Suppose Levered Bank is funded with 2% equity and 98% debt. Its current market capitalization is

$10 billion, and its market to book ratio is 1. Levered Bank earns a 4.22% expected return on its

assets (the loans it makes), and pays 4% on its debt. New capital requirements will necessitate that

Levered Bank increase its equity to 4% of its capital structure. It will issue new equity and use the

funds to retire existing debt. The interest rate on its debt is expected to remain at 4%.

a. What is Levered Banks expected ROE with 2% equity?

b. Assuming perfect capital markets, what will Levered Banks expected ROE be after it increases

its equity to 4%?

c. Consider the difference between Levered Banks ROE and its cost of debt. How does this

premium compare before and after the Banks increase in leverage?

d. Suppose the return on Levered Banks assets has a volatility of 0.25%. What is the volatility of

Levered Banks ROE before and after the increase in equity?

e. Does the reduction in Levered Banks ROE after the increase in equity reduce its attractiveness to

shareholders? Explain.