THE STANFORD BANK GAME
VERSION 12
INSTRUCTOR’S MANUAL
Terry Beals
President
Human Resources West, Inc.
San Francisco, California
Edited by Susan Becker
Computer Program Development by William Klemens
Copyright Human Resources West, Inc. 2005. No part of this book may be photocopied or reproduced in
any form without permission from Human Resources West, Inc.
CONTENTS
PREFACE
1
INTRODUCTION
2
COMPONENTS OF THE STANFORD BANK GAME
THE OPENING POSITION
THE INSTRUCTOR’S GUIDE
INSTRUCTOR’S REPORT
INSTRUCTOR OPTIONS
Competitive Communities
Economic Data
RUNNING THE STANFORD BANK GAME
HARDWARE AND SOFTWARE REQUIREMENTS
INSTALLING THE PROGRAM
STARTING THE PROGRAM
STARTING A NEW GAME
ENTERING THE DECISIONS
ENTERING THE DECISIONS
RUNNING THE NEXT CYCLE
PRINTING THE REPORTS
THE PRINTOUT
RERUNNING AN EARLIER CYCLE
MODEL SENSITIVITIES
SHARE PRICE COMPONENTS
MINIMUM MARKET PRICE OF STOCK (Based on Book Value):
K-FACTOR
FACTORS WHICH AFFECT CAPITAL NOTE ISSUES
2
2
3
3
3
3
4
4
4
4
5
5
10
10
11
12
13
14
15
15
15
15
18
FACTORS WHICH AFFECT THE INTEREST RATES OF NEW CD’S
FACTORS WHICH AFFECT TEMPORARY EMPLOYEES & OTHER EXPENSES
THE SALARY CALCULATION
HEDGING INTEREST RATE EXPOSURE
Current Securities Data (excluding T-bills)
Determining NF, the Optimal Number of Futures Contracts
The NF Calculation
Hedging Versus Speculating With Futures Contracts
Hedging Cost
Default Hedging Feature
Hedging Risks
Current Securities Data, page 5 – Portfolio Analysis
APPENDIX A
TERMINOLOGY
STANFORD BANK GAME, VERSION XI, INTERNATIONAL & U.S. EDITIONS
APPENDIX B
STOCK PRICING FACTORS and FINANCIAL STATEMENT ANALYSIS
STOCK PRICING FACTORS
FINANCIAL STATEMENT ANALYSIS
DEFINITIONS FOR DERIVED VARIABLES
APPENDIX C
MAXIMUM AND MINIMUM RATES
APPENDIX D
18
19
19
20
20
21
24
24
25
25
25
26
29
29
29
30
30
30
31
36
37
37
38
VALUE PLANNING AND MANAGEMENT:AN APPLICATION OF THE VALUE ADDED
VALUATION MODEL USING INFORMATION FROM THE STANFORD BANK GAME 38
INSTRUCTOR GUIDE 1
PREFACE
This manual is for both the U.S. and International versions of the Stanford Game. The computer models
for both editions are identical; only the names for items in the printouts and Players’ Manual are different.
Appendix A provides a listing of the differences in terminology. When terms that are different for the U.S.
and international versions are used, the U.S. version terminology is shown first, followed by the
international terminology in parenthesis in italics: for example, Federal Funds (LIBOR Funds).
We encourage user input on any suggestions or ideas you have. We are especially interested in hearing
about any possible bugs or errors.
Version 12 is a major departure from earlier editions of SBG as the new spreadsheet file allows instructors
to do things with the game that were not possible in the past. We hope all of our users will be generous in
sharing material that use this feature so we make it available to all users of the game.
The website for up to date information about SBG is www.hrwinc.com. Please include “sbg” in the
header of any e-mail to bankgame@hrwinc.com.
INTRODUCTION
The Stanford Bank Game (formerly known as the Stanford Bank Management Simulator or SBMS) is a
Microsoft® Windows™ program that runs on a personal computer. It simulates the operations of a
commercial bank, based on the decisions of management teams. The program is designed to be used as a
training device to give current and future managers of financial institutions a working knowledge of the
financial interrelationships within a commercial bank. Participants make short-term operating decisions
while at the same time considering the implications of these decisions for long-term growth and
profitability. Although the relationships in the program are idealized and do not necessarily reflect the
particular operations of any actual bank or class of banks, participants work with a fairly complex and
realistic model and are challenged to make optimal decisions within this framework.
The basic operational unit of the game is the individual bank. The basic time unit is the calendar
quarter. (No seasonal patterns exist). In each quarter of the game, the simulator computes the earnings
and operating results for each bank by processing the decisions of the participating banks, the financial
positions of the banks at the start of the quarter, and the economic data specifying the operating
environment.
At the end of each quarter, the program generates several computer printouts: the Instructor’s Report,
which summarizes the performance of each bank, and individual printouts for each bank, which give that
particular bank’s financial position and the composition of its loan and investment portfolios as well as
comparative information on all banks. Version 12 provides instructors with the option of creating a csv
file of the student report that can easily be copied into a spreadsheet, and instead of direct printing, a pdf
file option is now included. The ending financial position of each bank in one quarter becomes that bank’s
starting financial position in the following period. (You should always check the README.TXT file that
is shipped with the software).
COMPONENTS OF THE STANFORD BANK GAME
The Stanford Bank Game is a self-contained package which consists of the following items that can be
downloaded from the web site <www.hrwinc.com>.
1. Players’ Manual: This manual contains the information a participant needs to understand the
operating environment of the simulation, to make the input decisions, and to interpret the computer
printout. Ratios or terms used in the simulation are defined in the manual.
2. Instructor’s Manual: This manual contains information about the Instructor’s Report and the
computer operations of the simulation. “First time user guide” this is only available by e-mail
request. You must include you full University contact information including phone to obtain this
manual.
3. Software. The download is an installer with a demo version of the software. You need a license
to obtain a fully operational version.
4.
Supplemental student materials.
THE OPENING POSITION
The game begins with year 2, quarter 2. In the printouts for period 1.4 and 2.1 in the Players’ Manual and
period 2.1 in the Instructor’s Manual, Bank 1 represents the actual position of all of the banks at the
beginning of the game. By studying the changes that have occurred from period 1.4 to 2.1, the students
can begin to learn how the game works even before their first decision period.
INSTRUCTOR GUIDE 3
THE INSTRUCTOR’S GUIDE
INSTRUCTOR’S REPORT
Each quarter, the simulator prints reports to help the instructor assess the performance of the individual
banks. The Instructor’s Report summarizes key factors that are useful in evaluating the performance of the
individual bank teams. (See examples and definitions in Appendices B and C).
INSTRUCTOR OPTIONS
The instructor may operate Version 12 in one of two ways:
1. The Partially Competitive Option: Under this option, the banks compete only against the
environment. The decisions of any one bank playing the game do not influence the results of the other
banks.
2. The Completely Competitive Option: With this option, the banks compete both against the
environment and against each other. The competing banks are assigned to sets of banks, called
communities.
The competitive mode does not use a zero sum approach. In the competitive mode, the computer
program first allocates loans and deposits based on the various interest rates offered or charged by the
banks compared to “All Banks in the Economy.” If the banks in the competitive community have
substantive differences in their decision data, the model may adjust the loan and deposit allocations
accordingly. In the competitive mode, a bank cannot lose more than 10% of the business it would have
acquired in the non-competitive mode. Under certain circumstances, a bank may acquire a significant
amount of additional business by taking a small percentage from all of the other banks. Generally, the
competitive mode has only limited impact on the results of the game.
Most instructors use the partially competitive option for the first two or three quarters and then switch
to the completely competitive mode when the participants are more familiar with the game. In any case,
the instructor should tell the participants which option is being used.
Competitive Communities
You can run a maximum of eight banks in a single game, but only seven banks in a single competitive
community. If you have nine or more teams, you will need to divide the teams into two separate games.
If you want to have a single winning team in a game with more than seven banks (the maximum in a
single competitive community), you should run the program in the non-competitive mode for all groups.
Remember, the teams in a community compete only against the other banks in their community and the
environment. It is not entirely fair to compare the results between two competitive communities, because
in the competitive mode a bad decision by one or two banks can create positive results for other banks in
that community, but not in the other. If you want participants to compare or review the results in another
game, distribute copies of pages 8, 9, and 10 from the other program.
If you do not need to have a single winning team, you can divide the teams into separate competitive
communities, thereby reducing the amount of competitive data each team needs to analyze. In a single
game, you can have two competitive communities, as long as each community has the same number of
banks. If you have eight teams, you can divide the teams into two separate competitive communities of
four banks each.
If you run a game with five or six banks in a community, the participants receive the optimum
amount of data: enough to make their analysis meaningful, but not too much to be overwhelming. If you
run a game with less than four teams in a community, the participants may not have enough information
to evaluate the computer data properly. SBG ships with two test games. If you only have enough students
for one or two groups you can just overwrite the decisions in one of the test games and your students will
have information on other banks.
Economic Data
At the heart of the model are parameters defining specific economic conditions during each quarter of
simulation. Eight economic scenarios are included. You can play ten quarters—through period 4.4.
Economies 1,2,3 & 4 are simplified. Economies 5,6,7 & 8 are variations on the first 4 but are more
realistic and less predictable. They should be used with more advanced students.
Economies 1,2,5 & 6 are low inflation. Economies 3,4, 7 & 8 have slightly higher inflation rates.
RUNNING THE STANFORD BANK GAME
One unique aspect to the SBG software is that the only data that is saved is the student decision
information. Every time you start a new game a new “decis **.sbg” file is created in the “bankgame”
folder. There is a file called “gameini.sbg” that holds the general game setup information. You can open
this file with any text reader like Notepad and you can see all of the information such as the bank names
for any game you have. This information can be edited if the need arises. If you need to know which
decision file is associated with a particular game just open the gameini.sbg. Data 01 corresponds with the
decis01.sbg.
Every time you run a cycle with the SBG software all previous cycles are redone. There is never any
great need to save any SBG files as they are very easy to recreate at any time.
A downside to this approach is a modification to the equations in SBG, if a game is in progress,
changes data in the earlier student reports.
HARDWARE AND SOFTWARE REQUIREMENTS
You should be able to run SBG on any current Windows operating system. SBG 12 is a 32 bit
program and may present issues on some older Windows systems that were not set up for 32 bit programs.
There are some configuration issues due to changes Microsoft made to NT. If you have problems we can
provide you with a small file that is part of the installer that should resolve the issues.
INSTALLING THE PROGRAM
In today’s security conscience environment almost all PC’s that are not personally owned by an
individual have features to protect the operating system. Even individually owned PC’s if configured for a
network may have protection. You must have full administrative access to the PC in order to install the
SBG program. If you do not then you should have technically support do the install. Tech. support
personnel are not always completely aware of the levels of security on some systems. This is even more
complex on Networks as each is different. Almost all of the issues we have encountered in the past few
years with users installing the game have been related to security.
If you download the installer from the web site it installs the International edition. The game will only
run the period 2.2 – it is not functional beyond the first quarter. If you are a licensed user of SBG we will
e-mail you a working version of the software.
It is a good idea to have tech support download the install program as some networks have security that
prevents the download of programs. Running the setup.exe installs the program. You cannot copy the
SBG program from one computer to another, you must run the install. Our install program contains a few
Microsoft files that must be in the Windows system directory in order to run the SBG software.
When the installation is complete, you are returned to Windows. The Stanford Bank Game icon in a
Stanford Bank Game program group appears. You can now start the program by choosing the Stanford
Bank Game icon.
Before using SBG we suggest you create a subfolder “Originals” and place copies of the gameini.sbg
,decis99.sbg, and decis98.sbg in the folder, This allows you to easily go back to the original install
position. We also suggest you create a subfolder for your game files, Unlike earlier versions of SBG this
edition generates a large number of files if you use the new features.
INSTRUCTOR GUIDE 5
STARTING THE PROGRAM
To start the program
1) Start Windows, if it is not already running.
2) Choose the Stanford Bank Game icon. The Stanford Bank Game main window appears.
Stanford Bank Game Main Window
The main window displays the following information:
Course
The name of the professor, the assistant, and the course, and the scheduled time for the
Information
selected game. You enter this information in the Options window when you start a new
game.
Selected Game
The names of the bank games. You choose a name when you start a new game.
Period
The current period for the selected game. You can change the period by placing the cusor
in this window and pressing the “+” or “-“ keys
STARTING A NEW GAME
When you start a new game, you enter three sets of options: Course Identification, Bank Names, and
Game Options. Before you run the first cycle of the game, you must also set the Print options.
To start a new game
1) Start the Stanford Bank Game as explained earlier, if it is not already running.
2) From the File menu, choose New Game. The Options window appears with the Course
Identification tab on top.
Course Identification Tab, Options Window
To enter the Course Identification
1) Enter the following information in the text boxes:
Professor
Assistant
Course
Scheduled
Game
You can change this name if you want by typing directly in the text box.
