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 Bank’s expected ROE with 2% equity?
b. Assuming perfect capital markets, what will Levered Bank’s expected ROE be after it increases its equity to 4%?
c. Consider the difference between Levered Bank’s ROE and its cost of debt. How does this “premium” compare before and after the Bank’s increase in leverage?
d. Suppose the return on Levered Bank’s assets has a volatility of 0.25%. What is the volatility of Levered Bank’s ROE before and after the increase in equity?
e. Does the reduction in Levered Bank’s ROE after the increase equity reduce its attractiveness to shareholders? Explain.