HMI Bank has received a loan application from one of its clients Goodford Building and Construction. The bank has a two-stage approach for handling commercial loan applications. In the first stage, it has to decide whether the loan can be approved. In second stage, the bank decides upon what interest rate to charge the borrower.

a) Using Altmans Linear Discriminant Model, calculate Altmans Z-score and state whether the loan should be approved. Assume the following ratios:

Market value of equity-to-book value of long-term debt ratio = 0.9,

Sales-to-total asset ratio = 1.5,

Earnings before interest and taxes-to-total asset ratio = 0.1,

Working capital-to-total assets ratio = 0.04.

Retained earnings-to-total asset ratio = 0.3,

b) Assume that the bank decided to approve the loan application; it now decides what interest rate to charge. The bank currently charges a base lending (risk-free) rate of 4 per cent. It expects a probability of default of 7 per cent for this loan. If defaulted, for this type of loans, the bank recovers on average 80 per cent of loan value and expects the same recovery rate for this loan. Calculate required (expected) rate of return on this loan