================================================================================ Financial review Independent auditor's report 14 Five-year summary of selected financial data 15 Management's discussion & analysis 16 Consolidated financial statements 24 Notes to consolidated financial statements 28 ================================================================================ INDEPENDENT AUDITOR'S REPORT To the Stockholders and Board of Directors First Merchants Corporation Muncie, Indiana We have audited the accompanying consolidated balance sheet of First Merchants Corporation and subsidiaries as of December 31, 1999 and 1998, and the related consolidated statements of income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1999 (pages 24-43). These consolidated financial statements are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. The consolidated financial statements as of December 31, 1999 and for the three years then ended have been restated to reflect the pooling-of-interests with Jay Financial Corporation and Anderson Community Bank as described in Note 2 to the consolidated financial statements. We did not audit the 1998 or 1997 financial statements of Jay Financial Corporation and Anderson Community Bank, which statements reflect total assets of $185,355,000 as of December 31, 1998, and total revenues of $15,588,000 and $13,626,000 for the years ended December 31, 1998 and 1997. Those statements were audited by other auditors whose reports have been furnished to us and our opinion, insofar as it relates to the amounts included for First Merchants Corporation as of December 31, 1999 and for the three years then ended, is based solely on the report of the other auditors. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements described above present fairly, in all material respects, the consolidated financial position of First Merchants Corporation and subsidiaries as of December 31, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1999, in conformity with generally accepted accounting principles. OLIVE LLP Indianapolis, Indiana January 22, 2000 14 FIVE-YEAR SUMMARY OF SELECTED FINANCIAL DATA (in thousands, except share data) 1999 1998 1997 1996 1995 ==================================================================================================================================== Operations Net Interest Income Fully Taxable Equivalent (FTE) Basis ............... $ 56,513 $ 52,463 $ 49,403 $ 45,431 $ 41,321 Less Tax Equivalent Adjustment .......................... 2,948 2,767 2,611 2,312 2,243 ---------- ---------- ---------- ---------- ---------- Net Interest Income ..................................... 53,565 49,696 46,792 43,119 39,078 Provision for Loan Losses ............................... 2,241 2,372 1,735 1,790 1,543 ---------- ---------- ---------- ---------- ---------- Net Interest Income After Provision for Loan Losses .................... 51,324 47,324 45,057 41,329 37,535 Total Other Income ...................................... 14,573 12,880 10,146 9,317 8,188 Total Other Expenses .................................... 36,710 32,741 30,016 27,596 25,585 ---------- ---------- ---------- ---------- ---------- Income Before Income Tax Expense ................... 29,187 27,463 25,187 23,050 20,138 Income Tax Expense ...................................... 10,099 9,556 8,704 8,006 6,905 ---------- ---------- ---------- ---------- ---------- Net Income .............................................. $ 19,088 $ 17,907 $ 16,483 $ 15,044 $ 13,233 ========== ========== ========== ========== ========== Per share data (1) Basic Net Income ........................................ $ 1.59 $ 1.50 $ 1.40 $ 1.29 $ 1.15 Diluted Net Income ...................................... 1.58 1.48 1.38 1.27 1.14 Cash Dividends Paid (2) ................................. .84 .77 .69 .59 .51 December 31 Book Value .................................. 11.55 12.85 11.95 11.10 10.40 December 31 Market Value (Bid Price) .................... 25.56 26.00 24.33 16.83 17.17 Average balances Total Assets ............................................ $1,397,230 $1,254,223 $1,151,081 $1,079,816 $ 989,340 Total Loans ............................................. 935,716 870,317 799,430 698,417 612,641 Total Deposits .......................................... 1,073,074 1,016,629 825,808 778,096 714,660 Securities Sold Under Repurchase Agreements (long-term portion) ................................ 62,686 37,238 Total Federal Home Loan Bank Advances ................... 57,062 30,742 19,746 9,192 9,000 Total Stockholders' Equity .............................. 149,727 148,052 135,958 125,907 115,655 Year-end balances Total Assets ............................................ $1,474,048 $1,362,527 $1,181,359 $1,112,672 $1,037,509 Total Loans ............................................. 998,895 890,356 838,658 744,474 621,539 Total Deposits .......................................... 1,147,203 1,085,952 976,972 918,876 862,023 Securities Sold Under Repurchase Agreements (long-term portion) ............................... 35,000 48,836 Total Federal Home Loan Bank Advances ................... 73,514 47,067 25,500 10,150 9,000 Total Stockholders' Equity .............................. 126,296 153,891 141,794 130,250 121,339 Financial ratios Return on Average Assets ................................ 1.37% 1.43% 1.43% 1.39% 1.34% Return on Average Stockholders' Equity (3) .............. 12.75 12.09 12.12 11.95 11.44 Average Earning Assets to Total Assets .................. 94.77 94.80 94.62 94.39 94.61 Allowance for Loan Losses as % of Total Loans ........... 1.01 1.03 1.01 1.08 1.24 Dividend Payout Ratio ................................... 53.16 52.03 50.00 46.46 44.74 Average Stockholders' Equity to Average Assets .......... 10.72 11.80 11.81 11.66 11.69 Tax Equivalent Yield on Earning Assets (4) .............. 7.81 8.15 8.34 8.10 8.10 Cost of Supporting Liabilities .......................... 3.54 3.74 3.80 3.64 3.69 Net Interest Margin on Earning Assets ................... 4.27 4.41 4.54 4.46 4.41 (1) Restated for 3-for-2 stock splits distributed October, 1995 and October, 1998. (2) Dividends per share is for First Merchants Corporation only, not restated for pooling transactions. (3) Average stockholders' equity is computed by averaging the last five quarters ending balance. (4) Average earning assets include the average balance of securities classified as available for sale, computed based on the average of the historical amortized cost balances without the effects of the fair value adjustment. 15 MANAGEMENT'S DISCUSSION & ANALYSIS The Corporation's financial data for periods prior to mergers, which were accounted for as pooling of interests, has been restated. RESULTS OF OPERATIONS Net income for the year 1999 reached $19,088,000, up from $17,907,000 in 1998. Diluted earnings per share totaled $1.58, a 6.8% increase over $1.48 reported for 1998. Cash basis earnings per share were $1.60, an increase of 6.7% over the 1998 level of $1.50. During the year, the Corporation absorbed merger-related expenses amounting to $ .05 per share incurred during the successful completion of two acquisitions. Excluding these expenses, diluted earnings per share would have been $1.63, a 10.1% increase. In 1999, First Merchants Corporation ("Corporation") recorded the twenty-fourth consecutive year of improvement in net income on both an aggregate and per share basis. Return on equity was 12.75 percent in 1999, up from 1998 and 1997 figures of 12.09 percent and 12.12 percent. Return on assets was 1.37 percent in 1999, 1.43 percent in 1998 and 1997. [THE FOLLOWING TABLE WAS REPRESENTED BY A BAR CHART IN THE PRINTED MATERIAL.] Return on average assets (percent) Year % ---- --- 97 1.43 98 1.43 99 1.37 [THE FOLLOWING TABLE WAS REPRESENTED BY A BAR CHART IN THE PRINTED MATERIAL.] Return on average equity (percent) Year % ---- --- 97 12.12 98 12.09 99 12.75 CAPITAL The Corporation successfully completed a self-tender offer on December 17, 1999, repurchasing 1,130,669 shares of its own stock for a price of $28 per share. The buyback is expected to have a positive impact on the Corporation's EPS and ROE in future periods. The Corporation's capital strength continues to exceed regulatory minimums and management believes that its strong capital continues to be a distinct advantage in the competitive environment in which the Corporation operates. The Corporation's Tier I capital to average assets ratio was 9.2 percent at year-end 1999, and 11.9 percent at December 31, 1998. At December 31, 1999, the Corporation had a Tier I risk-based capital ratio of 12.7 percent, total risk-based capital ratio of 13.7 percent, and a leverage ratio of 9.2 percent. Regulatory capital guidelines require a Tier I risk-based capital ratio of 4.0 percent and a total risk-based capital ratio of 8.0 percent. The Corporation has an employee stock purchase plan and an employee stock option plan. Activity under these plans is described in Note 14 to the Consolidated Financial Statements. The transactions under these plans have not had a material effect on the Corporation's capital position. 16 ASSET QUALITY/PROVISION FOR LOAN LOSSES The Corporation's asset quality and loan loss experience have consistently been superior to that of its peer group, as summarized in the table below. Asset quality has been a major factor in the Corporation's ability to generate consistent profit improvement. The allowance for loan losses is maintained through the provision for loan losses, which is a charge against earnings. The amount provided for loan losses and the determination of the adequacy of the allowance are based on a continuous review of the loan portfolio, including an internally administered loan "watch" list and an independent loan review provided by an outside accounting firm. The evaluation takes into consideration identified credit problems, as well as the possibility of losses inherent in the loan portfolio that are not specifically identified. At December 31, 1999, non-performing loans totaled $4,515,000, a decrease of $2,000. Impaired loans included in the table at right totaled $1,380,000. The Corporation adopted Statement of Financial Accounting Standards ("SFAS") No. 114 and No. 118, Accounting by Creditors for Impairment of a Loan and Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosures, on January 1, 1995. At December 31, 1999, impaired loans totaled $7,140,000, a decrease of $1,947,000. An allowance for losses was not deemed necessary for impaired loans totaling $4,398,000, but an allowance of $1,061,000 was recorded for the remaining balance of impaired loans of $2,742,000. The average balance of impaired loans for 1999 was $8,770,000. At December 31, 1999, the allowance for loan losses was $10,128,000, up $919,000 from year end 1998. As a percent of loans, the allowance was 1.01 percent, down from 1.03 percent at year-end 1998. The provision for loan losses in 1999 was $2,241,000 compared to $2,372,000 in 1998. [THE FOLLOWING TABLE WAS REPRESENTED BY A BAR CHART IN THE PRINTED MATERIAL.] Net loan losses (as a percent of average loans) 99 98 97 ---- ---- ---- First Merchants Corporation .14 .18 .16 Peer Group NA .26 .29 The following table summarizes the risk elements for the Corporation. (dollars in thousands) December 31, - -------------------------------------------------------------------------------- 1999 1998 ================================================================================ Non-accrual loans .............................. $1,280 $1,073 Loans contractually past due 90 days or more other than non-accruing ..................... 2,327 2,334 Restructured loans ............................. 908 1,110 ------ ------ Total ....................................... $4,515 $4,517 ====== ====== The table below presents loan loss experience for the years indicated and compares the Corporation's loss experience to that of its peer group. (Dollars in Thousands) 1999 1998 1997 ==================================================================================================================================== Allowance for loan losses: Balance at January 1 ............................................... $ 9,209 $ 8,429 $ 8,010 ------- ------- ------- Chargeoffs ......................................................... 1,769 2,231 1,949 Recoveries ......................................................... 447 639 633 ------- ------- ------- Net chargeoffs ..................................................... 1,322 1,592 1,316 Provision for loan losses .......................................... 