Solution manual bank management and financial services 9th edition by rose, peter chap017

Chapter 17 - Lending to Business Firms and Pricing Business Loans

CHAPTER 17
LENDING TO BUSINESS FIRMS AND PRICING BUSINESS LOANS
Goal of This Chapter: The purpose of this chapter is to explore how bankers can respond to a
business customer seeking a loan and to reveal the factors they must consider in evaluating a
business loan request. In addition, we explore the different methods used today to price business
loans and to evaluate the strengths and weaknesses of these pricing methods for achieving a
financial institution’s goals.
Key Topics in This Chapter
•
•
•
•
•
•
I.
II.
III.
IV.

V.

VI.

Types of Business Loans: Short Term and Long Term
Analyzing Business Loan Requests
Collateral and Contingent Liabilities
Sources and Uses of Business Funds
Pricing Business Loans
Customer Profitability Analysis

Chapter Outline
Introduction
Brief History of Business Lending
Types of Business Loans
A.
Short-Term Business Loans
B.
Long-Term Business Loans
Short-Term Loans to Business Firms
A.
Self-Liquidating Inventory Loans
B.
Working Capital Loans
C.
Interim Construction Financing
D.
Security Dealer Financing
E.
Retailer and Equipment Financing
F.
Asset-Based Financing
G.
Syndicated Loans (SNCs)
Long-Term Loans to Business Firms
A.
Term Business Loans
B.
Revolving Credit Financing
C.

Long-Term Project Loans
D.
Loans to Support the Acquisition of Other Business Firms—Leveraged Buyouts
Analyzing Business Loan Applications
A.
Most Common Sources of Loan Repayment
B.
Analysis of a Business Borrower's Financial Statements
1.
Important Balance Sheet Composition Ratios
a.
Percentage Composition of Assets
b.
Percentage Composition of Total
Liabilities and Net Worth

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Chapter 17 - Lending to Business Firms and Pricing Business Loans

2.

VII

VIII

IX.

X.

XI.

Important Income Statement Composition Ratios
a.
Percentage Composition of Total Income
Financial Ratio Analysis of a Customer's Financial Statements
A.
The Business Customer's Control over Expenses
B.
Operating Efficiency: Measure of a Business Firm's Performance Effectiveness
C.
Marketability of the Customer's Product or Service
D.
Coverage Ratios: Measuring the Adequacy of Earnings
E.
Liquidity Indicators for Business Customers
F.
Profitability Indicators
G.
The Financial Leverage Factor as a Barometer of a Business Firm's Capital
Structure
Comparing a Business Customer’s Performance to the Performance of Its Industry
A. Contingent Liabilities
1.
Types of Contingent Liabilities
2.
Environmental Liabilities
3.
Underfunded Pension Liabilities

Preparing Statements of Cash Flows from Business Financial Statements
A.
Statement of Cash Flows
B.
Pro Forma Statements of Cash Flows and Balance Sheets
C.
The Loan Officer's Responsibility to the Lending Institution and the Customer
Pricing Business Loans
A. The Cost-Plus Loan Pricing Method
B.
The Price Leadership Model
C.
Below-Prime Market Pricing
D.
Customer Profitability Analysis (CPA)
1.
An Example of Annualized Customer Profitability Analysis
a.
Problem
b.
Interpretation
2.
Earnings Credit for Customer Deposits
3.
The Future of Customer Profitability Analysis
Summary of the Chapter
Concept Checks

17-1. What special problems does business lending present to the management of a business
lending institution?

While business loans are usually considered among the safest types of lending (their default rate,
for example, is usually well below default rates on most other types of loans), these loans
average much larger in dollar volume than other loans and, therefore, can subject an institution to
excessive risk of loss and, if a substantial number of loans fail, can lead to failure. Moreover,
business loans are usually much more complex financial deals than most other kinds of loans,
requiring larger numbers of personnel with special skills and knowledge. These additional
resources required an increase in the magnitude of potential losses unless the business loan
portfolio is managed with great care and skill.

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17-2. What are the essential differences among working capital loans, open credit lines, assetbased loans, term loans, revolving credit lines, interim financing, project loans, and acquisition
loans?
a.
Working capital loans are short-run credits to fund the current assets of a business, such
as accounts receivable, inventories, or to replenish cash. Usually a working capital loan is
designed to cover seasonal peaks in a business customer’s production levels.
Normally, working capital loans are secured by accounts receivable or by pledges of inventory
and carry a floating interest rate on the amounts actually borrowed against the approved credit
line.
b.
Open credit lines include a credit agreement allowing a business to borrow up to a
specified maximum amount of credit at any time until the point in time when the credit line
expires.
c.
Asset-based loans are secured on the basis of the shorter-term assets of a firm that are
expected to roll over into cash in the future. Generally, the amount and timing of the credit is

based directly upon the value, condition, and maturity of certain assets held by a business firm
(such as accounts receivable or inventory) and those assets are usually pledged as collateral
behind the loan.
d.
Term loans are business credit that have an original maturity of more than one year and
are normally used to fund the purchase of new plant and equipment or to provide for a permanent
increase in working capital. Term loans usually look to the flow of future earnings of a business
firm to amortize and retire the credit. Term loans normally are secured by fixed assets (e.g., plant
or equipment) owned by the borrower and may carry either a fixed or a floating interest rate.
e.
Revolving credit lines are lines of credit that promise the business borrower access to any
amount of borrowed funds up to a specified maximum amount; moreover, the customer may
borrow, repay, and borrow again any number of times until the credit line reaches its maturity
date. It is one of the most flexible of all business loans, and is often granted without specific
collateral and may be short-term or cover a period as long as five years
f.
Interim construction financing involves bank funding to start construction or to complete
construction of a business project in the form of a short-term loan; once the project is completed,
long-term funding will normally pay off and replace the interim financing.
g.
Project loans are basically given to support the startup of a new business project, such as
the construction of an offshore drilling platform or the installation of a new warehouse or
assembly line; often such loans are secured by the property or equipment that are part of the new
project.