Use the mouse or the TAB key to move between the text boxes.
2) Enter the Bank Names as explained next.
To enter the Bank Names
1) In the Options window, choose the Bank Names tab.
INSTRUCTOR GUIDE 7
Bank Names Tab, Options Window
The Bank Names tab shows the name, number, and number of players for each bank.
2) Enter the following information in the text boxes:
Banks
After each bank number, enter a name for the bank. The number of bank names
that you enter sets the number of banks in the game.
Players
After each bank number and name, enter the number of players for that bank.
The number of players is used to determine the number of copies of the reports
to print. It is usually easier to use a copier to make more than one copy.
To set the Game Options
In the Options window, choose the Game Options tab
Options Window
1)
Choose an economy. If you change the economy after you run one or more cycles, the results
for all of the cycles are affected, even the quarters you have already run. If you change the
economy, you will need to reprint and redistribute all reports from the period 2.2 on.
2)
Only Position 1 is currently available
3)
If you want to play in the competitive mode, select the Play in Competitive Mode option.
When this option is selected, the competitive mode begins. Most instructors start the
competition in period 2.4. You can highlight this box and change the quarter to start the
competitive mode.
Warning: Once you have begun the competitive mode, you cannot return to the noncompetitive mode.
To set the Print Options
1)
In the Options window, choose the Print Options tab.
INSTRUCTOR GUIDE 9
Print Options Tab, Options Window
Note: The Print Options apply to all of the games, not just the current one. If you want different Print
Options for a game, change the options before printing.
2)
Set the following options by selecting the check boxes. The option is selected if an X
appears in the box.
Print Date/Time on Reports If this option is selected, the actual calendar date and time that the report is
printed appear on the report.
Print Cover Sheet If this option is selected, a cover sheet with the text entered under the Course tab is
printed with the report.
3)
Choose one of the following options by selecting the option button.
One Copy of Each Page If this option is selected, one copy of each page of the report is printed.
One Copy for Each Player If this option is selected, one copy of the report is printed for each player – this
creates a very large print job that can be too large for some network printer setups..
Change Printer To change the printer or printer options, choose the Printer button. The Windows Printer
dialog box appears. For best results, print in portrait. In version 12 there is special code designed to work
specifically with pdffactory software. You must obtain and load this on your PC – it is available at
www.pdffactory.com. The free version of the software prints a small message at the bottom of each
page. The paid version removes the message and a special academic/non-profit price of $20 is available at
http://www.fineprint.com/company/education.html. When you select it as your printer SBG makes
separate pdf files of the reports for easy e-mailing.
Change Fonts To change the fonts for the reports, choose the Fonts button. The Windows Font dialog box
appears. This should not be necessary unless you are printing on A11 paper.
ENTERING THE DECISIONS
After you have set up a new game, you can enter the decisions for the first quarter, 2.2, and then run the
cycle and print the reports. Each quarter, you repeat the same process; enter the decisions, run the cycle,
print the reports.
Decisions Window
The Decisions window displays the following information:
Cycle
The current period for the game. You can change the period by highlighting this and
pressing the plus or minus keys.
Game
The name of the bank game you selected in the main window.
Bank
The number of the bank whose tab is selected.
Decision
Variables
The decisions. The decision variables and their allowable values are discussed in the
Players’ Manual. If these are incorrect you can reset the game by running the prior cycle.
Value
The values for the decision variables.
Remarks
The allowable ranges of values where appropriate.
INSTRUCTOR GUIDE 11
The Decisions window has three command buttons:
Revert to Saved Changes all the values to what they were before you last saved.
For example, if you enter all of Bank 1 and part of Bank 2 and then choose Revert to
Saved, all of the decisions that you entered for Bank 1 and Bank 2 are replaced with the
previously saved values. If you enter all of Bank 1 and choose Save to Disk, then enter part
of Bank 2 and choose Revert to Saved, only the decisions that you entered for Bank 2
(since you last saved) are replaced with the previously saved values.
Save to Disk
Saves the values you have entered.
Save and Return Saves the values you have entered and returns to the main window.
To enter the decisions
1) Start the Stanford Bank Game as explained earlier, if it is not already running.
2) Select the game that you want to work on in the Stanford Bank Game main window. The
window shows the game information and the current quarter. If you need to enter decisions
for an earlier quarter, see the directions on Rerunning Previous Periods later in this manual.
3) Choose the Enter Decisions button in the main window or from the Edit menu, choose
Decisions. Wait until the Decisions window appears.
4) Choose the tab for the bank whose decisions you want to enter. If there are more than five
banks in the game, use the scroll bar to display the other bank tabs.
5) Use the mouse or the TAB key to move the cursor to the Value column after the Decision
Variable that you want to enter.
6) Type the value in the box. The Remarks column indicates the allowable range of values
where appropriate. For more information, see the description of the decision form in the
Players’ Manual.
7) Use the mouse, TAB key, or arrow keys to move the cursor to the next Value box and
continue entering the values until the decision form is complete. All of the values do not
appear on one screen; you will need to scroll down to enter all the values.
Note: TAB or ENTER moves the cursor to the next box in which you can enter data;
SHIFT+TAB moves the cursor to the previous box.
1) Choose the Bank 2 tab to open the next bank and enter the decisions for that bank. Continue
with the other banks until all of the decisions are entered. Choose Save to Disk frequently to
save your work.
2) When you are finished, choose the Save and Return button to close the Decisions window
and return to the main window.
There are activities that can confuse the counters SBG uses to identify the correct set of economic data, If
the limits on loan rates do not agree with the economic data for the quarter you may not be able to enter
data. This problem is corrected by rerunning the prior cycle as this resets the information.
RUNNING THE NEXT CYCLE
When you are satisfied with the decisions you have entered, you can run the next cycle of the game.
To run the next cycle
•
In the main window, choose the Run A Cycle button, or from the Run menu, choose Cycle.
When the cycle is completed, the Reports window appears. Print the reports as explained next or choose
the Close button to return to the main window. Printing a full set of reports is a very large print job and
some networked printers may need to have the size of the cache file expanded. You can use the print pdf
file option as a work around.
PRINTING THE REPORTS
After you have run a cycle of the game, you can print the reports for that cycle. To print the reports for a
previous quarter, you must first rerun that quarter.
Reports Window
The Reports window shows the number of copies that will be printed of each page for each bank. The
default values appears when you open the window or when you choose the Reset button. The default
values are determined by the numbers you entered in the Parameters window. For example, if you entered
5 players for Bank 1 and selected the option “One Copy for Each Player,” a “5” appears after each page in
the column under Bank 1.
The Reports window displays the following information:
Quarter
The report period.
Bank Number
The bank number.
Page Number
The report page number. The cell created by the bank number and page number shows the
number of pages that will be printed of that page for each bank. NOTE you can disable
single pages by clicking on that cell – page 1 & 2 for bank # 1 will not print in the above
example. If you click on “bank 1” it will change the setting for all the pages for bank 1. If
you click on “page 1” it will change all the settings for page 1.
Print Instructor’s Select this option if you want to print the Instructor’s Reports.
Reports
Create Spread
sheets
If checked you get a csv file for each bank. The csv file (s) will be identical to the regular
print report you have configured. So if you decide to only print one page from one bank,
INSTRUCTOR GUIDE 13
the csv file will only contain that page of information.
Total
The total number of pages that will be printed.
To Go
During the printing process, the number of pages remaining to be printed.
The Reports window has four command buttons:
Print
Starts the printing.
Reset
Resets all the numbers to the default values. After the Reset button is selected, it changes to
the Zero button.
Zero
Sets all the values to zero. After the Zero button is selected, it changes to the Reset button.
Setup
Opens the Windows Printer dialog box.
Close
Closes the Reports window without printing.
To print the reports for the current quarter
1) After you run a cycle, the Reports window appears.
•
If you want to change the Print Options before printing, choose the Close button to
return to the main window. Then choose the Options button or, from the Edit menu,
choose Options, and set the Print Options as explained earlier under Starting a New
Game.
•
If you have closed the Reports window after running a cycle, return to main window.
Then choose the Print Reports button or, from the Run menu, choose Reports. The Print
Reports button and Run Reports command are dimmed each time you start the program
until you run a cycle of the game.
2) Set the number of reports you want to print, by doing any of the following:
•
To enter the default values, choose the Reset button or from the File menu, choose Reset.
After the Reset button is selected, it changes to the Zero button.
•
To return to all zeros, select the Zero button, or from the File menu, choose Zero. After
the Zero button is selected, it changes to the Reset button.
•
Click on the bank number to toggle a column between zero and one.
•
Click on the page number to toggle a row between zero and one.
•
Type a number in the appropriate row and column.
The total number of pages to be printed appears at the bottom of the window under Total.
1) If you want to print the Instructor’s Report for this period, select Print Instructor’s Report.
An X appears in the box when the option is selected.
2) If you need to change your printer setup, choose the Setup button or from the File menu,
choose Printer Setup to open the Windows Printer dialog box.
3) Choose the Print button or from the File menu, choose Print. As the reports print, the
number under To Go changes accordingly.
4) When the printing is complete, choose the Close button or from the File menu, choose Close
to return to the main window.
THE PRINTOUT
The Stanford Bank Game report has two sections for participants:
1) Information specific to their bank only
2) Information Common to All Banks
There are also Instructor’s Reports. You can use parts of the Instructor’s Report as additional handouts for
the participants. However, the participants should not see the other banks’ decision information because it
includes the officer time allocation, the only unknown variable in the game.
RERUNNING AN EARLIER CYCLE
You can rerun previous cycles of the game if necessary. There are three situations in which you may want
to rerun a cycle.
• Many instructors have their students submit a second set of decisions for the first quarter, 2.2, after
they have studied the first set of reports. They then enter the decisions and rerun 2.2.
• If you need to reprint the reports from an earlier quarter without changing any decisions, you must
first rerun the quarter. As long as you do not change any decisions, the reports will be duplicates of
the earlier reports.
• If you want to change a decision from an earlier period, you need to return to that period, change the
decisions, rerun the cycle, and print the reports. The changes affect every quarter from the changed
quarter to the current quarter, whether you rerun the interim quarters or not. To produce reports for
the interim quarters, run a quarter and print its report; then run the next quarter and print its report,
and so on.
To rerun a previous cycle
1) In the Stanford Bank Game main window, change the period. You can type in the new
period or press the minus or plus sign on your keyboard (-) until the quarter you want
appears.
2) If you want to change the decisions, enter the decisions as explained earlier. Remember that
the changes affect every quarter from the changed quarter to the current quarter, whether you
rerun the interim quarters or not.
3) Choose the Run A Cycle button. When the game is complete, the Reports window appears.
Print the reports as explained earlier or choose the Close button to return to the main
window.
INSTRUCTOR GUIDE 15
MODEL SENSITIVITIES
SHARE PRICE COMPONENTS
Market price of individual bank stock is a function of—
1) K-factor: P/E adjustment multiplier
2) Current quarter’s industry P/E ratio
3) Twenty percent of Weighted Adjusted non-operating earnings per share
4) Weighted and smoothed operating earnings per share net of reductions to shareholder value
5) Book value per share
6) The previous quarter’s stock price (if you are in the competitive mode of the program)
MINIMUM MARKET PRICE OF STOCK (Based on Book Value):
Total Equity X .041
Number of Shares Outstanding
X
Industry P/E Ratio
K-FACTOR
K-factor is a function of—
1) Capital Adequacy
A capital adequacy ratio (total qualifying capital divided by total required capital) greater
than 1.3 has no further positive effect. A ratio below 1.0 has a negative effect. The neutral
point is 1.0.
- - - - - - - - - / + + + + + + + + +/
1.0
1.3
2) Capital Notes
Leverage (capital notes divided by total equity) below 17.5% has a positive effect until it
reaches 7.5%. Above 17.5% there is a negative effect which accelerates above 22.5% and
reaches a regulatory maximum at 30%; 17.5% is the neutral point.
/++++/-----//
7.5% 17.5%
22.5%
30%
3) Non-Accruing Loans
The neutral point for non-accruing loans (as a percentage of total loans) is 1.75%. Levels
above that will hurt stock price until 6.25%.
/ + + + + + / - - - - -/
0
1.75
6.25%
4) Growth in Assets
A 3% quarterly growth rate in weighted total assets is a neutral position. This is a 12%
annualized growth rate with no maximum or minimum limits.
---------/+++++++++
12% per year
5) Growth in Weighted Adjusted Operating Earnings Per Share
A 3% quarterly (12% annual) growth rate in WEPS has a neutral effect. However, this factor
is weighted very heavily for determining the overall K-factor. That is, earnings growth
greater than this is rewarded substantially and growth less than this is punished
substantially.
+
+
+
+
/
12%
6) Liquidity Effect
Liquidity is calculated as follows:
Cash - Required Reserves + Funds Sold + 90-day Gov.+Loans Maturing - CD’s Maturing
Total Assets
A ratio greater than 25% has no additional effect; 15% is the neutral point. Below 15% there
is a negative effect.
