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FRM Part II · FRM Exam Part II · Capital Structure in Banks

A bank's risk committee compares two business units. Unit A earns a net profit of USD 24 million using economic capital of USD 150 million. Unit B earns USD 30 million using economic capital of USD 250 million. The bank's cost of equity is 14%. Which conclusion is correct on a risk-adjusted basis?

Unit A earns 16% on economic capital (24/150), above the 14% cost of equity, so it adds value. Unit B earns 12% (30/250), below the hurdle, so it destroys value. Absolute profit is misleading because it ignores the capital each unit consumes.

  1. AUnit B creates more value because its profit is higher
  2. BBoth units destroy value because both returns are below 20%
  3. CUnit A earns 16% on capital and adds value; Unit B earns 12% and destroys valueCorrect
  4. DUnit A earns 12% and destroys value; Unit B earns 16% and adds value

Explanation

RAROC for A = 24/150 = 16%, above the 14% hurdle, so it creates value (excess of 2% × 150 = USD 3 million). B = 30/250 = 12%, below the hurdle (shortfall of 2% × 250 = USD 5 million). Comparing absolute profit ignores the capital consumed.

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