2,241 2,372 1,735 ------- ------- ------- Balance at December 31 ............................................. $10,128 $ 9,209 $ 8,429 ======= ======= ======= Ratio of net chargeoffs during the period to average loans outstanding during the period ....................... .14% .18% .16% Peer Group .......................................................... NA .26% 29% 17 ================================================================================ MANAGEMENT'S DISCUSSION & ANALYSIS ================================================================================ LIQUIDITY, INTEREST SENSITIVITY AND DISCLOSURES ABOUT MARKET RISK Asset/Liability Management has been an important factor in the Corporation's ability to record consistent earnings growth through periods of interest rate volatility and product deregulation. Management and the Board of Directors monitor the Corporation's liquidity and interest sensitivity positions at regular meetings to ensure that changes in interest rates will not adversely affect earnings. Decisions regarding investment and the pricing of loan and deposit products are made after analysis of reports designed to measure liquidity, rate sensitivity, the Corporation's exposure to changes in net interest income given various rate scenarios and the economic and competitive environments. It is the objective of the Corporation to monitor and manage risk exposure to net interest income caused by changes in interest rates. It is the goal of the Corporation's Asset/Liability function to provide optimum and stable net interest income. To accomplish this, management uses two asset liability tools. GAP/Interest Rate Sensitivity Reports and Net Interest Income Simulation Modeling are both constructed, presented and monitored quarterly. The Corporation's liquidity and interest sensitivity position at December 31, 1999, remained adequate to meet the Corporation's primary goal of achieving optimum interest margins while avoiding undue interest rate risk. The table below presents the Corporation's interest rate sensitivity analysis as of December 31, 1999. INTEREST RATE SENSITIVITY ANALYSIS (dollars in thousands) At December 31, 1999 - ------------------------------------------------------------------------------------------------------------------------------------ 1-180 DAYS 181-365 DAYS 1-5 YEARS BEYOND 5 YEARS TOTAL ==================================================================================================================================== Rate-Sensitive Assets: Federal funds sold and interest-bearing deposits ......... $ 27,130 $ 27,130 Investment securities .................................... 43,442 $ 41,194 $ 198,838 $ 60,497 343,971 Loans .................................................... 360,779 81,769 405,523 150,885 998,956 Federal Reserve and Federal Home Loan Bank stock ......... 5,858 5,858 ---------- ---------- ---------- ---------- ---------- Total rate-sensitive assets ......................... 437,209 122,963 604,361 211,382 $1,375,915 ---------- ---------- ---------- ---------- ---------- Rate-Sensitive Liabilities: Interest-bearing deposits ................................ 494,495 183,111 328,452 598 1,006,656 Securities sold under repurchase agreements .............. 21,957 21,000 35,000 77,957 Other short-term borrowings .............................. 38,391 38,391 Federal Home Loan Bank advances .......................... 44,914 2,450 17,450 8,700 73,514 ---------- ---------- ---------- ---------- ---------- Total rate-sensitive liabilities .................... 599,757 206,561 380,902 9,298 1,196,518 ---------- ---------- ---------- ---------- ---------- Interest rate sensitivity gap by period ..................... $ (162,548) $ (83,598) $ 223,459 $ 202,084 Cumulative rate sensitivity gap ............................. (162,548) (246,146) (22,687) 179,397 Cumulative rate sensitivity gap ratio at December 31, 1999 ..................................... 72.9 % 69.5% 98.1% 115.0% The Corporation had a cumulative negative gap of $246,146,000 in the one-year horizon at December 31, 1999, just over 16.7 percent of total assets. Net interest income at financial institutions with negative gaps tends to increase when rates decrease and decrease as interest rates increase. 18 ================================================================================ MANAGEMENT'S DISCUSSION & ANALYSIS ================================================================================ LIQUIDITY, INTEREST SENSITIVITY AND DISCLOSURES ABOUT MARKET RISK CONTINUED The Corporation places its greatest credence in net interest income simulation modeling. The GAP/Interest Rate Sensitivity Report is known to have two major shortfalls. The GAP/ Interest Rate Sensitivity Report fails to precisely gauge how often an interest rate sensitive product reprices nor is it able to measure the magnitude of potential future rate movements. The Corporation's asset liability process monitors simulated net interest income under three separate interest rate scenarios; rising (rate shock), falling (rate shock) and flat. Net interest income is simulated over an 18-month horizon. By policy, the difference between the best performing and the worst performing rate scenarios are not allowed to show a variance greater than 5 percent. Assumed interest rate changes are simulated to move incrementally over 18 months. The total rate movement (beginning point minus ending point) to noteworthy interest rate indexes are as follows: RISING FALLING ================================================================================ Prime 300 Basis Points (300)Basis Points Federal Funds 300 (300) 90-Day T-Bill 310 (275) One-Year T-Bill 290 (270) Three-Year T-Bill 290 (265) Five-Year T-Note 290 (255) Ten-Year T-Note 290 (245) Interest Checking 100 (57) MMIA Savings 150 (100) Money Market Index 219 (215) Regular Savings 100 (57) Results for the flat, rising (rate shock), and falling (rate shock) interest rate scenarios are listed below. The net interest income shown represents cumulative net interest income over an 18-month time horizon. Balance sheet assumptions are the same under both scenarios: FLAT/BASE RISING FALLING ================================================================================ Net Interest Income (dollars in thousands) $ 82,872 $ 80,233 $ 82,248 Change vs. Flat/Base Scenario $ (2,639) $ (624) Percent Change -3.18% -0.75% 19 ================================================================================ MANAGEMENT'S DISCUSSION & ANALYSIS ================================================================================ Earning assets Earning assets increased $82.6 million during 1999. The table below reflects the earning asset mix for the years 1999 and 1998 (at December 31). Loans grew by $108.5 million while investment securities declined by $7.2 million. High loan demand combined with the Corporation's self-tender resulted in a minimal decrease to the investment securities portfolio. EARNING ASSETS (dollars in millions) December 31, ================================================================================ 1999 1998 Federal funds sold and interest-bearing time deposits $ 27.1 $ 46.3 Securities available for sale ....................... 329.7 329.5 Securities held to maturity ......................... 14.3 21.7 Mortgage loans held for sale ........................ 0.8 Loans ............................................... 998.9 890.4 Federal Reserve and Federal Home Loan Bank stock .... 5.8 4.5 -------- -------- Total ........................................... $1,375.8 $1,293.2 ======== ======== Deposits, securities sold under repurchase agreements, other short-term borrowings and Federal Home Loan Bank advances The table below reflects the level of deposits and borrowed funds (Federal funds purchased, repurchase agreements, U.S. Treasury demand notes and Federal Home Loan Bank advances) based on year-end levels at December 31, 1999 and 1998. As of December 31 (dollars in millions) - ------------------------------------------------------------------------------------------------------------------- SECURITIES SOLD UNDER OTHER SHORT-TERM FEDERAL HOME LOAN DEPOSITS REPURCHASE AGREEMENTS BORROWINGS BANK ADVANCES =================================================================================================================== 1999 $1,147.2 $78.0 $38.4 $73.5 1998 $1,086.0 $48.8 $17.8 $47.1 20 ================================================================================ MANAGEMENT'S DISCUSSION & ANALYSIS ================================================================================ NET INTEREST INCOME Net interest income is the primary source of the Corporation's earnings. It is a function of net interest margin and the level of average earning assets. The table below reflects the Corporation's asset yields, interest expense, and net interest income as a percent of average earning assets for the three-year period ending in 1999. In 1999, asset yields declined 34 basis points (FTE), interest cost declined 20 basis points, resulting in a 14 basis point (FTE) decline in net interest income. This decline primarily resulted from a $90 million investment project in the fourth quarter of 1998 and another $30 million in the first quarter of 1999. The "spread" from both projects was approximately 120 basis points. (dollars in thousands) - -------------------------------------------------------------------------------------------------------------- INTEREST INCOME INTEREST EXPENSE NET INTEREST INCOME NET INTEREST INCOME (FTE) as a Percent as a Percent (FTE)as a Percent AVERAGE On a of Average of Average of Average EARNING Fully Taxable Earning Assets Earning Assets Earning Assets ASSETS Equivalent Basis ============================================================================================================== 1999 7.81% 3.54% 4.27% $1,324,172 $56,513 1998 8.15 3.74 4.41 1,188,981 52,463 1997 8.34 3.80 4.54 1,089,192 49,403 Average earning assets include the average balance of securities classified as available for sale, computed based on the average of the historical amortized cost balances without the effects of the fair value adjustment. OTHER INCOME The Corporation has placed emphasis on the growth of non-interest income in recent years by offering a wide range of fee-based services. Fee schedules are regularly reviewed by a pricing committee to ensure that the products and services offered by the Corporation are priced to be competitive and profitable. Other income in 1999 amounted to $14,573,000 or 13.1 percent higher than in 1998. The increase of $1,693,000 is primarily attributable to the following factors: 1. Service charges on deposit accounts increased $744,000 or 20.1 percent due to increased number of accounts and price adjustments. 2. Other customer fees increased $462,000, or 17.6 percent, due to increased fees from electronic card usage and price adjustments. 3. Commission income increased $455,000, or 42.4 percent, due to the acquisition of the Muncie office of Insurance & Risk Management, Inc., renamed First Merchants Insurance Services, on April 1, 1998. 4. Revenues from fiduciary activity grew $391,000, or 9.3 percent, due to strong new business activity and markets. 5. Other income decreased $489,000, or 43.0 percent due primarily to a $442,000 gain on sale of a Bank building in 1998. 21 ================================================================================ MANAGEMENT'S DISCUSSION & ANALYSIS ================================================================================ The Corporation's emphasis to increase revenue from non-interest income resulted in a 13.1% rise for 1999 to $14.6 million, following a double-digit increase in 1998. OTHER INCOME continued Other income in 1998 amounted to $12,880,000 or 26.9 percent higher than in 1997. The increase of $2,734,000 is primarily attributable to the following factors: 1. Revenues from fiduciary activity grew $763,000, or 22.1 percent, due to strong new business activity and markets. 2. Commission income increased $712,000, or 196.7 percent, due to the acquisition of the Muncie office of Insurance and Risk Management, Inc., renamed First Merchants Insurance Services, on April 1, 1998. 3. Other income increased $663,000 or 139.9 percent, due primarily to a $442,000 gain on sale of a Bank building. 4. Other customer fees increased $521,000 or 24.7 percent due to increased fees from electronic card usage and price adjustments. Equipment expense increased $552,000 or 17.5%, reflecting the Corporation's efforts to provide state-of-the-art products to its customers. OTHER EXPENSES Total "other expenses" represent non-interest operating expenses of the Corporation. Those expenses amounted to $36,710,000 in 1999, an increase of 12.1 percent from the prior year, or $3,969,000. Three major areas account for most of the increase: 1. Salary and benefit expenses, which account for over one-half of the Corporation's non-interest operating expenses, grew by $1,514,000, or 8.3 percent, due to normal salary increases and staff additions. 2. Non-recurring merger related costs in 1999 were $804,000 representing just over 5 cents per share. 3. Equipment expenses increased $552,000, or 17.5 percent, reflecting the Corporation's efforts to improve efficiency and provide electronic service delivery to its customers. Expenses for 1998 amounted to $32,741,000, an increase of 9.1 percent from the prior year, or $2,725,000. Three major areas account for most of the increase: 1. Salary and benefit expenses, which account for over one-half of the Corporation's non-interest operating expenses, grew by $1,668,000 or 10.0 percent, due to normal salary increases and staff additions. 2. Equipment expenses increased $399,000, or 14.4 percent, reflecting the Corporation's efforts to improve efficiency and provide electronic service delivery to its customers. 3. Net occupancy expense grew by $237,000, or 13.0 percent, due primarily to increased branch expansion into new markets. 