The OneNation Bank must decide whether to open a new branch. The current market value of the Bank is $25 million. According to company policy (and industry practice), the Bank’s capital structure is highly leveraged. The present (and optimal) ratio of debt to total assets is 0.9. The OneNation Bank’s debt is almost exclusively in the form of demand, savings, and time deposits. The average return on these deposits to the Bank’s clients has been 3% over the past five years. However, recently interest rates have risen sharply, and as a result the Bank presently pays an average annual rate of 4.25% on its accounts in order to be competitive. In addition, the Bank incurs a service cost of 0.75% per account. Because Federal regulation 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), the OneNation Bank’s president has stipulated that for the branch project to be acceptable its entire cost of $5,000,000 will have to be raised by 90% debt and 10% equity. The Bank’s cost of equity capital is 9%. Its marginal tax rate is 38%. Market analysis indicates that the new branch may be expected to return net cash flows according to the following schedule:
Estimated Cash Flows for OneNation Bank
Year 0 1 2 3 4 5 to infinity
Cash Flows ($) -5,000,000 250,000 350,000 450,000 450,000 500,000
(i) Should OneNation Bank open the new branch? Show all your work [30 Points].
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