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The Uganda Bank (E.A.) Ltd has only two-branches. The head office branch is in the center of Kampala and the Kagera branch outside Kampala. The head...

      

The Uganda Bank (E.A.) Ltd has only two-branches. The head office branch is in the center
of Kampala and the Kagera branch outside Kampala. The head office staff consists of the
managing director and finance manager. With minor exceptions, the branch managers are
permitted to conduct their affairs like the heads of two independent banks. The planning
and control system centers on branch income statements prepared by the Finance Manager.
The Kagera branch, on the other hand, is located outside Kampala in a large and growing
retirement community and as primary retail branch. Mr. Obok, the manager, is in his first
year with the Uganda Bank. In his attempts to sell the bank‟s services to the
Kagera residents, he has found that his only success is the area of foreign deposits. Loan
business, on the other hand, is both competitive and scarce.
The interest rate he can charge is constrained by the fact that the manager of the local
competing branch of the other bank while not actively soliciting loan business is apparently
charging rates below the prevailing Kampala prime rate. Additionally, there seems to be
fundamental resistance in the part of the Kagera residents to the idea of borrowing even at
the 12% rate Obok has been offering.
The Kampala branch located in the growing central business district, serves primarily
commercial customers. The manger, Mr. Kamau, has found in recent years that while he
faces a number of vigorous competitors the principal constraint on his ability to generate
new loan business is lack of supporting deposits. The only alternative source of lending
funds is the purchase of Euro currency, which are foreign deposits held in a bank outside
Africa.
This opinion is considered less than acceptable by Kamau, as the 22% interest he would
have to pay for such funds is higher than the rate he is able to charge loan customers
currently at 20%.
In spite of his frequent lectures on the merits of leverage, the best Obok has been able to do
is to generate a few goll-carat installment and social security cheque receivable loans. As a
result, he finds himself with substantial excess savings deposits, which he has to keep in the
vault to satisfy the government‟s 20% cash reserve requirement, the vault
additionally contains excess lendable funds equal to almost 70% of total savings deposits.
The finance manager has suggested that he lends these funds to Kamau at the Kampala
branch. This was acceptable to both managers, although some disagreement arose as to the
interest rate appropriate for such a loan. The argument was finally settled by the finance
manger, who indicated that the theoretically correct rate was the rate Obok was paying on
savings deposits, 10%. It has been further agreed that if Obok could find additional loans,
any or all of the funds lent to Kamau would be returned.
Required:
a) Evaluate the 10% interbranch loan rate and suggest appropriate changes in relation to
the following criteria:
i Motivating managers to act in a manner consistent with the best interests of the
bank as a whole.
ii Evaluating the performance of individual branches.
b) Would your answer change if the Kagera branch loan rate were to rise to 14%, while all
other rates as well as the level of loan demand at Kampala b ranch, remained the same?
c) Would your answer change if all rates were the same as in (a) above except that he cost
of Euro currency dropped to 18%.
d) Based on your answers to the above, what general statements can you make about the
interbranch loan rate appropriate for evaluation of individual managers?

  

Answers


Kavungya
(a)
Solution to (i) and (iii)
- Where this transfer rate will provide the proper motivation, it?s not clear
that it is appropriate for evaluating branch performance. With this rate the
Uganda Bank (E.A) Ltd. receives all the credit for the 7.5% incremental systemwise
contribution associated with lending Kampala Branch deposits at Uganda
Bank Ltd. (i.e. 20% -12.5%), while the Kampala Branch will always show a loss of
slightly less than it?s fixed and other expenses.
- Moreover, given that Uganda Bank Ltd?s only source of funds is the
22%Eurodollars, this incremental contribution is to a large extent attributable to
the Kampala Branch.
- Perhaps a transfer rate equal to the 20% Uganda Bank (EA) Ltd loan rate is
appropriate for evaluating the performance of the Kampala Branch.
- This would however fail to compensate Uganda Banks for the costs associated
with soliciting and serving the loans. Thus the best policy may be to use dual
rates, with the Uganda Bank rate being tied to the Kampala Branch cost of funds
and the Kampala Branch rate being tied to the Uganda (EA) Ltd. rate (This
structure would also provide the appropriate motivation, as transfers would take
place except when the Uganda Bank (Ltd) loan rate dropped below the Kampala
Branch cost of funds or Kampala branch loan rate which ever is higher or when
the Kampala Branch cost of funds rose above the Uganda Bank (EA) Ltd Loan
rate).
- At this point, it is worthy noting that the need for dual rates highlights the fact
that the branches are sufficiently interdependent so as to make evaluation as
individual financial performance centers a questionable practice. Since neither
branch can obtain the 7.5% incremental contribution acting separately, it is
difficult or impossible to evaluate them meaningfully as separate entities.
- Some students may raise the question about whether dual rates may lead to
“Loose” cost of control by both branches. After all, each branch will be
enjoying extremely favourable transfers prices.

