BU FE 101 - Final Exam Study Guide

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1"Final&Exam&Study&Guide!5"C’s"of"Credit"5!questions!1. Character:""The"assessment"of"the"seriousness"of"the"borrower’s"intent"to"repay"the"loan""2. Capacity:""The"legal"authority"to"sign"a"binding"loan"contract"and"the"adequacy"of"the"borrowe r’s"cash "flow "ava ilable"to "rep a y"th e"p rin cip a l"an d "inte res t"on "a "loa n"3. Collateral:""Adequate"assets"to"support"the"loan"in"the"case"of"default"@"measured"by"a"value"ratio"a. may"include"personal"security"of"the"borrower"4. Conditions:""Assessing"the"impact"of"changing"economic"condition s"o n "th e"borrower’s"ability"to"repay"5. Capital:""Assessment"of"the"adequacy"o f"the"bo rrow er ’s"capital"to"prevent"insolven c y"""*Capital"is"the"net"worth"of"th e"b o rr ower,"whe re as "co lla te ra l"is "th e"a ss et s"p le d ge d "to "b ac k "the"security0Regulatory"Capital"1!question!!Regulatory0Capital""Regulator"capital"is"the"amount "of"c ap it al "th at "ba n k s"a re "re qu ir ed "to "h o ld "to "m e e t"m in imum"capital"requirements"as"determined"by"regulators."• Note"that"regulators"are"most"concerned"with"the"safety"and"soundness"of"banks"and"the"banking"and"financial"systems."• The"optimum"amount"of"capital"may"differ"between"banks"and"their"regulators"since"they"have"different"m o tivation s"an d"ince ntive s."Regulatory"Capital"Requirements"are"a"reaction"to""• Negative"externalities"associated"with"bank"failures"and"the"potential"systemic"risk"o The"losses"to"society"resulting"from"a"bank"failure"significantly"exceed"the"private"losses"to"the"stakeholders"of"the"bank"• The"moral"hazard"problem"intro du c e d"b y "d ep o s it"in su ra n ce ."Deposit0Insurance0Value"&"Discount"of"deposit"insurance"• Regulators"give"the"deposit"insurance"at"a"discount"to"motivate"banks"to"join"• Banks"are"happy"to"have"subsidized"deposit"insurance"but"they"are"unhappy"that"the"regulator"requ ires"the m "to"ha ve"m or e"cap ital"than "they "think "they"n eed "to"hold"• Regulators"will"give"deposit"insurance"at"less"than"the"full"value,"but"in"return"they"want"to"m a ke"th e"ba nk ing"ind ustry "safer"ov era ll"(holding "m ore "capita l)"2"• The"moral"hazard"problem"introduced"by"deposit"insurance"has"provided"an"incentive "fo r"b a nk "re gulators"to"in cr ea s e"regulatory"capital"requirements "Graphing"the"Value:"• The"difference"between"the"only"tax"line"and"the"tax"w ith"bankruptcy"cost"is"the"value0of0deposit0insurance"Basle0II0&0Basle0III0• Basle"II"requires"banks"to"hold"regulatory"capital"against"potential"losses"from"o Credit"Risk"o Market"Risk"o Operational"Risk"• Basle"III"will"add"liquidity"risk"to"capital"requirements"but"has"not"yet"been"formalize d "b y"B IS "or "ad op te d "Z5Score"Analysis"4!Questions!Z;Score0Analysis"&"Edward0Altman0(The0Altman0Model)0The"Z@score"analysis"uses"historical"data"on"actual"loan"(or"bond)"performance"to"determine"the"performa nc e"(defau lt"vs."non @default)."Edward"Alt man"cre a te d "t h e "original"model;"it "used"22"ratios"and"615"companies"historical"information."• Z@Score"Analysis"has"been"found"to "b e"a n "acc u ra te "predictor"of"bankruptcy"up"to"2"years"prior"to"experiencing"financial"distress."