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h.
Acquisition loans are made to finance mergers and acquisitions of businesses. Among the
most noteworthy of these acquisition credits are leveraged buyouts of firms by small groups of
investors.
17-3. What aspects of a business firm's financial statements do loan officers and credit analysts
examine carefully?
Analysis of the financial statements of a business borrower typically begins when the lender’s
credit analysis department analyses how key figures on the borrower’s financial statement have
changed (usually during the last three, four, or five years.) The percentage-composition ratios
reflected in such financial statements, control for differences in size of firm, permitting the loan
officer to compare a particular business customer with other firms and with the industry as a
whole. With the help of these ratios, the loan officers and credit analysts examine the following
aspects of a business firm's financial statements:
a.
Control over expenses: A business firm’s management keeps a check on its quality by
analyzing how carefully it controls its expenses and how well its earnings are likely to be
protected and grow.
Key financial ratios to monitor a firm’s expense control program include, cost of goods sold/net
sales; selling, administrative and other expenses/net sales; wages and salaries/net sales; interest
expenses on borrowed funds/net sales; overhead expenses/net sales; depreciation expenses/net
sales, and taxes/net sales.
b.
Operating efficiency: It is also important to look at how effectively are assets being
utilized to generate sales and how efficiently are sales converted into cash.
The important ratios here are, net sales/total assets, annual cost of goods sold/average inventory
levels, net sales/net fixed assets, and net sales/accounts and notes receivable.
c.
Marketability of a product or service: A financial lender can often assess public
acceptance of what the business customer has to sell by analyzing such factors as the growth rate
of sales revenues, changes in the business customer’s share of the available market, and the gross

profit margin (GPM) These key factors can be found by computing the following ratios:
To measure the gross profit margin the manager has to divide the difference of net sales and cost
of goods sold with the net sales. Also, the net profit margin can be found by dividing net income
after taxes to net sales.
d.
Coverage Ratio: The coverage ratio measures the adequacy of earnings to know whether
the borrower will be able to pay back the loan.
Important measures here include interest coverage which can be computed by dividing the
income before interest and taxes by total interest payments, coverage of interest and principal
payments can be found by dividing earnings before interest and taxes by the sum of annual
interest payments and principal repayments adjusted for the tax effect. Also, the coverage of all

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fixed payments can be found by dividing income before interest, taxes and lease payments by the
sum of interest payments and lease payments.
e.
Profitability indicators: The ideal standard of performance in a market-oriented economy
is how much net income remains for the owners of a business firm after all expenses are charged
against revenue.
Key barometers of such financial success include the following ratios
Before-tax net income/total assets, net worth, or total sales,
After-tax net income/total assets (or ROA)
After-tax net income/net worth (or ROE)
After-tax net income/total sales (or ROS)
f.
Liquidity indicators: It reflects the borrower’s liquidity position so as to raise cash

regularly and at a reasonable cost. The lender mainly looks at the borrower’s ability to meet the
loan payments when they come due.
Important ratio measures here usually include the current ratio (current assets/divided by current
liabilities), acid-test ratio [(current assets – inventory)/ divided by current liabilities)], net liquid
assets (current assets – inventory − current liabilities), and net working capital (current assets −
current liabilities).
g.
Leverage indicators: The term financial leverage refers to use of debt expecting that the
borrower can generate earnings that exceed the cost of debt, thereby increasing potential returns
to a business firm’s owners.
Ratios indicating trends in this dimension of business performance usually include the leverage
ratio (total liabilities/total assets), capitalization ratio (long-term debt/total long-term liabilities
and net worth), and the debt-to-sales ratio (total liabilities/net sales).
One problem with employing ratio measures of business performance is that they only reflect
symptoms of a possible problem but usually don't tell us the nature of the problem or its causes.
Management must look much more deeply into the reasons behind any apparent trend in a ratio.
Moreover, any time the value of a ratio changes that change could be due to a shift in the
numerator of the ratio, in the denominator, or both.
17-4. What aspect of a business firm's operations is reflected in its ratio of cost of goods sold to
net sales? In its ratio of net sales to total assets? In its GPM ratio? In its ratio of income before
interest and taxes to total interest payments? In its acid-test ratio? In its ratio of before-tax net
income to net worth? In its ratio of total liabilities to net sales? What are the principal limitations
of these ratios?
The ratio of cost of goods sold to net sales is a widely used indicator of a business firm's expense
controls. The ratio of net sales to total assets reflects the operating efficiency indicating the
efficiency with which the assets are being utilized to generate sales. The gross profit margin
(GPM) measure reflects the marketability of the customer's products or services. A firm's ratio of

