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 institutions goals. Key Topics in This Chapter 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 I. Introduction II. Brief History of Business Lending III. Types of Business Loans IV. 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) V. 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 VI. Analyzing Business Loan Applications A. Most Common Sources of Loan Repayment B. Analysis of a Business Borrower's Financial Statements

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VII 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 VIII Comparing a Business Customers performance to the Performance of Its Industry A. Contingent Liabilities B. Environmental Liabilities C. Underfunded Pension Liabilities IX. Preparing Statements of Cash Flows from Business Financial Statements A. Cash Flow Statements B. Pro Forma Statements of Cash Flow and Balance Sheets C. The Loan Officer's Responsibility to the Lending Institution and the Customer X. 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 2. Earnings Credits for Customer Deposits 3. The Future of Customer Profitability Analysis XI. 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 increase the magnitude of potential losses unless the business loan portfolio is managed with great care and skill. 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?

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a. Working Capital Loans -- Loans to fund the current assets of a business, such as accounts receivable, inventories, or to replenish cash. b. Open Credit Lines -- 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 -- Credit secured by the shorter-term assets of a firm that are expected to roll over into cash in the future. Credit whose amount and timing is based directly upon the value, condition, and maturity of certain assets held by a business firm (such as accounts receivable or inventory) with those assets usually being pledged as collateral behind the loan. d. Term Loans -- Business loans that have an original maturity of more than one year and normally are 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. e. Revolving Credit Lines -- 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. f. Interim Financing -- 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 -- Credit to support the start up 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. h. Acquisition Loans--Loans 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?

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Loan officers and credit analysts examine the following aspects of a business firm's financial statements: a. Control Over Expenses? Key ratios here 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? Important ratios here are net sales/total assets, annual cost of goods sold divided by average inventory levels, net sales/net fixed assets and net sales/accounts and notes receivable. c. Marketability of a Product, Service, or Skill? Key ratio measures in this area are the gross profit margin, or net sales less cost of goods sold to net sales, and the net profit margin, or net income after taxes to net sales. d. Coverage? Important measures here include interest coverage (such as income before interest and taxes divided by total interest payments), coverage of interest and principal payments (such as earnings before interest and taxes divided by annual interest payments plus principal payments adjusted for the tax effect), and the coverage of all fixed payments (such as income before interest, taxes and lease payments divided by interest payments plus lease payments). e. Profitability Indicators? Key barometers in this area can include such ratios as before-tax net income divided by total assets, net worth, or sales, and after-tax net income divided by total assets (or ROA), net worth (or ROE), or total sales (or ROS) or profit margin. f. Liquidity Indicators? Important ratio measures here usually include the current ratio (current assets divided by current liabilities), and the acid-test ratio (current assets less inventories divided by current liabilities). g. Leverage indicators? Ratios indicating trends in this dimension of business performance usually include the leverage ratio (total liabilities/total assets or net worth), the capitalization ratio (of long-term debt divided by total long-term liabilities and net worth), and the debt-to-sales ratio (of total liabilities divided by 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.

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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 to 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 and operating efficiency. The ratio of net sales to total assets reflects activity or operating efficiency, while the gross profit margin (GPM) measure reflects the marketability of the customer's products or services. A firm's ratio of 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 acid-test ratio provides a rough measure of a firm's liquidity position, while the ratio of before-tax income to net worth represents a measure of profitability. Finally, the ratio of liabilities to 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 include such pending or possible future obligations as 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. Another example is a credit guaranty 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 also has recently become of great concern as a contingent liability for many banks 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.

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17-6. What is cash-flow analysis, and what can it tell us about a business borrowers financial condition and prospects? A cash flow statement shows 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. From the perspective of a loan officer the cash flow statement indicates whether the firm is relying heavily upon borrowed funds and sales of assets. These are two less desirable funding sources from the point of view of lending money to a business firm. In contrast, loan officers usually prefer to focus upon cash flow whether the firm is generating sufficient cash flow (net income plus noncash expenses) to repay most of its debt. The Statement of Cash Flows shows how cash receipts and disbursements are generated by operating, investing, and financing activities. 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 borrowers 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. Loan officers will inevitably be confronted with some 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. Even in these cases, however, 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. 17-9. What methods are used today to price business loans? The following methods are in use today to price business loans: a. Cost-plus pricing d. Customer Profitability Analysis b. Price leadership pricing model c. Below-prime market pricing Cost-plus-profit pricing requires the bank to estimate the total cost involved in making a loan and then adds to that cost estimate a small margin for profit. The price-leadership model, on the other hand, bases the loan rate upon a national or international rate (such as prime or LIBOR) posted by major banks and then adds a small increment on top for profit or risk.

