000 151,000,000
Net revenues $ 29,000,000 $ 29,000,000 $ 29,000,000
Interest on capital ------------------- ------------------- 800,000
notes

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

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

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

 Preferred stock ---------------------- 720,000 ---------------------
dividends

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

stockholders

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

outstanding

Earnings per share of $ 3.35 $3.41 $3.45

common stock

In this case sale of the debt would yield the highest EPS for the bank's shareholders
Because of the dilution effect of issuing stock.

Optional sections to solve in class:

If operating revenue rose to $225 million the situation would be the following:

(a) (b) (c)

Sale of Sale of 9%
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 $ 42,5000,000 $ 42,500,000
Interest on capital ------------------- ------------------- 800,000
notes

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

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

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

 Preferred stock ---------------------- 720,000 ---------------------
dividends

Net income for common $ 28,050,000 $ 27,330,000 $ 27,522,000

stockholders

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

outstanding

Earnings per share of $4.90 $5.06 $5.1

common stock

And again the capital notes would be the best option, although the preferred stock comes closer
this time.

If operating revenues drop to $110 million, then the situation would be the following:

(a) (b) (c)

Sale of Sale of 9%
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 ------------------- ------------------- 800,000
notes

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

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

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

 Preferred stock ---------------------- 720,000 ---------------------
dividends

Net income for common $ 5,280,000 $ 4,560,000 $ 4,752,000

Stockholders

Shares of common Stock 5,720,000 5,400,000 5,400,000

outstanding

Earnings per share of $ 0.92 $0.84 $ 0.88

common stock

In this case issuing the common stock is the best alternative from the point of view of the
common stockholders.