Deck 20: Managing Credit Risk on the Balance Sheet

Question 1

A firm's cash account grew by $300 over the year when the firm had cash flow from financing of -$150 and cash flow from investing of $100. The firm's operating cash flow must have been +$250.

Answer 1

False

Question 2

If you are a lender evaluating a loan application and you calculate the following ratio: (EBIT + Lease payments)/[Interest + Lease payments + (Sinking Fund/(1-T))] then you are calculating a debt service ratio and it should be less than one in order to approve the loan.

Answer 2

False

Question 3

Which one of the following is usually the better predictor of default?

A) Standard & Poor's credit rating
B) Moody's credit rating
C) Altman Z-score
D) KMV's EDF
E) All of the above are equally effective at predicting default.

Answer 3

D

Question 4

The base loan rate accounts for
I) the firm's cost of funds.
II) the firm's required return on equity.
III) the credit risk of the loan.

A) I only
B) I and II only
C) II and III only
D) I and III only
E) I, II, and III

Question 5

As long as overall cash flow growth is positive, a bank loan officer would not be concerned if cash flow from operations was projected to be negative over the term of the loan.

Question 6

Which one of the following 5 Cs of credit is NOT correctly defined?

A) Capacity - Whether the borrower has enough other credit available to pay off the loan in the event of cash flow problems.
B) Capital - The borrower's equity.
C) Character - A measure of the borrower's intention/willingness to repay the loan.
D) Conditions - Assessing how economic conditions could affect the borrower's ability to repay the loan.
E) Collateral - An asset of the borrower that the lender may seize in the event of default on the loan.

Question 7

Provision for loan losses, net charge-offs, and the percentage of nonperforming loans all increased dramatically in 2007.

Question 8

The more variable are a borrower's cash flows, the lower the fixed charge coverage ratio should be to limit risk.

Question 9

Credit analysis of a mid-market corporate borrower differs from the analysis of a small business in that the analysis of the mid-market borrower is more focused on the business itself and less on the business owners.

Question 10

A well-managed bank tries to keep the ratio of nonperforming loans to total loans at about 8% to 10%.

Question 11

Asset management ratios are used in credit analysis to help understand the borrower's ability to generate sales from the amount invested in some asset category.

Question 12

Individuals with higher levels of income must have higher GDS and TDS ratios to qualify for a loan.

Question 13

The five Cs of credit are financial capacity, collateral, conditions, connections with the bank, and capital.

Question 14

Collateral on a mortgage is normally only considered if the applicant has enough income to service the loan.

Question 15

If you were a loan officer evaluating a small business credit application for a loan secured by working capital, you would generally want to see a higher (rather than lower) number of days in inventory and number of days' sales in receivables.

Question 16

Issuance of short-term debt would result in an increase in cash flow from operations on the statement of cash flows.

Question 17

Gross debt service usually must be greater than 30% before a residential mortgage will be approved.

Question 18

A rising sales to working capital ratio may indicate a potential borrower is using its net current assets more efficiently.

Question 19

Non-performing loans are loans that are past due ___________ that are not accruing interest.

A) 30 days
B) 60 days
C) 90 days
D) 120 days
E) 180 days

Question 20

_____________________ is the process of taking possession of the mortgaged property to satisfy the debt in the event of failure to repay the mortgage and foregoing claim to any deficiency.

A) Perfecting collateral
B) Foreclosure
C) Power of sale
D) Conditions precedent
E) Lien enforcement

Question 21

In analyzing credit risk for a loan to a major diversified corporation, the bank typically has which of the following advantages?
I) Market-based models to analyze credit risk
II) Greater negotiating power due to the size of the loan required
III) Ratings agency measures of default risk

A) I only
B) I and II only
C) II and III only
D) I and III only
E) I, II, and III

Question 22

Altman's Z-score model is Z = 1.2X₁ + 1.4X₂ + 3.3X₃ + 0.6X₄ + 1.0X₅
X₁ = Working Capital/Total Assets
X₂ = Retained Earnings/Total Assets
X₃ = EBIT/Total Assets
X₄ = Market Value Equity/Book Value Long-Term Debt
X₅ = Sales/Total Assets
Using the Altman's Z model, Big Valley's Z-score is

A) 3.22.
B) 2.88.
C) 2.65.
D) 2.11.
E) 1.85. WC/TA = 7.44%; RE/TA=23.14%; EBIT/TA=19.01%; MVE/BVLTD = 1.50; S/TA = 1.28; These numbers give a Z-score of 3.22, which indicates low default risk.

Question 23

Using only the TDS criteria, which one of the following statements is true?