/--------/++++++++/
0
15%
25%
7) Business Development Expenditures
When the weighted average quarterly amount spent on advertising is .05% of total assets, it
has a neutral effect. There are no benefits for having a ratio higher than .09%. Therefore, for
a bank with $1 billion in assets the business development budget should be between
$500,000 and $900,000 per quarter.
---------/++++++++/
.05%
.09%
INSTRUCTOR GUIDE 17
8) Fed (LIBOR) Funds Borrowed
The neutral point for the ratio, Fed (LIBOR ) funds purchased divided by total assets, is 5%.
Above that, there is a negative effect. Below that, to 2%, there is a positive effect. There is
no additional positive effect below 2%.
/++++++++/-------2%
5%
9) Federal Reserve (Central) Bank Borrowing
FRB (Central Bank) borrowing will have a substantial negative effect. This penalty reaches
its maximum at 15% (borrowing divided by total assets) and remains at that level even if the
ratio is increased.
/---------/
0
15%
10) Dividend Payout
Dividend Per Share
25% of previous 4 quarters’ adjusted operating income
You are penalized for a payout ratio anywhere below 25% and greater than 99%. You are
slightly rewarded for payouts between 25% and 35%. Once your ratio gets as low as 5%,
there are no further negative effects.
no effect/ - - - - / + + + + /no effect/ - - 5%
25%
35%
99%
11) Dividend Cut
Once a team cuts its dividend, the model will remember it for the remainder of the game.
Although the effects will diminish over time, stock price will suffer for at least 3 quarters.
The extent of the penalty depends on the percentage cut in the dividend. There is no
expressed reward for increasing the dividend.
FACTORS WHICH AFFECT CAPITAL NOTE ISSUES
1) The previous quarter’s capital adequacy ratio
A ratio above 1.20 does nothing to lower the interest rate further. A ratio below 1.20 has a
progressively negative effect on the interest rate (i.e., increases it).
- - - - - - - - - - - - / (no effect)
1.2
2) The previous quarter’s debt ratio
A debt ratio (debt/equity) greater than 21.2% has a progressively negative effect on the
interest rate (i.e., increases it). A ratio below 21.2% has no effect.
(no effect)
/----------21.2%
3) Purchased funds available
If relatively few purchased funds are available, the rate the bank has to pay on its new capital
notes increases. If either Fed funds (LIBOR funds) or CD’s available as a percentage of assets
are less than 10% and 35% respectively, this increases the interest rate.
If the approximate rate for capital notes from the previous quarter is different from the
actual, there are two reasons:
1) The capital adequacy effect is squared for the actual, but not for the approximate.
2) The approximate rate assumes that the bank will issue $5 million in new notes. If the
bank issues more than this, the actual rate will increase, and if the bank issues less than
$5 million, the actual rate will decrease (everything else being equal).
FACTORS WHICH AFFECT THE INTEREST RATES OF NEW CD’S
1) The Government Bond Rates
For instruments with similar maturities, each bank’s CD rates will float approximately 25-75
basis points above these rates. Premiums above this are attributable to any combination of the
following factors.
2) The Capital Adequacy Ratio
The higher the capital adequacy ratio is above 1.0125, the less the bank pays for CD’s.
Likewise, the lower the capital adequacy ratio is below .9875, the more the bank pays for
CD’s. A capital adequacy ratio above 1.175 has no further effect on the interest rate for new
CD’s.
- - -/
/+ + + + + + + +/ no further effect
.9875 1.0125
1.175%
3) ROE
The lower a bank’s ROE in the previous quarter, the higher their CD rates. ROE’s greater
than 10% have no penalties. Below this, penalties get steeper as ROE’s decrease to
negatives.
ROE - - - / - - - / - - - /
0%
5%
10%
INSTRUCTOR GUIDE 19
4) Officer Time
5) Supply of Funds in the Economy
FACTORS WHICH AFFECT TEMPORARY EMPLOYEES & OTHER EXPENSES
1) Credit card processing costs.
2) Direct expenses associated with loan commitments (.02% to .03% of total commitments).
3) Total deposits and demand deposit processing costs.
4) Economic activity which affects total loans and deposits available in the market.
5) Salaries and benefits (approximately 5%). Also, if salaries decrease by more than 5% in any
given quarter, this increases expenses even more.
6) Security sales ($4,000 for each sale).
7) Capital flags for either notes or equity ($110,000 for each flag).
8) Officer time devoted to new business. Once this exceeds approximately 50%, the expenses
increase exponentially.
9) Salary policy and the previous quarter’s ROE. Basically, if the bank has good or even just
respectable earnings, expenses will increase if salary policy doesn’t properly compensate
employees.
10) Credit policy. The more conservative the credit policy, the more expensive it is to the bank.
The cost of this additional scrutiny is reflected here.
THE SALARY CALCULATION
The salary expense each quarter is based on the size and types of assets and liabilities in the bank. To
calculate salary expense, the computer model first divides the accounts into categories.
Category I:
Securities and Fed (LIBOR) Funds Purchased/sold;
Category II: Prime & Syndicated Loans, Commercial Demand Deposits, Due to Banks, CD’s,
and FRB (Central Bank) Borrowing;
Category III: High Loans, Public (State) Time Deposits, Public (State) Demand Deposits, and
Money Market Time Deposits;
Category IV: Medium Loans, Real Estate, Consumer, and Credit Card Loans, and Regular
Demand Deposits;
Category V: Net Premises
The computer program adds the ending balances of the accounts in each category and multiplies by a
factor in order to obtain the quarterly salary expense.
Quarterly Salary = .00063 (I) + .00125 (II) + .002 (III) + .00313 (IV) + .0625 (V)
If participants complete calculation, the number will be slightly different from the figure in their
printout, because the computer model is smoothing the changes that occur in the account balances over
several quarters.
HEDGING INTEREST RATE EXPOSURE
The SBG provides one futures contract for hedging a bank’s fixed-income security portfolio to
interest rate risk. The futures contract matures one-quarter hence and has an underlying five-year, 8%
fixed-coupon U.S. Treasury note with a face value of $1 million.
The objective in hedging the bank’s fixed-income security portfolio is to protect the future value
of the portfolio from interest rate change. The hedge is accomplished by taking a position in the futures
contract. In particular, the bank’s security portfolio represents an asset and its exposure to interest rate
change is hedged by selling futures contracts. The SBG automatically offsets a bank’s sale of futures
contracts a few days prior to the contract’s expiration by buying futures contracts. The bank neither
makes payment nor takes delivery on the security underlying the futures contract. Thus, by offsetting the
contract, the bank realizes only the positive or negative cash flow from the change in the contract’s price.
The information and procedures for hedging the bank’s security portfolio are provided in the
report on the bottom half of the page 5. The “Current Securities Data (excluding T-Bills)” report
contains maturity, market value, and duration data for the bank’s fixed-income security portfolio. Under
the report, on the left side of page 5, are worksheets which contain selected information (from the report)
together with calculations required to use the NF formula at the bottom of the worksheets. The NF
formula estimates the number of futures contracts to sell that will offset the fixed-income security
portfolio’s change in value as a result of interest rate changes over the following period of play. The
computation of NF is the primary objective of the current securities data report and worksheets.
NF Formula: Cross-Hedging Security Portfolio With Futures Contracts
At the bottom of the page 5, the price-sensitivity model for hedging the bank’s interest rate
positions (embodied in the security portfolio) is shown as formula NF. The model is a version of the
Klob-Chiang Price Sensitivity Model which determines the number of futures contracts to sell that will
make the value of the “combined portfolio” invariant to small changes in interest rates. The “combined
portfolio”: consists of (1) the bank’s fixed-income security portfolio and (2) the interest rate futures
contracts. As shown by the model, the optimal number of futures contracts, NF, that achieves this
invariance objective is:
 AWD   AMV   Yield, F 
NF = 



 DF   Ft   Yield, P 
where:
AWD
DF
AMV
Ft
Yield, F
Yield, P
=
=
=
=
=
=
the Adjusted Weighted Duration of the security portfolio,
the Duration of the 5-year T-Note underlying the futures contract,
the current Adjusted Market Value of the security portfolio,
the current period Price of the 5-year T-Note futures contract,
average weighted Yield-to-Maturity implied by the futures contract, and
average weighted Yield-to-Maturity on the security portfolio.
The NF cross-hedging model amends a naïve hedging model by adding ratios compensating (1)
for differences in the weighted duration of the portfolio relative to the duration of the security underlying
the futures contract, (AWD/DF), and (2) for differences in the average weighted yield-to-maturity of the
bank’s security portfolio relative to the yield-to-maturity of the security underlying the futures contract,
(Yield, F/Yield, P). These amendments make the cross-hedging model far more effective than a naïve
model.
Current Securities Data (excluding T-bills)
INSTRUCTOR GUIDE 21
The “Time to Maturity” columns show all possible maturity ranges in years, going from 1 to 10
years. The MV column shows the total market values of all securities currently held in the bank’s security
portfolio for each 1-year maturity range. For example, the table demonstrates that the bank currently
holds in the 1–year maturity range total market values of $17.940 million and $146.808 million for State
& Muni and U.S Treasury securities, respectively. The total values of $408.450 and $384.891 represent
the total current market value of all State & Muni and U.S Treasury securities, respectively, across all
maturity ranges.
The WD columns show the average weighted durations of securities currently held in each
maturity range. The security’s durations for each maturity range are weighted by the market values of the
securities currently held in that maturity range. Thus, the table demonstrates, in the WD columns that the
bank currently holds securities in the 1-year maturity range with average weighted durations of 0.8005
years and 0.6928 years for State & Muni and U.S Treasury securities, respectively.
The WMV columns show the weighted market values of securities currently held in each
maturity range. The weighted values are determined by dividing the MV of securities held in each
maturity range by the total market value of all portfolio securities. For the 1-year maturity range the
WMV for State & Muni securities in the 1-year maturity range is .0226 (which is calculated as
$17.940/$793.341). Therefore, the State & Muni securities held in the 1-year maturity range comprise
about 2.26% of the fixed-income security portfolio’s total market value. Note that the sum of the WMVs
is equal to 1.0, i.e., 0.5148 + 0.4852 = 1.0, thus, accounting for all market values.
The WPD columns show the weighted portfolio durations of securities currently held in each
maturity range. The WPDs are determined by multiplying the WMV of the maturity range times the WD
of securities held in the maturity range. The table shows that the WPD of State & Muni securities held in
the 1-year maturity range is 0.0181 years (i.e., 0.8005 x 0.0226 = 0.0181). This WPD of 0.0181 years
indicates that the State & Muni securities held in the 1-year maturity range contribute 0.0181 duration
years to the State & Muni portfolio’s average weighted total duration of 2.4779 years.
The total Weighted Portfolio Duration of both State & Muni and U.S. Treasury securities is the
sum of the total WPDs . The report shows that the total for State & Muni securities is 2.4779 years and
the total for U.S. Treasury securities is 1.0288 years. The sum of these totals, 3.5067 years (= 2.4779 +
1.0288), represents the estimated Weighted Portfolio’s Duration.
Determining NF, the Optimal Number of Futures Contracts
In order to determine the optimal number of futures contracts to sell that will achieve the hedging
invariance objective, the numerical values of the ratios and the six variables contained in the three ratios
are required by the NF formula – (AWD/ DF), (AMV/ Ft), and (Yield F/Yield P). The SBG provides all
calculations required to calculate NF, save those adjustments occasioned by a team’s policy decisions to
purchase and sell securities at the current period’s security market prices, such prices prevailing at the end
of the current period. The SBG calculations are given in the table “Current Securities Data (excluding Tbills).” The table’s calculated values relevant for determining NF are reproduced in the worksheet section
“Futures Policy – Hedging Data and Hedge Ratio.”
The Yield Ratio (Yield F/Yield P):
For each and every decision period, the SBG automatically calculates the yield ratio. The ratio is
shown in the NF formula at the bottom of the report on page 5 as 0.513121. The ratio demonstrates that
the promised yield-to-maturity of the security underlying the futures contract is 51.312% of the average
weighted promised yield-to-maturity of the bank’s security portfolio. The value of this ratio will change
in each period as yields change.
The Duration Ratio (AWD/DF):
For each and every decision period, the SBG automatically calculates the denominator, DF, of the
Duration Ratio. The denominator of the Duration Ratio is given as “Duration of 5-Year T-Note (DF).” in
the page 5 report.
The numerator, AWD, of the Duration Ratio must be derived by banks by combining the
portfolio’s Weighted Portfolio Duration, shown as 3.5067 years, with adjustments for maturing securities
and current period sales and purchases. In order to obtain this Adjusted Weighted Duration, calculations
and adjustments are required. These calculations and adjustments are made to the “Weighted Portfolio
Duration - Sum of WPDs.” The adjustments will result in an Adjusted Weighted Duration of the Portfolio
(AWD), which is the numerator of the Duration Ratio.
