Transcript
Chapter SeventeenLending to Business Firms and Pricing
Business Loans
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 institution’s goals.
Key TopicsTypes 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 (CPA)
Short Term Business LoansSelf-Liquidating Inventory LoansWorking Capital LoansInterim Construction LoansSecurity Dealer FinancingRetailer and Equipment Financing
Asset-Based FinancingSyndicated Loans
Syndicated LoansA loan or line of credit extended to a business firm by a group of lenders in order to reduce the risk exposure to any one lending institution.
Long Term Business LoansTerm LoansRevolving Credit LinesProject LoansLoans to support acquisitions of other business firms
Sources of Repayment for Business Loans
The borrower’s profits or cash flows
Business assets pledged as collateral
Strong balance sheet with ample marketable assets and net worth
Guarantees given by businesses
Analyzing Business Loan ApplicationsCommon size ratios of customer over time
Financial ratio analysis of customer’s financial statements
Current and pro forma sources and uses of funds statement
Financial Ratio AnalysisControl over expensesOperating efficiencyMarketability of product or serviceCoverage ratios: measuring adequacy of
earningsLiquidity indicators for business
customersProfitability indicatorsThe financial leverage factor as a
barometer of a business firm’s capital structure
Expense Control MeasuresCost of Goods Sold/Net SalesSelling, Administrative and Other Expenses/Net Sales
Depreciation Expenses/Net SalesInterest Expenses on Borrowed Funds/Net SalesTaxes/Net Sales
Operating EfficiencyAnnual Costs of Goods Sold/Average Inventory
Net Sales/Net Fixed AssetsNet Sales/Total AssetsAvg collection period = A/R/(credit sales)/360
Marketability of Product or ServiceGross Profit Margin:(Net Sales – Cost of Goods Sold)
Net Sales
Net Profit Margin:Net Income After Taxes
Net Sales
Coverage Measures Interest Coverage:
Coverage of Interest and Principal Payments:
Income Before Interest and Taxes Interest Payments
Income Before Interest and Taxes (Interest Pay. + Princ. Pay/(1-Marg.Tax))
Income Before Interest, Taxes and Lease Payments Interest Payments + Lease Payments
Liquidity MeasuresCurrent Assets/Current Liabilities:
Acid Test Ratio:
Working Capital:
Net Liquid Assets:
Current Assets Current Liabilities
Current Assets – Inventory Current Liabilities
Current Assets – Inventory (raw) –Current Liabilities
Current Assets – Current Liabilities
Profitability Measures Before Tax Net Income/Total Assets
After Tax Net Income/Total Assets
Before Tax Net Income/Net Worth
After Tax Net Income/Net Worth
Leverage or Capital Structure Measures Leverage Ratios:
Capitalization Ratio:
Debt to Sales Ratio:
Total Liabilities Total Assets
Long Term Debt (LTD) Total LTD + Net Worth
Total Liabilities Net Sales
Total Liabilities Net Worth
Problem 17-3From 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 firm’s performance each ratio represents.
Problem 17-3 (continued)AssetsCash account $ 50Accounts receivable 155Inventories 128Fixed assets 286Miscellaneous assets 96
715Liabilities and EquityShort-term debt: Accounts payable 108 Notes payable 107*Long-term debt (bonds) 325*Miscellaneous liabilities 15Equity capital 160
715
Annual Revenue and Expense Items
Net sales$ 650Cost of goods sold 485Wages and salaries 58Interest expense28Overhead expenses 29Depreciation expenses 12Selling, administrative, and other expenses 28Before-tax net income 10Taxes owed 3After-tax net income 7
Problem 17-3 (continued)
36.128
38CoverageInterest
days 85.58650/360
155 Period Collection Average
79.3128
485 RatioTurnover Inventory
Problem 17-3 (continued)
%375.4160
7
Equity
NIROE
469.4160
715
Equity
Assets Total MultiplierEquity
909.715
650
Assets Total
SalesTurnoverAsset Total
%08.1650
7
Sales
NIMarginProfit Net
Problem 17-3 (continued)
x
x
95.0215
128-333Test-Acid
549.1215
333RatioCurrent
%88.346160
555
Equity
sLiabilitie TotalRatioEquity Debt to
%62.77715
555
Assets Total
sLiabilitie TotalRatioDebt
Types of Contingent LiabilitiesGuarantees or warrantees behind products
Litigation or pending lawsuitsUnfunded pension liabilitiesTaxes owed but unpaidLimiting regulations
Comprehensive Environmental Response, Compensation and Liability Act
This law makes current and past owners of contaminated property, current and past owners and prior operators of businesses located on contaminated property and those who transport hazardous substances potentially liable
Component of Sources and Uses of Funds Statement – Statement of Cash FlowsCash flows from operations
Cash flows from investing activities
Cash flows from financing activities
Sources and Uses of FundsIncrease in Assets = Use of FundsDecrease in Assets = Source of Funds
Increase in Liabilities = Source of Funds
Decrease in Liabilities = Use of Funds
Increase in Equity = Source of Funds
Decrease in Equity = Use of Funds
Traditional (Direct) Operating Cash FlowsNet Sales Revenue from Operations
– Cost of Goods Sold – Selling, General and Administrative – Taxes Paid in Cash + Non Cash Expenses
Indirect Operating Cash Flows Net Income
+ Non Cash Expenses
+ Losses from the Sale of Assets
– Gains from the Sale of Assets
– Increases in Assets Associated with Operations
+ Increases in Current Liabilities Associated with Operations
– Decreases in Current Liabilities Associated with Operations + Decreases in Current Assets Associated with Operations
Methods Used to Price Business LoansCost-Plus Loan Pricing Method
Price Leadership Model
Below Prime Market Pricing (Markup Model)
Customer Profitability Analysis
Loan Interest
Rate=
Marginal Cost of Raising
Loanable Funds to Lend to
Borrower
+
Nonfund Bank
Operating Costs
+
Estimated Margin to
Compensate Bank for
Default Risk
+
Bank's Desired Profit
Margin
Cost-Plus Loan Pricing
Problem 17-7In 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 today’s prevailing interest rate of 3.25 percent.