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income before interest expense and taxes to total interest payments indicates how effectively a
business is covering its interest expenses through the generation of before-tax income. The acidtest ratio provides a rough measure of a firm's liquidity position The ratio of before-tax income to
net worth represents a measure of profitability of the business. Finally, the ratio of liabilities to
net sales is an indicator of management's use of financial leverage.
These ratios are affected by changes in the numerator or the denominator or both; a financial or
credit analyst would want to know the source of any change in a ratio's value. These ratios only
measure problem symptoms; you must dig deeper to find the cause.
17-5. What are contingent liabilities, and why might they be important in deciding whether to
approve or disapprove a business loan request?
Contingent liabilities are usually not shown on customer balance sheets. These liabilities can be
in various forms such as pending or possible future obligations like lawsuits against a business
firm, and warranties or guarantees the firm has given to others regarding the quality, safety, or
performance of its product or service. Other forms of contingent liabilities that business firms are
likely to incur are unfunded pension liabilities the firm will owe toward its employees in the
future, taxes owed but unpaid, or limiting regulations. Another example is a credit guarantee in
which the firm may have pledged its assets or credit to back up the borrowings of another
business, such as a subsidiary. Environmental damage caused by a business borrower has also
recently become a great cause of concern of contingent liability for many banks. This is because
a bank foreclosing on business property for nonpayment of a loan could become liable for
cleanup costs, especially if the bank becomes significantly involved with a customer's business
or treats foreclosed property as an investment rather than a repossessed asset that is quickly
liquidated to recover the unpaid balance on a loan.
Loan officers must be aware of all contingent liabilities because any or all of them could become
due and payable claims against the business borrower, weakening the firm's ability to repay its
loan to the bank. Hence, it becomes important for the loan officer to ask the customer about
pending or potential claims against the firm and then follow up with his or her own investigation,
checking government records, public notices, and newspapers.

17-6. What is cash-flow analysis, and what can it tell us about a business borrower’s financial
condition and prospects?
The statement of cash flows shows how cash receipts and disbursements are generated by
operating, investing, and financing activities of a business firm. Such a cash flow statement
indicates the changes in a business firm's assets and liabilities as well as its flow of net profit and
noncash expenses (such as depreciation) over a specific time period. It shows where the firm
raised its operating capital during the time period under examination and how it spent or used
those funds in acquiring assets or paying down liabilities. It also examines all purchases and
sales of securities and long-term assets, such as plant and equipment in the form of investing
activity. The financing activities section of the firm will include cash flows from short- and longterm funds provided by lenders and owners, while cash outflows will include the repayment of
borrowed funds, dividends to owners, and the repurchasing of outstanding stock.

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From the perspective of a loan officer, the cash flow statement indicates whether the firm is
relying heavily upon borrowed funds or on sales of assets. These are two less desirable funding
sources from the point of view of lending money to a business firm as these sources of cash
inflow suggest the company may be exhausting its liquidity and capacity to borrow, casting
doubts regarding its ability to repay future borrowings. Loan officers usually prefer to focus upon
the generation of sufficient cash flows to repay most of its debt and remain viable in the long run.
17-7. What is a pro forma statement of cash flows, and what is its purpose?
A pro forma statement of cash flows is useful not only to look at historical data in a statement of
cash flows, but also to estimate the business borrower’s future cash flows and financial condition
and its ability to repay the loan.
17-8. Should a loan officer ever say “no” to a business firm requesting a loan? Please explain
when and where.
A loan request may not appear of having reasonable prospects for being repaid in the future. The

loan officer can come to this conclusion after noticing the borrowing company’s recent record of
sales revenue, expenses, cash flow, and net earnings. Loan officers will inevitably be confronted
with such loan requests that will have to be flatly rejected, particularly in those cases where the
borrower has falsified information or has a credit history of continually "walking away" from
debt obligations.
In such cases, the loan officer should be as polite as possible, suggesting to the customer what
needs to be changed or improved for the future to permit the customer to be seriously considered
for a loan. The officer can offer to provide noncredit services, such as cash management services,
advice on a proposed merger, or assistance with a new security offering the customer may be
planning. Another possible option is a counteroffer on the proposed loan that is small enough and
secured well enough to adequately protect the lender. Also, the loan rate can be shaped in such a
way that it further protects and compensates the lender for any risks incurred.
17-9. What methods are used to price business loans?
The following methods are in use today to price business loans:
a. Cost-plus loan pricing
b. Price leadership pricing model
c. Below-prime market pricing
d. Customer profitability analysis (CPA)
Cost-plus-profit pricing requires the bank to add the cost of raising adequate funds to lend, the
lender’s nonfunds operating costs, compensation for the degree of default risk inherent in a loan
request, and the desired profit margin.

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The price-leadership model, on the other hand, bases the loan rate upon a uniform national or
international rate (such as prime or LIBOR) posted by major commercial banks. The prime rate
is usually considered to be the lowest rate charged to the most creditworthy customers on shortterm loans. The actual loan rate charged to any particular customer is determined by adding the

default-risk premium and the term-risk premium as a markup over the prime rate. Lending
institutions can expand or contract their loan portfolios simply by contracting or expanding their
loan-rate markups.
The below-prime market pricing prices a loan on the basis of cost of borrowing in the money
market plus a small profit margin. Customer profitability analysis looks at all the revenues and
costs involved in serving a customer and then the bank is required to calculate the net rate of
return from some large corporates covering a loan for only a few days or weeks.
17-10. Suppose a bank estimates that the marginal cost of raising loanable funds to make a $10
million loan to one of its corporate customers is 4 percent, its nonfunds operating costs to
evaluate and offer this loan are 0.5 percent, the default-risk premium on the loan is 0.375
percent, a term-risk premium of 0.625 percent is to be added, and the desired profit margin is
0.25 percent. What loan rate should be quoted to this borrower? How much interest will the
borrower pay in a year?
According to the cost-plus loan pricing model:
Loan interest rate =
Marginal cost of raising loanable funds to lend to the borrower +
Nonfunds operating costs + Estimated margin to compensate for default risk +
Desired profit margin
Loan interest rate = 4 percent + 0.50 percent + 0.375 percent + 0.25 percent = 5.125 percent
Based on a $10 million loan to be raised, the customer will pay interest of: $10,000,000 × 5.125
percent = $512,500.
17-11. What are the principal strengths and weaknesses of the different loan-pricing methods in
use today?
Cost plus pricing is the simplest loan pricing model as it considers the cost of raising loanable
funds and the operating costs of running the lending institution. However, the model assumes
that a lending institution can accurately judge the costs which often don’t turn out to be accurate.
Price leadership overcomes the problems of accurately predicting what the costs of a loan will be
for a lending institution as major commercial banks establish a uniform base lending fee, the
prime rate, Moreover, LIBOR, which is being switched over from prime rates, offer a common
pricing standard for all banks, both foreign and domestic, and give customers a common basis

