[Question_3: Home Work]

3. From the date given in the following table, please construct as many of the financial ratios
discussed in this chapter as you can and then indicate what dimension of a business firm’s
performance each ratio represents.

Business Assets Annual Revenue and Expense Items

Cash account $ 10 Net sales $ 680
Accounts receivable 95 Cost of goods sold 520
Inventories 108 Wages and salaries 61
Fixed assets 301 Interest expense 18
Miscellaneous assets 96 Overhead expenses 29
610 Depreciation expenses 15
Liabilities and Equity Selling, administrative,
Short-term debt: and other expenses 30
Accounts payable 83 Before-tax net income 7
Notes payable 107* Taxes owed 2
Long-term debt (bonds) 325* After-tax net income 5
Miscellaneous liabilities 15
Equity capital 80

Solution:
From this data given on the tables, I am going to prepare profitability, liquidity and leverage
ratios.
Profitability Ratios:
a) Net Profit Margin:
Formula = (Net income/Net sales)
= (5)/680
= 0.76%
b) Gross profit Margin:
Formula = (Gross profit/Net sales)
= (680-520)/680
= 23.5%
c) Total Asset Turnover:
Formula = (Net sales/Total Assets)
= 680/610
= 111.5%
d) Return on Assets:
Formula = (Net income/Total Assets)
= 5/610
 = 0.82%
e) Operating Profit Margin:
Formula = (EBIT/Net sales)
= (7+18)/680
= 3.68%
f) Sales to Fixed Assets:
Formula = (Net sales/Net Fixed Assets)
= 680/301
= 226%
g) Return on Total Equity:
Formula = (Net income/Total Equity)
= 5/80
= 6.25%
Liquidity Ratios:
a) Inventory Turnover:
Formula = (COGS/Ending inventory)
= 520/108
= 4.81
b) Working Capital:
Formula = (Current Assets-Current Liabilities)
= (10+95+108)-(83+107+15)
= 213-205 = 8
c) Current Ratio:
Formula = (Current Assets/Current Liabilities)
= 213/205
= 1.04
d) Acid-Test (Quick) Ratio:
Formula = (Current Assets-Inventories/Current Liabilities)
= (213-108)/205
= 0.51
e) Accounts Receivables Turnover:
Formula = (Net sales/ Accounts Receivables)
= 680/95
= 7.16 times
Leverage Ratio:

a) Time Interest Earned:

Formula = (Earning before Tax + Interest)/ Total Interest Expense
= (7+18)/18
= 1.39
b) Debt Ratio or Leverage Ratio:
Formula = (Total Liabilities/Total Assets)
= (83+107+325+15)/610
= 86.9%
c) Debt to Equity:
Formula = (Total Liabilities/Share Holder’s Equity Capital)
= 530/80
= 662.5%
d) Debt-to-Sales Ratio:
Formula = (Total Liabilities/Net Sales)
= 530/680
= 77.9%
4.Conway Corporation has placed a term loan request with its lender and submitted the
following balance sheet entries for the year just concluded and the pro forma balance sheet
expected by the end of the current year. Construct a pro forma Statement of Cash Flows for
the current year using the consecutive balance sheets and some additional needed
information. The forecast net income for the current year $ 217 million
With $65 million being paid out in dividends. The depreciation expense for the year will be
$100 million and planned expansions will require the acquisition of $300 million in fixed
assets at the end of the current year. As you examine the pro forma Statement of Cash Flows,
do you detect any changes that might be of concern either to the lender’s credit analyzer,
loan-officer, or both?

Conway Corporation
(All amounts in millions of dollars)

Assets at Assets Liabilities Liabilities

the projected and Equity and Equity
End of the for the End at the End Projected
Most of the of the Most for the End
Recent Current Recent of the
Year Year Current
Year
Cash $ 532 $ 460 Accounts $ 970 1023
payable
Account 1018 1210 Notes 2950 2950
receivable’s payable
Inventories 894 973 Taxes 216 216
payable
Net fixed 2740 2898 Long-term 872 931
assets debt
obligations
Other assets 66 87 Common 85 85
stock
Undivided 263 373
profits

Total assets $ 5250 $ 5628 $ 5250 $ 5268

Total
liabilities
and equity
capital

Solution:
 Conway Corporation
Pro Forma Statement of Cash Flows (amounts in millions of dollars)
Cash Flows from Operations Amount ($m)
Net income 217
Add: Depreciation 100
Subtract: increase in accounts receivables (192)
Subtract: increase in inventory (79)
Subtract: increase in other assets (21)
Add: increase in accounts payable 53
Subtract: decrease in taxes payable (111)
Net cash flow from operations (33)

