FIN 413 Lecture Notes - Lecture 3: Reinvestment Risk, Interest Expense

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limecricket928

4 Sep 2016

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Net interest income = interest income interest expense. = assets * rate for assets (ra) less liabilities * rate for liabilities (rl) Net interest rate margin / spread = ra rl (+) repricing gap reinvestment risk when ra decreases (-) repricing gap refinancing risk when rl increases. Commercial banks must report repricing gaps for assets and liabilities with maturities of: Change in net interest income = gap * change in interest rate. = (rsa rsl) * change in interest rate. If interest rate goes up by 1%, change in nii = -15 million * 1% = -150,000. If changes in ra is not equal to change in rl, the spread changes. Change in nii = (rsa * change in ra) (rsl * change in rl) Ra goes up by 1. 2 % rsa =155m, rl goes up by 1% rsl = 155m. Change in nii = 155m x 1. 2% - 155m * 1% = 310 000.

Related Questions

PROBLEMS, GRAPGHING

1. Suppose a candidate who runs on a platform of âsoak the richâ wins the 2016 presidential election. After being elected, he or she persuades Congress to raise the top marginal tax rate on the federal personal income tax to 65%.

a. Use one graph to show the effect of this change in tax rates on the market for municipal bonds and another graph to show the effect on the market for U.S. Treasury bonds.

b. What happened to the interest rate spread between municipal bonds and U.S. Treasury bonds and why?

Suppose that, holding yield constant, investors are indifferent as to whether they hold bonds issued by the federal government or bonds issued by state or local governments (they consider the bonds the same with respect to default risk and liquidity). Suppose that state government issued console with $60 annual payments and that the federal government has also issued console with $60 annual payments.

a. If the federal and state consoles have both the same after-tax yields of 6%, what are their pretax yields? (Assume that the federal income tax rate is 36%)

2. Suppose it is 2020 and 1-year interest rate is 5 percent. You observe that the interest rate on 2-year bond is 4.5%. Assume there is no liquidity premium and the interest rates are determined according to expectation hypothesis of the yield curve

a. Based on the interest rates above, what is the expected 1-year interest rate, starting one year from today?

b. If the interest rate on 3-year bond is 4%., what is the expected 1-year interest rate starting 2 years from today?

c. If the interest rate on 4-year bond is 4%., what is the expected 1-year interest rate starting 3 years from today?

d. Draw the yield curve for the next four years.

e. Is the yield curve for the next four years upward sloping or downward sloping? Explain why

f. What might the yield curve today indicate about future interest rates?

g What might the yield curve today indicate about future economic activity? Explain why?

h. What might the yield curve indicate about the marketsâ prediction for inflation rate in the next four years?

i. What might the yield curve indicate about monetary policy today?

j. What might the yield curve indicate about a long-term bonds price? Expected return on long-term bonds? Explain

k. Given the slope of the yield curve today, would you rather be lender or borrower in the next five years? Why?

3. The following is from an article in the Wall Street Journal, describing events in the market for Treasury securities on the given day: âTreasury prices were mixed, with the shorter end of the yield curve falling and the longer- dated Treasury rising in pricesâ.

a. Draw Treasury yield curve, showing the situation on that day as described in the sentence above.

Explain why prices of Treasury were mixed with the shorter end of the yield curve rising in prices and the longer- dated Treasury falling in prices.

Given the latest data on the state of the U.S. economy, assume that the Fed signals the next increase in the target for the federal funds. The increase wonât happen until the Fedâs meeting in summer of 2016.

Will the Treasury yield curve become more or less steep today?

Which of the following would you expect in the market for Treasury? Explain your choice

- There will be an increase in demand for bond today?

There will be a decrease in supply of bonds today?

There will be a decrease in demand for bonds today?

There will be an increase in supply of bonds today?

What will happen to the yields on Treasury? Explain

4. The table below shows current and expected future one-year interest rates, as well as current interest rates on n-year bonds

Year One-year Bond Rate N-Year Bond Rate Liquidity premium

1 2% 2% _______

2 3% 3% _______

3 4% 5% _______

4 6% 6% _______

5 7% 8% _______

Assume the expectation theory of the term structure and calculate interest rates in the term structure for maturities of one to five years.

Draw the yield curve for the next four years.

Is the yield curve for the next four years upward sloping or downward sloping? Explain why

What might the yield curve today indicate about future interest rates?

What might the yield curve today indicate about future economic activity? Explain why?

What might the yield curve indicate about the marketsâ prediction for inflation rate in the next four years?

Calculate the liquidity premium for each n-year bond

What does the liquidity premium stay for?