for comparing the terms on loans offered by different lenders. However, it is still difficult to

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Chapter 17 - Lending to Business Firms and Pricing Business Loans

assign risk premiums to loans as it would differ among borrowers based on the risk that they
carry.
Below prime market pricing uses LIBOR as the base rate and includes only a small profit margin
as part of the loan price. This has been proposed only for short term loans for large, well known
corporations but is not generally used for small and medium sized companies or longer term
loans.
Customer profitability analysis is similar to cost plus pricing. It however differs from the same
technique as in that it considers the whole customer relationship into account when pricing a loan
Customer profitability analysis has become increasingly sophisticated as computer models have
been designed to help with the analysis. Often the borrowing company itself, its subsidiary firms,
major stockholders, and top management are all consolidated into one profitability analysis
statement so that the lender receives a comprehensive picture of the total customer relationship.
Automated CPA systems permit lenders to plug in alternative loan and deposit pricing schedules
to see which pricing schedule works best for both customer and lending institution. CPA can also
be used to identify the most profitable types of customers and loans and the most successful loan
officers.
17-12. What is customer profitability analysis? What are its advantages for the borrowing
customer and the lender?
Customer profitability analysis is a loan pricing method that takes into account the lender’s entire
relationship (all revenues and expenses associated with a particular customer) with the customer
when pricing the loan. It is based on the difference between revenues from loans and other
services provided and expenses from providing loans and other services to the customer is taken
over net loanable funds. Net loanable funds are those funds used in excess of the customer’s

deposits. If the calculated net rate of return from a customer’s relationship is positive the loan is
made and if it is not, the rate is raised or the loan is not made.
As CPA takes the entire relationship of the borrowing company itself, its subsidiary firms, major
stockholders, and top management into account, it gives a better picture of which customer
relationships are profitable to the lender.
Problems and Projects
17-1.
a.
b.
c.
d.
e.

From the descriptions below please identify what type of business loan is involved.
A temporary credit supports construction of homes, apartments, office buildings, and
other permanent structures.
A loan is made to an automobile dealer to support the shipment of new cars.
Credit extended on the basis of a business’s accounts receivable.
The term of an inventory loan is being set to match the length of time needed to generate
cash to repay the loan.
Credit extended up to one year to purchase raw materials and cover a seasonal need for
cash.

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f.
g.

h.
i.
j.

A securities dealer requires credit to add new government bonds to his securities
portfolio.
Credit granted for more than a year to support purchases of plant and equipment.
A group of investors wishes to take over a firm using mainly debt financing.
A business firm receives a three-year line of credit against which it can borrow, repay,
and borrow again if necessary during the loan’s term.
Credit extended to support the construction of a toll road.

Based upon the descriptions given in the text the type of business loan being discussed is:
a.
b.
c.
d.
e.
f.
g.
h.
i.
j.

Interim construction financing
Retailer and equipment financing
Asset-based financing
Self-liquidating inventory loan
Working capital loan
Security dealer financing

Term business loan
Acquisition loan or leveraged buyout
Revolving credit financing
Long-term project loan

17-2. As a new credit trainee for Evergreen National Bank, you have been asked to evaluate the
financial position of Hamilton Steel Castings, which has asked for renewal of and an increase in
its six-month credit line. Hamilton now requests a $7 million credit line, and you must draft your
first credit opinion for a senior credit analyst. Unfortunately, Hamilton just changed
management, and its financial report for the last six months was not only late but also garbled.
As best as you can tell, its sales, assets, operating expenses, and liabilities for the six-month
period just concluded display the following patterns:
Millions of Dollars
Net sales
Cost of goods sold
Selling, administrative,
and other expenses
Depreciation
Interest cost on
borrowed funds
Expected tax obligation
Total assets
Current assets
Net fixed assets
Current liabilities
Total liabilities

January February
$48.1
$47.3

27.8
28.1

March
$45.2
27.4

April
$43.0
26.9

May
$43.9
27.3

June
$39.7
26.6

19.2
3.1

18.9
3.0

17.6
3.0

16.5
2.9

16.7
3.0

15.3
2.8

2.0
1.3
24.5
6.4
17.2
4.7
15.9

2.2
1.0
24.3
6.1
17.4
5.2
16.1

2.3
0.7
23.8
5.5
17.5
5.6
16.4

2.3
0.9
23.7
5.4
17.6
5.9
16.5

2.5
0.7
23.2
5.0
18.0
5.8
17.1

2.7
0.4
22.9
4.8
18.0
6.4
17.2

Hamilton has a 16-year relationship with the bank and has routinely received and paid off a
credit line of $4 million to $5 million. The department’s senior analyst tells you to prepare

