Describe how a linear discriminant analysis model works

Reference no: EM13502586

1.MNO, Inc., a publicly traded manufacturing firm in the United States, has provided the following financial information in its application for a loan. All numbers are in thousands of dollars.

Assets Liabilities and Equity

Cash $ 20 Accounts payable $ 30

Accounts receivables 90 Notes payable 90

Inventory 90 Accruals 30

Long-term debt 150

Plant and equipment 500 Equity (ret. earnings = $0) 400

Total assets $700 Total liabilities and equity $700

Also assume sales = $500,000, cost of goods sold = $360,000, taxes = $56,000, interest payments = $40,000, net income = $44,000, 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:

b. Should you approve MNO, Inc.'s application to your bank for a $500,000 capital expansion loan?

c. If sales for MNO were $300,000, the market value of equity was only half of book value, and the cost of goods sold, interest, and tax rate were unchanged, what would be the net income 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?

d. Would the discriminant function change for firms in different industries? Would the function be different for manufacturing firms in different geographic sections of the country? What are the implications for the use of these types of models by FIs?

2.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.

3.Suppose the estimated linear probability model used by an FI to predict business loan applicant default probabilities is PD = .03X₁ + .02X₂ - .05X₃ + error, where X₁ is the borrower's debt/equity ratio, X₂ is the volatility of borrower earnings, and X₃ = 0.10 is the borrower’s profit ratio. For a particular loan applicant, X₁ = 0.75, X₂ = 0.25, and X₃ = 0.10.

a. What is the projected probability of default for the borrower?

b. What is the projected probability of repayment if the debt/equity ratio is 2.5?

c. What is a major weakness of the linear probability model?

4.What are covenants in a loan agreement? What are the objectives of covenants? How can these covenants be negative? Positive?

5.Why could a lender’s 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?

Reference no: EM13502586

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