22 ================================================================================ MANAGEMENT'S DISCUSSION & ANALYSIS ================================================================================ INCOME TAXES The increase in 1999 tax expense of $543,000 is attributable primarily to a $1,724,000 increase in net pre-tax income, mitigated somewhat by a $336,000 increase in tax-exempt income and increased tax credits of $204,000. Likewise, the $852,000 increase in 1998 resulted primarily from a $2,276,000 increase in pre-tax net income, mitigated by a $291,000 increase in tax-exempt income. ACCOUNTING MATTERS ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES During 1998, the Financial Accounting Standards Board (FASB) issued Statement No. 133, Accounting for Derivative Instruments and Hedging Activities. This Statement requires companies to record derivatives on the balance sheet at their fair value. Statement No. 133 also acknowledges that the method of recording a gain or loss depends on the use of the derivative. The new Statement applies to all entities. If hedge accounting is elected by the entity, the method of assessing the effectiveness of the hedging derivative and the measurement approach of determining the hedge's ineffectiveness must be established at the inception of the hedge. Statement No. 133 amends Statement No. 52 and supersedes Statements No. 80, 105 and 119. Statement No. 107 is amended to include the disclosure provisions about the concentrations of credit risk from Statement No. 105. Several Emerging Issues Task Force consensuses are also changed or nullified by the provisions of Statement No. 133. Statement No. 133 was originally effective for all fiscal years beginning after June 15, 1999 and was amended. It is now effective for all fiscal years beginning after June 15, 2000 and is not expected to have a material impact on the operations of the Corporation. The Statement may not be applied retroactively to financial statements of prior periods. INFLATION Changing prices of goods, services and capital affect the financial position of every business enterprise. The level of market interest rates and the price of funds loaned or borrowed fluctuate due to changes in the rate of inflation and various other factors, including government monetary policy. Fluctuating interest rates affect the Corporation's net interest income, loan volume and other operating expenses, such as employee salaries and benefits, reflecting the effects of escalating prices, as well as increased levels of operations and other factors. As the inflation rate increases, the purchasing power of the dollar decreases. Those holding fixed-rate monetary assets incur a loss, while those holding fixed-rate monetary liabilities enjoy a gain. The nature of a bank holding company's operations is such that there will be an excess of monetary assets over monetary liabilities, and, thus, a bank holding company will tend to suffer from an increase in the rate of inflation and benefit from a decrease. 23 CONSOLIDATED BALANCE SHEET (in thousands, except share data) December 31, ==================================================================================================================================== 1999 1998 Assets Cash and due from banks ........................................................... $ 58,893 $ 35,474 Federal funds sold ................................................................ 25,400 45,295 ----------- ----------- Cash and cash equivalents ......................................................... 84,293 80,769 Interest-bearing time deposits .................................................... 1,730 1,008 Investment securities Available for sale ............................................................. 329,668 329,508 Held to maturity (fair value of $14,284 and $22,061) ........................... 14,303 21,709 ----------- ----------- Total investment securities .................................................. 343,971 351,217 Mortgage loans held for sale ...................................................... 61 776 Loans ............................................................................. 998,895 890,356 Less: Allowance for loan losses ................................................ (10,128) (9,209) ----------- ----------- Net loans .................................................................... 988,767 881,147 Premises and equipment ............................................................ 20,073 18,963 Federal Reserve and Federal Home Loan Bank stock .................................. 5,858 4,455 Interest receivable ............................................................... 11,279 10,797 Core deposit intangibles and goodwill ............................................. 2,885 3,117 Other assets ...................................................................... 15,131 10,278 ----------- ----------- Total assets ................................................................. $ 1,474,048 $ 1,362,527 =========== =========== Liabilities Deposits Noninterest-bearing ............................................................. $ 140,547 $ 139,469 Interest-bearing ................................................................ 1,006,656 946,483 ----------- ----------- Total deposits ............................................................ 1,147,203 1,085,952 Borrowings ........................................................................ 189,862 113,703 Interest payable .................................................................. 4,599 4,134 Other liabilities ................................................................. 6,088 4,847 ----------- ----------- Total liabilities ......................................................... 1,347,752 1,208,636 COMMITMENTS AND CONTINGENT LIABILITIES Stockholders' equity Preferred stock, no-par value Authorized and unissued -- 500,000 shares Common stock, $.125 stated value Authorized -- 50,000,000 shares Issued and outstanding -- 10,936,617 and 11,975,955 shares ..................... 1,367 1,497 Additional paid-in capital ........................................................ 25,481 31,263 Retained earnings ................................................................. 103,640 118,920 Accumulated other comprehensive income ............................................ (4,192) 2,211 ----------- ----------- Total stockholders' equity ................................................... 126,296 153,891 ----------- ----------- Total liabilities and stockholders' equity ................................... $ 1,474,048 $ 1,362,527 =========== =========== See notes to consolidated financial statements. 24 CONSOLIDATED STATEMENT OF INCOME (in thousands, except share data) Year Ended December 31, ==================================================================================================================================== 1999 1998 1997 Interest income Loans receivable Taxable ............................................................. $ 78,366 $ 75,971 $ 71,058 Tax exempt .......................................................... 233 234 163 Investment securities Taxable ............................................................. 15,459 11,596 11,587 Tax exempt .......................................................... 5,243 4,906 4,686 Federal funds sold .................................................... 657 1,026 308 Deposits with financial institutions .................................. 59 30 35 Federal Reserve and Federal Home Loan Bank stock ...................... 446 398 347 -------- -------- -------- Total interest income ............................................. 100,463 94,161 88,184 -------- -------- -------- Interest expense Deposits .............................................................. 38,539 39,873 37,370 Securities sold under repurchase agreements ........................... 4,273 2,015 1,563 Federal Home Loan Bank advances ....................................... 3,260 1,923 1,121 Other borrowings ...................................................... 826 654 1,338 -------- -------- -------- Total interest expense ........................................... 46,898 44,465 41,392 -------- -------- -------- Net interest income ...................................................... 53,565 49,696 46,792 Provision for loan losses ............................................. 2,241 2,372 1,735 -------- -------- -------- Net interest income after provision for loan losses .......................................... 51,324 47,324 45,057 -------- -------- -------- Other income Fiduciary activities .................................................. 4,600 4,209 3,446 Service charges on deposit accounts ................................... 4,450 3,706 3,763 Other customer fees ................................................... 3,089 2,627 2,106 Net realized gains (losses) on sales of available-for-sale securities .............................. 257 127 (5) Commission income ..................................................... 1,529 1,074 362 Other income .......................................................... 648 1,137 474 -------- -------- -------- Total other income ............................................... 14,573 12,880 10,146 -------- -------- -------- Other expenses Salaries and employee benefits ........................................ 19,820 18,306 16,638 Net occupancy expenses ................................................ 2,139 2,064 1,827 Equipment expenses .................................................... 3,715 3,163 2,764 Marketing expense ..................................................... 869 903 928 Deposit insurance expense ............................................. 129 125 118 Outside data processing fees .......................................... 1,647 1,465 1,367 Printing and office supplies .......................................... 1,275 984 1,117 Merger-related expenses ............................................... 804 Other expenses ........................................................ 6,312 5,731 5,257 -------- -------- -------- Total other expenses ............................................. 36,710 32,741 30,016 -------- -------- -------- Income before income tax ................................................. 29,187 27,463 25,187 Income tax expense .................................................... 10,099 9,556 8,704 -------- -------- -------- Net income ............................................................... $ 19,088 $ 17,907 $ 16,483 ======== ======== ======== Net income per share: Basic ................................................................. $ 1.59 $ 1.50 $ 1.40 Diluted ............................................................... 1.58 1.48 1.38 See notes to consolidated financial statements. 25 CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME (dollar amounts in thousands) Year Ended December 31, 1999 1998 1997 ==================================================================================================================================== Net income ............................................................................. $ 19,088 $ 17,907 $ 16,483 -------- -------- -------- Other comprehensive income, net of tax: Unrealized gains (losses) on securities available for sale: Unrealized holding gains (losses) arising during the period, net of income tax (expense) benefit of $4,258,$(499), $(487) ...................... (6,249) 731 715 Less: Reclassification adjustment for gains (losses) included in net income, net of income tax (expense) benefit of $(103), $(51), $2 ......................... 154 76 (3) -------- -------- -------- (6,403) 655 718 -------- -------- -------- COMPREHENSIVE INCOME $ 12,685 $(18,562) $ 17,201 ======== ======== ======== CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (In thousands, except share data) - ------------------------------------------------------------------------------------------------------------------------------------ COMMON STOCK ----------------------- ADDITIONAL RETAINED ACCUMULATED OTHER SHARES AMOUNT PAID-IN CAPITAL EARNINGS COMPREHENSIVE INCOME TOTAL ----------- -------- -------------- --------- -------------------- ------- Balances, January 1, 1997 ...................... 7,825,960 $ 1,021 $ 28,837 $ 99,554 $ 838 $ 130,250 Net income for 1997 .......................... 16,483 16,483 Cash dividends ($ .69 per share) ............. (7,090) (7,090) Other comprehensive income, net of tax ....... 718 718 Stock issued under employee benefit plans .... 13,690 2 289 291 Stock issued under dividend reinvestment and stock purchase plan ................... 23,276 3 723 726 Stock options exercised ...................... 47,522 28 389 417 ----------- -------- -------- --------- --------- --------- Balances, December 31, 1997 .................... 7,910,448 1,054 30,238 108,947 1,556 141,795 Net income for 1998 .......................... 17,907 17,907 Cash dividends ($ .77 per share) ............. (7,934) (7,934) Other comprehensive income, net of tax ....... 655 655 Stock issued under employee benefit plans . .. 14,471 2 383 385 Stock issued under dividend reinvestment and stock purchase plan ................... 19,092 2 677 679 Stock options exercised ...................... 52,460 19 463 482 Stock redeemed ............................... (2,000) (72) (72) Three-for-two stock split .................... 3,981,769 420 (420) Cash paid in lieu of issuing fractional shares (285) (6) (6) ----------- -------- -------- --------- --------- --------- Balances, December 31, 1998 .................... 11,975,955 1,497 31,263 118,920 2,211 153,891 Net income for 1999 ............................ 19,088 19,088 Cash dividends ($ .84 per share) ............. (9,759) (9,759) Other comprehensive income, net of tax ....... (6,403) (6,403) Stock issued under employee benefit plans .... 20,870 3 454 457 Stock issued under dividend reinvestment and stock purchase plan ................... 30,227 4 718 722 Stock options exercised ...................... 55,234 6 265 271 Stock redeemed ............................... (1,145,669) (143) (7,384) (24,609) (32,136) Tax benefit of stock dispositions ............ 165 165 ----------- -------- -------- --------- --------- --------- Balances, December 31, 1999 .................. 10,936,617 $ 1,367 $ 25,481 $ 103,640 $ (4,192) $ 126,296 =========== ======== ======== ========= ========= ========= See notes to consolidated financial statements. 26 CONSOLIDATED STATEMENT OF CASH FLOWS (in thousands, except share data) Year Ended December 31, 1999 1998 1997 ==================================================================================================================================== Operating activities: Net income .......................................................... $ 19,088 $ 17,907 $ 16,483 Adjustments to reconcile net income to net cash provided by operating activities: Provision for loan losses ......................................... 2,241 2,372 1,735 Depreciation and amortization ..................................... 