Chapter 20 - Managing Credit Risk on the Balance Sheet

SOLUTIONS MANUAL
Chapter Twenty
Answers to Chapter 20
Questions:
1. Credit risk management is important for FI managers becase it determines se!eral featres of
a loan" interest rate# matrit$# collateral and other co!enants. Riskier pro%ects re&ire more
anal$sis before loans are appro!ed. If credit risk anal$sis is inade&ate# defalt rates cold be
higher and psh an FI into insol!enc$# especiall$ if the markets are competiti!e and the margins
are lo'.
2. (he techni&es sed for mortgage loan credit anal$sis are !er$ similar to those applied to
indi!idal and small bsiness loans. Indi!idal consmer loans are scored like mortgages# often
'ithot the borro'er e!er meeting the loan officer. )nlike mortgage loans for 'hich the focs is
on a propert$# ho'e!er# nonmortgage consmer loans focs on the indi!idal*s abilit$ to repa$.
(hs# credit scoring models pt more 'eight on personal characteristics sch as annal gross
income# the (+S score# and so on.
Small bsiness loans are more complicated becase the FI is fre&entl$ asked to assme the
credit risk of an indi!idal 'hose bsiness cash flo's re&ire considerable anal$sis# often 'ith
incomplete acconting information a!ailable to the credit officer. (he pa$off for this anal$sis is
also small# b$ definition# becase loan principal amonts are sall$ small. , -.0#000 loan 'ith
a / percent interest spread o!er the cost of fnds pro!ides onl$ -1#.00 of gross re!enes before
loan loss pro!isions# monitoring costs# and allocation of o!erheads. (his lo' profitabilit$ has
cased man$ FIs to bild small bsiness scoring models similar to# bt more sophisticated than#
those sed for mortgages and consmer credit. (hese models often combine compter-based
financial anal$sis of borro'er financial statements 'ith beha!ioral anal$sis of the o'ner of the
small bsiness.
/. Besides the ob!ios difference in the si0es the borro'ers# there is also a better defined
corporate strctre and a clearer delineation of the corporate assets from the personal assets of
the o'ners. (he mid-market borro'er is also more likel$ to ha!e a track record to se as a basis
for ftre performance.
1. 2ne particlar consideration is the life of the compan$. ($picall$# loans are made to small
bsinesses to help start p the compan$. (his creates se!eral problems. (here is less histor$ to
base the loan on. 3merical scoring rles ma$ be less sefl in this case. , start-p bsiness that
fails ma$ also ha!e less collateral !ale compared to a larger compan$. Becase of this# the
personal assets of the small bsiness o'ner ma$ be sed as collateral on the loan. , loan to a
small bsiness 'ill necessaril$ be small# so the si0e of the profits to be earned b$ the FI from the
loan is not likel$ to be !er$ sbstantial.
20-1
Chapter 20 - Managing Credit Risk on the Balance Sheet
.. ,lthogh financial ratios are normall$ thoght to represent financial health# the$ also
demonstrate other aspects of the compan$*s health. 4enerall$# a set of health$ ratios shold
reflect a 'ell managed compan$. , compan$ 'ith strong profits# an abilit$ to pa$ off its debt#
and an abo!e a!erage trno!er of assets shold be good position to meet ftre obligations. More
specificall$# the profitabilit$ and asset management ratios reflect the prodction efficienc$ of
management. Recei!ables trno!er and da$s sales otstanding are indicators of the compan$*s
credit polic$ and collection policies 'hich are indicati!e of the marketing efficienc$ of the
compan$.
5. ,lthogh 6/# or 7BI(8total assets# has the highest coefficient 9/./:# it is not necessaril$ the
most important !ariable. Since the !ale of 6/ is likel$ to be small# the prodct of /./ and 6/
ma$ be &ite small. For some firms# particlarl$ those in the retail bsiness# the asset trno!er
ratio# 6. ma$ be &ite large and the prodct of the 6. coefficient 91.0: and 6. ma$ be
sbstantiall$ larger than the corresponding nmber for 6/. 4enerall$# the factor that adds most to
; score !aries from firm to firm.
<. ,n increase in risk premims indicates a riskier pool of clients 'ho are more likel$ to defalt
b$ taking on riskier pro%ects. (his redces the repa$ment probabilit$ and lo'ers the e=pected
retrn to the lender.
>. ?oan portfolio risk# as the name implies# refers to the risk of a portfolio of loans as opposed to
the risk of a single loan. Inherent in the distinction is the elimination of some of the risks of
indi!idal loans becase of benefits from di!ersification.
