BUS308 Credit and Lending Decisions: Loan-to-value Ratio

Questions:

Q1. A.

SBSC bank currently pays 1.55% p.a. on 12-month term deposits and expects to be able to attract similar funds in 12 months’ time at a cost of 1.35%. Accordingly, it has priced a fixed two-year loan of $5,500,000 at 1.0% over the expected cost of funds with interest paid annually. The day following the issue of the loan, the yield on both one- year and two-year maturity government bonds (indicators of market rates) decreased by 0.20% p.a.

  • Ignoring all other assets and liabilities calculate the present value of the expected interest margin.
  • What is the importance of the loan-to-value ratio (LVR)? If the LVR is 55% for a loan based on a firm’s accounts receivable, is the credit risk of the lender fully covered?

b.

  • ESG Prime Bank has an obligation of $750 at the end of the first period and $550 at the end of the second period. It also has $1,528.93 to invest and can choose between zero-coupon bond or the coupon bond. The coupon bond matures in two years, pays an annual coupon of $100, and has a balloon payment of $1,400. The zero-coupon bond has a balloon payment of $1,610 at the end of the second year. The default-free yield on a one-year bond is 10%, and the annualized yield on a two-year bond is also 10%. What is the present value of the bank’s equity?

(ii) Suppose the interest rate at t = 1 is 8%. What will be ESG Prime Bank’s equity if it invests in the zero-coupon bond?

c.

Match Microsoft, Boeing, and Cathay Pacific to their respective 2019 Annual Reports. Provide justification for your selections.  No calculations are required.

Balance Sheet Structure

Company A

Company B

Company C

(in percentage)

 

 

 

Cash and securities

15

18

37

Accounts Receivable

10

4

18

Inventories

16

1

2

Other Current Assets

5

5

7

Fixed Assets

54

72

36

Total Assets

100

100

100

Short-term debt

1

1

0

Accounts payable

10

5

5

Accruals and others

42

17

33

Long-term debt

13

13

0

Other long-term liabilities

19

21

13

Owners’ equity

15

43

49

Total Liabilities & Owners’ Equity

100

100

100

Profitability Structure

Company A

Company B

Company C

ROTA = EBIT/Total Assets  (%)

10

7

32

Margin  = EBIT/Sales (%)

9

10

39

Total asset turnover = Sales/Total assets

1.13

0.64

0.81

Leverage effect = Pretax ROE/ROTA

6.87

2.08

2.03

Pretax ROE = EBT/Owners’ Equity (%)

68

14

65

Tax effect = EAT/EBT = (1-Effective Tax Rate)

0.66

0.89

0.7

After Tax ROE = EAT/Owners’ Equity (%)

45

12

45

2(a)

The senior lending officer has provided you with the data below and you have to consider what analysis your wish to undertake. Please discuss pertinent questions that you would ask the senior lending officer before you commence the analysis and provide a rationale for the analyses you wish to undertake. Note: CF_TD (cash flow to total debt), NI_TA (net income to total assets), CA_CL (current assets to current liabilities), CA_NS (current assets to net sales) and F_OR_NF (fail or not fail). 

CF_TD

NI_TA

CA_CL

CA_NS

F_OR_NF

-0.4485

-0.4106

1.0865

0.4526

1

-0.5633

2.0114

3.5134

0.1642

1

0.0643

0.0156

1.0077

0.3978

1

-0.1421

-0.0651

0.7066

0.2794

1

0.0351

0.0147

1.5046

0.7080

1

-0.0653

-0.5660

1.3737

0.4032

1

0.0724

-0.0076

1.3723

0.3361

1

0.0713

0.0205

1.3124

0.2497

1

0.0109

0.0011

2.1495

0.6969

1

-0.2777

-0.2316

1.1918

0.6601

1

0.1454

0.0500

1.8762

0.0000

1

0.0115

-0.0032

1.2602

0.6038

1

0.1227

0.1055

1.1434

0.1655

1

-0.2843

-0.2703

1.2722

0.5128

1

0.0777

-0.2316

1.1218

0.7601

1

0.5135

0.1001

2.4871

0.5368

0

0.0769

0.0195

2.0069

0.5304

0

0.3776

0.1075

3.2651

0.3548

0

0.1933

0.0473

2.2506

0.3309

0

0.1184

0.0499

2.5210

0.6925

0

-0.0173

0.0233

2.0538

0.3484

0

0.1703

0.0695

1.7973

0.5174

0

0.1460

0.0518

2.1692

0.5500

0

0.1398

-0.0312

0.4611

0.2643

0

0.1379

0.0728

2.6123

0.5151

0

0.1486

0.0564

2.2347

0.5563

0

0.1633

0.0486

2.3080

0.1978

0

0.5383

5.5000

0.4835

0.4835

0

-0.3330

-0.0854

3.0124

0.4730

0

0.5603

0.1112

4.2918

0.4443

0

0.2029

0.0792

1.9936

0.3018

0

0.1661

0.0351

2.4527

0.1370

0

0.5808

0.0371

5.0594

0.1268

0

0.1446

0.0524

2.2407

0.5403

0

-0.0103

0.0433

2.1538

0.3584

0

2(b)

