Integrated Mini Case LOAN ANALYSIS As a senior loan officer at MC Bancorp, you have the following loan applications waiting for review. The bank uses Altman's Z score, default probabilities, mortality rates, and RAROC to assess loan acceptability. The bank's cost of equity (the RAROC benchmark) is 9 percent. The bank's loan policy states that the maximum probability of default for loans by type is as follows: Loan Type and Maturity AAA-rated A-rated Maximum Allowable Default Probability 0.50% 1.25 Which loans should be approved and which rejected? 1. An AAA-rated, one-year C&I loan from a firm with a liquidity ratio of 2.15, a debt-to-asset ratio of 45 percent, volatility in earnings of 0.13, and a profit margin of 12 percent. MC Bancorp uses a linear probability model to evaluate AAA-rated loans as follows: PD -0.08X, +0.15X+1.25X, -0.45X where X-Liquidity ratio X Debt-to-asset ratio X, Volatility in earnings X-Profit margin 2. An AA-rated, one-year C&I loan from a firm with the following financial statement infor mation (in millions of dollars): Liabilities and Equity Assets Cash $ 40 Accounts payable Accounts receivables 120 Notes payable Inventory 210 Accruals Long-term debt Plant and equipment 1,100 Equity (ret. earnings -$200) Total assets $1,470 Total liabilities and equity $ 55 60 70 550 735 $1,470 Also assume sales-$1,250 m, cost of goods sold $930 m, and the market value of equity is equal to 2.2 times the book value. MC Bancorp uses the Altman's Z score model to evaluate AA-rated loans. 3. An A-rated corporate loan with a maturity of three years. A-rated corporate loans are evaluated using the mortality rate approach. A schedule of historical defaults (annual and cumulative) experienced by the bank on its A-rated corporate loans is as follows: Years after Issuance Loan type A-rated corporate loans Annual default Cumulative default 1 year 2 years 0.10% 0.10 0.25% 0.325 4. A $2 million, five-year loan to a BBB-rated cor- poration in the computer parts industry. MC Bancorp charges a servicing fee of 75 basis points. The duration on the loan is 4.5 years. The cost of funds for the bank is 8 percent. 3 years 4 years 0.40% 0.595 0.65% 1.858 Based on four years of historical data, the bank has estimated the maximum change in the risk premium on the computer parts industry to be approximately 5.5 percent. The current market rate for loans in this industry is 10 percent.