A) Joe gets the loan but not Bill.
B) Bill gets the loan but not Joe.
C) Both get the loan.
D) Neither gets the loan. Joe: TDS = ((2700 x 12) + 3000)/100,000 = 35.40%; Bill: GDS = ((1150 x 12) + 1400)/45,000 = 33.78%; Joe is over the maximum of 35%, Bill is under

Question 24

Individual credit scoring models typically include all of the following information except

A) income.
B) length of time in residence.
C) credit history.
D) age.
E) ethnic background.

Question 25

Big Valley's return on equity indicates that the firm generates a _____ return to their shareholders than their peers.

A) 3.02% higher
B) 15.25% higher
C) 5.75% lower
D) 1.05% lower
E) 2.04% higher NI/Equity = (275 + 500 - 560 - 100 - 55 - 30)/(75 + 140) = 13.95%; industry = 15%

Question 26

Business credit-scoring models suffer from several weaknesses. These include which of the following?
I) Credit-score models are not statistically sound tools to use in making a lending decision.
II) The appropriate weights on a credit-score model are likely to change unpredictably over time.
III) These models ignore non-quantifiable behavioral factors, such as a relationship with the bank and reputation.
IV) Credit-scoring models discriminate against minorities.

A) I and II only
B) II and III only
C) II, III, and IV only
D) I, II, and III only
E) I, II, III, and IV

Question 27

A corporate loan applicant has cash of $40, receivables of $50, and inventory of $20. The applicant also has current debts of $65. If the bank's policy requires a current ratio of 1.75 or better and an acid test ratio of 1.25 or better would the applicant receive the loan?

A) Yes, because the applicant's current ratio and acid test ratios are acceptable.
B) No, because the applicant's current ratio and acid test ratios are both unacceptable.
C) No, because although the applicant's current ratio is acceptable, its acid test ratio is not.
D) No, because although the applicant's acid test ratio is acceptable, its current ratio is not. Current ratio = (40 + 50 + 20)/65 = 1.69, Not acceptable; Acid Test (40 + 50)/65 = 1.38, Acceptable

Question 28

Using only the GDS criteria, which one of the following statements is true?

A) Joe gets the loan but not Bill.
B) Bill gets the loan but not Joe.
C) Both get the loan.
D) Neither gets the loan. Joe: GDS = ((2100 x 12) + 3000)/100,000 = 28.20%; Bill: GDS = ((1000 x 12) + 1400)/45,000 = 29.78%; both are under the max of 30%

Question 29

Big Valley's use of debt to finance assets indicates that Big Valley has ____________ the typical firm in the industry.

A) more long-term solvency risk than
B) the same long-term solvency risk as
C) less interest expense than
D) less long-term solvency risk as
E) a lower market value of equity to book value of equity ratio than BV's Debt/TA = (160 + 230)/605 = 64.4%; Peer Debt/TA = 50%

Question 30

If you were a loan officer evaluating a small business credit application for a loan and you wanted to ensure that the applicant had more than sufficient cash flow to pay off its existing debt, the applicant's cash flow to debt ratio would have to be greater than

A) one.
B) zero.
C) the TIE ratio.
D) the interest rate on the debt.
E) peer average ratio.

Question 31

Big Valley's fixed asset efficiency is ___________ the typical firm in the industry.

A) the same as
B) lower than
C) higher than S/FA = (275 + 500)/400 = 1.9375; Peer S/FA = 1.8

Question 32

Big Valley is collecting their receivables about __________________ than the typical firm.

A) 22% more quickly
B) 12% more quickly
C) 17% more slowly
D) 12% more slowly BV's Days sales in receivables = (80 * 365)/500 = 58.4 days; 58.4/50 - 1 = 16.8%

Question 33

The EDF model uses the borrower's current market value of equity and assets and the option-pricing model to

A) determine if the equity is mispriced.
B) calculate the market value of the lender's investment.
C) assess the implied riskiness of the firm's investments.
D) estimate the likelihood that the Z-score model is correct.

Question 34

A firm with a low Z-score has high

A) insolvency risk.
B) interest rate risk.
C) liquidity risk.
D) international risk.
E) none of the above

Question 35

Big Valley's current ratio indicates that Big Valley is ______ liquid than the typical firm in the industry and Big Valley's quick ratio indicates that Big Valley is _______ liquid than the typical firm.

A) more; more
B) more; less
C) less; less
D) less; more
E) similar; similar Current = (10 + 80 + 115)/160 = 1.28, Peer = 1.35; Quick = (10 + 80)/160 = 0.56, Peer = 0.5

Question 36

A bank charges a commercial borrower a 6.55% interest rate on a 1-year loan. The bank also charges a 0.5% origination fee and requires compensating balances of 7% in the form of demand deposits. Reserve requirements are 10%. What is the promised gross rate of return on the loan?