b) Given an increase in the Kampala branch loan rate to 14% as well as no significant
increase in Loan demand at this branch the “Outlay cost plus opportunity
cost” rule will seem to profit to retention of the 12.5% transfer rate advocated in (a) as
Mr. Obok still has “excess capacity” (i.e. excess lendable funds) and therefore no
opportunity cost on these funds.
- However, in sight of the loan rate differential between the two branches, total bank
profits will be maximized only if all funds above the reserve requirement are
transferred to Uganda Bank (EA) Ltd. Thus the appropriate transfer rate would be
slightly above 14% because this is the lowest rate at which it is disadvantageous for
Mr. Obok to solicit loans with rates below the Uganda Bank (EA) Ltd rate.
- In other words, the “general rule” in the chapter is interpreted as 12.5% + (14.0
– 12.5%) = 14% on any funds having a valid opportunity cost. (The word solicit
was used because it is necessary to make a limited number of “Loss-
Leader” loans in order to compete for the deposit business.
- If a credit worthy pastor of the retired community requests a loan, it is usually a
competitive necessity that the loan be made.
- In a service, the outlay cost plus opportunity cost rule is still applicable because our
objective is to put Obok in a position where he would not have “excess capacity”
(i.e., where he is servicing something less than the potential Kampala
Branch Loan Demand). Only if the Uganda Bank Loan rate drops below 14%
would we prefer to have Mr. Obok lend his funds at Kampala Branch.
- The use of the 14% rate for evaluation of branch performance raises the
same problems outsourced above, because the total bank profit-maximizing
function of the Kampala Branch is to act as a saw material supplier for
Uganda Bank, if separate evaluation is to be made, the dual rate structure
outsourced above is still appropriate.

c) Assuming a decrease in the Eurodollar rate to 18%, as well as a 12% Loan rate at
Kampala Branch, the 12.5% transfer rate advocated above remains proper from a
motivational point of view.
- Under these circumstances, however it is possible to clearly indicate that
incremental contribution attributable to each branch with a transfer price.
Specifically, if the Kampala Branch had not been built, Uganda Bank would be
making an incremental contribution of 2% (i.e. 20% - 18%). Thus the incremental
contribution of the Kampala Branch is 5.5% (i.e. 18% - 12.5%), and the
appropriate transfer price for evaluation of branches is the 18% Eurodollar rate.
(In general, as long as the Eurodollar rate is below the Uganda Bank rate, a
transfer price tied to the Eurodollar rate will also provide the proper motivation.)
- Mr. Obok will be motivated to solicit and transfer deposits to Uganda Bank so
long as the Eurodollar rate is greater than his loan rate and/or cost of funds).
- It was pointed out in the above discussion on the transfer rate appropriate for
evaluating branches that the branches are sufficiently interdependent so as to
make individual evaluation by an income statement based on transfer prices of
limited value.
- The same conclusion applies to management evaluation. A related problem is the
fact that the income figure may fluctuate for seasons unrelated to the
performance of the individual manager.
- For example, assume that we had decided to use the dual rate (i.e. 20% for Mr.
Obok and 12.5% for Mr. Kamau) advocated above and that after the decline in
the Eurodollar rate in (c) it was decided to use 18% for evaluation. The resulting
2% decline in Mr.Obok?s contribution is no way related to his
performance or toany decision variables under his control.
- This type of fluctuation could probably be avoided by using the dual rate structure
for management evaluation. However, even the approach is less than acceptable
to the extent that Mr. Kamau?s performance is dependant on the rate Mr.
Obok has to pay on savings deposits while Mr. Obok?s performance is
dependent on the prevailing Uganda Bank (EA) Ltd. Loan rate, variables over
which neither of them really has control.
- If income statements are to be used for evaluating managers, they should
probably be based on dual rates combined with measures of variable more closely
connected with managerial performance such as deposit and loan market share
and cost control performance.
Kavungya answered the question on May 8, 2021 at 11:49


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    Using the same assumption as the MD, the PM points out that in making his calculation, the
    MD has not only ignored the bonus but also the fact that suppliers offer quantity discounts
    on purchase orders, where if the order size is 200 drums or above, the price per drum for an
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    and 199 drums and Shs. 5,010 when an order is between 50 and 99 drums.
    The Finance Director's view:
    The company's finance director (FD) accepts the need to consider quantity
    discounts and pay a bonus, but he also holds the view that the MD‟s approach is too
    simplistic. He points out that there is a three days lead time for an order and that demand has
    not been entirely even over the past year. Moreover, if the company has no drums of the
    chemical in stock, it will lose specific orders as potential customers will source the chemical from
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    fig1475906.png
    Under the circumstances, the MD decided that he would seek further advice on the
    course of action to be taken by the company.
    Required:
    (a) The EOQ as originally determined by the company‟s managing director.
    (b) Determine the optimum order quantity, taking into consideration the MD‟s
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    supplier quantity discount.
    (c) The safety stock the company should maintain after applying the finance director‟s
    assumptions and assuming further that the supplier‟s contract requires
    that the order quantity be constant for all the orders in a year.
    (d) As a consultant, write a brief report to the managing director on the
    company‟s stock ordering and stock holding policies, referring where necessary to
    your answers in (a) to (c) above. The report should refer to other factors that should be
    considered when making the final decisions on stock ordering and holding policies.

    Date posted: May 7, 2021.  Answers (1)

  • Tony Kichumi, a financial analyst at Green City Bus Company Ltd. is examining the behaviour of the company?s monthly transportation costs for budgeting purposes. The transportation costs...(Solved)

    Tony Kichumi, a financial analyst at Green City Bus Company Ltd. is examining the
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    fig1175853.png
    fig1275856.png
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    Date posted: May 7, 2021.  Answers (1)

  • Equi -solutions Ltd. was formed ten years ago to provide business equipment solutions tolocal business. It has separate divisions for research, marketing, product design, technologyand...(Solved)

    Equi -solutions Ltd. was formed ten years ago to provide business equipment solutions to
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    Date posted: May 7, 2021.  Answers (1)