@. Modern portfolio theor$ has demonstrated that a 'ell-di!ersified portfolio can pro!ide
opportnities for indi!idals to in!est in a set of efficient frontier portfolios# defined as those
portfolios that pro!ide the ma=imm retrns for a gi!en le!el of risk or the lo'est risk for a
gi!en le!el of retrns. B$ choosing portfolios on the efficient frontier# a banker ma$ be able to
redce credit risk to its fllest. ,s sho'n in Figre 20-/# a manager*s selection of a particlar
portfolio on the efficient frontier is determined b$ his or her risk-retrn trade-off.
Probles:
1. (he monthl$ pa$ment for this mortgage 'ill be -.>< 9->0#000 A BM(CD1-91891 E .
0>812:
/0912:
:F8.0>812G :# the ta= pa$ment is -100 per month and she earns -2#.00 per month. So
her 4+S A 9.><E100:82#.00 A .2<1># or 2<.1>H. (hs# Iane is eligible for the loan.
20-2
Chapter 20 - Managing Credit Risk on the Balance Sheet
2. Ioan +oe*s credit score is calclated as follo's"
Characteristic Jale Score
,nnal gross income -1.#000 20
(+S 10H 10
Relations 'ith FI Checking accont 10
Ma%or credit cards . 10
,ge 2< 2.
Residence 2'n8Mortgage 20
?ength of residence 2 2 $ears 2.
Iob stabilit$ . 2 $ears .0
Credit histor$ Missed 2 pa$ments 1 $ear ago -1.
Score 1>.
(he loan re&est 'ill go to the credit committee for re!ie' and decision.
/. 3et change in cash and marketable secrities A -1#02.#000 - -@.0#000 A -<.#000
Cash Flo's from 2perating ,cti!ities A -5#101#000
Cash Flo's from In!esting ,cti!ities A - 2#.5<#000
Cash Flo's from Financing ,cti!ities A - /#1.@#000
3et Change in Cash and Marketable Secrities A -<.#000
1. Statement of Cash Flo's for Kear 7nding +ecember /1# 201/
9in millions of dollars:
A! Cash "lows #ro Operatin$ A%ti&ities
3et income -15
,dditions 9sorces of cash:"
+epreciation 1
Increase accred 'ages and ta=es 1
Increase acconts pa$able 1
Sbtractions 9ses of cash:"
Increase acconts recei!able -1
Increase in!entor$ -<
3et cash flo' from operating acti!ities" -1<
'! Cash "lows #ro In&estin$ A%ti&ities
Sbtractions"
Increase fi=ed assets --1>
Increase other long-term assets 0
3et cash flo' from in!esting acti!ities" --1>
20-/
Chapter 20 - Managing Credit Risk on the Balance Sheet
C! Cash "lows #ro "inan%in$ A%ti&ities
,dditions"
Increase notes pa$able - 1
Increase long-term debt 1
Increase common and preferred stock 0
Sbtractions"
Ba$ preferred stock di!idends -1
Ba$ common stock di!idends -/
3et cash flo' from financing acti!ities" -1

(! Net Chan$e in Cash an) Mar*etable Se%urities +, 0

.. A! Cash "lows #ro Operatin$ A%ti&ities
3et income -/1.m.
,dditions 9sorces of cash:"
+epreciation 15m.
Increase accred 'ages and ta=es 1.m.
Increase acconts pa$able 20m.
Sbtractions 9ses of cash:"
Increase acconts recei!able -1>m. 9A-/10m.--/1.m.--15m.--1.m.--20m.E-/>m.:
Increase in!entor$ -/>m.
3et cash flo' from operating acti!ities" -/10m.
(hs# end of $ear balance of acconts recei!able A -.0m. E -1>m. A -5>m.
5. a. @5#000812000 A 2.2@6
b. .2#000=/5.8200000 A @1.@ da$s
c. 200#0008110#000 A 1.1/6
d. 10#000=/5.81/0#000 A 112./ da$s
e. 912#000E/5#000:8110#000 A ...< A ...<H
f. 912#000E>000:8<>#000 A .51 A 51H
g. 25#0108110#000 A .1>5 A 1>.5H
h. 25#010852#000 A .12 A 12H
<. (he ratios can be compared to indstr$ a!erages and trends o!er time. In addition# 'e cold
se the financial statement information to calclate the appropriate ratios for ,ltman*s ;-score.