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The below-prime market 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 requires the bank to calculate the net rate of return from this particular customer. 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 termrisk premium of 0.625 percent is to be added, and the banks desired profit margin is 0.25 percent. What loan rate should be quoted this borrower? How much interest will the borrower pay in a year? The loan rate quoted for this $10 million corporate loan would be: Loan Rate = 4 percent loan funds cost + .5 percent nonfunds operating cost + .375 percent default-risk premium + .625 percent term-risk premium + .25 percent profit margin = 5.75 percent Based on a $10 million loan this customer will pay in interest in a year: $10,000,000*.0575 = $575,000. 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. However, it assumes that a lending institution can accurately know what its costs are and often they dont. Price leadership overcomes the problems of accurately predicting what the costs of a loan will be to a lending institution. However, it is still difficult to assign risk premiums to loans. In addition, using something like the prime rate as the base rate has been challenged by LIBOR and other market based rates. Below prime market pricing uses LIBOR as the base rate and includes only a small profit margin as part of the loan price. This works well 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 but differs 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.

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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 lenders 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 is taken over net loanable funds. Net loanable funds are those funds used in excess of the customers deposits. If the calculated net rate of return from a customers relationship is positive the loan is made and if it is not, the rate is raised or the loan is not made. Because it takes the entire relationship into account it gives a better picture of what customer relationships are profitable. The chief problem with it is that it is a more complex model and takes an accurate picture of all of the relationships the lender has with the customer. It has also become increasingly complex as computer systems have put in place to help with the analysis of the total relationship a customer has with a lender. Problems and Projects 17-1. From the descriptions below please identify what type of business loan is involved. a. A temporary credit supports construction of homes, apartments, office buildings, and other permanent structures. b. A loan is made to an automobile dealer to support the shipment of new cars. c. Credit extended on the basis of a businesss accounts receivable. d. The term of an inventory loan is being set to match the length of time needed to generate cash to repay the loan. e. Credit extended up to one year to purchase raw materials and cover a seasonal need for cash. f. A security dealer requires credit to add new government bonds to his security portfolio. g. Credit granted for more than a year to support purchases of plant and equipment. h. A group of investors wishes to take over a firm using mainly debt financing. i. A business firm receives a three-year line of credit against which it can borrow, repay, and borrow again if necessary during the loans term. j. 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.Interim construction financing. B. Retailer financing or floor planning loan. C. Asset-based financing or factoring. D. Self-liquidating inventory loan. E. Working capital loan. F. Security capital loan. G. Term loan. H. Acquisition loan or leveraged buyout. I. Revolving credit line. J. Project loan.

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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 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 48.1 27.8 19.2 3.1 2.0 1.3 24.5 6.4 17.2 4.7 15.9 February 47.3 28.1 18.9 3.0 2.2 1.0 24.3 6.1 17.4 5.2 16.1 March 45.2 27.4 17.6 3.0 2.3 0.7 23.8 5.5 17.5 5.6 16.4 April 43.0 26.9 16.5 2.9 2.3 0.9 23.7 5.4 17.6 5.9 16.5 May 43.9 27.3 16.7 3.0 2.5 0.7 23.2 5.0 18.0 5.8 17.1 June 39.7 26.6 15.3 2.8 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 departments senior analyst tells you to prepare 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 Hamiltons president serves on Evergreens 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?

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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 declines 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 also noted that the firm, 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.

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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 the dimension of a business firms performance each ratio represents.

Business Assets Cash account Accounts receivable Inventories Fixed assets Miscellaneous assets Liabilities and Equity Short-term debt: Accounts payable Notes payable Long-term debt (bonds) Miscellaneous liabilities Equity capital

50 155 128 286 96 715

108 107* 325* 15 160 715

Annual Revenue and Expense Items Net sales Cost of goods sold Wages and salaries Interest expense Overhead expenses Depreciation expenses Selling, administrative, and other expenses Before-tax net income Taxes owed After-tax net income

650 485 58 28 29 12 28 10 3 7

* Annual principal payments on bonds and notes payable total $55. The firms marginal tax rate is 35 percent. Among the many financial ratios that could be computed given the data in this problem are the following: Expense Control Ratios Wages and salaries = 58 = .0892 Net Sales 650 Overhead expenses Net sales = 29 = .0446 650 Operating Efficiency Measures Inventory turnover ratio = 485 = 3.79 x 128 Net sales/ Total assets Net sales/ Fixed assets = 650 = .909 x 715 = 650 = 2.27 x 286 = 650 = 4.194 x 155

