Explanation:
Revenue:
$2 billion = $120 million$2 billion = $30 million$2 billion = $40 million$16 millionNet Income after Tax:
Net income before tax = Revenue - Expected loss - Funding cost - Operating cost
= $120M - $30M - $40M - $16M = $34 million
After tax = $34M × (1 - 0.25) = $34M × 0.75 = $25.5 million
Economic Capital: $200 million
Traditional RAROC:
RAROC = Net Income after Tax / Economic Capital
= $25.5M / $200M = 12.75%
Formula: ARAROC = (RAROC - Rf) / β Where:
ARAROC = (12.75% - 1%) / 1.6 = 11.75% / 1.6 = 7.34%
Since ARAROC (7.34%) > Risk-free rate (1%), the project is good.
Looking at the options:
The calculated traditional RAROC is 12.75%, which is closest to 13.5% in option D. However, the question asks for the "correct adjusted RAROC" and whether the project is advisable.
Given that our calculated ARAROC is 7.34% (which is above the risk-free rate of 1%), the project should be advisable. The traditional RAROC of 12.75% is closest to option D's 13.5%, and since ARAROC > Rf, the project is good.
Therefore, Option C is correct because:
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Assume a bank's $2.0 billion corporate loan portfolio offers a return of 6% per annum. The expected loss on the portfolio is estimated to be 1.5% per annum; i.e., $30 million. The portfolio is funded by $2 billion in retail deposits with a transfer-priced interest rate charge of 2%. The bank has a direct operating cost of $16 million per annum and an effective tax rate of 25%. Risk analysis of unexpected losses associated with the portfolio tell us we need to set aside economic capital of $200 million against the portfolio; i.e., 10% of the loan amount. The bank's economic capital must invested in risk-free securities and, unfortunately in the regime of ultra low interest rates, the risk-free rate on government securities is only 1%. Although the loan portfolio's risk-adjusted return on capital (RAROC) is positive and seemingly high, the bank wants to adjust the traditional RAROC calculation to obtain a RAROC measures that take into account the systemic riskiness of the expected returns. If the risk-free rate is 1%, and the expected rate of return on the market portfolio is 8% such that the equity risk premium is 7%, and the beta of the firm's equity is 1.6, which of the following is the correct adjusted RAROC and is the project advisable?
A
RAROC is 6.25% but no, the project is bad because ARAROC is below the risk-free rate.
B
RAROC is 8% but no, the project is bad because ARAROC is below the risk-free rate.
C
RAROC is 9.8% and yes, the project is good because ARAROC is above the risk-free rate.
D
RAROC is 13.5% and yes, the project is good because ARAROC is above the risk-free rate.