Compare the liquidity premium in 2-year bond and 5-year bond. Why is the liquidity premium on 2-year bond lower than the liquidity premium on 5-year bond?

5. A Suppose that you are the manager of the Bank One. Assume required reserve ratio 10 percent. The bank has the following balance sheet:

Assets Liabilities

Reserves $ 65 million Deposits $ 400 million

Loans $ 425 million Bank capital $ 90 million

Is Bank One meeting the reserve requirement?

By how much can Bank One increase its loans?

Suppose Bank One suffers a deposit outflow of $40 million .Illustrate numerically the effect of the deposit outflow of $40 million on the bankâs deposits and reserves

Does the bank now hold excess reserves?

Is the bank meeting a required reserve ratio of 10 percent?

What action must you take to meet the reserve requirement? List three or more actions. work

If a borrower defaults on a loan of $10 million, will be the bank able to sustain the loss?

Why no, why yes?

If Bank One ROA is 7%, what is the bank profit? What is the bank ROE?

How can you increase the bankâs ROE, what trade âoff do you face?

6. Suppose that you are the manager of the Bank One that has $30 million of fixed assets, $20 million of variable interest rate assets, $15 million of fixed liabilities and $25 million of variable interest rate liabilities.

a. Is the rate sensitivity gap positive or negative? Explain

b. Explain verbally and show numerically what will happen to the bank profits if interest rates rise by 4 percent.

c. What action would you take to reduce the bankâs interest-rate risk? Explain

d. Explain and show numerically what happens to the bank profit if interest rates fall by 4 percent

e. What action would you take to reduce the bankâs interest-rate risk? Explain

f. Given the bank assets and liabilities explain how you can use the interest rate swaps to reduce the bank interest rate risk. Would you trade variable- rate payments for fixed- rate payment? Why yes, why not?

7. Assume the following information about the banking system

Quantities in billions of dollars

Currency (C) = $762

Excess Reserves ( R ) = $66

Required reserves (RR) = $0

Checking deposits (D ) = $604

Give the numerical answer to the following questions:

a. What is the size of the monetary base?

b. What is the money supply in the economy?

c. What is the size of the money multiplier?

Assume that the currency to deposit ratio rises to 1.5

a. Compute the effect of the change in currency ratio on the money multiplier, m

b. What will be the money supply now given the monetary base?

If the Fed wants to keep the money supply at the initial level in part b, how must the Fed respond? Explain

Would the Fed adjust the money multiplier, the monetary base or both to keep the money supply at the initial level?

How much would the Fed buy or sell in the government bonds to keep the money supply at the initial level?

8. Assume that the MB = $828, Money supply = $1366, Currency in the circulation = $ $762, Deposit = $$604, the currency to deposits ratio c is 1.262, the excess reserve ratio is 0.109, the required reserve ratio is 0, and the money multiplier m= 1.650. The non-bank public shifts $40B from currency to deposits, and the Fed wishes to keep the money supply at the level of $1366 B. Explain verbally and show numerically the effect of the currency shift on the following

a. The level of reserves in the banking system

b. The monetary base

c. The size of the money multiplier

d. How should the Fed respond given his goal of keeping the money supply at the level of $1366? Explain

e. How much in the government bonds should the Fed buy or sell to keep the money supply at the level of $1366?

9. Use the graph of the market for reserves to analyze each of the following situations. Be sure that your graph clearly shows changes in the equilibrium federal funds rate, changes in the equilibrium level of reserves, any shifts in the demand and supply curves, and any change in equilibrium federal funds rate

Suppose that the Fed decides to increase the federal funds rate from 2%to 2.25%. Show graphically and explain verbally what policy tools the Fed can use to bring the change in the federal funds rate.

Suppose that the Fed decides to decrease the federal funds rate from 2.25%to 2.%. Show graphically and explain verbally what policy tools the Fed can use to bring the change in the federal funds rate.

Suppose that banks increase their demand for reserve. Show graphically and explain verbally how the Fed can offset this change in order to keep the equilibrium federal funds rate unchanged

Suppose there is a switch from currency into deposits, everything else held constant. Show graphically and explain verbally how the Fed can offset this change in order to keep the equilibrium federal funds rate unchanged

Suppose that the Fed decides to decrease the required reserve ratio. Show graphically and explain verbally how the Fed can offset this change in order to keep the equilibrium federal funds rate unchanged.

f. Suppose that banks decrease their demand for reserves. Show graphically and explain

verbally how the Fed can offset this change in order to keep the equilibrium federal funds

rate unchanged.

