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FRM Part I · FRM Exam Part I · Enterprise Risk Management and Future Trends

A bank considers expanding a lending business. The expansion is expected to generate net income of USD 9.6 million after expected losses, and it would require additional economic capital of USD 60 million. The bank's cost of equity is 11%. What is the expansion's economic value added (EVA), and what does it imply?

The capital charge is 11% of USD 60 million, or USD 6.6 million. Subtracting this from net income of USD 9.6 million gives EVA of USD 3.0 million. Because EVA is positive, the expansion earns more than its cost of capital and creates value.

  1. AEVA of USD 3.0 million; the expansion creates valueCorrect
  2. BEVA of USD 9.6 million; the expansion creates value
  3. CEVA of USD 3.0 million; the expansion destroys value
  4. DEVA of negative USD 3.0 million; the expansion destroys value

Explanation

Capital charge = 11% x 60 = USD 6.6 million. EVA = 9.6 - 6.6 = USD 3.0 million, which is positive so value is created. Option B ignores the capital charge.

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