Chapter-17: Lending to Business Firms and Pricing Business Loans

Solve Class
[Home Work: See Section 17-7 for similar problems].

Home work: See Section 17-11 for similar Problems

Answer:
(a). To come to a decision whether to lend to Fince Corp. using CPA method, we need to
calculate the Earnings before tax (EBIT).
(Figures are in million)
Expected Revenues Amount Estimated expenses Amount
Interest Income from loan 0.6m Interest to be paid on client’s 0.1275m
($10m x 0.06) deposit ($3mx0.0425)
Loan commitment fee 0.075m Expected cost of additional 0.28m
(10m x 0.0075) funds [$(10-3)m x 0.04]
Cash management fees 0.45m Labor costs and other operating 0.20m
(15mx0.03) expenses ($10mx0.02)
1.125m Cost of processing loan 0.15m
($10mx0.015)
Total Estimated Expenses $0.7575m
Earnings before tax rate of return= Expected Revenue – Estimated expenses/net Loanable
funds = $(1.125-0.7575)/($10-3) = $0.3675/$7 = 0.0525 = 5.25%
Yes, since the earnings before tax rate of return is 5.25%, which is higher than the required
benchmark, the First Commerce National Bank can sanction the credit to Fince Corp.

(b). In order to augment the probable return, the First Commerce N. Bank can enhance the
non-obvious revenue sources like loan commitment fees and cash management fees
(although cash management fee is already higher). From the bank’s expenses side, it can
reduce the interest income credited to client’s account for customer’s bank deposits, reduce
the processing and monitoring costs through improved technology or increasing the
efficiency.

©. From the perspective of the market competitions about loan pricing, I believe, it’s
always good to focus on indirect or less-obvious pricing rather than the direct one.
Therefore, our pricing strategies will not have caught the attention of the clients much and
can devoid of the harsh competition from other lenders.

[Home work: Difficult Problem. See the example of Customer Profitability Analysis (CPA) Pricing. I will discuss it again.
Answer:
Given,
Cost of raising the loanable funds = [($6mx0.035)+($4mx0.0325)=$(0.21+ 0.13)m=$0.34m
Operating Cost= $25000= $0.0025m
Required Risk premium or margin for credit risk= 1% = 0.01
Required profit margin= ¼% = 0.0025

We know as per the Cost-plus loan pricing method:

Loan Interest Rate= Marginal cost of raising funds+ Non-fund operating cost + Risk premium
(or margin) for credit/default risk+ desired profit margin
= [$0.34m+ $0.0025m+($10mx0.01)+ ($10mx0.0025)]/$10m
= $0.49m/$10m
=0.049 or 4.9%
The Lone Star Bank should a minimum rate of interest against the loan is 4.9 percentage.

Answer:
(a). Since Apex Export prefers a Primex Method. Therefore, Interest rate on loan will be
Loan Interest Rate= 1.014 times LIBOR= 1.014 X 4%= 4.056%

(b). However, if the Eaglewood Bank offers a Prime+ Method, then the interest rates will
be:
Loan Interest Rate= LIBOR Rate+¼ Percentage Points= 4%+0.25%=4.25%
The difference between the Primex Method and Prime+ Method is
= 4.25% (-) 4.056% = 0.194%
It means that If the Eaglewood Bank accepts the offer of the Apex Export, the bank has to
reduce the interest rate of the loan by a 0.194% or 1/5 of a percentage point.

(c). additionally, the Apex Exports preference of Primex Method reflects that it predicts that
LIBOR is supposed to fall in the 90-day period.

The End!