1. Confidence Bank has made a loan to Risky Corporation. The loan terms include a default risk-free base rate of 2 percent, a risk premium of 2.25 percent, an origination fee of 0.25 percent, and a 5 percent compensating balance requirement. Required reserves are no longer necessary. What is the rate of return the bank expects if full repayment is made by Risk Corporation?

2. Risky Corporations debt is rated by Moodys as Baa3 and currently is trading at an annual yield of 4.625 percent. The equivalent constant maturity US Treasury is selling to yield 1.32 percent. What is the probability of repayment and the probability of default implied by the market for Risky?

3. Given your answers to question 1 and question 2 above, what is the return that Confidence bank expects to receive from the Risky loan?

4. Based on past default (repayment) experience by Confidence Bank, their statisticians use a linear probability model to find common variables that may predict the probability of default by a borrower. They find that the debt-equity ratio (D/E), the sales-asset ratio (S/A), and the equity multiplier (E/A) were three factors influencing the past default behavior of borrowers.

The model has the following parameter estimates. Risk Corporation has a (D/E) ratio of 0.325, a profit margin (PM) of 1.8 and an EBIT/Sales of 2.25. What does the model predict as the probability of default for Risky?

5. Given the contractual return found in problem 1, and the probability of default from the linear probability model in problem 4, what is the return that Confidence Bank expects to receive from the Risky loan?