A CAPITAL BUDGETING CASE

The E-Check Company, a manufacturer of pollution detection systems, has enjoyed considerable success. In 2015, the company completed its 25^th year in business and generated a return on common equity of 20%. Rusty Rivet, Company C.E.O., is certain the Company can continue this performance. One thing that contributes towards his confidence is that almost all of the Companyâs sales are to governmental programs that, in order to help control pollution, force residents in communities located next to interstate highways to pay a fee to have their vehicle emissions systems tested. Given the high test pass-rates, the pollution in these areas obviously comes largely from traffic passing through the communities rather than from the localâs vehicles, but governments have come to rely on the income emission testing generates and are reluctant to cut the testing requirements. Another reason for his confidence is the fact that most of the Companyâs top managers hold an advanced engineering degree awarded by a variety of prestigious universities. Rusty also believes that stockholders like the fact that the Company pays out all earnings not needed to pay preferred dividends as common dividends (and because he is the majority stockholder in the Company it is unlikely this policy will change). It is estimated that the common dividend will continue to grow annually at an 8% rate.

In January 2016, managers of the Company have expansion plans; they have just completed an evaluation of six capital budgeting projects. The net cash flows (in millions of dollars) and risk assessment of each project are shown below. Company policy requires that average risk projects have an IRR at least equal to the Companyâs weighted average cost of capital (WACC). Policy also requires that the hurdle rate be increased (decreased) by 250 basis points when evaluating projects that are above (below) average risk. Management has determined that the Companyâs WACC is 9.63% and, therefore, management is making plans raise $52 million to implement all of the projects except Project E. As a part of your management training, you have been asked to review the analysis. In particular, management wants you to verify both the WACC calculation and project selection.

Project A B C D E F

0 (10) (12) (15) (5) (11) (10)

1 3.15 4.3 7 2 0 1

2 3.15 4.3 6.4 2 0 3

3 3.15 4.3 5.5 1 0 5

4 3.15 4.3 .5 0 3

5 3.15 .5 0 .55

6 .5 0

7 0

8 22

Risk High Ave. Ave. Low Ave. Low

The Company has one outstanding bond issue. It has an annual stated rate of 8% with annual interest payments. $50,000,000 of the bond issue, with an original term to maturity of 15 years was publicly placed 7 years ago at face value. The most recent price at which a bond traded on the secondary market was $900 (a $100 discount from face value). Any new long-term debt would be raised in the form of a new bond issue. Matilda Angle, E-Checkâs treasurer, has pointed out that the company would like any new bond issue to have an initial maturity of 15 years to lock in the interest rate for a long time, and she also points out that the good news is that the yield curve at this time is essentially flat. In addition, any new bond issues will be privately placed so there will be no flotation costs.

The company has 10 million shares of $1 par common stock outstanding. These shares are currently trading for $10.00 per share on the Cincinnati Stock Exchange. The company paid total dividends of $1,700,000 on these shares during 2015. The companyâs underwriter will charge flotation costs equal to 10% of the value of any new shares sold.

The company also has 100,000 shares of $200 par preferred stock outstanding. These shares are currently trading at $175 per share. The preferred share annual dividend (paid quarterly) is 9.5%. The underwriter will charge flotation costs of 5% of the value of new shares sold.

Managementâs WACC Calculation

Shown below are E-Checkâs simplified financial statements for 2015. Managers used information from the balance sheet to come up with the weights for their WACC calculation.

E-Check

Balance Sheet

December 31, 2015

Current assets 30,000,000 Current liabilities 30,000,000

Long-term assets 88,000,000 Long-term liabilities 50,000,000

Total assets 118,000,000 Total liabilities 80,000,000

Common shares 10,000,000

Preferred shares 20,000,000

Retained earnings 8,000,000

Total equity 38,000,000

Total liabilities & equity 118,000,000

E-Check

Income Statement

2015

Revenues 200,000,000

Cost of goods sold 110,000,000

Gross profit margin 90,000,000

Operating expenses 80,000,000

Operating income 10,000,000

Interest expense 4,000,000

Taxable income 6,000,000

Income tax 2,400,000

Net income 3,600,000

Specifically, the WACC was calculated as follows:

WACC = (K_d * wt_d) + (K_p * wt_p) + (K_e * wt_e)

= (8 * (80/118)) + (9.5 * (20/118)) + (17 * (18/118))

= 5.423 + 1.61 + 2.593

= 9.63%

Maria Sliderule, Company controller, has explained to you that 8% was used as the cost of debt because this is the stated rate of interest on the firmâs existing bond issue; 9.5% was used as the cost of preferred shares because this is the dividend rate on the Companyâs preferred stock, 17% was used as the cost of equity because dividends of $1.7 million were paid on the common shares with a book value of $10 million; and that the weights in the WACC calculation were derived directly from the balance sheet.