The first worksheet is used to obtain the AWD, which is the numerator of the Duration Ratio in
the NF formula. The worksheet in period 1.4 is reproduced below with comments showing SBG
calculated measures versus required bank team calculated measures.
Weighted Portfolio Duration – Sum of WPDs
Less
W Duration of Maturing Securities
Less
W Duration of Sales
Plus
W Duration of Purchases
Equals Adjusted Weighted Duration of Portfolio (AWD)
3.5067
0.0251
0.0000
0.02704
3.50864
Source of Measure
SBG, for every period
SBG, for every period
Bank team, each period
Bank team, each period
Maturing Securities
Since the securities currently held in the bank’s portfolio that mature in the next period will not
affect the market value of the portfolio in the next period as a result of interest rate changes, the
weighted durations of these maturing securities must be subtracted form the portfolio’s weighted
duration. The SBG automatically calculates the Weighted Duration of Maturing Securities and
inserts the value into the worksheet. In period 1.4, the contribution of maturing securities to the
portfolio’s overall duration is 0.0251 years, as shown above and on page 5.
Sales
If a bank decides to sell securities, then the Weighted Duration of Sales must be calculated and
subtracted form the Weighted Portfolio Duration. The Weighted Duration of Sales must be
subtracted from the Weighted Portfolio Duration since sales of securities are consummated at
security prices prevailing at the end of the current period. Thus, the portfolio’s change in value
next period, due to interest rate changes, will be unaffected by the securities sold this period. In
period 1.4, the bank sold no securities and the W Duration of Sales is therefore equal to zero. If
the bank had sold securities, then the W Duration of Sales would be calculated using the exact
same procedure as described below for calculating the weighted duration of purchases.
Purchases.
If a bank decides to purchase securities, then the Weighted Duration of Purchases must be
calculated by each team. The Weighted Duration of Purchases must be added to the Weighted
Portfolio Duration since purchases of securities are consummated at security prices prevailing at
the end of the current period. Thus, the portfolio’s change in value next period, due to interest
rate changes, will be affected by the securities purchased this period. This Weighted Duration of
Purchases must be added to the Weighted Portfolio Duration. In period 1.4, the bank decided to
purchase $5 million 1-Year and $5 million 5-Year U.S. Treasury securities.
The Weighted Duration of the two purchases in period 1.4 are calculated in the
following table. Columns (1) – (4) which present the information required to calculate the
Weighted Duration contribution for each purchase. Column (5) shows how to use the
information in columns (1) – (4) to calculate the Weighted Duration of Purchases. Column (5)
shows that the Weighted Duration for each security purchase is calculated as
INSTRUCTOR GUIDE 23
 column 2 
 column 3  x (column 4)


which is equal to
$ Purchase of Security
x WD of Maturity Range
Market Value of Portfolio
Weighted Duration of Purchases, Period 2.1
(1)
(2)
(3)
(4)
(5) = (2)/(3)
x (4)
Securities
Purchased
$ Purchases
(millions of $)
MV of
Portfolio
(millions of $)
WD of
Maturity
Range
Weighted
Duration of
Purchases
793.341
793.341
0.6928
3.8247
0.00437
0.02411
1-Year, U.S.
5-Year, U.S.
5
5
SUM = W Duration of Purchases =
0.02848
The ratio ($Pi/MVP) calculates the added market value of the purchases, calculated as a
percentage of the total portfolio’s value. When this percentage is multiplied times the WD of the
maturity range, the purchase’s added duration contribution to the overall portfolio is obtained.
The SUM of the Weighted Duration of each security purchase must be added to the Weighted
Portfolio Duration.
Calculating the Duration Ratio When There Are Purchases in Maturity Ranges With A
Zero Market Value
The calculation of the W Duration of a Purchase made in a maturity range for which the bank
has zero security holdings is identically the same as that described above for a purchase in a
maturity range for which the bank has security holdings. With the passage of time, it is possible
for a bank to have a zero market value in any given maturity range. Indeed, from period to
period, the effect of sales and shortening times-to-maturities of securities can result in a bank
holding zero securities in a given maturity range. If this occurs, then the MV column in the table
will show a zero or blank in that maturity range for which the bank has no security holdings.
However, the WD column will show a duration value. This duration value is the average
weighted duration of all securities that could have been held in the maturity range. In this case,
the market value weights are equal for all securities in the maturity range.
The Market Value Ratio
For each and every decision period, the SBG automatically calculates the denominator of the Market
Value Ratio. The denominator of the Ratio is given as Futures Price of Futures Contract (Ft). on page 5.
As shown for period 1.4, the market value of the futures contract’s underlying security is $0.974 million.
The numerator of the Market Value Ratio must be derived by combining the portfolio’s Market
Value, shown as $793.341, with three adjustments. The adjustments will result in an Adjusted Weighted
Market Value of the Portfolio (AWD), which is the numerator of the Ratio.
The numerator of the Market Value Ratio is the Adjusted Market Value of the Portfolio (AMV).
In order to obtain this adjusted value, the calculations and adjustments to the Market Value of the
Portfolio are straightforward. The calculations and adjustments for period 1.4 are as follows:
MV Worksheet, Page 5, Period 1.4
Market Value of Portfolio – Sum of MVs
Less MV of Maturing Securities
Less Sales of Securities
Plus Purchases of Securities
=
Adjusted Market Value of Portfolio (AMV)
793.341
15.000
0.000
10.000
788.341
Explanation
Given by the SBG
Given by the SBG
Sum of period sales
Sum of period purchases
The NF Calculation
The optimal number of futures contracts to-be-sold to make the security portfolio’s value invariant to
changes in interest rates is obtained by taking the product of the three ratios:
)( AMV
)(Yeild Ratio )
Ft
.341
NF = (43.,5086
)( 7880.974
)(0.513121 )
0680
NF = (0.82488 )(808.385 )(0.513121)
NF = (
AWD
DF
NF = 357.76 contracts
Since it is not possible to sell fractions of a futures contract, the number of contracts to-be-sold to hedge
the bank’s security portfolio is rounded to a whole number. In this case, 357 futures contracts are sold..
Hedging Versus Speculating With Futures Contracts
The objective of a hedge in the SBG is to protect the future value of the bank’s fixed-income
security portfolio from a change in value due to interest rate change. Since the bank’s portfolio represents
an asset, a hedge requires that a bank sell futures contracts. Irrespective of the actual change in interest
rates, any gain or loss on the portfolio will be offset by a corresponding loss or gain, respectively, on the
futures contracts sold. Thus, the net gain or loss of the combined portfolio will be about zero.
However, if a bank buys futures contracts, then the bank is speculating about the future change in
interest rates. To be sure, if interest rates in fact decrease and the bank purchased futures contracts, then
the gain in the portfolio’s value will be enhanced by the gain in the purchased futures contracts. However,
if interest rate increase and the bank purchased futures contracts, then the loss in value on the portfolio
will be enhanced by the loss in value on the purchased futures contracts.
Further, if a bank sells futures contracts, but sells a number of contracts that is greater than or
less than the number of contracts recommended by the NF formula, then, in effect, the bank is
speculating. If the bank sells fewer contracts than recommended by the NF formula, then gains in the
portfolio’s value will not be completely offset by losses on the futures contracts. Thus, for interest rate
decreases there will be a net gain from the combined portfolios. However, it is also true that losses on the
portfolio’s value will not be completely offset by gains on the futures contracts. Thus, for interest rate
increases there will be a net loss from the combined portfolio. Also, if the bank sells more contracts than
recommended by the NF formula, then gains in the portfolio’s value will be more than offset by losses on
the futures contracts. Thus, for interest rate decreases, there will be a net loss from the combined
portfolios. However, it is also true that losses on the portfolio’s value will be more than offset by gains on
INSTRUCTOR GUIDE 25
the futures contracts. Thus, for interest rate increases there will be a net gain from the combined
portfolio.
The SBG allows banks to speculate without penalty by selling futures contracts in an amount that
is greater than or less than 15% of the number of contracts recommended by the NF formula. If a bank
exceeds this 15% plus or minus limit when selling futures contracts or buys futures contracts, then a
speculation capital requirement of 15% of the value speculative contracts is imposed. This penalty can
have a significant impact on capital adequacy.
Hedging Cost
Even though no funds are exchanged between the buyer and seller of futures contracts at the
inception of the transaction, there are costs associated with hedging. First, there are brokerage and
exchange commissions and fees. Second, the futures exchange requires that both buyer and seller post
cash or a risk-free bond in the form of a margin account. Thus, the margin account has an associated
opportunity cost. In the SBG, both costs are calculated and charged as an expense in the bank’s income
statement. The hedging expense depends on two variables: the spread between the Fed Funds lending rate
and the yield on 90-day U.S .Treasuries and the number of futures contracts bought or sold. The greater
the spread and the number of contracts bought or sold, the greater will be the cost. However, the cost is
relatively small as compared with the benefits of hedging. For example, if a bank sells a very large
number of contracts, say 700, then the total hedging expense would be about $0.400 million; and if the
bank sells 350 contracts, then the hedging expense will be around $0.2400 million. The expense is shown
on page 3 in Item 19 as part of Other expenses.
Default Hedging Feature
Instructors have the option to use a default hedging feature in SBG. When default hedging is
used a decision of “-1” (minus one ) in Futures Sold results in a futures sold position based on the NF
calculation. Instructors decide if this feature is available. By using this feature instructors can delay the
introduction of hedging.
Hedging Risks
A perfect hedge is one that achieves perfect price invariance and therefore zero risk exposure.
Perfect hedges are the exception and not the rule. You will discover in the SBG that the NF formula will
not provide a perfect hedge. There are three types of hedging risk that preclude a zero risk exposure
position: quality risk, timing risk, and quantity risk.
Quality risk exists when the asset being hedged in not identical to the one underlying the futures
contract. The bank’s bond portfolio consists of State & Muni and Treasury bonds, the vast majority of
which are not identical to the bond underlying the futures contract. Indeed, the portfolio’s bonds have
different coupons, yields, and durations than the bond underlying the futures contract. Hedging the
bank’s portfolio with the one futures contract is a cross-hedge. Cross-hedging cannot eliminate risk
altogether, but can minimize it. In the SBG, cross-hedging occurs since the entire group of bonds is
hedged by one type of futures contract. This is referred to as macro-hedging. Generally, in practice,
banks avoid and attempt to minimize cross-hedging by separating the portfolio’s securities into groups or
individual securities that closely match the underlying security of derivative contracts. This procedure is
not followed in the SBG since it is not practical to do so, i.e., it would require a far more complex and
time-consuming analysis and hedging procedure than the one described above for the use in the SBG.
Timing risk occurs when the delivery date on the futures contract does not coincide with the date
the hedged assets need to be purchased/sold or revalued. The difference between the futures price and the
spot price is called the basis. The basis tends to narrow as expiration approaches and prior to expiration
the basis can vary. In the SBG, a bank’s futures contracts are offset at a date t prior to the expiration date
of the futures contracts. Thus, the basis can vary at time t when the futures contracts are offset. Given this
basis risk, the hedge will not be perfect. Even so, this timing risk will be very small compared to the
quality risk.
Quantity risk occurs because of the standardization of futures contracts. In other words, a perfect
hedge may require selling 360.45 futures contracts. However, the market for futures contracts does not
allow fractions of a contract to be sold or purchased. Thus, the hedge must be rounded to a whole number
and this rounding to a whole number of contracts results in quantity risk. Again, this risk will be small
compared to the quality risk.
The objective of the price-sensitivity NF hedging model is to minimize hedging risk. However,
for the reasons described above, hedging risk cannot be eliminated. Therefore, banks should expect to see
variance between the gains (losses) on the bank’s portfolio and the offsetting losses (gains) on the futures
contracts sold to hedge the portfolio’s interest rate exposure. Indeed, the variance can be as large as up to
15% and even larger under some circumstances.
Current Securities Data, page 5 – Portfolio Analysis
The table provides useful and summary information about a bank’s fixed-income security portfolio shown
on page 6. The data in the table is provided primarily for the purpose of hedging the bank’s fixed-income
security portfolio against unfavorable changes in interest rates. However, the table also provides useful
information for managing the risk and return features of the bank’s fixed-income security portfolio to
achieve an optimal return-risk trade-off.
First, the table, in the MV and WMV columns, provides an exact distribution of the current
market value holdings of securities by type (i.e., State/Muni and U.S. Treasury) and by maturity range.
For example, only 40.25% of the bank’s State & Muni securities are in the 1 to 5 year maturity range,
while 59.75% are in the 6 to 10 year maturity range. Therefore the State & Muni portfolio is skewed to
longer-term maturities. On the other hand, the bank’s holdings of U.S. Treasury securities are distributed
like a barbell around the 3-year maturity range with 26.42% and 30.81% of the portfolio’s securities in the
1-year and 5-year maturity ranges, respectively. This leaves only 42.76% if the securities distributed
across the 2 to 4 maturity ranges and the bulk of these securities are in the 2 and 4 maturity ranges.