2,517 2,394 2,259 Amortization of goodwill and intangibles .......................... 232 258 89 Deferred income tax ............................................... (1,122) 153 (140) Securities amortization, net ...................................... 358 221 264 Securities losses (gains), net .................................... (257) (127) 5 Gain on sale of premises and equipment ............................ (4) (442) Mortgage loans originated for sale ................................ (6,179) (10,251) (7,139) Proceeds from sales of mortgage loans ............................. 6,894 9,946 6,952 Net change in Interest receivable ........................................... (482) (448) (544) Interest payable .............................................. 465 37 290 Other adjustments ................................................. 1,932 (2,579) (910) --------- --------- --------- Net cash provided by operating activities ..................... 25,683 19,441 19,344 --------- --------- --------- Investing activities: Net change in interest-bearing deposits ............................. (722) (524) (194) Purchases of Securities available for sale ..................................... (148,210) (193,728) (77,274) Securities held to maturity ....................................... (2,667) (90) (2,652) Proceeds from maturities of Securities available for sale ..................................... 120,509 88,439 83,557 Securities held to maturity ....................................... 7,226 14,325 16,099 Proceeds from sales of Securities available for sale ..................................... 19,627 7,394 12,555 Net change in loans ................................................. (109,861) (53,761) (95,313) Acquisition of insurance subsidiary ................................. (1,254) Purchase of Federal Home Loan Bank stock ............................ (1,403) (402) (565) Purchases of premises and equipment ................................. (3,679) (5,231) (2,563) Proceeds from sale of fixed assets .................................. 56 1,347 Other investing activities .......................................... (645) (880) --------- --------- --------- Net cash used by investing activities ......................... (119,124) (144,130) (67,230) --------- --------- --------- Financing activities: Net change in Demand and savings deposits ....................................... 17,411 16,439 3,584 Certificates of deposit and other time deposits ................... 43,840 92,541 54,512 Repurchase agreements and other borrowings ........................ 49,713 37,656 (16,733) Federal Home Loan Bank advances ..................................... 314,500 27,657 15,350 Repayment of Federal Home Loan Bank advances ........................ (288,054) (6,089) Cash dividends ...................................................... (9,759) (7,934) (7,090) Stock issued under employee benefit plans ........................... 457 385 291 Stock issued under dividend reinvestment and stock purchase plan ........................................... 722 679 726 Stock options exercised ............................................. 271 482 417 Stock redeemed ...................................................... (32,136) (72) Cash paid in lieu of issuing fractional shares ...................... (6) --------- --------- --------- Net cash provided by financing activities ..................... 96,965 161,738 51,057 --------- --------- --------- Net change in cash and cash equivalents ................................ 3,524 37,049 3,171 Cash and cash equivalents, beginning of year ........................... 80,769 43,720 40,549 --------- --------- --------- Cash and cash equivalents, end of year ................................. $ 84,293 $ 80,769 $ 43,720 ========= ========= ========= Additional cash flows information: Interest paid ....................................................... $ 46,433 $ 45,678 $ 42,747 Income tax paid ..................................................... 10,157 9,861 9,446 See notes to consolidated financial statements. 27 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (table dollar amounts in thousands, except share data) NOTE 1 NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The accounting and reporting policies of First Merchants Corporation ("Corporation"), and its wholly owned subsidiaries, First Merchants Bank, N.A. ("First Merchants"), Madison Community Bank ("Madison"), and its subsidiary First Merchants Insurance Services, Inc., First United Bank ("First United"), The Randolph County Bank ("Randolph County"), Union County National Bank ("Union National"), and First National Bank ("First National"), (collectively "the Banks"), conform to generally accepted accounting principles and reporting practices followed by the banking industry. The more significant of the policies are described below. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The Corporation is a bank holding company whose principal activity is the ownership and management of the Banks and operates in a single significant business segment. First Merchants, Union National and First National operate under national bank charters and provide full banking services, including trust services. As national banks, First Merchants, First National and Union National are subject to the regulation of the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation ("FDIC"). Madison, First United and Randolph County operate under state bank charters and provide full banking services, including trust services. As state banks, Madison, First United and Randolph County are subject to the regulation of the Department of Financial Institutions, State of Indiana, and the FDIC. The Banks generate commercial, mortgage, and consumer loans and receive deposits from customers located primarily in central and east central Indiana and Butler County, Ohio. The Banks' loans are generally secured by specific items of collateral, including real property, consumer assets, and business assets. Although the Banks have a diversified loan portfolio, a substantial portion of their debtors' ability to honor their contracts is dependent upon economic conditions in the automotive and agricultural industries. CONSOLIDATION The consolidated financial statements include the accounts of the Corporation and the Banks, after elimination of all material intercompany transactions. INVESTMENT SECURITIES Debt securities are classified as held to maturity when the Corporation has the positive intent and ability to hold the securities to maturity. Securities held to maturity are carried at amortized cost. Debt securities not classified as held to maturity are classified as available for sale. Securities available for sale are carried at fair value with unrealized gains and losses reported separately in accumulated other comprehensive income, net of tax. Amortization of premiums and accretion of discounts are recorded as interest income from securities. Realized gains and losses are recorded as net security gains (losses). Gains and losses on sales of securities are determined on the specific-identification method. LOANS HELD FOR SALE are carried at the lower of aggregate cost or market. Market is determined using the aggregate method. Net unrealized losses are recognized through a valuation allowance by charges to income. LOANS are carried at the principal amount outstanding. Certain nonaccrual and substantially delinquent loans may be considered to be impaired. A loan is impaired when, based on current information or events, it is probable that the Banks will be unable to collect all amounts due (principal and interest) according to the contractual terms of the loan agreement. In applying the provisions of Statement of Financial Accounting Standards ("SFAS") No. 114, the Corporation considers its investment in one-to-four family residential loans and consumer installment loans to be homogeneous and therefore excluded from separate identification for evaluation of impairment. Interest income is accrued on the principal balances of loans, except for installment loans with add-on interest, for which a method that approximates the level yield method is used. The accrual of interest on impaired loans is discontinued when, in management's opinion, the borrower may be unable to meet payments as they become due. When interest accrual is discontinued, all unpaid accrued interest is reversed when considered uncollectible. Interest income is subsequently recognized only to the extent cash payments are received. Certain loan fees and direct costs are being deferred and amortized as an adjustment of yield on the loans. ALLOWANCE FOR LOAN LOSSES is maintained to absorb potential loan losses based on management's continuing review and evaluation of the loan portfolio and its judgment as to the impact of economic conditions on the portfolio. The evaluation by management includes consideration of past loan loss experience, changes in the composition of the loan portfolio, the current condition and amount of loans outstanding, and the probability of collecting all amounts due. Impaired loans are measured by the present value of expected future cash flows, or the fair value of the collateral of the loans, if collateral dependent. The determination of the adequacy of the allowance for loan losses is based on estimates that are particularly susceptible to significant changes in the economic environment and market conditions. Management believes that, as of December 31, 1999, the allowance for loan losses is adequate based on information currently available. A worsening or protracted economic decline in the area within which the Corporation operates would increase the likelihood of additional losses due to credit and market risks and could create the need for additional loss reserves. PREMISES AND EQUIPMENT are carried at cost net of accumulated depreciation. Depreciation is computed using the straight-line and declining balance methods based on the estimated useful lives of the assets. Maintenance and repairs are expensed as incurred, while major additions and improvements are capitalized. Gains and losses on dispositions are included in current operations. FEDERAL RESERVE AND FEDERAL HOME LOAN BANK STOCK are required investments for institutions that are members of the Federal Reserve Bank ("FRB") and Federal Home Loan Bank ("FHLB") systems. The required investment in the common stock is based on a predetermined formula. 28 continued Notes to consolidated financial statements (table dollar amounts in thousands, except share data) NOTE 1 NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES continued INTANGIBLE ASSETS are being amortized on the straight-line basis over periods ranging from 7 to 25 years. Such assets are periodically evaluated as to the recoverability of their carrying value. INCOME TAX in the consolidated statement of income includes deferred income tax provisions or benefits for all significant temporary differences in recognizing income and expenses for financial reporting and income tax purposes. The Corporation files consolidated income tax returns with its subsidiaries. STOCK OPTIONS are granted for a fixed number of shares to employees. The Corporation accounts for and will continue to account for stock option grants in accordance with APB Opinion No. 25, Accounting for Stock Issued to Employees, and accordingly, recognizes compensation expense for the stock option grants which have been granted with an exercise price less than the fair value of the shares at the date of grant. EARNINGS PER SHARE have been computed based upon the weighted average common and common equivalent shares outstanding during each year and have been restated to give effect to a three-for-two stock split distributed to stockholders on October 23, 1998. RECLASSIFICATIONS of certain amounts in the prior years consolidated financial statements have been made to conform to the 1999 presentation. NOTE 2 BUSINESS COMBINATIONS On January 21, 2000, the Corporation signed a definitive agreement to acquire Decatur Financial, Inc., Decatur, Indiana. The acquisition will be accounted for under the purchase method of accounting. Under the terms of the agreement, the Corporation will issue 1,130,000 shares of its common stock in exchange for all of the common stock of Decatur Financial, Inc. The transaction is subject to approval by stockholders of Decatur Financial, Inc., and appropriate regulatory agencies. The Corporation anticipates amortizing core deposit intangibles over eight years and goodwill over twenty years. As of December 31, 1999, Decatur Financial, Inc., had total assets and shareholders' equity of $128,140,000 and $14,253,000, respectively. On April 1, 1999, the Corporation issued 1,098,795 shares of it common stock in exchange for all of the outstanding shares of Jay Financial Corporation, Portland, Indiana. At December 31, 1998, Jay Financial Corporation had total assets and shareholders' equity of $114,895,000 and $14,903,000, respectively. The transaction was accounted for under the pooling-of-interests method of accounting. On April 21, 1999, the Corporation issued 810,642 shares of its common stock in exchange for all of the outstanding shares of Anderson Community Bank, Anderson, Indiana. At December 31, 1998, Anderson Community Bank had total assets and shareholders' equity of $77,984,000 and $7,740,000, respectively. The transaction was accounted for under the pooling-of-interests method of accounting. The financial information contained herein reflects the merger and reports the financial condition and results of operations as though the Corporation had been combined as of January 1, 1997. Separate operating results of Jay Financial Corporation and Anderson Community Bank for the periods prior to the merger were as follows: 1999 1998 1997 ==================================================================================================================================== Net interest income: First Merchants Corporation ............................. $ 50,175 $ 41,678 $ 39,750 Jay Financial Corporation ............................... 