Summarize the pros and cons of judgmental and empirically based credit evaluation systems. What would you recommend? Would your recommendation change if you were evaluating Singapore Airlines for a loan during the COVID-19 pandemic? No calculations are required but your answer must relate to the Statement of Financial Position presented.

3(a)

A company has a choice between a bullet loan and an equivalent amortized loan with a value of $3,500,000. Calculate the repayment cash flows for a four-year loan with 3.15% pa fixed interest rate bullet loan and the equivalent amortized loan.

Year

Bullet loan repayments

Amortized loan repayments

 

3.15%

2.35%

3.15%

2.35%

1

?

 

?

 

2

?

 

?

 

3

?

 

?

 

4

?

 

?

 

Based on your calculations for the bullet loan repayments and amortized loan repayments, explain why the bank recommends that the amortized loan be taken. If interest rates fell to 2.35% fixed rate, would that alter the bank’s recommendation?

3(b)

The accounts of 4,500 credit card customers out of a sample of 40,000 that were reviewed did not perform satisfactorily. The credit scores assigned to these applicants when originally assessed had a mean of 70 and standard deviation of 8. The scores of the remaining customers had a mean of 87 and a standard deviation of 12. Assuming these distributions are approximately normal, if the cut-off score was revised upward to 82.

  • Complete the following table:

 

Creditworthiness

High

Low

Mean credit score

87

70

Standard deviation of credit score

12

8

Probability of receiving credit (%)

 

 

Probability of being denied credit (%)

 

 

(ii) The original default rate on the sample of 40,000 card holders was extremely high. What impact would be setting the cut-off at 82 have on the default rate? Show calculations. Is this adjustment reasonable? Discuss.

(iii) Based on the credit evaluation process. Complete the following table and identify the Type I and Type II errors. All quadrants need to be identified.

Analysed credit quality

 

Actual credit quality

 

Good

 

Bad

 

Good

 

 

 

Bad

 

 

4(a)

Before Neo Goh Hian Distributors approaches the bank for a loan the company has asked their internal credit department to see if the firm can generate any internal funds.

What conclusions can you draw from your analysis?

What supplementary quantitative information is necessary to increase your confidence in your analysis?

Neo Goh Hian Distributors

Balance Sheet

as at

 

31-Dec-17

31-Dec-18

31-Dec-19

Assets

 

 

 

 

 

 

Current Assets

 

 

 

 

 

 

Cash

 

6

 

12

 

8

Accounts receivables

 

44

 

48

 

56

Inventories

 

52

 

57

 

72

Prepaid expenses

 

2

 

2

 

1

Total Current Assets

 

104

 

119

 

137

Non-current Assets

 

 

 

 

 

 

Property, Land & Equipment

90

 

90

 

93

 

Less Accumulated Depreciation

34

 

39

 

40

 

Total Non-current Assets

 

56

 

51

 

53

Total Assets

 

160

 

170

 

190

Liabilities and Owners’ Equity

 

 

 

 

 

 

Current Liabilities

 

 

 

 

 

 

Short-term debt

 

15

 

22

 

23

Bank

7

 

14

 

15

 

Current portion of Long-term Debt

8

 

8

 

8

 

Accounts payable

 

37

 

40

 

48

Accrued expenses

 

2

 

4

 

4

Total Current Liabilities

 

54

 

66

 

75

Non-current Liabilities

 

 

 

 

 

 

Long-term debt

 

42

 

34

 

38

Total non- current liabilities

 

42

 

34

 

38

Owners’ Equity

 

64

 

70

 

77

Total Liabilities and Owners’ Equity

 

160

 

170

 

190

4 (b)

How would your focus change if we were considering the COVID-19 crisis period?

5.

Examine pages 118 and 119 of the 2020 Annual Report for OCBC Bank reproduced below and consider how the five C’s discussed in the course have application in the present coronavirus pandemic. Discuss if and how the ranking of the 5Cs change depending on whether you are considering “Consumers and Small Business”, “Corporate and Institutional Customers” or “Private Lending Customers”.

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