Reference no: EM132934307

Bendigo Bank has received a loan application from one of its clients- Adelaide Building and Construction. The bank has a two-stage approach for handling commercial loan applications. In the first stage, it has to decide whether the loan can be approved. In second stage, the bank decides upon what interest rate to charge the borrower. a) Altman's Z-score =  (1.2 x Working capital-to-total assets ratio) + (1.4 x Retained earnings-to-total asset ratio) + (3.3 x Earnings before interest and taxes-to-total asset ratio) + (0.6 x Market value of equity-to-book value of long-term debt ratio) + ( 0.999 x Sales-to-total asset ratio)
= ((1.2 x 0.04) + (1.4 x 0.3) + (3.3 x 0.1) + (0.6 x 0.9) + (0.999 x 1.5) = 0.048 + 0.42 + 0.33 + 0.54 + 1.4985
= 2.8365

As the Z score 2.8365 is less than 2.99 but between 1.81. Thus, we can conclude that Adelaide Building and Construction is in the "grey zone" and has a moderate probability to go bankrupt and should not approve the loan.b) Assume that the bank decided to approve the loan application; it now decides what interest rate to charge. The bank currently charges a base lending (risk-free) rate of 4 per cent. It expects a probability of default of 7 per cent for this loan. If defaulted, for this type of loans, the bank recovers on average 80 per cent of loan value and expects the same recovery rate for this loan.

Problem 1: Calculate required (expected) rate of return on this loan