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# Federal Bank Solution Essay Sample

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## Federal Bank Solution Essay Sample

Model Use For consistency, we developed a spreadsheet model for the case. However, in class we emphasize ﬁnancial calculator solutions for learning the basics of the model and use the spreadsheet application for sensitivity analysis to determine how changes in the variables affect the results. There is some danger that beginning students will not really understand the basic logic underlying the model if they are not required to do some calculations by hand. The student versions of the models have some of the formula cells erased; thus the students get an idea about the model’s structure while they complete it. The spreadsheet also allows sensitivity analysis to determine how changes in the variables affect the results.

QUESTIONS
1. Using information contained in Table 1, Federal Finance’s balance sheet at the end of 2000, calculate Federal Finance’s capital asset ratio, risk based capital ratio, number of shares of stock outstanding, and book value per share of common stock. Based on the ratios, explain the bank’s capital adequacy. Capital Asset Ratio = Book value of core capital/assets = common stockholders’ equity/total assets = \$26,490 / \$525,826 = 0.05038 = 5.04%.

Case: 75 Federal Finance Bank – Instructor’s Solution

The Current Capital Asset or Leverage ratio of 5.04 percent is just above the minimum requirements set by federal regulations for well-capitalized institutions (5.0 percent, see Table 2). Risk Based Capital Ratio = Total capital/risk adjusted value of assets Total capital = core capital + allowance for loan losses = (\$26,490 + 2,680) = \$29,170 Risk adjusted value of assets = 0% (cash + U.S. Treasuries) + 20% (mortgage-backed securities + general obligation municipal bonds + government agency securities) + 50% (residential mortgage loans) + 100% (consumer loans + business loans + ﬁxed assets) Risk adjusted value of assets = 0(\$7,387+12,477) + .2(\$110,684+25,970+34,740) + .5(\$189,164) + 1.00(\$36,583 + 77,693 + 31,128) = .2(\$171,394) + .5 (\$189,164) + 1(\$145,404) = \$34,279 + 94,582 + 145,404 = \$274,265 Risk Based Capital Ratio = \$29,170 / \$274,265 =.10636 = 10.64%

The Risk Based Capital Ratio is 10.64 percent, and is above the minimum set by federal regulations. Total Number of Shares Outstanding = capital stock/par value per share = \$12,155,000/\$100 = 121,550 Book Value per Share = total equity/number of shares outstanding = \$26,490,000/121,550 =\$217.94 2. Using the data in Table 3, calculate Federal Finance’s 2000 ROA and average annual growth rate in assets from 1995 to 2000. (Hint: In your calculations, use only the data for 1995 and 2000.) ROA = Net Proﬁt/ Total Assets = \$7,863/\$525,826 = 1.50% The compounded annual growth rate in assets can be found as follows: Assets1995 (1+g)5 = Assets2000 \$273,617 (1+g)5 = \$525,826 (1+g)5 = \$525,826/273,617 = 1.92 (1+g) = 1.921/5 = 1.1396 g = 0.1396 = 13.96%. 3. For the four Bank’s listed in Table 4, calculate the following: a. The Capital Asset Ratio for 2000. b. Compound annual growth rates in assets for the ﬁve-year period 1995–2000. c. The ROA ratios in 2000. d. The market value/book value ratios for 2000. e. How does Federal Finance compare with the Capital Asset Ratios and growth rates of these institutions? a. Capital Asset Ratio = Shareholders’ equity/total assets Maryland Financial = \$11,800/\$220,000 = 5.36% Great Northern Bank = \$23,700/\$476,000 = 4.98% First Bank of California = \$15,400/\$305,000 = 5.05% Omaha Federal = \$12,900/\$238,000 = 5.42%

Case: 75 Federal Finance Bank – Instructor’s Solution

b. Assets Growth Rate = Assets1995(1+g)5=Assets2000 Maryland Financial = \$109,400(1+g)5=\$220,000 => g = 15.00% Great Northern Bank = \$241,600(1+g)5=\$476,000 => g= 14.53% First Bank of California = \$239,000(1+g)5=\$305,000 => g= 5.00% Omaha Federal = \$123,609(1+g)5=\$238,000 => g= 14.00% c. ROA Ratios = Net Proﬁt/Assets2000 Maryland Financial = \$3,322/\$220,000 = .0151 = 1.51% Great Northern Bank = \$6,172/\$476,000 = .0130 = 1.30% First Bank of California = \$2,745/\$305,000 = .009 = .90% Omaha Federal = \$3,546/\$238,000 = .0156 = 1.49% d. Market Value/Book Value Ratios = Price/book value per share Maryland Financial = \$34.68/\$31.35 = 1.106 Great Northern Bank = \$20.84/\$21.08 = 0.989 First Bank of California = \$36.54/\$40.56 = 0.901 Omaha Federal = \$30.36/\$25.75 = 1.179 These data are summarized in the table below. Summary Statistics for Publicly-Traded Financial Institutions CAPITAL ASSET RATIO 5.36% 4.98% 5.05% 5.42% 5.04% GROWTH RATE (G) 15.00% 14.53% 5.00% 14.00% 13.96% MARKET /BOOK 1.106 0.989 0.901 1.179