• Note:""model"predicts"bankruptcy"with"95%"accuracy"within"one"year"and"with"70%"accuracy"within"2"years"for"public ly"tr ad e d"manufactu r ing "firms"Altman"finds"that,"for"commercia l"loa n s"to "pu b licly "he ld "m a n u fac tu rin g"fir m s ,"th e "followin g "financial"ra tio s"a re"s tat istic ally "sig nific a nt"in "d istin g uis h ing "b etween"loan s"th a t"d efa u lt"an d "those"that"do"not:"X1!Working"Capital"Total"Asset"The"higher"this"ratio"the"more"liquid"assets"the"firm"has.""Greater"liquidity"implies"a"stronger"ability"to"pay"off"debts"in"the"short"run."X2"Retained"Earnings"Total"Asset"The"higher"retained"earnings"are"to"total"assets"the"greater"the"firm's"ability"to"generate"and"keep"profits.""This"should"indicate"a"greater"ability"to"pay"off"debt."X3"EBIT"Total"Assets"A"higher"value"for"this"ratio"indicates"a"greater"ability"to"generate"profits"off"the"given"assets"and"should"indicate"a"stronger"ability"to"pay"off"debt.""Also"a"measure"of"financial"le ve ra ge .""T ells "us "w h et he r"a "firm "is "pa y ing "for "assets"with"profits"or"debt."3"X4"Market"Value"Equity"Book"Value"LT"Debt"When"this"ratio"is"higher"it"signals"that"the"market"believes"the"firm's"ability"to"generate"cash"through"time"is"strong"relative"to"th e"princ ipal"ow e d"on "the"de bt,"thus"indicatin g"th e "eq u it y"in v es to rs "b elie v e"t he "firm's"prospects"are"good."X4A"Book"Value"Equity"Book"Value"LT"Debt"Use"this"formula"in"place"of"X4"when"the"company"is"not"publicly"traded."X5"Net"Sales"Total"Assets"This"ratio"measures"the"firm's"ability"to"turn"dollars"invested "in "as se ts "int o "sa les "re ve n u e .""Th e "hig h er "th e"ratio"the"greater"the"more"efficiently"mana gers"are"using "assets"to"generate"sales.""Sales"are"a"cornerstone"of"profitability"and"the"ability"to"pay"off"debts.""Terms"• Working"Capital=Current"Assets@Current"Liabilities"• EBIT"(Earnings"before"interest"and"taxes)=Net""Order0of0Importance01. X3—EBIT/Total"Assets02. X2—"Retained"Earnings/Total"Assets03. X4—"Market"Value"Equity/Book"Value"of"LT"Debt04. X5—Net"Sales/Total"Assets05. X1—Working"Capital/Total"Assets0Z;Score0Formula0The"Z@score"formula"for"commercial"loans"to"publicly"held"manufacturing"firms:"Z=1.2X1+"1.4X2"+3.3X3"+"0.6X4"+"1.0X5"Decision0Rules:0• Suggested"a"Critical"Z@Value"for"rejection"≤"1.81.""• Grey"Area"1.81"–"2.99"(classification"errors"occur)"o Any"z"score"higher"than"2.99"you"should"accept"§ Good"credit"risk"o Any"z"score"less"than"1.81"should"be"rejected"§ Bad"credit"risk"o The"area"between"1.81"and"2.99"is"called"th e"G re y "A re a,"o r"Z o n e"o f"Ig no r an c e"&"is"the"range"of"z@scores"in"which"misclassification"is"most"likely"to"occur.""§ Fairly"high"probability"that"if"you"are"in"that"zone"you"will"commit"a"type"1"or"type"2"erro r"§ The"5"financial"ratios"and"z"score"equation"do"not"give"you"enough"informa tio n "to "m a k e "a"d ec isio n "Reject"<1.81<"Zone)of)Ignorance"<"2.99"<"Accept"4"Usefulness0• Quantitative"credit"scoring"or"analysis"models"such"as"Altman’s"z@score"or"the"logistic"regre ssio n "ap p ro ac h"a re "m o st"u sefu l"fo r"ev


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BU FE 101 - Final Exam Study Guide

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