Internal announcement of the expansion possibilities has fostered some debate. One manager, Mel Lever, asserts that the Company should raise all the money needed in the form of debt, and since the cost of debt is only 8%, all projects should be accepted. Olm Meter, a Norwegian engineer who just joined the E-Check management team, argues that it makes no sense to invest in a project with an IRR less than the WACC. The input of all these individuals cannot be ignored because each is a valuable member of the management team and highly respected in the area of pollution detection technology. This is why you have been asked to review the analysis.

1. Please address the comments of Mr. Lever and Mr. Meter.

2. In which of the proposed capital budgeting projects should the Company invest?

3. What do you think is the Companyâs WACC?

4. List any errors in the 9.63% calculation?

orchidcrow953

Years are 2014 and 2015.

ABC is in its 4th year of operations. The company is experiencing cash flow issues and would like to utilize a budget to forecast cash flows. You are an outside consultant hired to assist in designing a model that ABC can utilize on an ongoing basis to forecast cash flow. The president of the company, Ms. Dream, has predicted an increase in sales of two percent per month from December 2014 through March 2015 Mr. Dream believes that after March, sales will remain steady through June 2015. The projected balance sheet for ABC as of December 31, 2015 is shown below: Cash $ 20,000 A/receivable 208,748 Marketable securities 25,000 Inventory 25,750 Buildings & equipment (net of accumulated depreciation) 225,000 Total assets $ 504,498 A/payable $ 101,384 Sales commissions payable 6,885 Bond interest payable 4,800 Property taxes payable 0 Bonds payable (4%- due in 2020) 360,000 Common stock 10,000 Retained earnings 21,429 Total liabilities and stockholders' equity $ 504,498 You will need the following information to prepare a master budget for the first quarter of 2015: 1) Projected sales for November 2015 are $225,000. Credit sales comprise 95% of total sales. Sales collected in the month of sale total 15%, in the month following the month of sale total 70%, and in the second month following the month of sale total 13%. Remaining sales are uncollectible. 2) Cost of goods sold total 55% of sales. Inventory purchases are made on account. Purchases paid for in the month of purchase total 20% and purchases paid for in the month following the month of purchase total 80%. Ending monthly Inventory is maintained at 20% of the following monthâs projected cost of goods. 3) Projected monthly expenses include: Sales salaries $ 60,000 Advertising and promotion 4,000 Administrative salaries 25,000 Depreciation 3,000 Interest on bonds 1,200 Property taxes 1,500 Sales commissions of 3.0 percent of sales are paid in the month following the month of sale. 4) Additional manufacturing equipment would allow the company to increase production. The cost of the new equipment is $150,000. Ms. Dream plans on purchasing the equipment on January 1st and plans on paying for the equipment with cash and by liquidating the companyâs marketable securities. Mr. Clark wishes to maintain a minimum cash balance of $15,000 at the end of each month. If necessary, he plans on obtaining a short-term note payable from a local bank. The minimum lending period for such a loan is three months. The current short-term interest rate is 7 percent per year and is expected to remain at this rate through the time the equipment is purchased. Mr. Clark would like to pay off the loan as quickly as possible. Payments must be made in $1,000 increments. 5) The board of directors would like to declare and pay dividends of $125,000 on the last day of each quarter. 6) The interest on any short-term borrowing will be paid when the loan is repaid. Interest on the bond payable is paid semiannually on February 28 and August 31 for the preceding six-month period. 7) Property taxes are paid quarterly on March 31, June 30, September 30, and December 31 for the preceding three-month period. Required: Assist ABC by building a model to forecast cash flow. Set up your model for the first quarter of 2015. The model should contain the master budget schedules shown below. Round all amounts to the nearest dollar. The model should allow ABC to change the assumptions provided above and quickly recalculate the forecasted cash balance at March 31, 2015. The assumptions may be included on a separate worksheet in your Excel file but all of the schedules below must be on one worksheet. Please Prepare Summary Cash budget in following table with all shown calculations and formulas.

Summary Cash Budget


		January	February	March	1st Quarter
	Cash receipts(Sch 2)
	Less: Cash disbursement (Sch 4)
	Change in cash balance during period due to operations
	Sales of marketable securities(1/1/15)
	Proceeds from bank loan
	Purchase of equipment
	Repayment of bank loan(03/31/15)
	Interest on bank loan
	Payment of dividends
	Change in cash balance during the month
	Beginning cash balance
	Ending cash balance

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FIN 413 Lecture Notes - Lecture 3: Reinvestment Risk, Interest Expense

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