Tutorial chapter 11
1. Suppose the estimated linear probability model is PD = 0.3X1 + 0.2X2 - .05X3 + error,
where X1 = 0.75 is the borrower's debt/equity ratio; X2 = 0.25 is the volatility of
borrower earnings; and X3 = 0.10 is the borrower’s profit ratio.
a. What is the projected probability of default for the borrower?
PD = 0.3(.75) + 0.2(.25) - 0.05(.10) = 0.27
b. What is the projected probability of repayment if the debt/equity ratio is 2.5?
PD = 0.3(2.5) + 0.2(.25) - 0.05(.10) = 0.795
The expected probability of repayment is 1 - 0.795 = 0.205.
c. What is a major weakness of the linear probability model?
A major weakness of this model is that the estimated probabilities can be below 0 or
above 1.0, an occurrence that does not make economic or statistical sense.
2. MNO, Inc., a publicly traded manufacturing firm in the United States, has provided
the following financial information in its application for a loan.
Assets Liabilities and Equity
Cash $ 20 Accounts Payable $ 30
Accounts Receivables $ 90 Notes Payable $ 90
Inventory $ 90 Accruals $ 30
Long Term Debt $150
Plant and equipment $500 Equity $400
Total Assets $700 Total Liabilities & Equity $700
Also assume sales = $500, cost of goods sold = $360, taxes = $56, interest
payments = $40, net income = $44, the dividend payout ratio is 50 percent, and the
market value of equity is equal to the book value.
X1 =( (20+90+90)-30-90-30)/700=50/700=7.14 %
X2 = RE/total assets = (44*50%)/700= 3.14%
X3= EBIT/total assets = 140/700 = 0.2
X4= MVe/Long term debt = 400/150=2.67
X5 = Sales / total assets = 500/700= 0.7143
Z score =1.2*7.14%+1.4*3.14%+3.3*20%+0.6*2.67+1*71.43% = 3.1
a. What is the ltman discriminant function value for MNO, Inc.? Recall that:
Net working capital = Current assets minus current liabilities.
Current assets = Cash + accounts receivable + inventories.
Current liabilities = Accounts payable + accruals + notes payable.
EBIT = Revenues - Cost of goods sold - depreciation.
Taxes = (EBIT - Interest)(tax rate).
Net income = EBIT - interest - taxes.
Retained earnings = Net income (1 - dividend payout ratio)
Altman’s discriminant function is given by: Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 +
1.0X5
Assume prior retained earnings are zero.
X1 = (200 -30 -30 -90)/ 700 = .0714 X1 = Working capital/total assets (TA)
X2 = 22 / 700 = .0314 X2 = Retained earnings/TA
X3 = 140 / 700 = .20 X3 = EBIT/TA
X4 = 400 / 150 = 2.67 X4 = Market value of equity/long term
debt
X5 = 500 / 700 = .7143 X5 = Sales/TA
Z = 1.2(0.07) + 1.4(0.03) + 3.3(0.20) + 0.6(2.67) + 1.0(0.71) = 3.104
= .0857 + .044 + .66 + 1.6 + .7143 = 3.104
3. Metrobank offers one-year loans with a 9 percent stated or base rate, charges a 0.25
percent loan origination fee, imposes a 10 percent compensating balance
requirement, and must pay a 6 percent reserve requirement to the Federal Reserve.
The loans typically are repaid at maturity.
a. If the risk premium for a given customer is 2.5 percent, what is the simple
promised interest return on the loan?
The simple promised interest return on the loan is BR + m = 0.09 + 0.025 = 0.115
or 11.5 percent.
b. What is the contractually promised gross return on the loan per dollar lent?
K = 1+ (11.5% +0.25%)/(1-(0.1(1-0.06)) -1 = 0.1175/0.906 = 12.969%
4. If the rate of one-year T-Bills currently is 6 percent, what is the repayment
probability for each of the following two securities? Assume that if the loan is
defaulted, no payments are expected. What is the market-determined risk premium
for the corresponding probability of default for each security?
a. One-year AA rated bond yielding 9.5 percent?
Probability of repayment = p = (1 + I)/(1 + k)
For an AA-rated bond = (1 + .06)/ (1 + .095) = 0.968, or 96.8 percent
The market determined risk premium is 0.095 – 0.060 = 0.035 or 3.5 percent
b. One-year BB rated bond yielding 13.5 percent?
Probability of repayment = p = (1 + I)/(1 + k)
For BB-rated bond = (1 + .06)/(1 + .135) = 93.39 percent
The market determined risk premium is 0.135 – 0.060 = 0.075 or 7.5 percent
5. A bank has made a loan charging a base lending rate of 10 percent. It expects a
probability of default of 5 percent. If the loan is defaulted, it expects to recover 50
percent of its money through the sale of its collateral. What is the expected return
on this loan?
E(r) = p(1 + k) + (1 - p)(1 + k)( ) where is the percentage generated when the loan is
defaulted. E(r) = .95(1 + .10) + .05(1 + .10)(.50) = 1.0450 + .0275 = 1.0725 - 1.0 =
7.25%
6. Assume a one-year T-Bill is currently yielding 5.5 percent, and a AAA-rated
discount bond with similar maturity is yielding 8.5 percent.
a. If the expected recovery from collateral in the event of default is 50 percent of
principal and interest, what is the probability of repayment of the AAA-rated
bond? What is the probability of default?
p(1 + k) + (1 - p)(1 + k) = 1+I. Solve for the probability of repayment (p):
Therefore the probability of default is 1.0 - .9447 = 0.0553 or 5.53 percent.
b. What is the probability of repayment of the AAA-rated bond if the expected
recovery from collateral in the case of default is 94.47 percent of principal and
interest? What is the probability of default?
P=(1.055/1.085-0.9447)/(1-0.9447)=50% of default probability
Therefore the probability of default is 1.0 – 0.5000 = 0.5000 or 50.00 percent.
c. What is the relationship between the probability of default and the proportion of
principal and interest that may be recovered in the case of default on the loan?
The proportion of the loan’s principal and interest that is collectible on default is a
perfect substitute for the probability of repayment should such defaults occur.