Second, the table also shows the exact market value distribution of fixed-income securities across
maturity ranges for the entire portfolio of securities. Note that 51.48% (= $408.450/793.341) and 48.52%
(= $384.891/$793.341) of the total market value of all securities is distributed between State & Muni and
U.S. Treasury securities, respectively. Unlike the distribution of the individual security types, 69.24% and
30.76% of the entire portfolio is distributed across 1 to 5 year and 6 to 10 year maturity ranges,
respectively. Thus, the entire portfolio of securities is skewed to the shorter term 1 to 5 year maturity
ranges.
Third, the WD columns provide an exact accounting of the price sensitivity of the security types
in terms of the security’s weighted durations per maturity range. Generally, bond price volatility is
proportional to a bond’s duration and thus, duration becomes a natural measure of a bond’s pricesensitivity to interest rate exposure. The greater the duration measure, the greater is the price sensitivity
of a bond to a change in interest rates. Thus, securities in the 6 to 10 maturity ranges with higher
durations are more price-sensitive to interest rate changes relative to securities with lower durations in the
1 to 5 year maturity ranges. The least and most price-sensitive securities are those held in the 1-year and
10-year maturity range, respectively.
Fourth, WPD column provide an exact distribution of the duration contribution of security
holdings in each maturity range. Thus, as a group, State & Muni securities contribute 2.4779 duration
years to the portfolio’s total average weighted duration of 3.5067, while U.S. Treasury securities
contribute only 1.0288 duration years to the portfolio’s total average weighted duration of 3.5067. Thus,
the State & Muni portfolio accounts for 70.66% of the total security portfolio’s duration of 3.5067 years,
while U.S. Treasury securities account for only 29.34%. Given any change in interest rates, the State &
Muni security portfolio will account for the majority of the change in total portfolio value due to a change
in interest rates. Not only is this true because State & Muni securities account for the over 50% of the
market value of the total portfolio and account for all holdings of securities in the 6 to 10 year maturity
INSTRUCTOR GUIDE 27
ranges, but also because State & Muni securities with the same times-to-maturity as U.S. Treasury
securities will have higher duration measures.
The combination of all these features provides an indication of a portfolio’s risk-return trade-off. For
example, and generally, longer term securities offer the potential for greater fixed-income and capital
gains, but also greater risk of loss due to their higher price-sensitivity as estimated by their higher
durations. Hedging provides protection form the price-sensitivity exposure of these higher risk securities.
APPENDICES 29
APPENDIX A
TERMINOLOGY
STANFORD BANK GAME, VERSION XI, INTERNATIONAL & U.S. EDITIONS
The Computer models are identical and the only differences are in the terms used in the printouts and
Players’ Manuals. Equivalent terminology is as follows:
U.S. Edition
International Edition
1) Federal Funds
1) LIBOR Funds
2) (U.S.)Treasury Bills
2) 90 Day Government Securities
3) Trust Fees and Income
3) Pension Fees and Income
4) U.S. Government Notes
4) (Other) Government Securities
5) Federal Reserve Bank
5) Central Bank
6) Public Demand Deposits
6) State Demand Deposits
7) Trust Department Deposit Accounts
7) Pension Department Deposit Accounts
8) Municipal Bonds
8) State Bonds
9) U.S. Treasury Tax and Loan Accounts
9) Government Tax and Loan Accounts
10) Public Time Deposits
10) State Time Deposits
11) Municipal Securities
11) State Securities
12) Rediscount Rate
12) Central Bank Rate
APPENDIX B
STOCK PRICING FACTORS and
FINANCIAL STATEMENT ANALYSIS
STOCK PRICING FACTORS
In the simulator’s idealized market, a bank’s stock price represents what investors are willing to pay for
each share of common stock. The primary determinants of the stock price are the bank’s Adjusted
Operating EPS (exponentially smoothed), the average P/E ratio of all banks in the economy, and the K
factor. The K factor may be less than or greater than 1.0, meaning that an individual bank’s stock is
selling for a discount or a premium relative to the average P/E ratio.
The simulator includes a simplified hedging feature. In order to keep the hedging feature simple, we
had to bend a few accounting rules. For the purpose of calculating stock price, we calculate the difference
between non-operating earnings and the after tax adjustment to retained earnings.
If the number is negative, operating earnings are reduced by this amount. All calculations in the
Stanford Game that would normally use “earnings” (for example, ROE) use this adjusted operating
earnings figure. If the number is positive, 20% of the average value over the last two quarters is used as a
positive addition to stock price. Basically, the model rewards sustainable increases to shareholder value
and penalizes decreases. Changes in equity also have a direct effect on the capital ratio, which is an
important variable in the cost of funds for each bank.
The stock price of a particular bank is determined by taking the product of its exponentially smoothed
earnings (which include the adjustments noted above), the economy average P/E ratio, and the bank’s K
factor. Stock price is weighted over several quarters of time and previous stock prices affect the current
price. Some of the measures in the stock price equation are in no way intended to be an exact replication
of real market behavior. Rather, they are to some extent replacements for regulatory constraints. For
detailed information on stock price and the K factor, see “Model Sensitivities.”
APPENDICES 31
FINANCIAL STATEMENT ANALYSIS
Ratio
Formula
Performance Ratios
Return on Equity (ROE)
(Net income x 4) ÷ Total equity
Return on Assets (ROA)
(Net income x 4) ÷ Total resources
Equity Multiplier (EM)
Total resources ÷ total equity
Profit Margin (PM)
Net income ÷ gross operating income
Asset Utilization (AU)
Gross operating income x 4 ÷ total resources
Net Interest Margin (NIM)
(Total interest income - Total interest paid) ÷ (Federal funds sold +
Total securities + Gross loans and mortgages - Provision for loan
losses from the Balance Sheet)
Earnings Base (EB)
(Federal funds sold + Total securities + Gross loans and mortgages Provision for loan losses) ÷ Total resources
Spread
[Total interest income ÷ (Federal funds sold + Total securities + Net
loans and mortgages)] - [Total interest paid ÷ (Time deposits +
Federal funds purchased + Funds borrowed from FRB)]
Burden/Total assets
[(Service charge income + Fees and other income) - (Salaries and
benefits + Occupancy expense + Business development + Other
expenses x 4)] ÷ Total resources
Noninterest income/Overhead
Expense
(Service charge income + Fees and other income) ÷ (Salaries and
benefits + Occupancy expense + Business development + Other
expense)
Expense Control:
PM Components
Interest expense/Total revenue
Total interest paid ÷ Gross operating income
Average interest cost of
liabilities:
Public funds
(Public interest expense x 4) ÷ Public time deposit accounts
Certificates of deposit
(CD's interest expense x 4) ÷ CD's time deposit accounts
Savings deposits
(Savings interest expense x 4) ÷ Public time deposit accounts
Federal funds purchased
(Fed fund purchases interest expense x 4) ÷ Federal funds
purchased
FRB borrowing
(FRB borrowing interest expense x 4) ÷ Funds borrowed from the
FRB
Capital notes
(Capital notes interest x 4) ÷ Capital notes
Liabilities
(Percent of Total Assets)
Demand deposit accounts:
Demand deposits ÷ total resources
Commercial
(Commercial demand deposits + Due-to-banks Demand deposits) ÷
Total resources
Consumer
Regular checking demand deposits ÷ Total resources
Public funds
Public demand deposits ÷ Total resources
Time deposit accounts:
Time deposits ÷ Total resources {BS}
Money market savings
Money market savings ÷ Total resources
Certificates of deposit
Certificates of deposit (private) ÷ Total resources
Public funds
Public time deposit accounts ÷ Total resources
Federal funds purchased
Federal funds purchased ÷ Total resources
FRB borrowing
Funds borrowed from FRB ÷ Total resources
Capital notes
Capital notes ÷ Total resources
Other borrowed funds
Other liabilities ÷ Total resources
Interest-bearing liabilities
(Time deposits + Federal funds purchased + Funds borrowed from
FRB) ÷ Total resources
Stockholders' equity
Total equity ÷ Total resources
Overhead Expenses
(Percent of Total Revenue)
Personnel expense
Salaries and benefits ÷ Gross operating income
Occupancy expense
Occupancy expense ÷ Gross operating income
Business development expense
Business development expense ÷ Gross operating income
Other operating expenses
Other expenses ÷ Gross operating income
Total operating expenses
(Salaries and benefits + Occupancy expense + Business
development expense + Other expenses) ÷ Gross operating income
Current Loan Loss
Provision/Total Revenue
Addition to the loan loss provision for: (Syndicated loans + Prime
loans + High loans + Medium loans + Real estate loans + Consumer
loans + Credit card loans) ÷ Gross operating income
Income Taxes/Total
Revenue
Applicable taxes ÷ Gross operating income
Extraordinary Gains/Total
Revenue
Gains on securities and loans (after tax) ÷ Gross operating income
Gross Income:
AU Components
Interest income/Total assets
(Total interest income x 4) ÷ Total resources
Gross yields on assets:
Syndicated loans
(Syndicated loan interest x 4) ÷ Beginning syndicated loan balance
Prime commercial loans
(Prime loan interest x 4) ÷ Beginning prime loan balance
High grade commercial loans
(High loan interest x 4) ÷ Beginning high loan balance
APPENDICES 33
Medium grade commercial
loans
(Medium loan interest x 4) ÷ Beginning medium loan balance
Real estate loans
(Real estate loan interest x 4) ÷ Beginning real estate loan balance
Consumer loans
(Consumer loan interest x 4) ÷ Beginning consumer loan balance
Credit card receivables
(Credit card loan interest x 4) ÷ Beginning credit card loan balance
Federal funds sold
(Fed funds sales interest x 4) ÷ Federal funds sold
Treasury bills
(Treasury bills interest x 4) ÷ Treasury bills
U.S. Government notes
(U.S. Government notes interest x 4) ÷ U.S. Government notes
State and municipal securities
(State and municipal bonds interest x 4) ÷ State and municipal
securities
Assets
(Percent of Total Assets)
Gross loans and mortgages:
Gross loans and mortgages ÷ Total resources
Syndicated loans
Ending syndicated loan balance ÷ Total resources
Prime commercial loans
Ending prime loan balance ÷ Total resources
High grade commercial loans
Ending high loan balance ÷ Total resources
Medium grade commercial
loans
Ending medium loan balance ÷ Total resources
Real estate loans
Ending real estate loan balance ÷ Total resources
Consumer loans
Ending consumer loan balance ÷ Total resources
Credit card receivables
Ending credit card loan balance ÷ Total resources
Loan loss reserve
Provision for loan losses ÷ Total resources
Total investment securities:
Total securities ÷ Total resources
Treasury bills
Treasury bills ÷ Total resources
U.S. Government notes
U.S. Government notes ÷ Total resources
State and municipal securities
State and municipal securities ÷ Total resources
Cash and due from banks
Cash and due from banks ÷ Total resources
Bank premises
Bank premises (net of depreciation) ÷ Total resources
Other assets
Other assets ÷ Total resources
Noninterest Income
(Percent of Total Assets)
Total noninterest income:
[(Service charge income + Fees and other income) x 4] ÷ Total
resources
Service charge income
(Service charge income x 4) ÷ Total resources
Trust income
(Trust fees x 4) ÷ Total resources
Real estate income
[(Real estate servicing income + Real estate loan initiation fees) x 4]
÷ Total Resources
Credit card income
(Credit card fees x 4) ÷ Total resources {BS & #18}
Commercial loan fee income
[(Financial services fees + Letter of credit fees + Loan commitment
fees) x 4] ÷ Total resources
Other fee income
(Other fee income x 4) ÷ Total resources
Credit Risk Ratios
Net loan charge-offs/Gross loans
and mortgages
[(Charge-offs for: Syndicated Loans + Prime loans + High loans +
Medium loans + Real estate loans + Consumer loans + Credit cards)
x 4] ÷ Gross loans and mortgages
Loan loss reserves/Gross loans
and mortgages
Provision for loan losses ÷ Gross loans and mortgages
Loan loss reserves/Nonaccrual
loans
Provision for loan losses ÷ (Nonaccruing loans in: Prime loans +
High loans + Medium loans + Real estate loans +Consumer loans +
Credit cards) }
Current provision for loan
losses/Gross loans and
mortgages
[(Addition to the loan loss provision for: Syndicated loans + Prime
loans + High loans + Medium loans + Real estate loans + Consumer
loans + Credit cards) x 4] ÷ Gross loans and mortgages
Loans refused/Gross loans and
mortgages
[(Loans refused in: Prime loans + High loans + Medium loans +
Real estate loans + Consumer loans + Credit cards) x 4] ÷ Gross
loans and mortgages
Annualized growth in gross
loans and mortgages
Quarterly percentage change in gross loans and mortgages x 4
Annualized growth in provision
for loan losses
Quarterly percentage change in provision for loan losses x 4
Liquidity Risk Ratios
Total equity/Total assets
Total equity ÷ Total resources
Core deposits/Total assets
[(Total demand deposits x 0.6) + Money market savings + Public
time deposit accounts] ÷ Total resources
Volatile liabilities/Total assets
10% of Demand Deposits + CD’s maturing in 90 days + F. Funds
Purchased + FRB Borrowing ÷ Total resources
Liquid Assets/Total Assets
Cash and Due From + F. Funds sold + Govt. Securities ÷ Total
Assets
Net Volatile Assets/Total Assets
Total Securities – total pledge ( if positive number) + Due from
Banks + FF sold ÷ Total resources
Securities maturing within one
year/Total assets
[U.S. Government securities maturing in: (1 to 90 days + 91 to 180
days + 181 to 270 days + 271 to 365 days) + State and muni
securities maturing in: (1 to 90 days + 91 to 180 days + 181 to 270
days + 271 to 365 days)] ÷ Total resources
Net loans and mortgages/Total
assets
(Gross loans and mortgages - Provision for loan losses) ÷ Total
resources
Net loans and mortgages/Total
deposits
(Gross loans and mortgages - Provision for loan losses) ÷ Total
deposits
Interest Rate Risk
Repriceable assets/Total assets:
APPENDICES 35
Within three months
Total rate sensitive assets maturing in 1 to 90 days ÷ Total
resources
Within one year
[Total rate sensitive assets maturing in: (1 to 90 days + 91 to 180
days + 181 to 270 days + 271 to 365 days)] ÷ Total resources
Repriceable liabilities/Total
assets:
Within three months
Total rate sensitive liabilities maturing in 1 to 90 days ÷ Total
resources
Within one year
[Total rate sensitive liabilities maturing in: (1 to 90 days + 91 to
180 days + 181 to 270 days + 271 to 365 days)] ÷ Total resources
Repriceable gap/Total assets:
Within three months
Balance sheet gap in 1 to 90 days ÷ Total resources
Within one year
[Balance sheet gap in: (1 to 90 days + 91 to 180 days + 181 to 270
days + 271 to 365 days)] ÷ Total resources
Capital Risk
Total equity/Total assets
Total equity ÷ Total resources
Total qualifying capital/Total
assets
Total qualifying capital ÷ Total resources
Capital notes/Total assets
Capital notes ÷ Total resources
Cash dividends/Net income
Dividend declared ÷ Net income
Annualized growth in total
equity
Quarterly percentage change in total equity x 4
Annualized growth in total
qualifying capital
Quarterly percentage change in total qualifying capital x 4
Operational Risk
Personnel expense/Total assets
(Salaries and benefits x 4) ÷ Total resources
Occupancy expense/Total assets
(Occupancy expense x 4) ÷ Total resources
Business development
expense/Total assets
(Business development expense x 4) ÷ Total resources }
Total assets/Number of branches
Total resources ÷ Current number of branches
Total deposits/Number of
branches
Total deposits ÷ Current number of branches
Total loans/Number of branches
(Gross loans and mortgages - provision for loan losses) ÷ Number
of branches
DEFINITIONS FOR DERIVED VARIABLES
Ratio
Formula
1.