2,250 4,824 4,678 Anderson Community Bank ................................. 1,140 3,194 2,364 ---------- ---------- ---------- Combined .............................................. $ 53,565 $ 49,696 $ 46,792 ========== ========== ========== Net income: First Merchants Corporation ............................. $ 17,934 $ 15,399 $ 14,373 Jay Financial Corporation ............................... 703 1,431 1,485 Anderson Community Bank ................................. 451 1,077 625 ---------- ---------- ---------- Combined .............................................. $ 19,088 $ 17,907 $ 16,483 ========== ========== ========== Net income per share: Basic: First Merchants Corporation ............................. $ 1.49 $ 1.29 $ 1.22 Jay Financial Corporation ............................... .06 .12 .13 Anderson Community Bank ................................. .04 .09 .05 ---------- ---------- ---------- Combined .............................................. $ 1.59 $ 1.50 $ 1.40 ========== ========== ========== Diluted: First Merchants Corporation ............................. $ 1.48 $ 1.27 $ 1.21 Jay Financial Corporation ............................... .06 .12 .12 Anderson Community Bank ................................. .04 .09 .05 ---------- ---------- ---------- Combined .............................................. $ 1.58 $ 1.48 $ 1.38 ========== ========== ========== 29 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (table dollar amounts in thousands, except share data) NOTE 3 RESTRICTION ON CASH AND DUE FROM BANKS The Banks are required to maintain reserve funds in cash and/or on deposit with the Federal Reserve Bank. The reserve required at December 31, 1999, was $16,244,000. note 4 INVESTMENT SECURITIES - -------------------------------------------------------------------------------- GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIR COST GAINS LOSSES VALUE ==================================================================================================================================== Available for sale at December 31, 1999 U.S. Treasury ........................................... $ 7,337 $ 3 $ 72 $ 7,268 Federal agencies ........................................ 61,215 50 1,199 60,066 State and municipal ..................................... 94,598 568 945 94,221 Mortgage-backed securities .............................. 141,673 58 4,332 137,399 Other asset-backed securities ........................... 21,773 758 21,015 Corporate obligations ................................... 9,082 4 140 8,946 Marketable equity securities ............................ 915 162 753 -------- -------- -------- -------- Total available for sale ............................. 336,593 683 7,608 329,668 -------- -------- -------- -------- Held to maturity at December 31, 1999 U.S. Treasury ........................................... 250 2 248 State and municipal ..................................... 13,243 77 13 13,307 Mortgage-backed securities .............................. 311 1 1 311 Other asset-backed securities ........................... 499 81 418 -------- -------- -------- -------- Total held to maturity ............................... 14,303 78 97 14,284 -------- -------- -------- -------- Total investment securities .......................... $350,896 $ 761 $ 7,705 $343,952 ======== ======== ======== ======== Available for sale at December 31, 1998 U.S. Treasury ........................................... $ 22,275 $ 120 $ 22,395 Federal agencies ........................................ 61,605 627 $ 32 62,200 State and municipal ..................................... 93,198 2,778 21 95,955 Mortgage-backed securities .............................. 128,610 440 198 128,852 Other asset-backed securities ........................... 265 1 11 255 Corporate obligations ................................... 18,624 143 8 18,759 Marketable equity securities ............................ 1,200 108 1,092 -------- -------- -------- -------- Total available for sale ............................. 325,777 4,109 378 329,508 -------- -------- -------- -------- Held to maturity at December 31, 1998 U.S. Treasury ........................................... 249 4 253 Federal agencies ........................................ 500 1 501 State and municipal ..................................... 18,335 370 1 18,704 Mortgage-backed securities .............................. 864 3 867 Other asset-backed securities ........................... 1,761 2 27 1,736 -------- -------- -------- -------- Total held to maturity ............................... 21,709 380 28 22,061 -------- -------- -------- -------- Total investment securities .......................... $347,486 $ 4,489 $ 406 $351,569 ======== ======== ======== ======== 30 continued NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (table dollar amounts in thousands, except share data) NOTE 4 INVESTMENT SECURITIES continued The amortized cost and fair value of securities held to maturity and available for sale at December 31, 1999, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties. - ------------------------------------------------------------------------------------------------------------------------------------ AVAILABLE FOR SALE HELD TO MATURITY AMORTIZED COST FAIR VALUE AMORTIZED COST FAIR VALUE ==================================================================================================================================== Maturity distribution at December 31, 1999: Due in one year or less........................................... $ 26,911 $ 26,939 $ 5,330 $ 5,338 Due after one through five years ................................. 102,747 101,891 7,543 7,605 Due after five through ten years ................................. 25,723 25,338 245 245 Due after ten years .............................................. 16,851 16,333 375 367 -------- -------- -------- -------- 172,232 170,501 13,493 13,555 Mortgage-backed securities ....................................... 141,673 137,399 311 311 Other asset-backed securities .................................... 21,773 21,015 499 418 Marketable equity securities ..................................... 915 753 -------- -------- -------- -------- Totals ......................................................... $336,593 $329,668 $ 14,303 $ 14,284 ======== ======== ======== ======== Securities with a carrying value of approximately $161,462,000 and $146,903,000 were pledged at December 31, 1999 and 1998, to secure certain deposits and securities sold under repurchase agreements, and for other purposes as permitted or required by law. In addition, all otherwise unpledged securities are pledged as collateral for Federal Home Loan Bank advances with qualified first mortgage loans. Proceeds from sales of securities available for sale during 1999, 1998 and 1997 were $19,627,000, $7,394,000, and $12,555,000. Gross gains of $257,000, 127,000 in 1999 and 1998 and gross losses of $5,000 in 1997 were realized on those sales. 31 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (table dollar amounts in thousands, except share data) NOTE 5 LOANS AND ALLOWANCE 1999 1998 ========================================================================================================== Loans at December 31: Commercial and industrial loans ..........................................$ 224,712 $ 188,841 Bankers' acceptances and loans to financial institutions ................. 900 Agricultural production financing and other loans to farmers ............. 21,547 21,951 Real estate loans: Construction ........................................................ 31,996 31,719 Commercial and farmland ............................................. 150,544 137,671 Residential ......................................................... 380,596 361,611 Individuals' loans for household and other personal expenditures ......... 181,906 143,075 Tax-exempt loans ......................................................... 4,070 2,652 Other loans .............................................................. 3,552 2,073 --------- --------- 998,923 890,493 Unearned interest on loans .............................................. (28) (137) --------- --------- Total loans .........................................................$ 998,895 $ 890,356 ========= ========= 1999 1998 1997 ========================================================================== Allowance for loan losses: Balance, January 1 ..............$ 9,209 $ 8,429 $ 8,010 Provision for losses ............ 2,241 2,372 1,735 Recoveries on loans ............. 447 639 633 Loans charged off ............... (1,769) (2,231) (1,949) -------- -------- -------- Balance, December 31 ............$ 10,128 $ 9,209 $ 8,429 ======== ======== ======== Information on impaired loans is summarized below: 1999 1998 1997 ================================================================================================================ As of, and for the year ending December 31: Impaired loans with an allowance .......................... $2,742 $2,105 $1,956 Impaired loans for which the discounted cash flows or collateral value exceeds the carrying value of the loan ............................ 4,398 6,982 1,158 ----- ----- ----- Total impaired loans ............................... $7,140 $9,087 $3,114 ====== ====== ====== Allowance for impaired loans (included in the Corporation's allowance for loan losses) .............. $1,061 $ 795 $ 448 Average balance of impaired loans ......................... 8,770 8,881 4,155 Interest income recognized on impaired loans .............. 705 873 191 Cash basis interest included above ........................ 637 745 173 The Banks have entered into transactions with certain directors, executive officers, significant stockholders, and their affiliates or associates ("related parties"). Such transactions were made in the ordinary course of business on substantially the same terms and conditions, including interest rates and collateral, as those prevailing at the same time for comparable transactions with other customers, and did not, in the opinion of management, involve more than normal credit risk or present other unfavorable features. The aggregate amount of loans, as defined, to such related parties is as shown on the right: Balances, January 1, 1999 ........ $17,926 New loans, including renewals............. 16,646 Payments, etc., including renewals............. 6,054 ------- Balances, December 31, 1999 ...... $28,518 ======= 32 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (table dollar amounts in thousands, except share data) NOTE 6 PREMISES AND EQUIPMENT 1999 1998 ================================================================================ Cost at December 31: Land .......................................... $ 3,442 $ 3,442 Buildings and leasehold improvements .......... 18,949 17,314 Equipment ..................................... 20,393 18,570 -------- -------- Total cost ................................ 42,784 39,326 Accumulated depreciation and amortization ........ (22,711) (20,363) -------- -------- Net ....................................... $ 20,073 $ 18,963 ======== ========= The Corporation is committed under various noncancelable lease contracts for certain subsidiary office facilities. Total lease expense for 1999, 1998 and 1997 was $336,000, $250,000, and $190,000, respectively. The future minimum rental commitments required under the operating leases in effect at December 31, 1999, expiring at various dates through the year 2013, follow on the right for the years ending December 31: ==================================================== 2000 ................................ $ 246 2001 ................................ 204 2002 ................................ 186 2003 ................................ 161 2004 ................................ 152 After 2004 ........................... 693 ------ Total future minimum obligations $1,642 ====== NOTE 7 DEPOSITS 1999 1998 ================================================================================ Deposits at December 31: Demand deposits ............................. $ 300,309 $ 307,506 Savings deposits ............................ 283,249 258,641 Certificates and other time deposits of $100,000 or more ....................... 197,658 114,374 Other certificates and time deposits ........ 365,987 405,431 ---------- ---------- Total deposits .......................... $1,147,203 $1,085,952 ========== ========== ===================================================== Certificates and other time deposits maturing in years ending December 31: 2000 ....................... $396,773 2001 ....................... 111,634 2002 ....................... 37,178 2003 ....................... 9,887 2004 ....................... 7,747 After 2004 ................. 426 -------- $563,645 ======== 33 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (table dollar amounts in thousands, except share data) NOTE 8 BORROWINGS 1999 1998 ================================================================================ Borrowings at December 31: Securities sold under repurchase agreements ....... $ 77,957 $ 48,836 Federal funds purchased ........................... 28,885 15,170 U. S. Treasury demand notes ....................... 9,506 2,629 Federal Home Loan Bank advances ................... 