Question

8. What are the benefits and costs for a bank when it decides to increase the amount of its bank
capital?

9. The Great Dammam Bank Co. pays an annual dividend of $2 per share on its common stock.
This dividend amount has been constant for the past ten years and is expected to remain constant.
Given this, how do you evaluate the current price of a stock of the firm if your required rate of
return is 5%?

Answer 1

8. Associated benefits: If a bank increases its bank capital, it can ensure to maintain a decent capital cushion. This is useful and is usually employed when the bank wants to prepare against the possible losses on its loans or other assets.

Associated cost: For a bank, both ROA (Return on Assets) and ROE (Return on Equity) are important parameters. For the same ROA (considering other parameters constant for now), if a bank increases its Bank Capital, the ROE will decrease in a proportional amount, thus for the same ROA, ROE will be much lower if bank capital is increased.

9. When Stock price, dividend growth and RoR is provided, it is advisable to use the DDM (Dividend Discount Model).

It goes as:

Value of stock = (Dividend per share) / (cost of capital - expected growth rate of dividend)

Note: Cost of capital here would be the expected rate of return.

Hence, value of the above stock = 2/(5%-0%) [since dividend growth rate, existing and expected, is 0]

= 2/5%

=$40

Thus, current price of a stock of the firm is $40.