Net interest income
Total interest income - Total interest paid
2.
Earning assets
Federal funds sold + Total securities + Gross loans and mortgages Provision for loan losses
3.
Net interest margin
Net interest income ÷ Earning assets
4.
Earnings base
Earning assets ÷ Total assets
5.
Interest-bearing liabilities
Time deposits + Federal funds purchased + Funds borrowed from
FRB
6.
Spread
(Total interest income ÷ Earning assets) - (Total interest paid ÷
Interest bearing liabilities)
7.
Burden
Noninterest income - Noninterest expense
8.
Noninterest income
Service charge income + Fees and other income
9.
Noninterest expense
(overhead)
Salaries and benefits + Occupancy expense + Business development
expense + Other expenses
10. Core deposits
(Demand deposits x 0.6) + Money market savings + Public time
deposits
11. Volatile liabilities
(Demand deposits x 0.4) + CD's (private)
12. Total qualifying capital
[Total equity + Capital notes + (Loan loss reserves x 0.5)]
Net loans and mortgages
Gross loans and mortgages - Provision for loan losses
APPENDICES 37
APPENDIX C
MAXIMUM AND MINIMUM RATES
The annual interest rates on the decision forms are compared to the annual rates in the economic
information. In any given quarter:
ASSET OR LIABILITY
MAXIMUM RATE
MINIMUM RATE
ABOVE MARKET
BELOW MARKET
IN BASIS POINTS
Prime Loans
20
150
High Loans
30
150
Medium Loans
40
150
Real Estate Loans
300
250
Consumer Loans
300
250
Money Market Savings
150
150
APPENDIX D
VALUE PLANNING AND MANAGEMENT:AN APPLICATION OF
THE VALUE ADDED VALUATION MODEL USING
INFORMATION FROM THE STANFORD BANK GAME
Although some question the use of this type of model for the banking industry we have made this
material available for those who might want to teach this in classes. SBG contains the data for Value
planning on page 7 of the student reports.
INTRODUCTION
Increasingly, bankers are trying to use economic and financial management approaches -- such as the
Value Added Valuation Model -- that differ from traditional accounting models in order to manage their
institutions more efficiently. However, banks are unique and some of the issues that arise when applying
the Model to banks are complex. This situation is further complicated by the bank regulatory
environment. The primary objective here is to explain the basics of the Economic Value Added Valuation
Model as a bank value planning and managing tool. The Model is simplified in many respects in order to
meet this objective better. Further, the historical starting positions of banks in the Stanford Bank Game
(SBG) are used for illustrative purposes. The Stanford Bank Game has the necessary data and
information for those that want to explore the Model’s economic and financial management concepts.
The relevant economic/financial information in the SBG includes the bank’s capital market Beta (derived
using the Capital Asset Pricing Model), Corporate Return, and the Weighted Average Cost of Capital.
The following explains the Economic Value Added Model and the economic appraisals that were used
with the SBG’s data.
THE ECONOMIC FRAMEWORK
Allocating and managing capital efficiently is the key to the success of a bank and in determining its share
price value. Banks are in the business of competing for capital and putting capital to its most promising
uses. The economic framework demonstrates that if the rate of return (r) a bank earns is not at least equal
to the return (R) offered by other equally risky investments, then the bank’s added value will decline
relative to these other investments. The economic framework explains this competition for capital
through the following diagram:
(r)-Bank’s
Rate of Return
(%)
Investment Opportunity
r>R
r=R
r<R
1
2
(R) - Risk-Adjusted
Required Return (%)
3
Net New Investment ($)
The downward sloping return schedule represents the bank’s investment opportunities. Three specific
investment opportunities are shown -- 1, 2, and 3. For the sake of illustration assume that all three
projects involve roughly the same amount of risk. There is also shown a cutoff rate, R, below which
projects should not be accepted. The cutoff rate, R, or risk-adjusted cost of capital, is the rate of return
investors would expect to earn from investments of similar risk. Management should not accept projects
earning less than R because such acceptance diverts capital from higher return, value creating uses.
APPENDICES 39
The cutoff rate allows us to categorize three types of capital projects, and in the aggregate, three types of
companies and industries:
1. Projects or companies that are expected to earn more than the required return
(r > R) create value because investors, by investing capital in the company, can
earn more than investing in the capital market for the same level of risk.
2. Projects or companies that break even in economic terms (r =R), earn an
expected or normal or average risk adjusted return and just cover the cost of
capital.
3. Projects or companies that earn less than their cost of capital (r < R), create an
economic or opportunity loss and decrease value.
The implications of the competition for capital can be summarized in the following relationship:
Corporate Return (r) ÷ Required Return (R) = (MV) ÷ (BV),
where
MV
BV
= the market value of the bank’s common equity as determined by
the capital market (stock market), and
= the book value of the bank’s common equity as shown on the
bank’s balance sheet.
The relationship states or implies that
1: if r > R, then Market value will be greater than Book Value,
2. if r = R, then Market Value will be equal to Book Value, and
3. if r < R, then Market Value will be less than Book Value.
In other words, the relationship implies a capital market value (a stock market value) that is based on the
expected performance of the bank (r) as compared to its risk-adjusted required return or cost of capital
(R). If the ratio r/R is greater than one, this translates into a market-to-book value greater than one and
vice-versa for a ratio less than one. The efficient use of capital, in place, tends to define the relationship
currently, while the growth of capital tends to magnify the relationship either positively or negatively.
Thus, a simple comparison of a bank’s corporate return (r) to its risk-adjusted cost of capital (R) provides
an immediate indication of whether management is creating value. Further, r and R can be used to
provide an intrinsic valuation of the bank and, in so doing, can be used as a planning tool.
THE ECONOMIC VALUE ADDED (EVA) VALUATION MODEL
The Economic Value Added (EVA) model identifies value created or destroyed through the effective
allocation and management of capital. The discounted present value of all future EVA is equal to the
premium or discount that is added to the economic book value of capital employed:
Value = Capital in place (Economic Book Value) + Present Value (PV) of EVA.
In other words, value is equal to the value of the assets as capital assets plus a premium (or possibly a
discount) for the quality of EVA capitalized. This model makes clear that it is not the value of capital in
place that truly matters in determining value, but rather the quality of EVA.
For purposes of valuing a bank in SBG, “capital in place” is Total Qualifying Capital (as defined in the
SBG) and provided on page 1 of the printout. Thus, the
Intrinsic Value of Total Qualifying Capital (TQC) = TQCt + PV of Future EVA
or, in more detail,
Intrinsic Value of TQC = TQCt + ∑(rt - R)(TQCt-1)[1/(1 + R)t] +
(rt - R)(TQCT+1)(1/R)[1/(1 + R)T],
where the three major components in the formula are defined as
(1) TQCt
(2) ∑(rt - R) TQCt-1 [1/(1 + R) t]
(3) (rt - R)(TQCT+1)(1/R)[1/(1 + R)T]
= Total Qualifying Capital in place at the end of the
period (page 1 of the SBG printout),
T
= ∑(rt - R) TQCt-1 [1/(1 + R) t] = Sum of the PV of
t=1
EVA to T, and
= The PV of the Perpetual Value of EVA after T,
when r = R.
The individual variables in the formula are defined as
TQCt-1
=
Total Qualifying Capital in place at the
beginning of the period (page 1 of the SBG
printouts)
[1/(1 + R) t]
=
The Present Value Factor in each period t,
T
=
the period of time over which market
competition forces the Corporate Return (r) to
be equal to the cost of capital (R),
(1/R)
=
perpetual value of one dollar,
rt
= Corporate return in period t is Operating Profits
After Tax in period t (OPATt) divided by
beginning TQC t-1 for each period or OPATt
÷TQCt-1 (page 7 of the SBG printouts), and
R
= Weighted Average Cost of TQC or Risk
Adjusted Cost of TQC (page 7 of the SBG
printouts).
The EVA model looks complex. However, this complexity is reduced if we consider the model’s three
major components: (1) Total Qualifying Capital in place at the end of the period, (2) the Present Value
(PV) of EVA through period T, and (3) the PV of the perpetual value of EVA after T. Viewing the model
in this way demonstrates that the second and third terms (Present Value, PV, of all EVA) cannot be
positive unless corporate return (r) is greater than the WACC (R). It also demonstrates that a firm’s value
is decreased if r < R. In order to use the model, four calculations must be made: (1) OPAT, (2) TQC, (3)
r, and (4) R.
RATE OF RETURN ON CAPITAL (r)
APPENDICES 41
While it is not necessary for SBG players to calculate the corporate return (r), since the SBG provides the
calculation for each bank on page 7 of the printout, the following explanation of its calculation is
provided for a full understanding of its meaning and use.
In place of the standard accounting measure often used to calculate return (i.e., ROE), the economic
model’s corporate return is computed as follows:
Corporate Return (r) = OPATt ÷ TQCt-1 .
OPAT represents Operating Profits After Tax and TQC represents Total Qualifying Capital (TQC), as
defined in the SBG. Therefore, for a bank in the SBG, corporate return is measured as
Corporate Return (r) = OPATt ÷ TQCt-1,
where
OPAT
Total Qualifying Capital
= Adjusted Net Income*
= Total Equity
+ Capital Notes Interest
+ Capital Notes
After Tax
Outstanding
+ 0.50(Increase in Loan
+ 0.50 (Loan Loss
Loss Reserves)
Reserves)
--------------------------------------------------------------------------------------------------------* Adjusted Net Income (page 1 of printout)= Net Income (page 1 of printout) +
Adjustment to
Retained Earnings After Tax (page 5 of printout). Gains on
Securities and Loans after tax
(page 1 of printout) includes Commissions on Sales,
Muni Defaults, Futures Contract
Gains/Losses, and Real Estate Loan Gains/Losses
on Sales.
