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County Bank offers one-year loans with a stated rate of 9 percent but requires a compensating balance of 10 percent. What is the true cost of this loan to the borrower? How does the cost change if the compensating balance is 15 percent? If the compensating balance is 20 percent? In each case, assume origination fees and the reserve requirement are zero.

The true cost is the loan rate ÷ (1 – compensating balance rate) = 9% ÷ (1.0 – 0.1) = 10 percent. For compensating balance rates of 15 percent and 20 percent, the true cost of the loan would be 10.59 percent and 11.25 percent respectively. Note that as the compensating balance rate increases by a constant amount, the true cost of the loan increases at an increasing rate. 10. Metrobank offers one-year loans with a 9 percent stated or base rate, charges a 0.25 percent loan origination fee, imposes a 10 percent compensating balance requirement, and must pay a 6 percent reserve requirement to the Federal Reserve. The loans typically are repaid at maturity. a. If the risk premium for a given customer is 2.5 percent, what is the simple promised interest return on the loan? The simple promised interest return on the loan is BR + m = 0.09 + 0.025 = 0.115 or 11.5 percent. b. What is the contractually promised gross return on the loan per dollar lent?

of +( BR +m) 0.0025 +(0.09 +0.025) 0.1175 k= 1+ − 1= 1+ − 1= 1+ − 1= 12.97 percent 1− [b(1 −RR )] 1− [0.1(1 −0.06)] 0.906

c. Which of the fee items has the greatest impact on the gross return? The compensating balance has the strongest effect on the gross return on the loan. Without the compensating balance, the gross return would equal 11.75 percent, a reduction of 1.22 percent. Without the origination fee, the gross return would be 12.69 percent, a reduction of only 0.28 percent. Eliminating the reserve requirement would cause the gross return to increase to 13.06 percent, an increase of 0.09 percent. 18. Suppose the estimated linear probability model is PD = 0.3X1 + 0.2X2 - .05X3 + error, where X1 = 0.75 is the borrower's debt/equity ratio; X2 = 0.25 is the volatility of borrower earnings; and X3 = 0.10 is the borrower’s profit ratio. a. What is the projected probability of default for the borrower? PD = 0.3(.75) + 0.2(.25) - 0.05(.10) = 0.27 b. What is the projected probability of repayment if the debt/equity ratio is 2.5?

11-21

Retained earnings = Net income (1 .25) .0714 X1 = Working capital/total assets (TA) X2 = 44(1-.104 = .2(0.10) = 0.3(2.Depreciation. what would be the net income 11-22 .6(2.5) / 700 = .Current liabilities.05(. c. If sales for MNO were $300.4(0.0857 + .795 = 0. net income = $44.Cost of goods sold .67 X4 = Market value of equity/long term debt X5 = 500 / 700 = .3(0. EBIT = Revenues . Inc.’s application for a capital expansion loan should be approved.795 The expected probability of repayment is 1 .03) + 3.? Recall that: Net working capital = Current assets . has provided the following financial information in its application for a loan.6X4 + 1.104 is greater than 2.3X3 + 0.0.interest . Inc. Inc. Assets Cash Accounts receivables Inventory Plant and equipment Total assets $ 20 90 90 500 $700 Liabilities and Equity Accounts payable Notes payable Accruals Long-term debt Equity (ret.PD = 0.5) + 0.20 X3 = EBIT/TA X4 = 400 / 150 = 2.7143 = 3.2(. MNO.205.99.4X2 + 3. earnings = $0) Total liabilities and equity $ 30 90 30 150 400 $700 Also assume sales = $500.Dividend payout ratio) Altman’s discriminant function is given by: Z = 1. Should you approve MNO.7143 X5 = Sales/TA Z = 1.20) + 0. Net income = EBIT . cost of goods sold = $360. taxes = $56.0314 X2 = Retained earnings/TA X3 = (500-360) / 700 = . interest payments = $40. the dividend payout ratio is 50 percent. a.71) = 3.'s application to your bank for a $500 capital expansion loan? Since the Z-score of 3. and the market value of equity is equal to the book value. and the cost of goods sold and interest were unchanged..044 + . a publicly traded manufacturing firm in the United States.104 b.taxes.0. Current liabilities = Accounts payable + Accruals + Notes payable.2X1 + 1.6 + .07) + 1. 20.0X5 X1 = (20+90+90-30-30-90)/ 700 = .0(0. ABC Inc. What is the Altman discriminant function value for MNO. the market value of equity was only half of book value.67) + 1. Current assets = Cash + Accounts receivable + Inventories.66 + 1.

Thus.042/1.000. b. A bank is planning to make a loan of $5.12)) = 6.for MNO? Assume the tax credit can be used to offset other tax liabilities incurred by other divisions of the firm.250.000 = $25. The loan has a maturity of 8 years and a duration of 7.000 DLN = 1.000.000/1. based on two years of historical data.0050 x $5. Since RAROC is lower than the cost of funds to the bank.9434 < 1.5 years.000/(5. or ∆LN = -DLN*LN*(∆R/(1 + R) = = -7.0714 X2 = -44 / 700 = -0.12) = -$1. then: X1 = (20 + 90 + 90 . The current market interest rate for loans in this sector is 12 percent. 11-23 . that ABC's tax liability is -$56. The cost of funds (the RAROC benchmark) for the bank is 10 percent.10 x $5.89 percent.30 .5 years.000 to a firm in the steel industry.000 = $600. determine whether the bank should make the loan? RAROC = Fees and interest earned on loan/ Loan or capital risk Loan risk.4286 Since ABC's Z-score falls to $.000.000.000 Less cost of funds = 0. Note. credit should be denied.000 ⇒ -DLN * LN * (∆R/(1 + R)) = 1. this loan can be made if the duration is reduced to 6. the bank should not make the loan.81.10 = $1.3333 X5 = 300 / 700 = 0. Using the RAROC model.000 Net interest and fee income = $125.000 * (0.000/∆LN = 0.12 x $5. Would your credit decision change? ABC’s net income would be -$100 without taking into account text credits.250.000 Servicing fees = 0. Assume the bank has estimated the maximum change in the risk premium on the steel manufacturing sector to be approximately 4.250.30 .000 RAROC = $125.000 / 0.406. a.10 ⇒ ∆LN = 125.5 * $5m * (. It expects to charge a servicing fee of 50 basis points. 32. What should be the duration in order for this loan to be approved? For RAROC to be 10 percent.000 = -$500.67 years from 7.250 = 8.67 years.0629 X3 = -60 / 700 = -0.90) / 700 = .042/1.000.406.250 Expected interest = 0. loan risk should be: $125.0857 X4 = 200 / 150 = 1. If we assume that ABC uses this tax credit against other tax liabilities.2 percent.

how much additional interest and fee income would be necessary to make the loan acceptable? Necessary RAROC = Income/Risk ⇒ Income = RAROC * Risk = $1.$125.10 = $1.625 Therefore.625 .000)/(-7.000) = 0.0373 11-24 . what adjustment in the risk premium would be necessary to make the loan acceptable? $125.000 = $15.000/0.000 = -7.12) Thus ∆R = 1.250.250.000*(∆R/1.000. additional income = $140.625.c. d.406.10 = $140.000 ⇒ -$1.5*$5.5*$5.250 *0.250.12(-$1. Assuming that duration cannot be changed. Given the proposed income stream and the negotiated duration.000.

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