Depreciation expenses = 12 = .0185 Net sales 650 Interest expense Net sales = 28 = .0431 650

Net sales/Accounts receivable

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Cost of goods sold/ Net sales Taxes/Net sales

= 485 = .7462 650 = 3 / 650 = .0046

Average = (155) / (650 /360) = 85.85 days collection period

Selling, administrative, and other expenses/Net sales =28/650 = .0431 Coverage Ratios

Marketability Indicators GPM = 650 485 = .2538 650 7 = .0108 650

Interest coverage

= 38 = 1.36 x 28

NPM =

Coverage of principal and interest payments =

Profitability Measures Before-tax net income/ = 10 = .014 Total assets 715 After-tax net income/ = 7 = .0098 Total assets 715 Before-tax net income/ = 10 = .0625 Net worth or equity 160 capital After-tax net income/= 7 = .0438 Net worth or equity 160 capital

Liquidity Indicators Current ratio = Acid-test ratio = Net liquid assets = $333 = 1.549 x $215 $333 - $128 = .95 x $215 $333 - $128 -$215 = - 10

Net working capital= $333 - $215 = $118 Leverage Ratios

Before-tax net income/ = 10 = .0154 Total liabilities/Total Net sales 650 assets

555 = .7762 = 715

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After-tax net income/ = 7 = .0108 Net sales 650

Long-term debt = Long-term liabilities Total liabilities = Net sales

325 = .6701 485 555 = .8538 650

17-4. Pecon 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 $225 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 lenders credit analyst, loan officer, or both?
Pecon Corporation (all amounts in millions of dollars) Assets Projected for the End of the Curreny Year $ 624 1,210 973 2,940 87 $ 5,834 Liabilities Liabilities and Equity and Equity at the End for the End of the most of the recent Current Year Year $ 970 $ 1,279 2,733 2,950 327 216 872 85 263 5,250 931 85 373 5,834

Asstes at the End of the Most Recent Year Cash $ 532 Accounts receivable 1,018 Inventories 894 Net fixed assets Other assets Total assets $ 2,740 66 5,250

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

The Sources and Uses of Funds Statement for Pecon Corporation would appear as follows:

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Cash Flows from Operations Net income Add: Depreciation Subtract: increase in acc/rec Subtract: increase in inventory Subtract: increase in other assets Add: increase in accounts payable Subtract: decrease in taxes payable Net cash flow from operations

225 100 (192) (79) (21) 309 (111) 231 (300) (300) 217 59 226 157

Cash Flows from Investment Activities Acquisition of fixed assets Net cash flow from investment activities Cash Flows from Financing Activities Increase in notes payable Increase in long term debt Dividends paid (50) Net Cash Flows from Financing Activities Increase (Decrease) in Cash

There are several areas of possible concern for a bank loan officer viewing Pecon'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 $217 million indicates 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 Conway's assets. Pecon 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 and inventories (as well as net fixed assets) are growing rapidly, perhaps reflecting troubles in collecting from the firm's customers and in marketing Pecon's 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.

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17-5 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 loans 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 customers $3 million deposit ? Expected cost of additional funds needed to support the loan (4%) ? Labor costs and other operating expenses associated with monitoring the customers 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 loans 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*.06 = $600,000 $10,000,000*.0075 = $75,000 $15,000,000*.03 = $300,000 $1,125,000 $3,000,000*.0425 $10,000,000*.04 $10,000,000*.02 $10,000,000*.015 = $127,500 = $400,000 = $200,000 = $150,000 $877,500

Estimated Expenses: Interest on Deposit Expected Cost of Additional Funds Labor Costs and Other Operating Costs Costs of Processing the Loan Total Expenses

Net Before Taxes Rate of Return = ($1,125,000 - $877,500)/$7,000,000 = 0.0354 or 3.54 percent

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a. No, it should not because the bank is earning less than the 4 percent annual before tax rate of return. 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 Sun Flower National Bank, you have been responsible for the banks 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:
Expected Revenues Interest income from the requested loan (assuming an annualized loan rate of 4% for 9 months) Loan commitment fee (1%) Deposit management fees Wire transfer fees Fees for agency services Expected Costs Interest paid on customer deposits (3.5%) 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

? 100,000 4,500 3,500 4,500

The banks credit analysts 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? The expected revenues and costs from continuing the present relationship between Sun Flower 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.