73,514 47,068 -------- -------- Total borrowings .............................. $189,862 $113,703 ======== ======== Securities sold under repurchase agreements consist of obligations of the Banks to other parties. The obligations are secured by U.S. Treasury, Federal agency obligations and corporate asset-backed securities. The maximum amount of outstanding agreements at any month-end during 1999 and 1998 totaled $91,261,000 and $78,302,000, and the average of such agreements totaled $78,877,000 and $36,506,000. Maturities of Federal Home Loan Bank advances and securities sold under repurchase agreements as of December 31, 1999 are as follows: FEDERAL HOME LOAN SECURITIES SOLD UNDER BANK ADVANCES REPURCHASE AGREEMENTS - ------------------------------------------------------------------------------------------------------------------------------------ WEIGHTED-AVERAGE WEIGHTED-AVERAGE AMOUNT INTEREST RATE AMOUNT INTEREST RATE ==================================================================================================================================== Maturities in years ending December 31: 2000 .............. $51,350 5.88% $42,957 5.45% 2001 .............. 7,000 5.45 2,500 5.73 2002 .............. 150 7.07 9,600 5.49 2003 .............. 3,000 5.26 13,800 5.80 2004 .............. 9,100 5.68 After 2004 ........ 12,014 6.26 ------- ------- Total ...... $73,514 5.88% $77,957 5.55% ======= ======= The terms of a security agreement with the FHLB require the Corporation to pledge, as collateral for advances, qualifying first mortgage loans and all otherwise unpledged investment securities in an amount equal to at least 160 percent of these advances. Advances are subject to restrictions or penalties in the event of prepayment. NOTE 9 LOAN SERVICING Mortgage loans serviced for others are not included in the accompanying consolidated balance sheet. The loans are serviced primarily for the Federal Home Loan Mortgage Corporation and the unpaid balances totaled $22,769,000 and $15,541,000 at December 31, 1999 and 1998. The Corporation has adopted SFAS No. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. The adoption of this statement has had no material impact on the Corporation's financial condition and results of operations for all years presented. 34 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (table dollar amounts in thousands, except share data) NOTE 10 INCOME TAX 1999 1998 1997 ==================================================================================================================================== Income tax expense, for the year ended December 31: Currently payable: Federal ................................................................. $ 8,491 $ 7,269 $ 6,857 State ................................................................... 2,730 2,134 1,987 Deferred: Federal ................................................................. (939) 138 (119) State ................................................................... (183) 15 (21) -------- -------- -------- Total income tax expense ............................................. $ 10,099 $ 9,556 $ 8,704 ======== ======== ======== Reconciliation of federal statutory to actual tax expense: Federal statutory income tax at 34% ..................................... $ 9,924 $ 9,338 $ 8,563 Tax-exemptm interest .................................................... (1,555) (1,424) (1,378) Graduated tax rates ..................................................... 291 173 (7) Effect of state income taxes ............................................ 1,656 1,418 1,298 Other ................................................................... (217) 51 228 -------- -------- -------- Actual tax expense ........................................................ $ 10,099 $ 9,556 $ 8,704 ======== ======== ======== Tax expense (benefit) applicable to security gains and losses for the years ended December 31, 1999, 1998 and 1997, was $103,000, $51,000 and $(2,000), respectively. A cumulative net deferred tax asset is included in other assets. The components of the asset are as follows: 1999 1998 ==================================================================================================================== Deferred tax asset at December 31: Assets: Differences in accounting for loan losses ............................. $4,429 $3,552 Deferred compensation ................................................. 668 427 Differences in accounting for pensions and other employee benefits ......................................... 33 199 Net unrealized loss on securities available for sale .................. 2,736 Other ................................................................. 138 47 ------ ------ Total assets ...................................................... 8,004 4,225 ------ ------ Liabilities: Differences in depreciation methods ................................... 896 $1,171 Differences in accounting for loans and securities .................... 305 360 Differences in accounting for loan fees ............................... 336 286 Net unrealized gain on securities available for sale .................. 1,505 State income tax ...................................................... 238 141 Other ................................................................. 238 134 ------ ------ Total liabilities ................................................. 2,013 3,597 ------ ------ Net deferred tax asset ............................................ $5,991 $ 628 ====== ====== 35 Notes to consolidated financial statements (table dollar amounts in thousands, except share data) NOTE 11 COMMITMENTS AND CONTINGENT LIABILITIES In the normal course of business, there are outstanding commitments and contingent liabilities, such as commitments to extend credit and standby letters of credit, which are not included in the accompanying financial statements. The Banks' exposure to credit loss in the event of nonperformance by the other party to the financial instruments for commitments to extend credit and standby letters of credit is represented by the contractual or notional amount of those instruments. The Banks use the same credit policies in making such commitments as they do for instruments that are included in the consolidated balance sheet. Financial instruments whose contract amount represents credit risk as of December 31, were as follows: 1999 1998 Commitments to extend credit $228,598 $207,322 Standby letters of credit 6,031 4,477 Commitments to extend credit are agreements to lend to a customer, as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Banks evaluate each customer's credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Banks upon extension of credit, is based on management's credit evaluation. Collateral held varies, but may include accounts receivable, inventory, property and equipment, and income-producing commercial properties. Standby letters of credit are conditional commitments issued by the Banks to guarantee the performance of a customer to a third party. The Corporation and subsidiaries are also subject to claims and lawsuits which arise primarily in the ordinary course of business. It is the opinion of management that the disposition or ultimate resolution of such claims and lawsuits will not have a material adverse effect on the consolidated financial position of the Corporation. NOTE 12 STOCKHOLDERS' EQUITY National and state banking laws restrict the maximum amount of dividends that a bank may pay in any calendar year. National and state banks are limited to the bank's retained net income (as defined) for the current year plus those for the previous two years. The amount at December 31, 1999, available for 2000 dividends to the Corporation is $30,356,000. The subsidiaries restrict dividends to a lesser amount because of the need to maintain an adequate capital structure. Total stockholders' equity for all subsidiaries at December 31, 1999, was $155,460,000, of which $125,104,000 was restricted from dividend distribution to the Corporation. The Corporation has a Dividend Reinvestment and Stock Purchase Plan, enabling stockholders to elect to have their cash dividends on all shares held and automatically reinvested in additional shares of the Corporation's common stock. In addition, stockholders may elect to make optional cash payments up to an aggregate of $2,500 per quarter for the purchase of additional shares of common stock. The stock is credited to participant accounts at fair market value. Dividends are reinvested on a quarterly basis. At December 31, 1999, there were 476,063 shares of common stock reserved for purchase under the plan. On August 11, 1998, the Board of Directors of the Corporation declared a three-for-two stock split on its common shares. The new shares were distributed on October 23, 1998, to holders of record on October 16, 1998. NOTE 13 REGULATORY CAPITAL The Corporation and Banks are subject to various regulatory capital requirements administered by the federal banking agencies and are assigned to a capital category. The assigned capital category is largely determined by three ratios that are calculated according to the regulations: total risk adjusted capital, Tier 1 capital, and Tier 1 leverage ratios. The ratios are intended to measure capital relative to assets and credit risk associated with those assets and off-balance sheet exposures of the entity. The capital category assigned to an entity can also be affected by qualitative judgments made by regulatory agencies about the risk inherent in the entity's activities that are not part of the calculated ratios. There are five capital categories defined in the regulations, ranging from well capitalized to critically undercapitalized. Classification of a bank in any of the undercapitalized categories can result in actions by regulators that could have a material effect on a bank's operations. At December 31, 1999, the management of the Corporation believes that it meets all capital adequacy requirements to which it is subject. The most recent notifications from the regulatory agencies categorized the Corporation and Banks as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Corporation and Banks must maintain a minimum total capital to risk-weighted assets, Tier I capital to risk-weighted assets and Tier I capital to average assets of 10 percent, 6 percent and 5 percent, respectively. There have been no conditions or events since that notification that management believes have changed this categorization. Actual and required capital amounts and ratios are on the following page. 36 ontinued NOTE 13 REGULATORY CAPITAL continued 1999 1998 - ------------------------------------------------------------------------------------------------------------------------------------ REQUIRED FOR REQUIRED FOR ACTUAL ADEQUATE CAPITAL (1) ACTUAL ADEQUATE CAPITAL (1) AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO ==================================================================================================================================== December 31 Total Capital (1)(to risk-weighted assets) Consolidated ...................... $137,714 13.71% $ 80,378 8.00% $157,653 17.00% $ 74,388 8.00% First Merchants ................... 86,350 14.90 46,323 8.00 79,685 15.70 40,678 8.00 Madison ........................... 24,267 16.40 11,826 8.00 21,879 16.60 10,578 8.00 First United ...................... 8,797 13.90 5,053 8.00 8,069 18.50 3,484 8.00 Randolph County ................... 10,819 19.70 4,404 8.00 10,574 18.20 4,640 8.00 Union County ...................... 20,646 15.60 10,594 8.00 19,375 16.40 9,541 8.00 First National .................... 16,030 21.20 6,049 8.00 15,498 19.60 6,331 8.00 Tier I Capital (1)(to risk-weighted assets) Consolidated ...................... $127,586 12.70% $ 40,189 4.00% $148,511 16.00% $ 37,194 4.00% First Merchants ................... 82,009 14.20 23,161 4.00 75,752 14.90 20,338 4.00 Madison ........................... 22,509 15.20 5,913 4.00 20,353 15.40 5,289 4.00 First United ...................... 8,196 13.00 2,527 4.00 7,599 17.40 1,742 4.00 Randolph County ................... 10,128 18.40 2,202 4.00 9,848 17.00 2,320 4.00 Union County ...................... 19,124 14.40 5,297 4.00 17,966 15.20 4,726 4.00 First National .................... 15,085 20.00 3,024 4.00 14,509 18.30 3,165 4.00 Tier I Capital (1) (to average assets) Consolidated ...................... $127,586 9.15% $ 55,773 4.00% $148,511 11.90% $ 49,951 4.00% First Merchants ................... 82,009 10.20 32,310 4.00 75,752 10.80 27,982 4.00 Madison ........................... 22,509 11.60 7,773 4.00 20,353 11.30 7,184 4.00 First United ...................... 8,196 10.50 3,119 4.00 7,599 11.50 2,646 4.00 Randolph County ................... 10,128 14.90 2,723 4.00 9,848 13.00 3,042 4.00 Union County ...................... 19,124 8.80 8,728 4.00 17,966 8.60 8,362 4.00 First National .................... 15,085 14.40 4,198 4.00 14,509 13.00 4,469 4.00 (1) as defined by regulatory agencies 37 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (table dollar amounts in thousands, except share data) NOTE 14 EMPLOYEE BENEFIT PLANS The Corporation's defined-benefit pension plans cover substantially all of the Banks' employees. The benefits are based primarily on years of service and employees' pay near retirement. Contributions are intended to provide not only for benefits attributed to service-to-date, but also for those expected to be earned in the future. The table below sets forth the plans' funded status and amounts recognized in the consolidated balance sheet at December 31: December 31 1999 1998 =========================================================================== Change in benefit obligation Benefit obligation at beginning of year ...... $ 16,319 $ 14,454 Service cost ................................. 737 688 Interest cost ................................ 1,081 1,044 Actuarial (gain) loss ........................ (1,542) 793 Benefits paid ................................ (789) (660) -------- -------- Benefit obligation at end of year ............ 15,806 16,319 -------- -------- Change in plan assets Fair value of plan assets at beginning of year 19,243 18,865 Actual return of plan assets ................. 