Maryland Financial Great Northern Bank First Bank of Calif. Omaha Federal Federal Finance

ROA 1.51% 1.30% 0.90% 1.49% 1.50%

e. Federal Finance’s Capital Asset Ratio is slightly lower than that of First Bank of California. Omaha Federal and Maryland Financial have much higher capital asset ratios and are less risky. Great Northern’s capital asset ratio falls below the threshold for a well-capitalized institution. Federal Finance’s growth rate is greater than First Bank of California and similar to Omaha Federal, but below Great Northern Bank and Maryland Federal 4. Considering your answers to Questions 1 through 3: a. Develop a range of values that you think would be reasonable for Federal Finance’s market/book ratio if it were a publicly held company. Great Northern Bank is the riskiest of the ﬁnancial institutions studied as its capital asset ratio is below the federal requirement. Although earnings have grown faster than Federal Finance, the ROA is lower, and the market to book ratio is below one. First Bank of California has a minimally adequate capital asset ratio but a very weak growth rate over the past ﬁve years and also has a market/book ratio below one. Maryland Financial and Omaha Federal appear to be in the best ﬁnancial condition of the listed ﬁnancial institutions. They have enjoyed rapid growth in earnings and have a capital asset ratio above federal requirements. This information is consistent with its top ranking for price/earnings and a market/book ratio above one.

Case: 75 Federal Finance Bank – Instructor’s Solution

From the information developed thus far, it seems that the ﬁnancial performance of Federal Finance has not been as strong as Maryland Financial. With the exception of the capital asset ratio (which will be strengthened by the new stock issue), Federal Finance is stronger than Omaha Federal. Thus, a market value/book value ratio in the range of 1.1 to 1.2 would probably be appropriate for Federal Finance. b. Discuss the valuation difference between a privately held and publicly traded ﬁrm. Public trading would add a premium value to the stock. This premium results from easier access to information that is required by the SEC and a more liquid market for the stock. 5. Regardless of your answer to Question 4, assume that 1.15 is an appropriate market value/book value ratio for Federal Finance. What would be the market value per share of the company? Market value per share = 1.15 × Book value = 1.15 × \$217.94 = \$250.63. 6. Investment bankers generally like to offer the initial stock of companies that are going public at a price ranging from \$10 to \$30 per share.

If Federal Finance stock were to be offered to the public at a price of \$20 per share, how large a stock split would be required prior to the sale? How many shares of stock would be outstanding following the split but before new shares are issued? To determine the size of the stock split required that would bring the stock price down to \$20 per share, divide the computed market price for the privately held stock by \$20: Split size = \$250.63/\$20 = 12.53 ≈ 13 for 1 # of shares outstanding before new shares are issued = (old # shares) × (13). Thus, the post split number of shares of stock outstanding before the new issue = 121,550 × 13 = 1,580,150 7. Assume that Federal Finance chooses to raise \$8 million through the sale of stock to the public at \$20 per share. a. Approximately how large would the percentage ﬂotation cost be for such an issue? Base your answer on available published statistics. The latest SEC ﬁgures on ﬂotation costs are relatively old, but they are still approximately correct for ﬁrms issuing stock today.

Total ﬂotation costs (underwriting commissions, other expenses, and under-pricing costs) for new issues between \$2 and \$10 million average about 13.28 percent. (See Brigham, Gapenski, and Daves, Intermediate Financial Management: Theory and Practice, 6th ed. (Fort Worth, TX: The Dryden Press, 1999), Table 15-4.) b. How many shares of stock would have to be sold in order for Federal Finance to pay the ﬂotation cost and receive \$8 million net proceeds from the offering? First, determine the net proceeds per share to Federal Finance. Net per share = \$20(1 – 0.1328) = \$17.34. The number of shares the ﬁrm must sell is the net amount of funds needed divided by the net price the company will receive from the sale of the stock. \$ 8,000,000/ \$17.34 = 461,255 shares. 8. Assume that Zudlum decided to sell half of his stock. a. How many shares of stock and what total amount of money (assuming that the stock split occurred and that these shares were sold at a price of \$20 per share) would be involved in this secondary offering? (A secondary offering is deﬁned as the sale of stock that is already issued and outstanding.

