Reference no: EM132207845
Management of Financial Assignment - Credit Risk Analysis
Q1. Select values for the following for a commercial loan:
a. The base rate (the lender's cost of funds - depending on the lender, it may include overhead in addition to borrowing costs), between 3% and 6%.
b. A credit risk premium, between 2% and 5%.
c. Origination fees, between 0.25% and 0.75%.
d. A compensating balance, between 5% and 10%.
e. Reserve requirement (set by management rather than by a regulator), between 5% and 10%.
f. An expected default rate between 2% and 5%.
g. Expected recovery rate between 25% and 75%.
Q2. What is the contractually promised return (the contract rate) on a loan described in question 1. (Assume that reserves are maintained with respect to compensating balances.)
Q3. How does the answer to question 2 change if all values from question 1 are the same as in question 1 except the base rate is 2% higher than in 1a. Comment on how changes in the base rate affect the contract rate.
Q4. How does the answer to question 2 change if all values from question 1 are the same as in question 1 except the credit risk premium is 2% higher than in 1b. Comment on how changes in the credit risk premium affect the contract rate.
Q5. How does the answer to question 2 change if all values from question 1 are the same as in question 1 except the origination fee is double the amount in 1c. Comment on how changes in the origination fee affect the contract rate.
Q6. How does the answer to question 2 change if all values from question 1 are the same as in question 1 except the compensating balance is 2% larger than in 1d. Comment on how changes in the compensation balance affect the contract rate.
Q7. How does the answer to question 2 change if all values from question 1 are the same as in question 1 except the reserve requirement is 2% higher than in 1e. Comment on how changes in the reserve requirement affect the contract rate.
Q8a. What is the expected return on the loan from question 2 if the loan has the expected default rate from 1f, and the lender is not able to recover any amount with respect to the loan in the event of a default?
b. What is the expected return on the loan from part a if the default rate is 1% higher than in 1f.
c. Comment on how changes in the default rate affect the contract rate.
Q9a. What is the expected return on the loan from question 2 if the loan has the expected default rate from 1f, and the expected recovery rate in the event of default is given by 1g.
b. What is the expected return on the loan from part a if the expected recovery rate is 5% greater than 1f.
c. Comment on how changes in the expected recovery rate affect the contract rate.
Q10. Find the following from the most recent annual financial statements for a publicly traded manufacturing company of your choice (do not use either Tesla, Inc. or Deere and Co.:
a. the ratio of net working capital to total assets, x1
b. the ratio of retained earnings to total assets, x2
c. the ratio of earnings before interest and taxes to total assets, x3
d. the ratio of market value of equity to book value of long term debt, x4 (be sure that you adjust as necessary if book value is stated in thousands of dollars and equity value, in dollars).
e. the ratio of sales to total assets, x5.
Q11a. Using the ratios from question 10, compute the Altman Z score for the company. (The Z score equation is Z = 1.2x1 + 1.4 x2 + 3.3 x3 +0.6 x4 +1.0 x5).
b. explain what it indicates about the company's risk of default.
Q12. A proposed loan of $1m has total annual interest rate and fees of 6.25%. The loan's duration is 6.7 years. The lender's cost of funds is 5.625%. Comparable loans have an interest rate of 6.25%. The expected maximum change in the loan rate due to a change in the credit risk premium for the loan is 0.875% (based on actual change in credit risk premium for the worst 1% of comparable loans over some prior period).
a. What is the RAROC on this loan?
b. If the lender requires RAROC to exceed 15.0%, how could the terms of the loan be changed to make this loan acceptable?
Q13a. If the expected default rate on a 1-year personal loan card is 6.5% and the risk free rate is 3%, what risk premium must a financial institution charge on the credit card in order to have an expected return equal to the risk free rate? (Assume the financial institution assumes a 0% recovery rate in the event of default.)
b. If the expected default rate on a 1-year automobile loan is 3.25%, the risk free rate is 3%, and the financial institution expects to recover 40% of the total loan return in the event of default, what risk premium must a financial institution charge on the automobile loan in order to have an expected return equal to the risk free rate?
Q14a. Obtain 5 years of monthly returns for a public company that has long term debt (book value) equal to at least 20% of the company's total market value (enterprise value). Assume that the debt is payable in 5 years, and the risk free interest rate is 3.5%. (You can obtain 5 years of monthly prices and calculate monthly returns.)
b. Using the monthly returns on the company's stock, calculate the standard deviation of monthly returns. Use that value to calculate the annual standard deviation (i.e., the standard deviation of annual returns.)
c. Using option pricing with the enterprise value as the spot price of the firm's assets and the book value of debt as the strike price and assuming the company pays no dividends, determine the probability that the company default on its debt.