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Assignment 1

This document contains 6 questions regarding financial concepts such as life insurance premium calculation, corporate takeovers, IPO financing, bank liquidity risk, interest rate risk, and duration gap management. It provides relevant financial information and calculations for students to analyze and answer each question.

Uploaded by

Motivational speaker Pratham Gupta
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
39 views

Assignment 1

This document contains 6 questions regarding financial concepts such as life insurance premium calculation, corporate takeovers, IPO financing, bank liquidity risk, interest rate risk, and duration gap management. It provides relevant financial information and calculations for students to analyze and answer each question.

Uploaded by

Motivational speaker Pratham Gupta
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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Assignment 1

Note:
The Due time is by 5:30pm, Wednesday, October 4 (the hardcopies of solutions
will be placed at door of my office immediately after the due time).

Question 1
A male customer of 35 years old wants to purchase a two-year term life insurance
policy from your insurance company Nova Life. Premium will be received at beginning of
each year, and claim of $80,000 would be paid in the middle of the year if ever death
occurs. With an annual interest rate of 6%, and using the Nova Scotia Life Table, what
minimum premium will you charge on the policy?

Question 2
The firm T, as a standalone business, has asset = $105,008,000, debt = $3,040,000,
total number of shares NT = 3,565,315.
An eminent entrepreneur A, along with an investment bank, estimate that a
potential value of U = $42,003,200 can be unlocked after a takeover of T that will replace
the current management of T and implement innovative ways to operate the business of T.
The investment bank is hired to assist the takeover which costs F = $3,360,256 to the
entrepreneur.
The entrepreneur A already owns 12% of the shares of T through anonymous
trading in the stock market.
1) If the entrepreneur A plans to pay $32.50 per share to buy all the remaining
shares of T, how much cash does the acquiring entrepreneur A need?
2) With the offer price $32.50 per share, what would be the percentage change in
the equity value of T’s shareholders excluding the acquiring entrepreneur, following the
takeover?
3) If shareholders of T require rather a 18% premium, but entrepreneur A’s offer
price remains at $32.50, how large at least must the potential value U be for the acquiring
entrepreneur A to realize a profitable takeover?

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Question 3
Through IPO, an investment bank is helping a manufacturing firm to issue new
equity to finance the firm’s $120 million investment project that has a present value of
$165 million. The firm has a debt of $45.1 million in place. The firm’s average annual
earnings has been $12.8 million, and EBITDA $17 million. P/E and V/EBITDA ratios of
similar firms without debt are 14 and 11.3, respectively.

a) If the issuing firm wants to increase its old shareholders’ wealth by a minimum of 20%
with the issuance and investment, what is the maximum issuance costs (IC) the
investment bank can charge?

b) Given the IC calculated above, what is the fraction of ownership does the firm need to
sell to the new investors?

c) If the target share price after the issuance is $22.60, how many shares need to be sold
to the new investors?

Question 4

A bank faces uncertainty of liquidity needs which are represented by deposit


withdrawals following a normal distribution with mean of $2 million and standard
deviation of $12 million. If the spread (rL - r) = 5.25%, and penalty of liquidity shortage rp
= 15%. How much should the bank set aside as its cash reserve to cope with the liquidity
risk? (Note: Use both EXCEL and Table method)

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Questions 5
Use the following to answer Questions 1) – 15)

Bank of Regional Business ($ million)


Assets Liabilities
91 days; T-bills $150 1 year; Certificates of Deposit $825
2 years; Corporate bonds; 5 years; Bonds $80
9% coupon rate; trading at par $75 Demand deposits $60
10 years; Mortgages; Overnight borrowing $50
annual floating rate $500 91 days; Commercial papers
5 years, Business loans; pure discount $250
var rate; reset quarterly $600
Equity $65
Cash $5
Note:
Corporate bonds pay semi-annual coupons.
Certificates of Deposit incur annually fixed-rate interest at 2.75% p.a. The 5 years Bonds pay
8.5% p.a. semi-annually with a yield of 7.5% p.a. and have a duration of 4.1948 years.
All values are in market value. All assets and liabilities rollover at maturities.

1) What is the bank’s financial leverage?

2) What is the bank’s 91-day cumulative repricing dollar gap?

3) What is the impact on the bank’s net interest income if interest rates rise by 25 basis
points over the next quarter?

4) What is the 1-year cumulative repricing dollar gap?

5) What is the impact on the bank’s net interest income if interest rates fall by 25 basis
points over the next six months?

6) How can the bank eliminate its interest rate risk exposure over the next quarter via
direct refinancing which involves equal amount on both sides of the balance sheet?
And what is the dollar amount involved in each of the transactions?

7) What is the duration of the T-bills?

8) What is the duration of the Corporate bonds?

9) What is the duration of the Mortgages?

10) What is the duration of the Business loans?

11) What is the duration of the bank’s assets, DA?

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12) What is the duration of the bank’s liabilities, DL?

13) What is the bank’s duration gap, DG?

14) What is the impact on the bank’s equity values if interest rates fall by 50 basis points
from 5%?

15) How is this bank exposed to (i.e. falling or rising) interest rate changes? How can
the bank use direct refinancing to restructure the maturities of its assets or/and
liabilities that would modify the DG and reduce its exposure to interest rate risk?

Question 6

A bank wants to use direct refinancing to manage its duration gap, DG. Currently,
for its assets, Loans = $22 million and Cash = $6 million. Equity = $4 million. Average DA
= 2.75 yrs, and average DL = 4 yrs.

6.1 Should the bank buy loans with cash or sell existing loans for cash to reduce its
interest rate risk?

6.2 What is the duration of the bank’s existing loans?

6.3 How much cash will be used to eliminate the bank’s interest rate exposure, if the
loan available on the market has a duration of 7.6 years?

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