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Answers to Chapter 20
Questions:
1. Credit risk management is important for FI managers because it determines several features of a loan: interest
2. Two considerations dominate an FI’s decision to approve a mortgage loan application: (1) the applicant’s ability
and willingness to make timely interest and principal repayments and (2) the value of the borrower’s collateral.
Ability and willingness of the borrower to repay debt outstanding is usually established by application of qualitative
and quantitative models. The character of the applicant is also extremely important. Stability of residence,
3. Credit scoring models are used to calculate the probability of default or to sort borrowers into different default
risk classes. The primary benefit of credit scoring models is to improve the accuracy of predicting borrower’s
performance without using additional resources. This benefit results in fewer defaults and chargeoffs to the FI.
4. The techniques used for mortgage loan credit analysis are very similar to those applied to individual and small
business loans. Individual consumer loans are scored like mortgages, often without the borrower ever meeting the
loan officer. Unlike mortgage loans for which the focus is on a property, however, nonmortgage consumer loans
focus on the individual’s ability to repay. Thus, credit scoring models put more weight on personal characteristics
such as annual gross income, the TDS score, and so on.
5. Besides the obvious difference in the sizes the borrowers, there is also a better defined corporate structure and a
6. One particular consideration is the life of the company. Typically, loans are made to small businesses to help start
up the company. This creates several problems. There is less history to base the loan on. Numerical scoring rules
7. Having gathered information about the credit applicant, an account officer decides whether it is worthwhile to
pursue the new business, given the applicant’s needs, the FI’s credit policies, the current economy, and the
8. Although financial ratios are normally thought to represent financial health, they also demonstrate other aspects
of the company’s health. Generally, a set of healthy ratios should reflect a well-managed company. A company with
9. Liquidity provides the defensive cash and near-cash resources for firms to meet claims for payment. Liquidity
ratios express the variability of liquid resources relative to potential claims. When considering the liquidity of a loan
10. Conditions precedent are those conditions specified in the credit agreement that must be fulfilled before
11. An FI’s bargaining strength is severely diminished when it deals with large creditworthy corporate customers.
Large corporations are able to issue debt and equity directly in the capital markets as well as to make private
placements of securities. Also, they typically maintain credit relationships with several FIs and have significant
Specifically, the FI’s relationship with large corporate clients goes beyond lending. The FI’s role as broker,
dealer, and advisor to a corporate client may rival or exceed the importance of its role as a lender. A large corporate
12. Although X3, or EBIT/total assets, has the highest coefficient (3.3), it is not necessarily the most important
variable. Since the value of X3 is likely to be small, the product of 3.3 and X3 may be quite small. For some firms,
14. A compensating balance is the portion of a loan that a borrower must keep on deposit with the credit-granting
16. Modern portfolio theory has demonstrated that a well-diversified portfolio can provide opportunities for
individuals to invest in a set of efficient frontier portfolios, defined as those portfolios that provide the maximum
Problems:
1. The monthly payment for this mortgage will be $587 ($80,000 = PMT{[1 - (1/(1 + 0.08/12)30(12))]/0.08/12} ), the
2. Joan Doe’s credit score is calculated as follows:
The loan request will go to the credit committee for review and decision.
3. Net change in cash and marketable securities = $1,025,000 - $950,000 = $75,000
4. Statement of Cash Flows for Year Ending December 31, 2016
(in millions of dollars)
B. Cash Flows from Investing Activities
Subtractions:
C. Cash Flows from Financing Activities
Additions:
D. Net Change in Cash and Marketable Securities -$ 0
5. A. Cash Flows from Operating Activities
6. a. 96,000/42000 = 2.29X
b. 52,000x365/200000 = 94.9 days
8. Lake of Egypt Marina, Inc. Industry
a. Current ratio 390/210=1.86 times 2.0 times
b. Quick ratio (390-200)/210=0.90 times 1.2 times
c. Days sales in receivables (115x365)/515=81.50 days 32.50 days
Lake of Egypt Marina is performing below the industry in all areas. Liquidity is lower, asset management is poorer, and
profit ratios are lower.
10. a. Altman’s discriminant function is given by: Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5
c. ABC=s net income would be $12,000, then:
d. There are several problems with using a discriminant function model such to evaluate credit risk:
i) It discriminates only between two extreme cases, default or no default.
14. RAROC = One-year net income on loan/ Loan or capital risk
Since RAROC is higher than the cost of funds to the bank, the bank should make the loan.