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Chapter 17 - Lending to Business Firms and Pricing Business Loans

because you will be asked for your opinion of this loan request (though you have been led to
believe the loan will be approved anyway, because Hamilton’s president serves on Evergreen’s
board of directors).
What will you recommend if asked? Is there any reason to question the latest data
supplied by this customer? If this loan request is granted, what do you think the customer will do
with the funds?
The figures given in the case as well as the supporting background information suggest several
developing problems. Hamilton has had a recent shakeup in its senior management, which
usually leads to loss in control of the firm until the new management gains sufficient experience.
Among the obvious problems are decline in sales (from $48.1 million to $39.7 million) in the
past six months. Hamilton's cost of goods sold dropped but by less than the decline in sales,
thereby squeezing the firm's margin and net income. We can also note that the firm, probably
faced with declining cash flows, has been forced to rely more heavily on borrowings which will
mean that the bank's position will be less secure. Current assets have also declined while current
liabilities are on the rise, thus reducing the firm's net liquidity position. The bank's relationship
with Hamilton needs to be reviewed carefully with an eye to gaining additional collateral or
reducing the bank's total credit commitment to the firm.
Additional information that would be desirable and helpful, if not essential, should include:
1) Past financial statements for the last two or three years, preferably on a monthly basis. This
could help us verify seasonality and improvement.
2) Industry outlook for the next six to eighteen months would also help in reinforcing Hamilton's
ability to service the debt from the summer and fall cash flows.
3) Additionally, information about the company's suppliers, other creditors, customers, and
competitors would be helpful.
4) Also, more information about other relationships that Hamilton has with Evergreen would
certainly be helpful.
In summary, the more information we have, the better our analysis and subsequent decisions will

be.
17-3. From the data given in the following table, please construct as many of the financial ratios
discussed in this chapter as you can and then indicate what dimension of a business firm’s
performance each ratio represents.
Business Assets
Cash account
Accounts receivable
Inventories
Fixed assets
Miscellaneous assets

$60
155
128
286
96

Annual Revenue and Expense Items
Net sales
$600
Cost of goods sold
445
Wages and salaries
52
Interest expense
28
Overhead expenses
29

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Liabilities and Equity
Short-term debt:
Accounts payable
Notes payable
Long-term debt (bonds)
Equity capital

725 Depreciation expenses
Selling, administrative,
and other expenses
108 Before-tax net income
117* Taxes owed
325* After-tax net income
15
160
725

*Annual principal payments on bonds and notes payable total $55. The firm’s marginal tax rate is 35 percent.

The financial ratios that could be computed given the data in this problem are the following:
A.

Expense Control Ratios:

Cost of goods sold $445
=

= 74.17 percent
Net sales
$600
Wages and salaries $52
=
= 8.67 percent
Net sales
$600
Interest expense $28
=
= 4.67 percent
Net sales
$600
Overhead expenses $29
=
= 4.83percent
Net sales
$600
Depreciation expenses $12
=
= 2.00 percent
Net sales
$600
Selling, administrative, and other expenses expenses $28
=
= 4.67 percent
Net sales
$600
Taxes owed
$1

=
= 0.17 percent
Net sales
$600
B.

Operating Efficiency: Measure of a Business Firm’s Performance Effectiveness

Annual cost of goods sold $445
=
= 3.48x
Average inventory
$128
Net sales
$600
=
= 2.10x
Net fixed assets $286

17-12

12
28
6
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Chapter 17 - Lending to Business Firms and Pricing Business Loans

Net sales
$600
=
= 0.83x
Total assets $725
Net sales
$600
=
= 3.87x
Accounts and notes receivable $155
Average collection period =

C.

(

Accounts receivable
$155
=
= 93 days
Annual credit sales
$600
360
360

) (

)

Marketability of the Customer’s Product or Service:

GPM =

Net sales - Cost of goods sold $600 -$445
=
= 25.83 percent
Net sales
$600

NPM =

Net income after taxes $5
=
= 0.83 percent
Net sales
$600

D.

Coverage Ratios: Measuring the Adequacy of Earnings

Interest coverage =

Income before interest and taxes $34
=
=1.214x
Interest payments
$28

Coverage of interest and principal payments =

=

E.

Income before interest and taxes
$34
=
= 0.411x
Principal repayments
$55
Interest payments +
$28 +
1- Firm's marginal tax rate
(1-35 percent)
Liquidity indicators for business customers:

Current ratio =

Current assets
$343
=
=1.52x
Current liabilities $225

Acid-test ratio =

Current assets - Inventory $343-$128
=
= 0.96 x

Current liabilities
$225

Net liquid assets = Current assets - Inventory - Current liabilities = $343-$128-$225 = -$10 million
Net working capital = Current assets - Current liabilities = $343 -$225 = $118 million
F.

Profitability indicators for business customers:

17-13


Chapter 17 - Lending to Business Firms and Pricing Business Loans

Before-tax net income
$6
=
= 0.83percent
Total assets
$725
After-tax net income
$5
=
= 0.69 percent
Total assets
$725
Before-tax net income
$6
=
= 3.75 percent

Net worth
$160
After-tax net income
$5
=
= 3.13percent
Net worth
$160
G.

The Financial leverage factor:

Leverage ratio =

Total liabilities $565
=
= 77.9 percent
Total assets
$725

Capitalization ratio =

Debt-to-sales ratio =

Long-term debt
$325
=
= 65 percent
Total long-term liabilities and net worth $500

Total liabilities $565
=
= 94.17 percent
Net sales
$600

17-4. Grape Corporation has placed a term loan request with its lender and submitted the
following balance sheet entries for the year just concluded and the pro forma balance sheet
expected by the end of the current year. Construct a pro forma Statement of Cash Flows for the
current year using the consecutive balance sheets and some additional needed information. The
forecast net income for the current year is $210 million with $50 million being paid out in
dividends. The depreciation expense for the year will be $100 million and planned expansions
will require the acquisition of $300 million in fixed assets at the end of the current year. As you
examine the pro forma Statement of Cash Flows, do you detect any changes that might be of
concern either to the lender’s credit analyst, loan officer, or both?