Credit investigation and recordkeeping costs are estimated at $25,000 and 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. Using cost-plus loan pricing, what loan rate should the bank charge?
Problem 17-7 (continued)The weighted average cost of bank funds in this case would be:
$ 6,000,000 * .0350 = $210,000$ 4,000,000 * .0325 = $130,000 Total Interest Cost = $340,000
Average interest costs = $ 340,000 /$10,000,000 = 3.40%Operating costs = $25,000/$10,000,000 = 0.25%Risk premium = 1.00%Profit margin = 0.25%
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%.
Loan Interest
Rate=
Base or Prime Rate
+
Default Risk
Premium for Non-
Prime Borrowers
+
Term Risk Premium for
Longer Term Credit
Price Leadership Model
Prime RateMajor banks established a base lending fee during the great depression. At that time it was the lowest interest rate charged their most credit worthy customers for short-term working capital loans.
LIBORThe London Interbank Offer Rate. The rate offered on short-term Eurodollar deposits with maturities ranging from a few days to a few months.
Problem 17-8Many 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 Eurodeposits (currently trading at 4.0%) plus a one quarter percentage point markup over LIBOR. APEX, however, wants the loan rate set at 1.014 ´ LIBOR.
Problem 17-8 (continued)If the bank agrees to this loan rate request what interest rate will attach to the loan if it is made today?Customer's requested rate:APEX preferred rate = 1.014 x 4.0% = 4.056%How does this compare with the loan rate the bank wanted to charge? Bank’s preferred rate = 4.0% + 0.25% = 4.25%What does this customer’s request reveal about the borrowing firm’s interest rate forecast for the next 90 days?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.
Loan Interest
Rate=
Interest Cost of Borrowing in the Money
Market
+Markup for Risk
and Profit
Below-Prime Market Pricing
Cap Rate Model
Banks offer a floating rate loan with an agreed upon upper limit on the loan contract regardless of the course of future interest rates.
Customer Profitability Analysis (CPA)Take the whole customer
relationship into accountEstimate total revenues from loans
and other servicesEstimate total expenses from
providing net loanable fundsEstimate net loanable fundsEstimate before tax rate of return by
dividing revenues less expenses by net loanable funds
Problem 17-6As a loan officer Sun Flower National Bank, you have been responsible for the bank’s relationship with USF Corporation, a major producer of remote control devices for activating television setsDVDs, 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. The bank’s credit analysts estimated the customer will keep an average deposit balance of $2,125,000 for the year in which the line is active.
Problem 17-6 (continued)Expected Revenues Expected CostsInterest Revenue $ 400,000* Deposit Interest (5.0%) $ 106,250Commitment Fees 100,000 Cost of Other Funds 180,000Deposit Service Wire Transfer Costs1,300 (Maintenance) Fees 4,500 Loan Processing Costs 12,400Wire Transfer Fees 3,500 Record keeping Expenses 4,500 Agency Fees 4,500 Account Activity Cost 5,000 Total Expected Rev $512,500 Total Expected Costs $ 277,575
*Interest revenue on $ 10 million line of credit at 4% for 12 monthsAverage deposit balance: $2,125,000
Customer profitability analysis:
Problem 17-6 (continued)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?
Net Revenue = $512,500 - $277,575 = $234,925
Net Funds Loaned = $10,000,000 - $2,125,000
= $7,875,000
Expected Net Rate of Return = $234,925/ $7,875,000
= .0298 or 2.98%
What decision should the bank make under the foregoing assumptions?
Since the 2.98% is positive, the bank should make the loan.
Problem 17-6 (continued)If you decide to turn down this request, under what assumptions regarding revenues, expenses, and customer-maintained deposit balances would you make this loan?
Problem 17-6 (continued)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.
Quick Quiz•What aspects of a business firm’s financial statements do loan officers and credit analysts examine carefully?
•What methods are used to price business loans?
Summary Types of bank loans Sources of repayment Contingent liabilities Analysis of the loan application
ŸRatio analysis ŸCommon-size statementsŸSources and uses of funds
Importance of loan pricing Loan pricing methods
ŸCost-Plus ŸCap ratesŸPrice leadership ŸCustomer profitability analysisŸMarkup model
Prime rate LIBOR
Problem Wren Corporation has requested a $5 million term loan with an annual interest rate of 5%, a $2 million revolving line of credit with a 4.5% interest rate (anticipated usage is 50% of the line). The Company has average bank deposit balance of $500,000 that will have a return of 2%. What is the interest income on the term loan?= $5,000,000 * .05 = $250,000
ProblemWhat is the interest income on the revolving line of credit?
= $1,000,000 * 0.045 = $45,000
What is the interest income on deposits?
= $500,000 * 0.02 = $10,000
If the bank has labor costs of 2.5%, what is the cost to the bank for the credit facilities?
= ($5,000,000 + $2,000,000) * 0.025 = $175,000
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