Community Bank must decide whether to open a new branch. The current market value of the bank is $2,500,000. According to company policy (and industry practice), the banks capital structure is highly leveraged. The present (and optimal) ratio of debt to total assets is .9. Community Banks debt is almost exclusively in the form of demand, savings, and time deposits. The average return on these deposits to the banks clients has been 5% over the past five years.
However, recently interest rates have climbed sharply, and as a result Community Bank presently pays an average annual rate of 64% on its accounts in order to remain competitive.
In addition, the bank incurs a service cost of n% per account. Because federal "Regulation Q" puts a ceiling on the amount of interest paid by banks on their accounts, the banking industry at large has been experiencing disintermediation-a loss of clients to the open money market (Treasury bills, etc.), where interest rates are higher.
Largely because of the interest rate situation (which shows no sign of improving), Community Banks president has stipulated that for the branch project to be acceptable its entire cost of $500,000 will have to be raised by 90% debt and 10% equity. The banks cost of equity capital, k,, is 11%. Community Banks marginal tax rate is .48. Market analysis indicates that the new branch may be expected to return net cash flows according to the following schedule
Should Community bank open the new branch?