Cash
Accounts
receivable

Assets
at the
End of
the Most
Recent
Year
$ 532
1,018

Grape Corporation

(all amounts in millions of dollars
Assets
Liabilities and Liabilities and
Projected
Equity at the
Equity
for the End
End of the
Projected for
of the
Most Recent the End of the
Current
Year
Current Year
Year
$ 600
Accounts payable
$ 970
$1,069
1,210
Notes payable
2,733
2,930

17-14


Chapter 17 - Lending to Business Firms and Pricing Business Loans

Inventories

Net fixed
assets
Other assets

894
2,740

973
2,940

66

87

Total assets

$5,250

$5,810

Taxes payable
Long-term debt
obligations
Common stock
Undivided profits
Total liabilities and
equity capital

327
872

216
1,072

85
263
$5,250

85
473
$5,810

The Sources and Uses of Funds Statement for Grape Corporation would appear as follows:
Cash Flows from Operations
Net income
Add: depreciation
Less:
increase in accounts receivable
increase in inventories
increase in other assets
Add: increase in accounts payable
Less: decrease in tax payable
Net cash flow from operations

$210
$100
($192)
($79)
($21)
$99

($111)
$6

Cash Flows from Investment Activities
Acquisition of fixed assets
Net cash flow from investment activities

($300)
($300)

Cash Flows from Financing Activities
Increase in notes payable
Increase in long-term debt
Less: dividends paid
Net Cash Flows from Financing Activities

$197
$200
($50)
$347

Increase (Decrease) in Cash

$53

There are several areas of possible concern for a bank loan officer viewing Grape's projected
figures. First, the firm is relying heavily upon increasing debt of all kinds to finance its growth in
assets. The increase in notes payable of $197 million indicates a growing reliance on bank debt
supplemented by sizable increases in supplier-provided credit (accounts payable) and long-term
debt obligations (most likely, bonds) with no change in funds provided by issuing stock. The

bank could experience a serious weakening in the strength of its claim against the firm as other
creditors post a more substantial claim against assets.
Grape is projecting a sizable increase in its retained earnings (undivided profits) which suggests
that management is counting on a year of strong earnings. However, both accounts receivable

17-15


Chapter 17 - Lending to Business Firms and Pricing Business Loans

and inventories (as well as net fixed assets) are growing rapidly, perhaps reflecting troubles in
collecting from the firm's customers and in marketing products and services. The bank's loan
officer would want to explore with the company the bases for its projected jump in net income
and why accounts receivable and inventories are expected to rise in such large amounts.
17-5 Blue Jay Corporation is a new business client for First Commerce National Bank and has
asked for a one-year, $10 million loan at an annual interest rate of 6 percent. The company plans
to keep a 2.75 percent, $3 million CD with the bank for the loan’s duration. The loan officer in
charge of the case recommends at least a 4 percent annual before-tax rate of return over all costs.
Using customer profitability analysis (CPA), the loan committee hopes to estimate the following
revenues and expenses which it will project using the amount of the loan requested as a base for
the calculations:
Estimated Revenues
Interest income from loan?
Loan commitment fee (0.75%)?
Cash management fees (3%)? (on an
annual average of $15 million)

Estimated Expenses
Interest to be paid on customer’s $3 million deposit?
Expected cost of additional funds needed to support

the loan (4%)?
Labor costs and other operating expenses associated
with monitoring the customer’s loan (2%)?
Cost of processing the loan (1.5%)?

a. Should this loan be approved on the basis of the suggested terms?
b. What adjustments could be made to improve this loan’s projected return?
c. How might competition from other prospective lenders impact the adjustments you have
recommended?
Estimated revenues:
Interest income from loan
Loan commitment fee
Cash management fee
Total revenues

$10,000,000 × 6.00% =
$10,000,000 × 0.75% =
$15,000,000 × 3.00% =

$600,000
$75,000
$450,000
$1,125,000

Estimated expenses:
Interest on deposit
Expected cost of additional funds
Labor costs and other operating costs
Costs of processing the loan
Total expenses

$3,000,000 × 2.75% =
$10,000,000 × 4.00% =
$10,000,000 × 2.00% =
$10,000,000 × 1.50% =

$82,500
$400,000
$200,000
$150,000
$832,500

Net amount of the bank’s reserves expected to be
drawn
Average amount of credit committed to customer
Less: Average customer deposit balances
Net amount of loanable reserves supplied to customer

17-16

$10,000,000
$3,000,000
$7,000,000


Chapter 17 - Lending to Business Firms and Pricing Business Loans

Before-tax rate of return over costs from the entire lender-customer relationship =
Revenues expected - Costs expected
Net amount of all loanable funds supplied customer

