Question

A DI has assets of $17 million consisting of $7 million in cash and $10 million in loans. It has core deposits of $13 million. It also has $2 million in subordinated debt and $2 million in equity. Increases in interest rates are expected to result in a net drain of $1 million in core deposits over the year.

a-1.	The average cost of deposits is 2 percent and the average yield on loans is 5 percent. The DI decides to reduce its loan portfolio to offset this expected decline in deposits. What is the cost of the firm from this strategy after the drain? (Enter your answer in dollars not in millions.)

Cost of the drain

$

a-2.	What will be the total asset size of the firm from this strategy after the drain? (Enter your answer in millions.)

Total asset size

$

million

b-1.	If the cost of issuing new short-term debt is 4.6 percent, what is the cost of offsetting the expected drain if the DI increases its liabilities? (Enter your answer in dollars not in millions.)

Cost of the drain

$

b-2.	What will be the total asset size of the DI from this strategy after the drain? (Enter your answer in millions.)

Total asset size

$  million

Answer 1

Answer:

a 1)

Cost of the drain        =   (Avearge Yield ( - ) Average Cost of Deposit ) x Net Drain        =    ( 5% (-) 2 %) x $ 1 million        =      3% x 1 million        =     $30,000

Cost of the drain   = $30,000

a 2)

Total asset size   =   No. of Assets (-) Net Drain                                   =    $17 million (-) $1 million                                   =   $16 million

Total asset size   = $16 million

b 1)

Cost of the drain        =   (Cost of issue of Debt ( - ) Average Cost of Deposit ) x Net Drain        =    ( 4.6 % (-) 2 %) x $ 1 million        =      2.6 % x 1 million        =     $26,000

Cost of the drain   = $26,000

b 2)

Total asset size   = $17 million