- State Bank has the following year-end balance sheet (in millions):
Assets Liabilities and Equity
Cash $10 Deposits $90
Loans $90 Equity $10
Total Assets $100 Total Liabilities & Equity $100
The loans primarily are fixed-rate, medium-term loans, while the deposits are either short-term or variable-rate. Rising interest rates have caused the failure of a key industrial company, and as a result, three percent of the loans are considered to be uncollectable and thus have no economic value. One-third of these uncollectable loans will be charged off. Further, the increase in interest rates has caused a 5 percent decrease in the market value of the remaining loans. What is the impact on the balance sheet after the necessary adjustments are made according to?
- Book value accounting.
- Market value accounting.
- What is the new market to book value ratio if State Bank has $1 million shares outstanding?
- Book value accounting.
Under book value accounting, the only adjustment is to charge off 1 percent of the loans. Thus the loan portfolio will decrease by $0.90 and a corresponding adjustment will occur in the equity account. The new book value of equity will be $9.10. We assume no tax affects since the tax rate is not given.
- Market value accounting.
Under market value accounting, the 3 percent decrease in loan value will be recognized, as will the 5 percent decrease in market value of the remaining loans. Thus equity will decrease by 0.03 x $90 + 0.05 x $90(1 – 0.03) = $7.065. The new market value of equity will be $2.935.
- What is the new market to book value ratio if State Bank has $1 million shares outstanding?
The new market to book value ratio is $2.935/$9.10 = 0.3225.
