International Sun Bank $($ISB$)$

Replacement Decision

$2019,$ California Pacific Sun Bank opened its doors as an Edge Act$*$ bank in Los Angeles. Within three years, the bank changed its charter from an Edge Act to a national bank charter issued by the Office of the Comptroller of the Currency $($OCC$)$ and its name to International Sun Bank $($ISB$).$

This transition allows the ISB to offer domestic and international wire transfers. So$,$ if you have an account, you can wire money within the US and to recipients in other countries. If you're headed abroad for work or study, an international bank account can make it easier to manage your money across different currencies and reduce banking costs. Global Connectivity: Easily manage multiple currencies, make international payments, or access global markets. A genuinely borderless banking experience!

At a recent conference in $2023,$ Sebastian Kash, the operation's vice president, learned about the latest technologies in the next generation of teller machines and software. This new machine is called Interactive Teller Machines or ITM.

Although ITMs are a controversial concept in the banking industry, Kash saw them as the future replacement of ATMs. He believed the primary value of the ITM is that it can expand bank hours worldwide.

In his discussion of replacing the current ATM, he told the bank executives the ITMs are a way to provide a full service$-$service experience so customers can get various tasks done at the ITM just outside of the branch's lobby worldwide.

ISB had installed an automated teller machine $($ATM$)$ four years ago at its branch. The ATM cost $$1,200,000$ and was estimated to have a useful economic life of $10$ years. The bank has been depreciating its ATM straight$-$line $($over ten years$)$ to an estimated book salvage value of $$200,000.$ The current actual market value of the old ATM is $$300,000.$

The Interactive Teller Machine will cost $$2,000,000$ and have an expected economic life of $6$ years. The bank plans to depreciate the ITM over five years using MACRS. The bank believes ITM will attract new customers and is expected to generate $$500,000$ in new revenues during the first year. Revenues from these new customers are expected to grow $4\%$ per year over the $6-$year life of the new ITM. The new ITM will have an annual maintenance cost of $$20,000$ during the first year and will increase by $3\%$ per year over the annual maintenance costs of the old ITM.

International Sun Bank has a $25\%$ marginal tax rate and has the following capital structure:

Capital Structure Amount $($in millions$)$

Debt $$400$

Preferred Stock $$350$

Common Stock $(10$ million shares$)$ $$250$

Paid$-$in$-$capital $$150$

Retained Earnings $$150$

Equity $$550$

Total $$1,300$

The debt is based on the corporate bond that the company issued several years ago. The bond has a $10\%$ coupon rate, a par value of $$1,000,$ and a $10-$year maturity left. Today, the bond is selling for $$900.$

The preferred stock has a par value of $$25$ with a $$6$ dividend annually. Today, the preferred stock is trading at $$50$ per share.

The common stock is selling for $$64$ per share on the stock market, and the company is expected to pay a $$4\mathrm{.}0$ dividend per share this year, which has increased from $$2\mathrm{.}5$ in the last six years.

$1.$ Compute the net investment required to purchase the ITM.

$2.$ Compute the annual incremental net cash flows for each year of the project's expected $6-$year life.

$3.$ Compute the cost of capital based on the book and market value of the capital structure.

$4.$ Compute the net present value of replacing the ATM, assuming the ITM to be of average risk.

$5.$ Based on the calculations performed in Questions $1-4,$ should International Sun Bank purchase the new ITM?

Part II

The bank's board of directors requires a risk$-$adjusted discount rate to evaluate any investments seen as expanding the bank's services. Please assume that the board considers the new ITM to fall into this category since it will handle an increased number of transactions and that the board requires an additional risk premium to be added when evaluating the project.

The bank has estimated that the Beta of this investment is equal to $1\mathrm{.}25,$ and the rate of return on the market portfolio and risk$-$free rate are $12\%$ and $4\%,$ respectively.

$6.$ What is the cost of equity based on the CAPM model?

$7.$ What is the weighted average cost of capital?

$8.$ Should the bank purchase the new ITM?