Misc. Finance Problems Assignment
Question # 00030673
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Updated on: 11/05/2014 12:57 AM Due on: 11/05/2014
1. 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 per-cent? If the compensating balance
is 20 percent? In each case, assume origination fees and the reserve requirement are zero.
2. Why could a lenders expected return be lower when the risk premium is increased on a
loan? In addition to the risk premium, how can a lender increase the expected return on a
wholesale loan? A retail loan?
3. What are covenants in a loan agreement? What are the objectives of covenants? How can
these covenants be negative? Positive?
4. Why is the degree of collateral as specified in the loan agreement of importance to a
lender? If the book value of the collateral is greater than or equal to the amount of the loan, is
the credit risk of a lender fully covered? Why or why not?
5. Why are FIs consistently interested in the expected level of economic activity in the markets
in which they operate? Why is monetary policy of the Federal Reserve System important to FIs?
6. Describe how a linear discriminant analysis model works. Identify and discuss the criticisms
which have been made regarding the use of this type of model to make credit risk evaluations.
7. Suppose that the financial ratios of a potential borrowing firm take the following values:
Working capital/total assets ratio ( X 1 ) = 0.75
Retained earnings/total assets ratio ( X 2 ) = 0.10
Earnings before interest and taxes/total assets ratio ( X 3 ) = 0.05
Market value of equity/book value of long-term debt ratio ( X 4 ) = 0.10
Sales/total assets ratio ( X 5 ) = 0.65
8. Suppose that an FI holds two loans with the following characteristics.
Loan:
Xi:
Expected
Annual Spread b/w Loan Rate and
Annual Fees:
Loss to
And FIs Cost of Funds:
FI Given Default:
Default:
____________________________________________________________________________
_________
1
4.0%
2
1.5
?
p(12)=- 0.10
?
4.0 %
1.50%
?%
2.5
1.15
?
The return on loan 1 is R 1 = 6.25%, the risk on loan 2 is Sigma 2 = 1.8233%, and the
return of the portfolio is R p = 4.555%. Calculate of the loss given default on
loans 1 and 2, the proportions of loans 1 and 2 in the portfolio, and the risk of
the portfolio, sigma p , using Moodys Analytics Portfolio Manager.
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 per-cent? If the compensating balance
is 20 percent? In each case, assume origination fees and the reserve requirement are zero.
2. Why could a lenders expected return be lower when the risk premium is increased on a
loan? In addition to the risk premium, how can a lender increase the expected return on a
wholesale loan? A retail loan?
3. What are covenants in a loan agreement? What are the objectives of covenants? How can
these covenants be negative? Positive?
4. Why is the degree of collateral as specified in the loan agreement of importance to a
lender? If the book value of the collateral is greater than or equal to the amount of the loan, is
the credit risk of a lender fully covered? Why or why not?
5. Why are FIs consistently interested in the expected level of economic activity in the markets
in which they operate? Why is monetary policy of the Federal Reserve System important to FIs?
6. Describe how a linear discriminant analysis model works. Identify and discuss the criticisms
which have been made regarding the use of this type of model to make credit risk evaluations.
7. Suppose that the financial ratios of a potential borrowing firm take the following values:
Working capital/total assets ratio ( X 1 ) = 0.75
Retained earnings/total assets ratio ( X 2 ) = 0.10
Earnings before interest and taxes/total assets ratio ( X 3 ) = 0.05
Market value of equity/book value of long-term debt ratio ( X 4 ) = 0.10
Sales/total assets ratio ( X 5 ) = 0.65
8. Suppose that an FI holds two loans with the following characteristics.
Loan:
Xi:
Expected
Annual Spread b/w Loan Rate and
Annual Fees:
Loss to
And FIs Cost of Funds:
FI Given Default:
Default:
____________________________________________________________________________
_________
1
4.0%
2
1.5
?
p(12)=- 0.10
?
4.0 %
1.50%
?%
2.5
1.15
?
The return on loan 1 is R 1 = 6.25%, the risk on loan 2 is Sigma 2 = 1.8233%, and the
return of the portfolio is R p = 4.555%. Calculate of the loss given default on
loans 1 and 2, the proportions of loans 1 and 2 in the portfolio, and the risk of
the portfolio, sigma p , using Moodys Analytics Portfolio Manager.
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Rating:
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Solution: Misc. Finance Problems Assignment Solution