=

$1,125,000 -$832,500
= 4.18 percent.
$7,000,000

a. Yes, it should be approved because the bank is earning more than its expenses and the net rate
of return from the entire lender–customer relationship is positive.
b. The fees that are charged could be made higher and the lender could try and find a way to
reduce the expenses on the loan. Both of these would have the effect of increasing the rate of
return on the loan.
c. In particular, it would be difficult to raise fees for this customer if they can get these same
services from other lenders more cheaply. It would not necessarily cause a direct impact on
expenses but other lenders might already be more efficient in providing these services and they
may already be charging a lower interest rate on this loan based on the customer profitability
analysis.
17-6. As a loan officer for Allium National Bank, you have been responsible for the bank’s
relationship with USF Corporation, a major producer of remote-control devices for activating
television sets, DVDs, and other audio-video equipment. USF has just filed a request for renewal
of its $10 million line of credit, which will cover approximately six months. USF also regularly
uses several other services sold by the bank. Applying customer profitability analysis (CPA) and
using the most recent year as a guide, you estimate that the expected revenues from this
commercial loan customer and the expected costs of serving this customer will consist of the
following:
Expected Revenues
Interest income from the requested loan
(assuming annualized loan rate of 4%)
Loan commitment fee (1%)
Deposit management fees
Wire transfer fees

Fees for agency services

—?
100,000
4,500
3,500
4,500

Expected Costs
Interest paid on customer
deposits (2.50%)
Cost of other funds raised
Account activity costs
Wire transfer costs
Loan processing costs
Recordkeeping costs

—?
180,000
5,000
1,300
12,400
4,500

The bank’s credit analysts have estimated the customer probably will keep an average deposit
balance of $2,125,000 for the period the line is active. What is the expected net rate of return
from this proposed loan renewal if the customer actually draws down the full amount of the
requested line for six months? What decision should the bank make under the foregoing
assumptions? If you decide to turn down this request, under what assumptions regarding
revenues, expenses, and customer deposit balances would you be willing to make this loan?

17-17


Chapter 17 - Lending to Business Firms and Pricing Business Loans

The expected revenues and costs from continuing the present relationship between Allium
National Bank and USF Corporation were given in this problem and the reader is asked to
estimate the expected net rate of return if the bank renews its loan to USF.
The total of expected revenues and expected costs is:
Expected revenues
Interest revenue
Loan commitment fees
Deposit service
(maintenance) fees
Wire transfer fees
Agency fees
Total expected revenues

Expected Costs
$200,000
100,000
4,500
3,500
4,500
$312,500

Deposit interest
Cost of other funds raised
Wire transfer costs

Loan processing costs
Record keeping expenses
Account activity cost
Total expected costs

Net amount of the bank’s reserves expected to be drawn
Average amount of credit committed to customer
Less: Average customer deposit balances
Net amount of loanable reserves supplied to customer

$26,563
180,000
1,300
12,400
4,500
5,000
$229,763

$10,000,000
$2,125,000
$7,875,000

Before-tax rate of return over costs from the entire lender-customer relationship =
Revenues expected - Costs expected
Net amount of all loanable funds supplied customer
=

$312,500 -$229,763
=1.05 percent
$7,875,000

The estimated net rate of return is positive but very negligible, hence the loan can be accepted
but after much consideration.
If we decide to turn down the loan, an initial reaction might be to increase loan revenues by
raising the interest rate on the loan or increasing the loan commitment fee. Depending on the
customer's relationship with the bank and with other banks, this may prove to be extremely
difficult. Initially, it was assumed that the customer would draw down the entire line of credit,
that is, borrow the full $10,000,000. If the customer were to borrow less than the full amount, the
cost of funds raised to support this loan could be reduced, increasing the net revenue from the
loan. Relative to expenses, it would be more likely that some adjustment in the expenses
associated with the relationship would be more appropriate. For example, a careful examination
of the relationship activities could allow for a revision of estimated costs incurred by the bank to
manage the various aspects of the relationship.

17-18


Chapter 17 - Lending to Business Firms and Pricing Business Loans

17-7. In order to help fund a loan request of $10 million for one year from one of its best
customers, Lone Star Bank sold negotiable CDs to its business customers in the amount of $6
million at a promised annual yield of 2.75 percent and borrowed $4 million in the Federal funds
market from other banks at today’s prevailing interest rate of 2.80 percent.
Credit investigation and recordkeeping costs to process this loan application were an
estimated $25,000. The Credit Analysis Division recommends a minimal 1 percent risk premium
on this loan and a minimal profit margin of one-fourth of a percentage point. The bank prefers
using cost-plus loan pricing in these cases. What loan rate should it charge?
Lone Star Bank has sold negotiable CDs in the amount of $6 million at a yield of 2.75 percent
and purchased $4 million in Federal funds at a rate of 2.80 percent. The weighted average cost of
bank funds in this case would be:

We can find the interest cost of funding a $10 million loan as follows:
Sale of negotiable CDs cost $165,000 ($6,000,000 × 2.75 percent) to the bank. Whereas, the
funds borrowed from Federal funds cost $112,000 ($4,000,000 × 2.80 percent).
Hence, the total interest cost of $277,000 is to be borne by the bank. On a $10 million loan, t
average annual interest cost is 2.77 percent ($277,000 ÷ $10,000,000).
The bank incurs a noninterest cost 0.25 percent ($25,000 ÷ $10,000,000) to process this loan
application. The bank considers a risk premium one percent and a 0.25 percent minimal profit
margin.
Based on the cost-plus loan pricing model:
Loan interest rate =
Marginal cost of raising loanable funds to lend to the borrower +
Nonfunds operating costs + Estimated margin to compensate for default risk +
Desired profit margin
Loan interest rate = 2.77 percent + 0.25 percent + 1 percent + 0.25 percent = 4.27 percent
17-8. Many loans to corporations are quoted today at small risk premiums and profit margins
over the London Interbank Offered rate (LIBOR). Englewood Bank has a $25 million loan
request for working capital to fund accounts receivable and inventory from one of its largest
customers, APEX Exports. The bank offers its customer a floating-rate loan for 90 days with an
interest rate equal to LIBOR on 30-day Eurodeposits (currently trading at a rate of 4 percent)
plus a one-quarter percentage point markup over LIBOR. APEX, however, wants the loan at a
rate of 1.014 times LIBOR. If the bank agrees to this loan request, what interest rate will attach
to the loan if it is made today? How does this compare with the loan rate the bank wanted to
charge? What does this customer’s request reveal about the borrowing firm’s interest rate
forecast for the next 90 days?

