Bank ABC has liabilities of $4 million with an average maturity of two years paying interest rates of 4.0 percent annually. It has assets of $5 million with an average maturity of 5 years earning interest rates of 6.0 percent annually. What is the bank's net interest income in dollars in year 3, after it refinances all of its liabilities at a rate of 6.0 percent? Show all work and discuss results.

Answer: There is no interest expense in year 3, so the Bank's net interest income in dollars is 300,000.

Explanation: The Bank's liabilities of $4 million have average maturity of 2 years with 4 percent interest. The interest on liabilities is called interest expense or finance cost. On a straight line and using simple interest formula, 4% of $4 million is $160,000 per annum, so the total interest income for the 2 years will be $320,000 ($160,000 * 2 years).

Similarly, the company has interest-earning assets to the tune of $5 million with average maturity of 5 years, interest of 6 percent. The interest on earning assets is called interest income. So, on a straight line and using the simple interest formula, 6% of $5 million is $300, 000 per annum. The total interest income for the 5 years is $1.5 million ($300,000 x 5 years).

In line with matching concept in accounting, expenses incurred in generating income for a particular period are matched against each other in the same period. And generally, the financial period of companies is 12 months. Therefore, it would be inappropriate to calculate the total interest, rather the yearly interest would be considered since the interests are not balance sheet components, they are income statement components.

The company stopped incurring interest expense at year 2 while it continues to enjoy interest income till year 5. So, as there is no interest expense in year 3, the net interest income, which is calculated as interest income minus interest expense, is $300,000.