3,871 1,038 Benefits paid ................................ (789) (660) -------- -------- Fair value of plan assets at end of year ..... 22,325 19,243 -------- -------- Funded status ................................ 6,519 2,924 Unrecognized net actuarial gain .............. (6,184) (2,579) Unrecognized prior service cost .............. (132) (144) Unrecognized transition asset ................ (344) (480) -------- -------- Accrued benefit cost ......................... $ (141) $ (279) ======== ======== 1999 1998 1997 =============================================================================================== Pension expense (benefit) includes the following components: Service cost-benefits earned during the year ............ $ 737 $ 688 $ 624 Interest cost on projected benefit obligation ........... 1,081 1,044 956 Actual return on plan assets ............................ (3,871) (1,038) (4,251) Net amortization and deferral ........................ 1,915 (946) 2,810 ------- ------- ------- Total pension expense (benefit) ...................... $ (138) $ (252) $ 139 ======= ======= ======= 1999 1998 1997 =============================================================================================== Assumptions used in the accounting as of December 31 were: Discount rate ........................................ 7.68% 6.77% 7.40% Rate of increase in compensation ..................... 4.00% 4.00% 4.50% Expected long-term rate of return on assets .......... 9.00% 9.00% 9.00% In 1989, stockholders approved the 1989 Stock Option Plan, reserving 253,125 shares of Corporation common stock for the granting of options to certain employees. The exercise price of the shares may not be less than the fair market value of the shares upon grant of the option. Options become 100 percent vested when granted and are fully exercisable generally six months after the date of grant, for a period of ten years. There were no shares available for grant at December 31, 1999. On March 31, 1994, stockholders approved the 1994 Stock Option Plan, reserving 472,500 shares of Corporation common stock for the granting of options to certain employees and non-employee directors. The exercise price of the shares may not be less than the fair market value of the shares upon the grant of the option. Options become 100 percent vested when granted and are fully exercisable generally six months after the date of the grant, for a period of ten years. There were no shares available for grant at December 31, 1999. 38 continued NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (table dollar amounts in thousands, except share data) NOTE 14 EMPLOYEE BENEFIT PLANS continued On April 14, 1999, stockholders approved the 1999 Long-term Equity Incentive Plan, reserving 1,427,177 shares of Corporation common stock for the granting of options to certain employees and non-employee directors. The maximum number of options granted in any given year cannot exceed 1.5% of the shares outstanding at the end of the prior fiscal year. Options become 100 percent vested when granted and are fully exercisable generally six months after the date of the grant for a period of ten years. There were 1,316,527 shares available for grant at December 31, 1999. The table below is a summary of the status of the Corporation's stock option plans and changes in those plans as of and for the years ended December 31, 1999, 1998 and 1997. The number of shares and prices have been restated to give effect to the Corporation's 1998 stock split. Year Ended December 31, 1999 1998 1997 - ------------------------------------------------------------------------------------------------------------------------------------ WEIGHTED-AVERAGE WEIGHTED-AVERAGE WEIGHTED-AVERAGE OPTIONS SHARES EXERCISE PRICE SHARES EXERCISE PRICE SHARES EXERCISE PRICE ==================================================================================================================================== Outstanding, beginning of year ................ 497,004 $ 17.62 471,037 $ 14.59 461,257 $ 12.23 Granted ....................................... 136,400 22.21 113,915 25.83 99,825 20.44 Exercised ..................................... (63,848) 9.81 (87,086) 11.96 (90,045) 8.97 Cancelled ..................................... (1,275) 24.58 (862) 28.71 ------- ------- ------- Outstanding, end of year ...................... 568,281 $ 19.56 497,004 $ 17.62 471,037 $ 14.59 ======= ======= ======= Options exercisable at year end ............... 443,006 397,221 372,112 Weighted-average fair value of options granted during the year ............ $ 5.77 $ 5.48 $ 4.14 As of December 31, 1999, other information by exercise price range for options outstanding and exercisable is as follows: OUTSTANDING EXERCISABLE - --------------------------------------------------------------------------------- ------------------------------- EXERCISE PRICE NUMBER WEIGHTED-AVERAGE WEIGHTED-AVERAGE NUMBER WEIGHTED-AVERAGE RANGE OF SHARES EXERCISE PRICE REMAINING CONTRACTUAL LIFE OF SHARES EXERCISE PRICE ========================================================================================================================== $ 0.00 - $16.08 195,574 $13.13 4.6 years 191,374 $13.42 16.17 - 22.75 242,924 20.56 7.9 years 145,374 19.08 23.69 - 30.44 129,783 27.37 8.8 years 106,258 28.01 ------- ------- 568,281 $19.56 7.0 years 443,006 $18.77 ======= ======= The Corporation's stock option plans are accounted for in accordance with Accounting Principles Board Opinion ("APB") No. 25, Accounting for Stock Issued to Employees, and related interpretations. APB No. 25 requires compensation expense for stock options to be recognized only if the market price of the underlying stock exceeds the exercise price on the date of the grant. Accordingly, the Company recognized compensation expense of $35,000 in 1999. No compensation expense was required to be recognized in 1998 or 1997. Although the Corporation has elected to follow APB No. 25, SFAS No. 123 requires pro forma disclosures of net income and earnings per share as if the Corporation had accounted for its employee stock options under that Statement. The fair value of each option grant was estimated on the grant date using an option-pricing model with the following assumptions: 1999 1998 1997 Risk-free interest rates........ 5.72% 5.45% 6.54% Dividend yields................. 3.23% 3.25% 3.37% Volatility factors of expected market price common stock... 21.98% 17.19% 11.20% Weighted-average expected life of the options ........ 8.50 years 8.50 years 8.50 years continued 39 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (table dollar amounts in thousands, except share data) NOTE 14 EMPLOYEE BENEFIT PLANS continued Under SFAS No. 123, compensation cost is recognized in the amount of the estimated fair value of the options and amortized to expense over the options' vesting period. The pro forma effect on net income and earnings per share of this statement are shown on the right: 1999 1998 1997 Net Income As reported.................... $19,088 $17,907 $16,483 Pro Forma...................... 18,661 17,147 16,056 Earnings per share Basic: As reported.................... $1.59 $ 1.50 $ 1.40 Pro forma...................... 1.55 1.44 1.36 Diluted: As reported $1.58 $ 1.48 $ 1.38 Pro forma 1.54 1.42 1.34 In 1994, the stockholders approved the 1994 Employee Stock Purchase Plan, enabling eligible employees to purchase the Corporation's common stock. A total of 253,125 shares of the Corporation's common stock are reserved for issuance persuant to the plan. The price of the stock to be paid by the employees is determined by the Corporation's compensation committee, but may not be less than 85 percent of the lesser of the fair market value of the Corporation's common stock at the beginning or at the end of the offering period. Common stock purchases are made annually and are paid through advance payroll deductions of up to 20 percent of eligible compensation. Participants under the plan purchased 20,870 shares in 1999 at $20.24 per share. The fair market value per share on the purchase date was $23.81. In 1999, the stockholders approved the 1999 Employee Stock Purchase Plan, enabling eligible employees to purchase the Corporation's common stock. A total of 250,000 shares of the Corporation's common stock are reserved for issuance persuant to the plan. The price of the stock to be paid by the employees is determined by the Corporation's compensation committee, but may not be less than 85 percent of the lesser of the fair market value of the Corporation's common stock at the beginning or at the end of the offering period. Common stock purchases are made annually and are paid through advance payroll deductions of up to 20 percent of eligible compensation. At December 31, 1999, there were 250,000 shares of Corporation common stock reserved for purchase under the plan, and $257,000 has been withheld from compensation, plus interest, toward the purchase of shares after June 30, 2000, the end of the annual offering period. The Corporation's Employee Stock Purchase Plan is accounted for in accordance with APB No. 25. Although the Corporation has elected to follow APB No. 25, SFAS No. 123 requires pro forma disclosures of net income and earnings per share as if the Corporation had accounted for the purchased shares under that statement. The pro forma disclosures are included in the table above and were estimated using an option pricing model with the following assumptions for 1999, 1998 and 1997, respectively: dividend yield of 3.23, 3.25 and 3.37 percent; an expected life of one year for all years; expected volatility of 21.98, 17.19 and 11.20 percent; and risk-free interest rates of 5.72, 5.45 and 6.54 percent. The fair value of those purchase rights granted in 1999, 1998 and 1997 was $4.50, $12.69 and $5.03, respectively. The Banks have retirement savings 401(k) plans in which substantially all employees may participate. The Banks match employees' contributions at the rate of 25-50 percent for the first 5-6 percent of base salary contributed by participants. The Banks' expense for the plans was $191,000 for 1999, $178,000 for 1998, and $189,000 for 1997. NOTE 15 NET INCOME PER SHARE Year Ended December 31, 1999 1998 1997 - ------------------------------------------------------------------------------------------------------------------------------- WEIGHTED-AVERAGE PER SHARE WEIGHTED-AVERAGE PER SHARE WEIGHTED-AVERAGE PER SHARE INCOME SHARES AMOUNT INCOME SHARES AMOUNT INCOME SHARES AMOUNT =============================================================================================================================== Basic net income per share: Net income available to common stockholders .......... $19,088 12,008,152 $1.59 $ 17,907 11,922,879 $1.50 $16,483 11,815,377 $1.40 Effect of dilutive stock options . 108,756 ===== 164,287 ===== 143,072 ===== ------- ---------- -------- ---------- ------- ---------- Diluted net income per share: Net income available to common stockholders and assumed conversions ...... $19,088 12,116,908 $1.58 $ 17,907 12,087,166 $1.48 $16,483 11,958,449 $1.38 ======= ========== ===== ======== ========== ===== ======= ========== ===== 40 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (table dollar amounts in thousands, except share data) NOTE 16 FAIR VALUES OF FINANCIAL INSTRUMENTS The following methods and assumptions were used to estimate the fair value of each class of financial instrument: Cash and cash equivalents The fair value of cash and cash equivalents approximates carrying value. Interest-bearing time deposits The fair value of interest-bearing time deposits approximates carrying value. Investment securities Fair values are based on quoted market prices. Mortgage loans held for sale The fair value of mortgages held for sale approximates carrying values. LOANS For both short-term loans and variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. The fair value for other loans is estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. INTEREST RECEIVABLE/PAYABLE The fair values of interest receivable/payable approximate carrying values. Federal Reserve and Federal Home Loan Bank stock The fair value of FRB and FHLB stock is based on the price at which it may be resold to the FRB and FHLB. DEPOSITS The fair values of noninterest-bearing demand accounts, interest-bearing demand accounts and savings deposits are equal to the amount payable on demand at the balance sheet date. The carrying amounts for variable rate, fixed-term certificates of deposit approximate their fair values at the balance sheet date. Fair values for fixed-rate certificates of deposit and other time deposits are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on such time deposits. FEDERAL FUNDS PURCHASED AND U.S. TREASURY DEMAND NOTES These financial instruments are short-term borrowing arrangements. The rates at December 31, 1999 and 1998, approximate market rates, thus the fair value approximates carrying value. Securities sold under repurchase agreements and Federal home loan bank advances The fair value of the these borrowings is estimated using a discounted cash flow calculation, based on current rates for similar debt. Off-balance sheet commitments Loan commitments and letters-of-credit generally have short-term, variable-rate features and contain clauses which limit the Banks' exposure to changes in customer credit quality. Accordingly, their carrying values, which are immaterial at the respective balance sheet dates, are reasonable estimates of fair value. The estimated fair values of the Corporation's financial instruments are as follows: 1999 1998 - ------------------------------------------------------------------------------------------------------------------------------------ CARRYING FAIR CARRYING FAIR AMOUNT VALUE AMOUNT VALUE ==================================================================================================================================== Assets at December 31: Cash and cash equivalents ................................... $ 84,293 $ 84,293 $ 80,769 $ 80,769 Interest-bearing time deposits .............................. 