17-19


Chapter 17 - Lending to Business Firms and Pricing Business Loans

At today’s prevailing LIBOR rate the customer's requested loan-rate formula would generate a
loan interest rate of 1.014 × 4.0 percent = 4.056 percent. However, the bank wanted to charge a
rate of 4.0 percent + 0.25 percent = 4.25 percent.
Loan rates tend to move up and down faster with the customer's loan-rate formula than with the
bank's formula. This customer appears to believe interest rates will decline in a period of 90 days
and hence pulls the loan rate lower.
17-9. Five weeks ago, Robin Corporation borrowed from the commercial finance company that
employs you as a loan officer. At that time, the decision was made (at your personal urging) to
base the loan rate on below-prime market pricing, using the average weekly Federal funds
interest rate as the money market borrowing cost. The loan was quoted to Robin at the Federal
funds rate plus a three-eighths percentage point markup for risk and profit.
Today, this five-week loan is due, and Robin is asking for renewal at money market
borrowing cost plus one-fourth of a point. You must assess whether the finance company did as
well on this account using the Federal funds rate as the index of borrowing cost as it would have
done by quoting Robin the prevailing CD rate, the commercial paper rate, the Eurodollar deposit
rate, or possibly the prevailing rate on U.S. Treasury bills plus a small margin for risk and
probability. To assess what would have happened (and might happen over the next five weeks if
the loan is renewed at a small margin over any of the money market rates listed below), you have
assembled these data from the Federal Reserve Statistical Release H15.
What conclusion do you draw from studying the behavior of these common money
market base rates for business loans? Should the Robin loan be renewed as
Weekly Averages of Money Market Rates over the Most Recent 5 Weeks
Money Market Interest Rates
Week 1
Week 2 Week 3 Week 4
Week 5
(1 week ago)
(5 weeks ago)
Federal funds
1.99%

2.04%
1.98%
2.06%
2.02%
Commercial paper
2.13
2.17
2.17
2.20
2.05
(one-month maturity)
CDs (one-month maturity)
2.47
2.58
2.52
2.53
2.43
Eurodollar deposits (three-month
3.00
3.00
3.00
3.10
2.85
maturity)
U.S. Treasury bills
1.84
1.87
1.85
2.04
1.86

(three-month, secondary market)
requested, or should the lender press for a different loan pricing arrangement? Please explain
your reasoning. If you conclude that a change is needed, how would you explain the necessity for
this change to the customer?
Robin Corporation was quoted a loan rate equal to the prevailing federal funds interest rate plus
3/8 of a percentage point (or 0.375 percent). On comparing the Federal funds rate with the
borrowing cost of quoting Robin the prevailing CD rate, the commercial paper rate, the
Eurodollar deposit rate, or possibly the prevailing rate on U.S. Treasury bills plus the margin of
0.375 percent charged for risk and profitability, we find the following trend:

17-20


Chapter 17 - Lending to Business Firms and Pricing Business Loans

Loan granted at Fed rate
Commercial paper
CDs (one-month maturity)
Eurodollar deposits
US Treasury

Week 1
2.3650%
2.505%
2.845%
3.375%
2.215%

Week 2
2.415%

2.545%
2.955%
3.375%
2.245%

Week 3
2.355%
2.545%
2.895%
3.375%
2.225%

Week 4
2.435%
2.575%
2.905%
3.475%
2.415%

Week 5
2.395%
2.425%
2.805%
3.225%
2.235%

Robin wants the loan renewed at money-market borrowing cost plus 0.25 percent. If the base rate
is set at the federal funds rate, the loan rate as requested by Robin would be:
Fed Funds
Margin

Loan Rate

Week 1
1.99%
0.25%
2.24%

Week 2
2.04%
0.25%
2.29%

Week 3
1.98%
0.25%
2.23%

Week 4
2.06%
0.25%
2.31%

Week 5
2.02%
0.25%
2.27%

If the interest rates fall over the period examined, it may result in lower loan revenues for the
bank. Hence, the bank would be better off offering its customers a fixed interest rate over the
next five weeks.

17-10. Eagle Corporation has posted an average deposit balance this past month of $325,000.
Float included in this one-month average balance has been estimated at $50,000. Required legal
reserves are 3 percent of net collected funds. What is the amount of net investable (usable) funds
available to the bank holding the deposit?
Suppose Eagle’s bank agrees to give the firm credit for an annual interest return of 2.25
percent on the net investable funds the company provides the bank. Measured in total dollars,
how much of an earnings credit from the bank will Eagle earn?
Net investable (usable) funds for the lender =
Customer average deposit balance - Average amount of float in the account -

( Required legal reserves behind the deposit× Net amount of collected funds in the account )
Net investable funds = $325,000 – $50,000 – (3 percent × $275,000) = $266,750.
Amount of earnings credited to the customer =
Annual earnings rate×Fraction of the year funds are available from the deposit×
Net investable (usable) funds
Earnings credit = 2.25 percent × 1/12 × $266,750= $500.16.

17-21