Consider the coefficients of Altman's Z-score.
On May 15, 2020, Tsingpre Airlines has applied for loan from your bank. After calculating Altman Z for Tsingpre Airlines you note that it exceeds the Altman Z threshold and recommend approval of the loan request. Unfortunately, your chief credit manager rejects the loan and suggests that you have omitted one of the 5Cs of credit. Present arguments on why the credit manager has disputed your decision.
What is underinvestment moral hazard? Explain how collateral can reduce this moral hazard.
In Question 1, we discussed Altman Z that measures a firm’s creditworthiness:
An index that measures ability to obtain external financing is the KZ Index. The KZ-Index (Kaplan-Zingales Index) is a relative measurement of reliance on external financing. Companies with a higher KZ-Index scores are more likely to experience difficulties when financial conditions tighten since they may have difficulty financing their ongoing operations.
The KZ-Index (Kaplan-Zingales Index) is described in Lamont, Polk and Saa-Requejo (2001)
Cash Flows = (Income Before Extraordinary Itemst + Total Depreciation and Amortizationt), K = Property, Plant and Equipmentt-1, Q = (Market Capitalizationt + Total Shareholder's Equityt - Book Value of Common Equityt – Deferred Tax Assetst) / Total Shareholder's Equityt, Debt = Total Long Term Debtt + Notes Payablet + Current Portion of Long Term Debtt ,Dividends = Total Cash Dividends Paidt (common and preferred) and Cash = Cash and Short-Term Investmentst. The ratio has been slightly modified by reducing the number of decimal places.
Your bank manager has asked you if it is possible to combine Altman Z and KZ index to permit improved decisions on whether a firm should have their loans approved (or rejected). You have created the figure below
Given the four quadrants (Quadrants 1 to Quadrant 4) develop justifications for either approving or rejecting a loan from each quadrant.
Please ensure that you use the spaces provided in the next page for your answer.
a.The Bank of Tinytown has two loans that have the following characteristics: Loan A equals $250 million with an expected return of 5 per cent and a standard deviation of returns of 5 per cent. The size, expected return and standard deviation of returns for loan B are $500 million, 8 per cent and 7.5 per cent, respectively. If the covariance between A and B is
0.0035, what are the expected return and standard deviation of this portfolio? Given the covariance can the calculation be simplified? What will the risk of the portfolio be, given the simplification?
b.Briefly describe any way(s) that the risk of this portfolio may be reduced? Be specific.
Ms Josephine Brown would like to borrow $280 from your bank to invest in a project that will pay off one period from now. The project is risky and its payoff is dependent on Ms Brown’s effort in managing it. If the project is successful, it pays off $670, but if it is unsuccessful it pays off nothing. Ms Brown can choose two levels of effort, high or low. If she chooses high effort, she suffers a personal cost of $70, but there is no personal cost associated with choosing low effort. With the two effort levels the probability that the project will succeed is 0.7 and 0.4 for the high and low effort levels respectively. The riskless rate is 5%. You consider designing a loan contract that involves the use of collateral. Ms Brown is willing to provide a personal guarantee that will result in collateral of $275 being available in case of project default. Assume that you cannot observe Ms Brown’s effort.
Determine the interest rates for the secured and for the unsecured loan? Determine if a Nash equilibrium will occur.
A bank is planning to make a loan of $40,000,000 to CIQ Maxigram a firm in the steel industry. It expects to charge a servicing fee of 20 basis points. The cost of funds - the risk adjusted return on capital (RAROC benchmark) for the bank is 7.2 percent. Assume that bank has estimated the maximum change in the risk premium on the steel manufacturing sector to be approximately 1.25% based on two years of historical data. The current market interest rate for loans in this sector is 7.5%.
CIQ Maxigram presents two loans to the bank:
Loan A: Bullet loan – interest only loan with principal repaid at the end of the loan life with duration of 6.75 years and a maturity of 10 years.
Loan B: Amortised loan – interest and principal with duration of 4.8 years and a maturity of 10 years.
Using the appropriate model determine whether the bank should make the loan?