1,730 1,730 1,008 1,008 Investment securities available for sale .................... 329,668 329,668 329,508 329,508 Investment securities held to maturity ...................... 14,303 14,284 21,709 22,061 Mortgage loans held for sale ................................ 61 61 776 776 Loans ....................................................... 988,767 983,147 881,147 890,542 FRB and FHLB stock .......................................... 5,858 5,858 4,455 4,455 Interest receivable ......................................... 11,279 11,279 10,797 10,797 Liabilities at December 31: Deposits .................................................... 1,147,203 1,145,134 1,085,952 1,089,083 Borrowings: Securities sold under repurchase agreements ............. 77,957 76,739 48,836 43,903 Federal funds purchased ................................. 28,885 28,885 15,170 15,170 U.S. Treasury demand notes .............................. 9,506 9,506 2,629 2,629 FHLB advances ........................................... 73,514 73,093 47,068 47,249 Interest payable ............................................ 4,599 4,599 4,134 4,134 41 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (table dollar amounts in thousands, except share data) NOTE 17 CONDENSED FINANCIAL INFORMATION (PARENT COMPANY ONLY) Presented below is condensed financial information as to financial position, results of operations, and cash flows of the Corporation: CONDENSED BALANCE SHEET December 31, 1999 1998 ================================================================================ Assets Cash .............................................. $ 212 $ 84 Loans to affiliates ............................... 2,350 1,500 Investment securities available for sale .......... 285 Investment in subsidiaries ........................ 155,460 151,409 Goodwill .......................................... 535 578 Other assets ...................................... 356 303 -------- -------- Total assets ................................... $158,913 $154,159 ======== ======== Liabilities Borrowings from affiliates ........................ $ 32,000 Other liabilities ................................. 617 $ 268 -------- -------- Total liabilities .............................. 32,617 268 Stockholders' equity ................................. 126,296 153,891 -------- -------- Total liabilities and stockholders' equity ..... $158,913 $154,159 ======== ======== CONDENSED STATEMENT OF INCOME Year Ended December 31, 1999 1998 1997 ==================================================================================================================================== Income Dividends from subsidiaries ................................................ $ 9,894 $ 7,980 $ 7,080 Gain on sale of available-for-sale securities .............................. 98 Other income ............................................................... 112 112 107 -------- -------- -------- Total income ............................................................ 10,104 8,092 7,187 -------- -------- -------- Expenses Amortization of core deposit intangibles, goodwill, and fair value adjustments ...................................... 43 71 71 Business combination expenses .............................................. 804 36 Other expenses ............................................................. 834 551 591 -------- -------- -------- Total expenses .......................................................... 1,681 658 662 -------- -------- -------- Income before income tax benefit and equity in undistributed income of subsidiaries ......................................... 8,423 7,434 6,525 Income tax benefit ...................................................... (321) (216) (191) -------- -------- -------- Income before equity in undistributed income of subsidiaries ................. 8,744 7,650 6,716 Equity in undistributed income of subsidiaries ............................ 10,344 10,257 9,767 -------- -------- -------- Net Income ................................................................... $ 19,088 $ 17,907 $ 16,483 ======== ======== ======== 42 continued NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (table dollar amounts in thousands, except share data) NOTE 17 CONDENSED FINANCIAL INFORMATION (PARENT COMPANY ONLY) continued CONDENSED STATEMENT OF CASH FLOWS Year Ended December 31, 1999 1998 1997 ==================================================================================================================== Operating activities: Net income ........................................................ $ 19,088 $ 17,907 $ 16,483 Adjustments to reconcile net income to net cash provided by operating activities: Amortization .................................................... 43 44 43 Equity in undistributed income of subsidiaries .................. (10,344) (10,257) (9,767) Security gains .................................................. (98) Net change in: Other assets ................................................. (53) (115) (32) Other liabilities ............................................ 349 154 16 -------- -------- -------- Net cash provided by operating activities ................. 8,985 7,733 6,743 -------- -------- -------- Investing activities: Security purchased with an agreement to resell to an affiliate .... 2,000 (1,000) Net change in loans ............................................... (850) (1,500) Proceeds from sales of securities available for sale .............. 383 Investment in subsidiary ............................................. (1,729) Other investing activities ........................................ 55 (272) (182) -------- -------- -------- Net cash used by investing activities ..................... (412) (1,501) (1,182) -------- -------- -------- Financing activities: Cash dividends .................................................... (9,759) (7,934) (7,090) Borrowing from affiliates ......................................... 32,000 Stock issued under employee benefit plans ......................... 457 385 291 Stock issued under dividend reinvestment and stock purchase plan ......................................... 722 679 726 Stock options exercised ........................................... 271 482 417 Stock redeemed .................................................... (32,136) (72) Cash paid in lieu of issuing fractional shares .................... (6) -------- -------- -------- Net cash used by financing activities ..................... (8,445) (6,466) (5,656) -------- -------- -------- Net change in cash ................................................ 128 (234) (95) Cash, beginning of year .............................................. 84 318 413 -------- -------- -------- Cash, end of year ................................................. $ 212 $ 84 $ 318 ======== ======== ======== NOTE 18 QUARTERLY RESULTS OF OPERATIONS (UNAUDITED) The following table sets forth certain quarterly results for the years ended December 31, 1999 and 1998: - ------------------------------------------------------------------------------------------------------------------------------------ AVERAGE SHARES OUTSTANDING NET INCOME PER SHARE QUARTER INTEREST INTEREST NET INTEREST PROVISION FOR NET -------------------------- -------------------- ENDED INCOME EXPENSE INCOME LOAN LOSSES INCOME BASIC DILUTED BASIC DILUTED 1999: March ............ $ 23,770 $ 10,931 $ 12,839 $ 505 $ 4,643 11,978,451 12,098,414 $ .39 $ .38 June ............. 24,916 11,453 13,463 522 4,649 12,004,475 12,101,757 .39 .39 Sept ............. 25,380 11,804 13,576 590 4,863 12,043,381 12,146,080 .40 .40 Dec .............. 26,397 12,710 13,687 624 4,933 12,005,285 12,125,563 .41 .41 ---------- ---------- ----------- -------- -------- ----- ----- $ 100,463 $ 46,898 $ 53,565 $ 2,241 $ 19,088 12,008,152 12,116,908 $1.59 $1.58 ========== ========== =========== ======== ======== ===== ===== 1998: March ............ $ 22,460 $ 10,509 $ 11,951 $ 508 $ 4,393 11,876,960 12,065,754 $ .37 $ .36 June ............. 23,209 10,993 12,216 504 4,414 11,903,127 12,097,882 .37 .37 Sept ............. 23,843 11,352 12,491 539 4,559 11,950,118 12,110,502 .38 .38 Dec .............. 24,649 11,611 13,038 821 4,541 11,960,598 12,106,589 .38 .37 ---------- ---------- ----------- -------- -------- ----- ----- $ 94,161 $ 44,465 $ 49,696 $ 2,372 $ 17,907 11,922,879 12,087,166 $1.50 $1.48 ========== ========== =========== ======== ======== ===== ===== 43 STOCKHOLDER INFORMATION [PHOTO] First Merchants Corporation was organized in September of 1982 as the bank holding company for Merchants National Bank of Muncie, now First Merchants Bank, N.A., an institution which has served Muncie and the east central Indiana market since 1893. Since its organization, First Merchants Corporation has acquired six additional affiliate banks and a multi-line insurance agency. Pendleton Banking Company of Pendleton, Indiana was acquired in November of 1988; First United Bank of Middletown, Indiana in July of 1991; The Union County National Bank of Liberty, Indiana in August of 1996; The Randolph County Bank of Winchester, Indiana in October of 1996; Anderson Community Bank of Anderson, Indiana and First National Bank of Portland, Indiana in April of 1999. Also, in April of 1998, First Merchants acquired the Muncie office of Insurance & Risk Management, an independent agency based in Fort Wayne, Indiana. The agency, renamed First Merchants Insurance Services, offers a full line of insurance products to customers in the Corporation's ten-county service area. First Merchants Bank also operates one of the ten largest trust departments in Indiana, with fiduciary assets in excess of one billion dollars at market value. In June of 1999, U.S. Banker magazine ranked First Merchants 24th out of 200 mid-sized public banking companies in the United States based on financial performance. In addition, the Corporation continues to receive an A+ rating from Standard & Poor's for its common stock and Blue Ribbon status from independent bank-rating service Veribanc. First Merchants Corporation is one of only two Indiana-based companies listed among America's Finest Companies, an investment guide published by The Staton Institute. [LOGO] Corporate Office 200 East Jackson Street Muncie, Indiana 47305 765-747-1500 http://www.firstmerchants.com 44 First Merchants Corporation currently provides services through offices located in Delaware, Fayette, Hamilton, Henry, Jay, Madison, Wayne, Randolph and Union counties in Indiana and Butler county in Ohio. ANNUAL MEETING The Annual Meeting of Stockholders of First Merchants Corporation will be held... Wednesday, April 12, 2000 o 3:30 p.m. Horizon Convention Center 401 South High Street Muncie, Indiana First Merchants Corporation Market Area Indiana Delaware County 1 Corporate Office o Muncie 2 Albany 3 Eaton 4 Daleville Fayette County 5 Connersville Hamilton County 6 Carmel 7 Noblesville Henry County 8 Middletown 9 Mooreland 10 Sulphur Springs Jay County 11 Portland Madison County 12 Anderson 13 Edgewood 14 Ingalls 15 Lapel 16 Markleville 17 Pendleton Randolph County 18 Winchester Union County 19 Liberty Wayne County 20 Richmond Ohio Butler County 21 Oxford 45 STOCK PRICE & DIVIDEND INFORMATION PRICE PER SHARE QUARTER HIGH LOW DIVIDENDS DECLARED ==================================================================================================================================== 1999 1998 1999 1998 1999 1998 -------------------------- -------------------------- --------------------------- First Quarter .............. $ 26.13 $ 27.67 $ 21.50 $ 24.50 $ .200 $ .187 Second Quarter ............. 24.75 31.83 21.50 25.67 .200 .187 Third Quarter .............. 25.69 30.83 22.25 24.00 .220 .200 Fourth Quarter ............. 29.25 28.75 21.88 21.50 .220 .200 The table above lists per share prices and dividend payments during 1999 and 1998. Prices are as reported by the National Association of Securities Dealers. Automated Quotation - National Market System. Numbers rounded to nearest cent when applicable. Restated for 3-for-2 stock split distributed October, 1998. STOCK INFORMATION Common stock listing First Merchants Corporation common stock is traded over-the-counter on the NASDAQ National Market System. Quotations are carried in many daily papers. The NASDAQ symbol is FRME (Cusip #320817-10-9). At the close of business on December 31, 1999, the number of shares outstanding was 10,936,617. There were 1,780 stockholders of record on that date. General stockholder inquiries Stockholders and interested investors may obtain information about the Corporation upon written request or by calling: Mr. Douglas B. Harris Vice President Investor Services & Bank Investments First Merchants Corporation P. O. Box 792 Muncie, Indiana 47308-0792 765-741-7278 1-800-262-4261 Ext. 7278 Stock transfer agent and registrar First Merchants Bank, N.A. Corporate Trust Department P. O. Box 792 Muncie, Indiana 47308-0792 MARKET MAKERS The following firms make a market in First Merchants Corporation stock: Robert W. Baird & Co., Inc. Keefe, Bruyette & Woods, Inc. Knight Securities, L.P. Herzog, Heine, Geduld, Inc. Howe, Barnes & Johnson, Inc. McDonald and Company NatCity Investments, Inc. Spear, Leads, and Kellog FORM 10-K AND FINANCIAL INFORMATION First Merchants Corporation, upon request and without charge, will furnish stockholders, security analysts and investors a copy of Form 10-K filed with the Securities and Exchange Commission. Please contact: Mr. James Thrash Senior Vice President and Chief Financial Officer First Merchants Corporation P. O. Box 792 Muncie, Indiana 47308-0792 765-747-1390 1-800-262-4261 Ext. 1390 46