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The total of expected revenues and expected costs is: Expected Revenues Interest Revenue Commitment Fees Deposit Service (Maintenance) Fees Wire Transfer Fees Agency Fees Total Expected Revenues $300,000 100,000 4,500 3,500 4,500 $412,500 Expected Costs Deposit Interest Cost of Other Funds Raised Wire Transfer Costs Loan Processing Costs Record keeping Expenses Account Activity Cost Total Expected Costs $ 74,375 180,000 1,300 12,400 4,500 5,000 $ 277,575

Given: Total Expected Revenues = $412,500 Total Expected Costs = $277,575 Net Revenue = $412,500 - $277,575 = $134,925 Net Funds Loaned = $10,000,000 - $2,125,000 = $7,875,000 Expected Net Rate of Return = $134,925/ $7,875,000 = .0171 or 1.71% Because the estimated net rate of return is positive, the bank should strongly consider approving the loan as requested because the bank can earn a premium over its costs. If you decide to turn down this request, under what assumptions regarding revenues, expenses, and customer-maintained deposit balances would you make this 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. As far as the customer-maintained balances are concerned, there could be an opportunity to revise these estimates upward, making the net funds loaned smaller and the expected net rate of return greater.

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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 3.50 percent and borrowed $4 million in the Federal funds market from other banks at todays 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 this cases. What loan rate would it charge? Lone Star Bank has sold negotiable CDs in the amount of $6 million at a yield of 3.50% and purchased $4 million in federal funds at a rate of 3.25%. The weighted average cost of bank funds in this case would be: $ 6,000,000 * .0350 $ 4,000,000 * .0325 Total Interest Cost = $210,000 = $130,000 = $340,000

On a $10 million loan this is an average annual interest cost of $340,000/$10,000,000 or 0.034 which is 3.4 %. There was also $25,000 in noninterest costs or 0.25% of the loan total of $10 million. With a one percent risk premium and a 0.25% minimal profit margin, the loan rate on a cost-plus basis would be: Interest Cost + Non-interest Cost + Risk Premium + Profit Margin = 3.40% + 0.25% + 1.00% + 0.25% = 4.90%. To break even we take out the profit margin, thus the loan rate would be 4.90 -.25 = 4.65% Interest Cost = Loan rate -Non-interest cost - risk premium Interest cost = 4.90 0.25 1.00 = 3.65% 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 Euro deposits (currently trading at a rate of 4 percent) plus a onequarter 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 customers request reveal about the borrowing firms interest rate forecast for the next 90 days?

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Chapter 17 - Lending to Business Firms and Pricing Business Loans

At todays prevailing LIBOR rate the customer's requested loan-rate formula would generate a loan interest rate of 1.014 * 4.0% = 4.056%. The bank wanted to charge a rate of 4.0% + 0.25% = 4.25%. Loan rates tend to move up and down faster with the customer's loan-rate formula than with the bank's LIBOR-plus formula. This customer appears to believe interest rates will soon decline, pulling its 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 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 above), you have assembled these data from the Federal Reserve Statistical Releases 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 Week 1 Week 2 Week 3 Week 4 Week 5 Money Market Interest Rates (1 week ago) (5 week ago) Federal funds 1.99% 2.04% 1.98% 2.06% 2.02% Commercial paper (one-month maturity) 2.13 2.17 2.17 2.20 2.05 CDs (one-month maturity) 2.47 2.58 2.52 2.53 2.43 Eurodollar deposits (three-month maturity) 3.00 3.00 3.00 3.10 2.85 U.S. Treasury bills (three-month, secondary market) 1.84 1.87 1.85 2.04 1.86

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?

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Chapter 17 - Lending to Business Firms and Pricing Business Loans

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%). Robin wanted the loan renewed at money-market borrowing cost plus 0.25%. 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%

Clearly the other money-market interest rates would have generated somewhat lower loan rates, especially the CP and Treasury bill rates. However, interest rates fell over the period examined, resulting in lower loan revenues for the bank. The bank would have been better off to offer its customer a fixed interest rate over the next five weeks. 17-10. Wren Corporation has posted an average deposit balance this past month of $265,500. 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 Wrens 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 Wren earn? Net investable funds = 265,500 50,000 (3% x 215,500) = $209,035 Earnings credit =2.25% x 1/12 x 209,035 = $391.94

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