Solve Class on Chapter-17: Lending to Business Firms and Pricing Business Loans
(Source: Bank Management and Financial Services, 8th Edition)
[Question_3: Home Work] See Section 17-7 for similar Problem:
[Question_4: Home Work]: See Section 17-11 for similar Problem:
5. Finch 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
4.25 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: Estimated Expenses:
Interest income from loan? Interest to be paid on customer’s $3 million deposit?
Loan commitment fee (0.75%)? Expected cost of additional funds needed to support
the loan (4%)?
Cash management fees (3%)? Labor costs and other operating expenses associated
(on an annual average of with monitoring the customer’s loan (2%)?
$15 million) 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?
5. Answer:
(a). To come to a decision whether to lend to Fince Corp. using CPA method, we need to
calculate the Earnings before tax (EBIT).
5. (Figures are in million)
Expected Revenues Amount Estimated expenses Amount
Interest Income from loan 0.6m Interest to be paid on client’s 0.1275m
($10m x 0.06) deposit ($3mx0.0425)
Loan commitment fee 0.075m Expected cost of additional funds 0.28m
(10m x 0.0075) [$(10-3)m x 0.04]
Cash management fees 0.45m Labor costs and other operating 0.20m
(15mx0.03) expenses ($10mx0.02)
1.125m Cost of processing loan 0.15m
($10mx0.015)
Total Estimated Expenses $0.7575m
Earnings before tax rate of return= Expected Revenue – Estimated expenses/net Loanable
funds = $(1.125-0.7575)/($10-3) = $0.3675/$7 = 0.0525 = 5.25%
Yes, since the earnings before tax rate of return is 5.25%, which is higher than the required
benchmark, the First Commerce National Bank can sanction the credit to Fince Corp.
(b). In order to augment the probable return, the First Commerce N. Bank can enhance the
non-obvious revenue sources like loan commitment fees and cash management fees
(although cash management fee is already higher). From the bank’s expenses side, it can
reduce the interest income credited to client’s account for customer’s bank deposits, reduce
the processing and monitoring costs through improved technology or increasing the
efficiency.
©. From the perspective of the market competitions about loan pricing, I believe, it’s always
good to focus on indirect or less-obvious pricing rather than the direct one. Therefore, our
pricing strategies will not have caught the attention of the clients much and can devoid of
the harsh competition from other lenders.
6. As a loan officer for Sun Flower 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 nine 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:
Estimated Revenues: Estimated Costs:
Annual interest income from the Interest paid on customer
requested loan (assuming an deposits (3.5%)
annualyzed loan rate of 4% percent Cost of other funds raised 180,000
for 9 months) Account activity costs 5,000
Loan commitment fee (1%) 100,000 Wire transfer costs 1,300
Deposit management fees 4,500 Loan processing costs 12,400
Wire transfer fees 3,500 Recordkeeping costs 4,500
Fees for agency services 4,500
The bank’s credit analysts have estimated the customer probably will keep an average deposit
balance of $2,125,000 for the year 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 nine 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?
6. Solution: [Please see the solutions on recording of the lecture done through Whiteboard.]
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 3.50 percent and borrowed $4 million in the Federal funds market
(Money market or Overnight Market) from other banks at today’s prevailing interest rate of 3.25
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?
7. Answer:
Given,
Cost of raising the loanable funds = [($6mx0.035)+($4mx0.0325)=$(0.21+ 0.13)m=$0.34m
Operating Cost= $25000= $0.0025m
Required Risk premium or margin for credit risk= 1% = 0.01
Required profit margin= ¼% = 0.0025
We know as per the Cost-plus loan pricing method:
Loan Interest Rate= Marginal cost of raising funds+ Non-fund operating cost + Risk premium
(or margin) for credit/default risk+ desired profit margin
= [$0.34m+ $0.0025m+($10mx0.01)+ ($10mx0.0025)]/$10m
= $0.49m/$10m
=0.049 or 4.9%
The Lone Star Bank should a minimum rate of interest against the loan is 4.9 percentage.
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 Euro deposits (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?
8. Answer:
(a). Since Apex Export prefers a Primex Method. Therefore, Interest rate on loan will be
Loan Interest Rate= 1.014 times LIBOR= 1.014 X 4%= 4.056%
(b). However, if the Eaglewood Bank offers a Prime+ Method, then the interest rates will be:
Loan Interest Rate= LIBOR Rate+¼ Percentage Points= 4%+0.25%=4.25%
The difference between the Primex Method and Prime+ Method is
= 4.25% (-) 4.056% = 0.194%
It means that If the Eaglewood Bank accepts the offer of the Apex Export, the bank has to
reduce the interest rate of the loan by a 0.194% or 1/5 of a percentage point.
(c). additionally, the Apex Exports preference of Primex Method reflects that it predicts that
LIBOR is supposed to fall in the 90-day period.
[Question_9: Home Work]
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 profitability. 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 above), 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 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?
Weekly Averages of Money Market Rates over the Most Recent 5 Weeks
Week 1 Week 2 Week 3 Week 4 Week 5
(1 week ago) (5 week
Money Market Interest Rates
ago)
Federal funds 1.99% 2.04% 1.98% 2.06% 2.02%
Commercial paper
(1-month maturity) 2.13 2.17 2.17 2.20 2.05
CDs (1-month maturity) 2.47 2.58 2.52 2.53 2.43
Eurodollar deposits
(3-month maturity) 3.00 3.00 3.00 3.10 2.85
U.S. Treasury bills
(3-month, secondary market) 1.84 1.87 1.85 2.04 1.86
The End!