20-1
Chapter 20 - Managing Credit Risk on the Balance Sheet
>. ?ake of 7g$pt Marina# Inc. Indstr$
a. Crrent ratio /@08210A1.>5 times 2.0 times
b. Lick ratio 9/@0-200:8210A0.@0 times 1.2 times
c. +a$s sales in recei!ables 911.=/5.:8.1.A>1..0 da$s /2..0 da$s
d. +a$s sales in in!entor$ 9200=/5.:8250A2>0.<< da$s 1.1./@ da$s
e. Sales to 'orking capital .1.89/@0-210:A2.>5 times 1.2. times
f. Sales to fi=ed assets .1.8.20A0.@@ times 1.1. times
g. (otal assets trno!er .1.8@10A0..< times 1.1> times
h. +ebt-to-assets 9210E/00:8@10A.5.01H 52..0H
i. (imes interest earned 2//8//A<.05 times @..0 times
%. Cash flo' to debt 92//E22:89210E/00:A.0H 52...H
k. 4ross margin 2..8.1.A1@..1H .....H
l. Brofit margin 1/>8.1.A25.>0H 2>.<.H
m. R2, 1/>8@10A1..15H 1@.<.H
n. R27 1/>8100A/1..0H /5.>>H
o. +i!idend pa$ot ratio 5.81/>A1<.10H /.H
?ake of 7g$pt Marina is performing belo' the indstr$ in all areas. ?i&idit$ is lo'er# asset
management is poorer# and profit ratios are lo'er.
@. (his &estion represents an opportnit$ to break do'n the R27 into its components"
R27 A BM = ,) 7M A .0/ = 1.. = 91891-.55:: A .1/21 A 1/.21H
10. a. ,ltman*s discriminant fnction is gi!en b$" ; A 1.261 E 1.162 E /./6/ E 0.561 E 1.06.
X1 A 920 E @0 E @0 -/0 - @0 -/0: 8 <00 A .0<11 X1 A Morking capital8total assets 9(,:
X2 A 22 8 <00 A .0/11 X2 A Retained earnings8(,
X/ A 110 8 <00 A .20 X/ A 7BI(8(,
X1 A 100 8 1.0 A 2.5< X1 A Market !ale of e&it$8long term debt
X5 A .00 8 <00 A .<11/ X. A Sales8(,
; A 1.290.0<11: E 1.190.0/11: E /./90.20: E 0.592.5<: E 1.090.<11/: A /.105
.0>.< E .011 E .55 E 1.5 E .<11/ A /.105
b. Since the ;-score of /.105 is greater than 1.>1# ,BC# Inc.=s# application for a capital
e=pansion loan shold be appro!ed.
c. ,BC=s net income 'old be -12#000# then"
X1 A 920 E@0 E @0 - /0 - @0 - /0: 8 <00 A .0<11
X2 A 12 8 <00 A .01<1
X/ A @0 8 <00 A .12>5
X1 A 100 8 1.0 A .555<
X. A 1.0 8 <00 A .512@

Since ,BCNs ;-score falls to 1..<< O 1.>1# credit shold be denied.
20-.
Chapter 20 - Managing Credit Risk on the Balance Sheet
d. (here are se!eral problems 'ith sing a discriminant fnction model sch to e!alate
credit risk"
i: It discriminates onl$ bet'een t'o e=treme cases# defalt or no defalt.
ii: It is a static model and forecasts the likelihood of borro'er defalt as if there is no change in
the borro'erNs circmstances o!er time. If the loan applicantNs earnings are c$clical# this point
estimate ma$ not be indicati!e of firm profitabilit$.
iii: It ignores &alitati!e factors# sch as reptation and other pri!ate information.
i!: ,cconting !ariables are pdated infre&entl$ 9e.g.# &arterl$ or annall$:. (his allo's scores
to be changed at generall$ infre&ent inter!als.
11. Z A 1.29.10: E 1.19.20: E /./9.22: E 0.59.50: E 1.09.@: A 2./>5
,ccording to the ,ltman*s ;-score# this firm shold be placed in the indeterminate bankrptc$
risk class.
12. (he tre cost 'ill be .10891-.10: A .1111 A 11.11H
1/. 1Ek A 1 E 9.002.E.0@:891-9.10:9.@1:: A 1 E .0@2.8.@05 A 1.102# k A .102 A 10.2H
11. R,R2C A 2ne-$ear net income on loan8 ?oan or capital risk
7=pected interest A 0.102> = -.#000#000 A -.11#000
)p-front fees A 0.0010 = -.#000#000 A -.#000
Ser!ice fees A 0.000. = -.#000#000 A -2#.00
?ess cost of fnds A 0.10 = -.#000#000 A 9-.00#000:
3et interest and fee income A -21#.00
R,R2C A -21#.0089-.#000#000:9.0/:9.@0: A 21#.0081/.#000 A .1.@/ A 1..@/H
Since R,R2C is higher than the cost of fnds to the bank# the bank shold make the loan.
1.. a. 7=pected retrn of , A .29.02: E .>9.11: A .115 A 11.5H
7=pected retrn of B A .29.00: E .>9.1>: A .111 A 11.1H
b. 7=pected retrn in state 1 A ..9.02: E ..9.00: A .01 A 1.0H
7=pected retrn in state 2 A ..9.11: E ..9.1>: A .15 A 15.0H
c. 7=pected retrn on the portfolio A ..9.115: E ..9.111: A .1/ A 1/.0H
20-5