A) 8.45%
B) 7.89%
C) 9.10%
D) 7.52%
E) 6.95% (0.005 + 0.0655)/[1 - (0.07 * (1 - 0.10))] = 7.52%

Question 37

A corporate customer obtains a $1.5 million loan from a bank. The customer agrees to pay a 6.25% interest rate and agrees to make compensating balances of 4% of the loan amount. These will be held in non-interest-bearing transactions deposits at the bank for one year. The bank charges a 1% loan origination fee on the amount borrowed. Reserve requirements are 10%. What is the expected rate of return to the bank (k) (to the nearest basis point)?

A) 6.95%
B) 7.52%
C) 7.99%
D) 8.01%
E) 8.45% (1% + 6.25%)/(1 - (4%(1 - 10%))) = 7.52%

Question 38

Mid-market commercial lending may be typically defined as borrowers
I) with sales revenue between $5 and $100 million.
II) with a recognizable corporate structure.
III) with ready access to deep and liquid capital markets.

A) I only
B) II only
C) III only
D) I and II only
E) I, II, and III

Question 39

The conditions specified in a credit agreement that must be fulfilled before a drawdown is allowed are called

A) collateral perfection.
B) power of sale conditions.
C) conditions precedent.
D) foreclosure agreements.
E) audit review terms.

Question 40

Big Valley has a times interest earned ratio that is _________, which indicates that Big Valley has _________ long-term insolvency risk than the typical firm in the industry.

A) 4; the same
B) 3.91; less
C) 3.91; more
D) 4.58; more
E) 4.58; less [(275 + 500 - 560)/55] = 3.91; more

Question 41

What are the five Cs of credit? Briefly describe each.

Question 42

Before allowing the lender to actually acquire the funds for a mid-market collateralized loan, what must the lender ensure? What type of monitoring occurs by the lender after the loan is granted?

Question 43

Explain the purpose/benefits in adding a credit-scoring model to evaluate a loan application.

Question 44

For most business loans, growing earnings are not a sufficient reason to grant a loan. Why?

Question 45

A bank is using the RAROC to evaluate large business loans. The benchmark rate of return is 7.55%. The 1-year loan interest rate is 8.00% and the bank must pay 7.40% to raise the funds. The cost to service the loan is 0.3%. If the loan defaults, 92% of the money lent will be lost. Based on historical default rates, the extreme worst-case loss scenario is about 5%. Should the bank make the loan? Why or why not?

A) Yes, because the RAROC is 7.11%.
B) No, because the RAROC is 7.11%.
C) Yes, because the RAROC is 6.52%.
D) No, because the RAROC is 6.52%.
E) No, because the RAROC is more than 7.55%. (0.080 - 0.074 - 0.003)/(0.05 * 0.92) = 6.52%, but this is below the benchmark of 7.55%.

Question 46

In concept, the RAROC measure indicates a loan is acceptable if the RAROC is greater than the

A) borrower's ROE.
B) lender's ROA.
C) borrower's ROA.
D) lender's ROE.
E) NCO rate.

Question 47

Explain what each ratio in the Altman credit model measures and explain why higher values of each of the variables predicts lower default probability.

Question 48

A bank has a base loan rate of 4.75% and for the loan under consideration it would apply a 2% risk premium. The bank also requires compensating balances (non-interest-bearing) equal to 5% of the loan amount. The bank's reserve requirements are 10%. The bank charges 1% of the loan amount as an origination fee. The borrower is asking for a $500,000 loan. Calculate the ROA on the loan.

Question 49

Describe the credit analysis process for a mid-market corporate loan applicant.

Question 50

A corporate loan applicant has had a growing cash account for the last 3 years but cash flow from operations has been negative in every year. Would this concern you if you were the loan officer charged with approving the loan? If so, why? If not, why not?

Question 51

As a business lender, you would prefer that the borrower have stable or growing cash flows resulting from which part of the statement of cash flows?

A) Financing cash flows
B) Cash flows from investment
C) Operating cash flows
D) Dividends
E) Common Stock

Question 52

Explain how the KMV model predicts bankruptcy probability.

Question 53

Why is bank lending to large corporations more difficult than making loans to small or mid-size firms? What additional factors are involved? Do banks have some additional tools to help in assessing credit risk of large firms? What are some examples?

Question 54

A $40,000 one-year loan with a 1% origination fee and a 7.50% interest rate is funded with money on which the bank owes 3%. What is the expected pretax dollar spread on the loan? If the bank needs to net at least 3.5% on the funds lent to make its ROE, how many dollars can the bank spend on credit investigation, loan servicing, etc.? Would the bank be able to spend more if the loan amount was greater? What does this example suggest about credit analysis?

Question 55

A bank can charge a corporate borrower 6.25% on a loan. The borrower is asking for a $600,000 loan. The extreme loss rate on this loan type is 4.0% and when default occurs, about 15% of the loan amount is recovered. The interest and noninterest cost of the loan is 5.85%. What is the RAROC of the loan? Under what circumstances should the bank make the loan?

Question 56

Why won't a loan officer usually approve a loan solely on the basis of collateral?