The proceeds of such offerings accrue to the individual owners of the stock, not to the company.) There are 1,580,150 shares of Federal Finance stock outstanding following the 13:1 split from question 6. Zudlum owns 31 percent of the ﬁrm’s stock, or 489,847 shares. If he sold one-half of his holdings in a secondary offering, the total sale would amount to 489,847/2 = 244,924 shares at \$20 per share or \$4,898,480.(Note rounding difference in Excel). Zudlum would need to pay some of the ﬂotation costs resulting from the sale. Therefore, his actual receipt of funds would be less. b. What is the impact on percentage ﬂotation cost if the investment bankers were to combine the major stockholders’ secondary offering with the sale by the company of sufﬁcient stock to provide it with \$8 million? If the major stockholders join the company in the underwriting, the gross proceeds will be \$8 million + \$4.9 million or approximately \$13 million. Larger offerings would require a smaller percentage ﬂotation cost.

The costs for issues between \$10 and \$19.99 million are 8.72%, according to Brigham, Gapenski, and Daves, Intermediate Financial Management: Theory and Practice, 6th ed. (Fort Worth, TX: The Dryden Press, 1999), Table 15-4. 9. Assume that the major stockholders decide that Federal Finance should go public. Outline in detail the sequence of events from the first negotiations with an investment banker to Federal Finance’s receipt of the proceeds from the offering. The ﬁrst step for the bank is to retain an attorney who specializes in security issues. The attorney prepares a report describing the advantages and disadvantages of going public and comments on the substantial economies of scale in the ﬂotation costs. Because ﬂotation costs would drop from 13.28 percent to 8.72 percent the principal stockholders would probably combine the secondary offering of half of Zudlum’s shares with the initial public offering. Next, informal discussions would be held with several investment-banking ﬁrms, and one banker would be chosen as the lead underwriter. At this point the investment banker, together with a CPA ﬁrm, would take over most of the chores, but the attorney would continue to play a role in the decision-making process. The principal issue at this point involves the price at which the stock would be issued. Actually, the decision to issue the stock at \$20 per share was made early.

The issue then becomes: What book value per share would be used in determining the number of shares outstanding after the split? The decision was made to sell the stock at 1.15 times book value in negotiations with the investment-banking ﬁrm. Once these basic decisions have been made, the attorney, the CPA ﬁrm, and the investment bankers would begin preparation of the registration statement and the prospectus. The investment bankers at the same time would form an underwriting syndicate consisting of the principal underwriter and two other ﬁrms, and a selling group consisting of thirty-one brokerage ﬁrms. After a number of conferences with the SEC—during which such matters as valuation reserves, accounting treatment of various items, and others would be discussed—the registration would be ﬁled with the SEC. After a twenty day waiting period, the issue would be sold to the public. 10. Explain why Brown and Zudlum might have personal differences of opinion on the question of public ownership.

Case: 75 Federal Finance Bank – Instructor’s Solution

The basic difference between Brown and Zudlum relates to outside holdings. Brown has diversiﬁed interests, but Zudlum has most of his net worth tied up in Federal Finance. Therefore, Zudlum is more interested in having Federal Finance go public so that he can diversify his personal holdings. Also, since Federal Finance is currently a privately held company, its shares are not very liquid. Thus, if Zudlum needed large amounts of cash, he might have signiﬁcant difﬁculty liquidating a portion of his shares. Finally, if the shares are not publicly traded, a market-determined value is not available. If one of the major stockholders were to die, this could cause problems in valuing his or her estate for tax purposes. This would be especially important for Zudlum since most of his net worth is represented by his Federal Finance stock. 11. The analysis was based on the comparability of Federal Finance with four other banking institutions. What factors might tend to invalidate the comparison? There may be a size difference between Federal Finance and the four other ﬁnancial institutions. Diverse economic forces may play on ﬁnancial institutions of differing size.

The nature of the loan portfolio also affects the comparability; risk and return are heavily intertwined with the loan portfolio. For instance, Federal Finance may have a conservative mortgage portfolio, while Great Northern Bank may have invested heavily in speculative real estate projects. Thirdly, the nature of the market in which the ﬁnancial institutions operate affects the comparability. Maryland Financial may be able to proﬁt from the relatively stable economic situation. Great Northern Bank may suffer from a depressed economy and investors may fear an economic downturn in California, which would affect First Bank of California. 12. All things considered, do you feel that Federal Finance should go public? Fully justify your conclusion.

On balance, the public offering seems to have been the correct decision. All the points listed by Zudlum in the case are valid reasons for the company to go public, and the only valid reason for not doing so had to do with the ancillary activities of the principals. What the three major stockholders actually did was to form a holding company, which owned the stock of Federal Finance and also the stock of the ancillary companies—the insurance agency, the title insurance agency, and so on. Then, the stock sold to the public was that of the holding company. Regulatory restrictions on savings banks preclude them from engaging in a number of ancillary activities, so these are carried on at the holding company level rather than at the association level. Life insurance companies operate similarly. Keep in mind, however, that the restrictions on ﬁnancial institutions are currently in a state of ﬂux and the restrictions may be eased in the future.

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