--------------------------------------------------------------------------------------------------------In the SBG, Capital is the sum of all “qualifying” cash invested in the bank’s net assets. OPAT is the
profits derived from the bank’s operations after taxes, but before the financing costs associated with Total
Qualifying Capital and net reinvestment. As such, OPAT is also the total pool of profits available to
provide a cash return to all financial providers of “qualifying capital” and to reinvest in the bank.
OPAT is net of depreciation since Adjusted Net Income is net of depreciation. Depreciation is not
included in OPAT because it is a true economic expense, albeit, a non-cash expense. The assets that are
consumed in the business must be replenished before investors achieve a return on their investment.
Another way to see this is to realize that consumable assets must be replaced in order to make OPAT
sustainable over time. To be consistent with OPAT, Total Qualifying Capital is also charged with the
accumulated depreciation suffered by the consumable assets, i.e., its calculation uses Total Equity, which
is net of depreciation.
CALCULATION OF OPAT AND CAPITAL
The calculations of OPAT, Total Qualifying Capital, and Free Cash Flow are illustrated below for the
SBG for periods 1.4 and 2.1. The Operating Profits After Tax (OPAT) earned by bank 1 in periods 1.4
and 2.1 decreased from $13.454 to $12.659 million, respectively. Total Qualifying Capital increased from
$288.413 to $297.474 million over the periods 1.3 to 1.4 and $297.474 to $305.749 million over the
periods 1.4 to 2.1, respectively. When the net new investment of total qualifying capital of $9.061 and
$8.275 million in periods 1.4 and 2.1, respectively, is charged against OPAT, $4.393 and $4.384 million
of free cash flow (FCF) is left as the additional cash at the end of periods 1.4 and 2.1, respectively. Again,
recall that this FCF does not include depreciation.
________________________________________________________________________
OPAT, TOTAL QUALIFYING CAPITAL, AND FCF FOR BANK 1
Period 1.3
OPAT :
Net Income (page 1 of printout))
+ Adj. to Retained Earnings after tax (page 5)
= Adjusted Net Income (page 1 of printout)
+ Capital Notes Interest (page 2, footnote 7)
- Tax on Interest (.48) x Capital Notes Interest
+ 0.5 x Increase in Loan Loss Reserves (page 1)
OPAT
Period Growth of OPAT
Annual Growth of OPAT: (5.909) x 4
Total Qualifying Capital (page 1 of printout)
Increase In Qualifying Capital (I)
$288.413
Period 1.4
Period 2.1
$13.337
(0.490)
12.847
0.909
(0.436)
0.134
$ 13.454
$12.814
(0.720)
12.094
0.894
(0.429)
0.100
$ 12.659
(5.909%)
(23.636%)
$297.474
$ 9.061
$305.749
$ 8.275
Free Cash Flow (FCF) = OPAT - I
$ 4.393
________________________________________________________________________
$
4.384
WEIGHTED AVERAGE COST OF CAPITAL (WACC = R)
While it is not necessary for players to calculate the WACC since the SBG provides the calculation for
each bank on page 7 of the printout, the following detailed explanation of its calculation is provided for a
full understanding of its meaning and use.
The WACC or R is the risk-adjusted, blended cost of the bank’s Total Qualifying Capital. It is not
necessarily a cash cost. It is better thought of as an opportunity cost equal to the return investors can
expect to earn from alternative investments of similar risk. Thus, a bank which has no capital notes, no
increase in the provision for loan losses, and pays no dividends, has a positive WACC even though it has
no explicit costs.
It is in this sense that the WACC (R) can be viewed as reflecting three components:
1. as the correct rate to discount operating cash flows to their present value,
2. as the benchmark for judging corporate returns earned on total qualifying capital, and
3. as the hurdle rate for project acceptance.
R or WACC is defined or measured in the SBG using a financing approach, i.e., weighting the individual
costs of debt and equity by the relative proportion of each in the bank’s target capital structure, as shown
below.
Debt
Equity
(1)
After-tax Cost
of Capital
(1 - t)rb
re
Weighted Average Cost of Capital (R) =
(2)
Target Capital
Structure (%)
Debt/Capital
Equity/Capital
(3) = (1) x (2)
Weighted Average
Cost of Capital
(1 - t)rb x D/Cap
re x E/Cap
Sum of Weighted Costs
From this perspective, the weighted cost of capital is the yield that must be earned on total qualifying
capital (equity and capital notes and 50% of loan loss reserves) in order to pay interest after taxes on the
debt, pay an equity-equivalent return to loan loss reserves, and still leave enough free cash flow to provide
sufficient return on equity.
Calculating the Cost of Equity -- the cost of equity can be found using the follow formula:
Cost of Equity (re) = Risk-free Rate + β x MRP(market risk premium).
APPENDICES 43
The Market Risk Premium (MRP) is defined as the return expected over the yield offered on long-term
risk free bonds to compensate for the risk of buying equity shares, in general. Empirical evidence
indicates that over long periods of time common stock investors in the U.S. are compensated for bearing
risk by an amount of 5.9% over the return earned on long-term risk-free bonds. Thus, at any point in
time, the average cost of equity for the market as a whole can be estimated by adding a 5.9% MRP to the
prevailing long-term risk-free rate of interest:
Cost of Equity (re) = Risk-free Rate + 5.9%.
A bank’s β or risk index may be similarly defined as the compensation required above risk-free bonds
yields for the specific risk taken by purchasing an individual bank’s common shares. The β or risk index
of 1 indicates that the bank’s common share returns matched the swings in the market as a whole and
hence entailed the same degree of risk as the market. A risk index greater (less) than one means that the
bank’s common share returns typically exaggerate (dampen) market movements and are judged by
investors to be riskier (safer) than investing in the overall market. In the SBG the current risk index or β
for each bank is provided on page 7 of the printout. For bank 1 the beta is shown to be 1.10 for period
2.1. Also shown on page 7 of the printout is the long term risk-free yield or the 10-Year Yield on U.S.
Government Securities. For period 2.1 this yield is 9.05%. Therefore, the starting cost of equity for all
SBG banks at the end of period 2.1 is 15.54%, calculated as follows:
Cost of Equity (re) = 9.05% + (1.10 x 5.9%) = 15.54%.
Calculating the After-Tax Cost of Debt or [(1 - t)rb] -- the after-tax cost of debt is the after-tax cost of
borrowing new long-term debt capital. In the SBG the banks’ pre-tax cost of borrowing is shown on page
7 of the printout as “your bank’s” Capital Notes Rate (25 million) or 11.04%. The marginal tax rate or t
is 48% throughout the term of the simulations. Therefore, the starting after-tax cost of capital for all SBG
banks at the end of period 2.1 is 5.772%, calculated as follows:
After-tax Cost of Debt (rb) = (1 - t)rb = (1 - .48)11.10% = 5.772%.
Calculating the WACC or R -- the WACC or R is calculated as follows:
________________________________________________________________________
(1)
(2)
(3) = (1) x (2)
After-tax Cost
Target Capital
Weighted Average
of Capital
Structure (%)
Cost of Capital
Debt
5.772%
37.837 ÷ 305.749
0.714%
Equity:
Total Equity
0.5(Loan Loss
Reserves)*
15.54%
256.337 ÷ 305.749
13.029%
15.54%
11.576 ÷ 305.749
0.588%
Weighted Average Cost of Capital (R)
14.33%
------------------------------------------------------------------------------------------------------------* It should be noted that the Reserves for Loan Losses (on the balance sheet) is being treated as an
equity equivalent and, as such, should earn the same risk-adjusted required return as Total Equity.
________________________________________________________________________
The bank’s WACC (R) or risk-adjusted required return is 14.33%. This represents the return required to
ensure that equity investors will earn the 15.54% risk-adjusted return calculated for the cost of equity. If
the bank’s actual return is greater (less) than the 14.33%, then equity investors will earn a return greater
(less) than the 15.54% required return to equity.
The WACC calculated above used the bank’s actual capital structure at the end of period 2.1. For
purposes of valuing a bank’s equity capital, the appropriate capital structure to use in the calculation of
the WACC is the “trailing 5-year average capital structure” of the bank (= the target or optimal capital
structure) since this is also the period of time over which β is calculated. This target or optimal capital
structure represents the structure that would tend to minimize the bank’s WACC. In other words, if the
cash flows to total qualifying capital are unaffected by the debt/equity mix and the WACC is reduced, the
value of equity will increase. Thus, if the objective in choosing the capital structure is to maximize the
value of equity, this can be accomplished, from a financing perspective, by minimizing the WACC.
To the extent that the “trailing 5-year average capital structure” does not represent the target or optimal
capital structure, then the determination of the optimal capital structure requires calculations that relate
the cost of equity and debt to leverage. These calculations must also consider the effect of using different
levels of leverage on the risk level associated with calculating the cost of equity (β) and the credit rating
associated with the required yields on capital notes. These determinations represent necessary
refinements for practitioners whose objective it is to value a bank for transaction purposes. In the SBG,
such refinements are not used and the approach is to use the bank’s current capital structure in computing
the WACC, as demonstrated above.
ECONOMIC PERFORMANCE FOR BANK 1
The Economic Performance of Bank 1 is shown below in the table titled “Selected Performance Measures
for Bank 1.” The Corporate Return (r) for Bank 1 was 4.67% and 4.26% in periods 1.4 and 2.1,
respectively. On an annualized basis the Corporate Return (r) in period 2.1 was 17.02%. The calculation
of this return of 17.02% is provided for each bank on page 7 of the printout. This return compares with a
WACC (R) at the end of period 2.1 of 14.33%. Because the Corporate Return exceeded the WACC (R),
the bank created added economic value over and above net new investment during period 2.1
Also, during periods 1.4 and 2.1, OPAT declined from $13.454 to $12.659, respectively, at a negative
period growth rate of 5.909%. Over the same periods Total Qualifying Capital grew at period rates of
3.142% and 2.782%, for an average growth rate of 2.962% per period.
SELECTED PERFORMANCE MEASURES FOR BANK 1
_________________________________________________________________________________________________________
Period 1.4
Corporate Return = OPATt ÷ TQCt -1:
r for Period 1.4 - [($13.454 ÷ $288.413) x 100] and
r for Period 2.1 - [($12.659 ÷ $297.474) x 100]
Corporate Return Annualized
Period 2.1
4.665%
18.659%
4.255%
17.022%
WACC (R)
--------------------------------------------------------------------------------------------------------OPAT
$ 13.454
Period Growth of OPAT
14.33%
Total Qualifying Capital (page 1 of printout)
Increase In Qualifying Capital (I)
Period Growth Rate of Total Qualifying Capital
Average Period Growth Rate of TQC
$288.413
$297.474
$ 9.061
3.142%
$ 12.659
(5.909%)
$305.749
$ 8.275
2.782%
2.962%
____________________
CURRENT HISTORICAL TRENDS OF BANK 1
Suppose the trends in OPAT and TQC, established over the periods 1.3 through 2.1, continued into the
future. OPAT would continue to decline and grow at the average period negative growth rate of 5.909%,
from a base of $12.659 at the end of period 2.1. TQC would continue to grow at the average period
APPENDICES 45
positive growth rate of 2.962%, from a base of $305.749 million, from beginning of period 2.2. Thus,
with two simple assumptions and the calculation of r and R, all relevant economic measures in the EVA
model have defined growth rates.
INTRINSIC VALUATION OF BANK 1 USING HISTORICAL TRENDS
This simple trend forecast, described directly above, is shown in the table below, titled “Economic Value
Added Valuation of Bank 1; Period 1.3 - 2.1 Trends Continued”. It shows that OPAT grows at the
average period negative growth rate of 5.909%, from a base of $12.659 million in period 2.1. It also
shows Total Qualifying Capital growing at an average period growth rate of 2.962%, from a base of
$305.749 million at the beginning of period 2.2 (or end of period 2.1). By assumption, this pattern is
continued into infinity. When the Spread between Corporate Return and the WACC is multiplied times
beginning TQC in each period, it can be seen that, after period 2.2, the bank will be creating negative
Economic Value Added (EVA). In other words, with each successive period after 2.2, the bank is reducing
its intrinsic value. If the bank is to survive as an on-going business, this trend cannot continue
indefinitely as the bank will bankrupt itself.
Economic Value Added Valuation of Bank 1:
Period 1.3 - 2.1 Trends Continued
________________________________________________________________________
÷
Period..........
.......
OPAT
Beginning Capital
=
-
Corp. Return (r) x 4
WACC (R)
=
x
SPREAD
Beginning Capital
2.2
11.911
305.749
2.3
11.207
313.032
2.4
10.545
320.488
3.1
9.922
328.122
3.2
.......
......................
......................
15.58%
14.44%
14.32%
14.44%
13.16%
14.44%
12.10%
14.44%
......................
......................
1.14%
305.749
(0.12%)
313.032
(1.28%)
320.488
(2.34%)
328.122
......................
......................
= EVA
3.486
(0.376)
(4.102)
(7.678) .....................
