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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.

2.

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?

k 1

of ( BR m)

0.0025 (0.09 0.025)

0.1175

11

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.

3.

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 borrowers 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?

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The expected probability of repayment is 1 - 0.795 = 0.205.

4.

MNO, Inc., a publicly traded manufacturing firm in the United States, has provided the

following financial information in its application for a loan.

Assets

Cash

Accounts receivables

Inventory

$ 20

90

90

Total assets

500

$700

Accounts payable

Notes payable

Accruals

Long-term debt

Equity (ret. earnings = $0)

Total liabilities and equity

$ 30

90

30

150

400

$700

Also assume sales = $500, cost of goods sold = $360, taxes = $56, interest payments = $40,

net income = $44, the dividend payout ratio is 50 percent, and the market value of equity is

equal to the book value.

a. What is the Altman discriminant function value for MNO, Inc.? Recall that:

Net working capital = Current assets - Current liabilities.

Current assets = Cash + Accounts receivable + Inventories.

Current liabilities = Accounts payable + Accruals + Notes payable.

EBIT = Revenues - Cost of goods sold - Depreciation.

Net income = EBIT - interest - taxes.

Retained earnings = Net income (1 - Dividend payout ratio)

Altmans discriminant function is given by: Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5

X1 = (20+90+90-30-30-90)/ 700 = .0714 X1 = Working capital/total assets (TA)

X2 = 44(1-.5) / 700 = .0314

X2 = Retained earnings/TA

X3 = (500-360) / 700 = .20

X3 = EBIT/TA

X4 = 400 / 150 = 2.67

X4 = Market value of equity/long term debt

X5 = 500 / 700 = .7143

X5 = Sales/TA

Z = 1.2(0.07) + 1.4(0.03) + 3.3(0.20) + 0.6(2.67) + 1.0(0.71) = 3.104

= .0857 + .044 + .66

+ 1.6

+ .7143 = 3.104

b. Should you approve MNO, Inc.'s application to your bank for a $500 capital expansion

loan?

Since the Z-score of 3.104 is greater than 2.99, ABC Inc.s application for a capital

expansion loan should be approved.

c. If sales for MNO were $300, the market value of equity was only half of book value,

and the cost of goods sold and interest were unchanged, what would be the net income

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for MNO? Assume the tax credit can be used to offset other tax liabilities incurred by

other divisions of the firm. Would your credit decision change?

ABCs net income would be -$100 without taking into account text credits. Note, that

ABC's tax liability is -$56. If we assume that ABC uses this tax credit against other tax

liabilities, then:

X1 = (20 + 90 + 90 - 30 - 30 - 90) / 700 = .0714

X2 = -44 / 700 = -0.0629

X3 = -60 / 700 = -0.0857

X4 = 200 / 150 = 1.3333

X5 = 300 / 700 = 0.4286

Since ABC's Z-score falls to $.9434 < 1.81, credit should be denied.

5.

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