---------------------------------------------------------------------------------------------------------
INTRINSIC VALUATION OF BANK 1 USING A REVERSAL OF
HISTORICAL TRENDS
If management realizes the negative trends established over periods 1.4 and 2.1, corrective actions could
be taken. These corrective actions could take one of three forms:
(1) Attempt to increase OPAT relative to TQC, and/or
(2) Attempt to decrease TQC relative to OPAT, and/or
(3) Attempt to reduce the WACC (R).
Successful implementation of the first two actions results in an increase in Corporate Return, EVA, and
the bank’s intrinsic value, relative to what they would have been in the absence of such actions. In both
cases, TQC is being used more efficiently. Successful implementation of the third action results in
increased Present Value of EVA and intrinsic bank value since the bank has reduced the cost of financing
TQC.
By way of illustration only, a reversal of the negative trends is shown on the following page in the table
titled “Economic Value Added Valuation of Bank 1; Period 1.3 - 2.1 Trends Reversed by Period 2.3”. It
is assumed that OPAT will continue to grow at the negative rate of 5.909% through period 2.2 only, and
then at a rate required to maintain the corporate rate of return at its 2.2 level. TQC also continues to grow
at the same historical rate through period 2.3. The rate of return on the TQC outstanding at the beginning
of each period is 15.58% across the board, and exceeds the WACC by 1.14% each period. When this
spread is applied to the opening balance of TQC employed, it reveals a positive and growing EVA.
This pattern is, by assumption, expected to prevail through 2.2, when it is assumed that T is reached.
Recall that T is the period of time over which competition forces the bank’s corporate return to fall (rise)
to its cost of capital. Thus, beyond period 2.2, new capital investment is assumed to earn a return
identical (equal to) the cost of capital of 14.33%. Thus, at the margin, EVA is not created, i.e., EVA will
no longer increase. For period 2.3 and beyond, then, EVA will remain frozen at $3.913 million. Its
present value is estimated using a perpetuity factor of 6.749.
Economic Value Added Valuation of Bank 1:
Period 1.3 - 2.1 Trends Reversed by Period 2.3
T
÷
Period..........
.......
OPAT
Beginning Capital
=
-
Corp. Return (r) x 4
Annualized WACC
=
x
SPREAD
Beginning Capital
=
x
EVA
PV Factor at
R of 14.33%*
2.2
11.911
305.749
2.3
2.4
3.1
3.2
12.192 ....................................................
313.032 ....................................................
15.58%
14.33%
15.58% ....................................................
14.33% ....................................................
1.25%
305.749
1.25% ....................................................
313.032 ....................................................
3.822
3.913............................................................
0.9671
6.749**______
= PV of EVA
$ 3.696 + $26.409 = $30.105
------------------------------------------------------------------------------------------------------------* The present value factors for periods 2.2 through T+ 1 are calculated using quarterly year
discounting, i.e., for period 2.2 the factor 0.9671 is calculated as 1 ÷ 1.1433.25.
** The present value factor for the perpetuity is calculated as ($1 ÷ 0.1433) x 0.9671 = 6.749. In other
words, the perpetual value of the right to receive $3.913 million beginning in period 2.3 at the cost of
capital of 14.33% = $3.913 million ÷ 0.1433 = $27.306 million. Thus, the perpetual value is worth
$27.306 million as of period 2.3. The $27.306 million perpetual value is discounted from period 2.3
APPENDICES 47
to its present value by the present value factor for period 2.2 = $27.306 million x 0.9671 = $26.409
million.
________________________________________________________________________
DERIVATION OF THE INTRINSIC VALUE OF EQUITY
The table below shows the Intrinsic Value of Total Qualifying Capital and the derivation of the
Intrinsic Value of Equity: The Present Value of all EVA represents the premium value created over the
commodity value of TQC. This premium value is added to the value of TQC employed at the beginning
of period 2.2 ($305.749 million) or end of period 2.1. Thus, the intrinsic value of the bank’s TQC is
portrayed as the sum the commodity value of TQC plus a premium for the quality of management
reflected in EVA. This makes obvious the critical importance of EVA as a means of creating value over
the life of the business.
Subtract from the Intrinsic Value of TQC the value of Capital Notes and 50% of Loan Loss Reserves at
the end of period 2.1 to obtain the Intrinsic Value of Equity = $286.351 million. The $286.351 million
of Intrinsic Value of Equity represents a 12%
________________________________________________________________________
Derivation of the Intrinsic Value of Equity
SUM of PV of EVA
+ TQC at the end of 2.1 x (1.1444).25
= Intrinsic Value of TQC
- Capital Notes =
- 0.5(Provision for Loan Losses) =
= Intrinsic Value of Equity =
$ 30.015 million
305.749 million
335.764 million
(37.837) million
(11.576) million
$286.351 million
Balance Sheet Book Value of Equity =
$256.337 million
Intrinsic Value of Equity ÷ Book Value =
1.12
Market Value of Equity ÷ Book Value =
1.24
________________________________________________________________________
premium over the $256.337 million of equity capital employed at the end of period 2.1. In other words,
every dollar of equity capital invested in the bank has been transformed into $1.12 of intrinsic equity
value. The additional 12% is a direct result of the fact that the forecast assumes that the bank can
maintain a corporate return (OPAT/Total Qualifying Capital) greater than the WACC through period 2.2
and equal to the WACC after 2.2. The 12% premium is below the actual market value of equity divided
by the book value of equity, which is 1.24. Either the market believes that the bank’s management can
create and/or maintain for a longer period of time a higher premium value then that indicated by the
simple forecast or the market overvalued the bank.
USING THE EVA MODEL
Case Study # 21 of the SBG provides a simplified and easy to use version of the EVA model. This Case
Study also provides suggestions and a format for using the model to evaluate, manage, and plan your
bank’s future. A portion of this Study is repeated directly below.
It is very useful to calculate OPAT, TQC, and FCF, for at least two successive periods, and compare these
financial variables to the Corporate Return and WACC. The calculations and comparisons are shown in
the table titled OPAT, Total Qualifying Capital, FCF and Performance. The table reveals that “r” is
greater than “R” for periods 1.4 and 2.1. Thus, during these periods, EVA was created. Further, the
OPAT. TQC, and FCF figures reveal that while TQC continued to grow, OPAT and FCF declined from
period 1.4 to 2.1. Thus, while EVA was created in periods 1.4 and 2.1, its value declined.
The table shows that the WACC (R) increased slightly while the Corporate Return (r) decreased by a
significant amount (from 18.66% to 17.02%}. The comparison of the trends in “r” and “R” reveal that
the major reason for the decline in EVA is the fact that “r” decreased significantly.
OPAT, TOTAL QUALIFYING CAPITAL, FCF
AND
PERFORMANCE
________________________________________________________________________
Period 1.3
OPAT :
= Adjusted Net Income (page 1 of printout)
+ Capital Notes Interest (page 2, footnote 7)
- Tax on Interest (0.48) x Capital Notes Interest
+ 0.5 x Increase in Loan Loss Reserves (page 1)
= OPAT
Total Qualifying Capital (page 1 of printout)
Increase In Qualifying Capital (I)
$288.413
Period 1.4
Period 2.1
12.847
0.909
(0.436)
0.134
$ 13.454
12.094
0.894
(0.429)
0.100
$ 12.659
$297.474
$ 9.061
$305.749
$ 8.275
Free Cash Flow (FCF) = OPAT - I
$ 4.393
---------------------------------------------------------------------------------------------------------------------------Corporate Return Compared to WACC (R)--------------WACC (R)
page 7 of printout 14.20%
14.33%
Corporate Return (r)
page 7 of printout
18.66%
--------------------------------------------------------------------------------------------------------------------------------------Corporate Return Derived-------------------------Investment Rate (It ÷ OPATt)
derived from figures above
0.67348
x Annualized Growth Rate of TQC
derived from figures above
12.57%
([TQCt - TQCt-1]/TQCt] x 4 x 100
= Annualized Corporate Return (r)
18.66%
________________________________________________________________________
$
4.384
17.02%
0.65369
11.13%
17.02%
Further, the table reveals that the when the Investment Rate is multiplied times the Annualized Growth
Rate of Capital, Corporate Return (r) is derived. This derivation of “r” shows that while the Growth Rate
of TQC declined, the OPAT earned on net new investment (I) declined by more, thereby reducing
Corporate Return (r).
The next table, titled Economic Performance, shows an analysis of corporate return in terms of the
following equation:
Corporate Return (r) =
Economic Profit Margin x Capital Turnover x (1 - Cash Tax Rate).
The analyses in this table reveal the reasons why Corporate Return (r) declined.
ECONOMIC PERFORMANCE
________________________________________________________________________
----------Adjusted EBIT and Adjusted Gross Revenues---------Period 1.4
(OPATt
from table above
13.454
+ Applicable Taxes
page 1 of printout
6.225
+ Tax on Int. Exp. on Cap.Notes
from table above
0.436
= Adjusted EBIT
20.115
Period 2.1
12.659
5.761
0.429
18.849
APPENDICES 49
Gross Revenuet
page 1 of printout
131.881 133.630
+ 0.5 x Inc. Loan Loss Reserves
page 1 of printout
11.476
11.576
= Adjusted Gross Revenue
143.357 145.206
---------------------------------------------------------------------------------------------------------------------Analysis of Corporate Return (r)-----------Economic Profit Margin:
(Adj. EBITt/Adjusted Gross Revenuet) 14.031%
12.981%
Capital Turnover:
x
Sales/TQC t-1 = [(Adj. Gross Revenue ÷TQC t-1 ] x 4
1.9882
1.9525
One minus Cash Tax Rate:
x
[1 - (App. Taxes + Tax on Int Exp.)/Adj. EBIT]
0.66885
0.67160
= Corporate Return (r)
18.66%
17.02%
-----------------------------------------------------------------------------------------------------------------------Components of Economic Profit Margin--------------------------------------Expenses-----------------------Salaries & Benefits/Adjusted Gross Revenues
page 1
Total Interest Paid/Adjusted Gross Revenues
page 1
Other Operating Expenses/Adjusted Gross Revenues
page 1
-----------------Other Income/Expense---------------[App. Taxes + Tax on Int. on Cap. Notes]/Adj. Gross Revenue
4.65%
(page 1 + above)
Gains on Security & Loans after tax/Adjusted Gross Revenues
0.26%
(page 1)
Pre-tax Adjustment to Retained Earnings/Adj. Gross Revenues
(page 5)
Futures Profit(Loss)/Adj. Gross Revenues
(page 5)
11.70%
41.15%
25.76%
11.73%
42.00%
25.76%
4.26%
0.25%
(0.66%)
(0.95%)
0.51%
0.75%
------------------------Income-----------------------Total Interest Income/Adjusted Gross Revenues
page 1
73.97%
Other Income/Adjusted Gross Revenues
page 1
18.03%
(0.5 x Loan Loss Reserves)/Adj. Gross Revenues
page 1
8.00%
TOTAL
100.00%
________________________________________________________________________
73.83%
18.20%
7.97%
100.00%
To conduct this analysis, Adjusted EBIT (Earnings before Interest and Taxes) and Adjusted Gross Income
must be calculated. These calculations are shown at the top of the table. The analysis of Corporate
Return reveals that the major reason for the decline in Corporate return over the periods 1.4 and 2.1 was
the large decline in the Economic Profit Margin, although both Capital Turnover and One minus the Cash
Tax Rate also contributed to the decline in “r”.
The Components of the Economic Profit Margin, shown at the bottom of the table, reveal that the primary
reason for the decline in the Margin was a decline in the spread between interest received and paid. This
decline in the spread is revealed by the increase in the Total Interest Paid ratio and the simultaneous
decline in the Total Interest Income ratio. All other expense and income ratios remained stable.
However, it should be noted that the Pre-tax Adjustment to Retained Earnings ratio declined significantly
and that this decline was partially offset by the increase in the Futures Profit (Loss) ratio.
Thus, with two tables only -- OPAT, TQC, FCF and Performance and Economic Performance -- all
relevant economic/financial performance statistics are revealed. In particular, the two tables show
1. a comparison of “r” to “R” (in particular, the difference between them} and therefore whether a
bank is creating EVA and producing Intrinsic Values greater than book values,
2.
the trend in “r” and “R” and therefore whether bank management decisions are
maintaining and enhancing EVA,
3. a corporate return derivation that shows the relationships between Net New Investment (I), TQC,
and OPAT,
4.
an analysis of Corporate Return, in terms of the economic profit margin, capital
turnover, and taxes, which diagnoses return and compares results from period to
period,
and
5. a further breakdown of performance which decomposes the Economic Profit margin into
categories of revenues and expenses.
All in all, these two tables provide an overall view of a bank’s economic performance and trends in that
performance. Since the WACC is computed using the same methodology for all banks, this risk-adjusted
rate is also useful as a comparison against industry peers. The corporate return measure is useful in the
same comparative way. When “r” and “R” are compared to each other and to industry peers, a bank’s
management also has a good indication of relative performance.