Cash flows from Investment Activities

Acquisition of fixed assets (300)
Net cash flow from investment activities (300)

Cash Flows from Financing Activities

Increase in notes payable 217
Increase in long term debt 59
Dividends paid (65)
Net Cash flows from financing Activities 211

Increase (Decrease) in Cash (122)

5. Finch Corporation is a new business client for First Commerce National Bank and has
asked for a one-year, $10 million loan at an annual interest rate of 6 percent. The
company plans to keep a 4.25 percent, $3 million CD with the bank for the loan’s
duration. The loan officer in charge of the case recommends at least a 4 percent annual
before-tax rate of return over all costs. Using customer profitability analysis (CPA), the
loan committee hopes to estimate the following revenues and expenses which it will
project using the amount of the loan requested as a base for the calculations:

Estimated Revenues: Estimated Expenses:

Interest income from loan? Interest to be paid on customer’s $3 million
Loan commitment fee (0.75%)? deposit? Expected cost of additional funds needed
to support the loan (4%)?
Cash management fees (3%)? Labor costs and other operating expenses
(on an annual average of associated with monitoring the customer’s loan
$15 million) (2%)?
Cost of processing the loan (1.5%)?

a. Should this loan be approved on the basis of the suggested terms?

b. What adjustments could be made to improve this loan’s projected return?
c. How might competition from other prospective lenders impact the adjustments you
have recommended?

5. Answer:

(a). To come to a decision whether to lend to Fince Corp. using CPA method, we need to
calculate the Earnings before tax (EBIT).
5. (Figures are in million)
Expected Revenues Amount Estimated expenses Amount
Interest Income from loan 0.6m Interest to be paid on client’s 0.1275m
($10m x 0.06) deposit ($3mx0.0425)
Loan commitment fee 0.075m Expected cost of additional 0.28m
(10m x 0.0075) funds [$(10-3) m x 0.04]
Cash management fees 0.45m Labor costs and other operating 0.20m
(15mx0.03) expenses ($10mx0.02)
1.125m Cost of processing loan 0.15m
($10mx0.015)
Total Estimated Expenses $0.7575m
Earnings before tax rate of return= Expected Revenue – Estimated expenses/net
Loanable funds = $(1.125-0.7575)/($10-3) = $0.3675/$7 = 0.0525 = 5.25%
 Yes, since the earnings before tax rate of return is 5.25%, which is higher than the
required benchmark, the First Commerce National Bank can sanction the credit to Fince
Corp.

(b). In order to augment the probable return, the First Commerce N. Bank can enhance
the non-obvious revenue sources like loan commitment fees and cash management
fees (although cash management fee is already higher). From the bank’s expenses side,
it can reduce the interest income credited to client’s account for customer’s bank
deposits, reduce the processing and monitoring costs through improved technology or
increasing the efficiency.

(C) From the perspective of the market competitions about loan pricing, I believe, it’s
always good to focus on indirect or less-obvious pricing rather than the direct one.
Therefore, our pricing strategies will not have caught the attention of the clients much
and can devoid of the harsh competition from other lenders.
6. As a loan officer for 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 sets, DVDs, 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:
Estimated Revenues: Estimated Costs:

Annual interest income from the Interest paid on customer

requested loan (assuming an deposits (3.5%)
annualized loan rate of 4% percent Cost of other funds raised 180,000
for 9 months) Account activity costs 5,000
Loan commitment fee (1%) 100,000 Wire transfer costs 1,300
Deposit management fees 4,500 Loan processing costs 12,400
Wire transfer fees 3,500 Recordkeeping costs 4,500
Fees for agency services 4,500

The bank’s credit analysts have estimated the customer probably will keep an average
deposit balance of $2,125,000 for the year the line is active. 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 for nine months? What decision should the bank make under
the foregoing assumptions? If you decide to turn down this request, under what
assumptions regarding revenues, expenses, and customer deposit balances would you be
willing to make this loan?

5. Solution:
7. In 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 (Money market or Overnight Market) from other banks at today’s
prevailing interest rate of 3.25 percent.

Credit investigation and recordkeeping costs to process this loan application were an
estimated $25,000. 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.
The bank prefers using cost-plus loan pricing in these cases. What loan rate should it
charge?

7. Answer:
Given,
Cost of raising the loanable funds = [($6mx0.035) +($4mx0.0325) =$(0.21+ 0.13)
m=$0.34m
Operating Cost= $25000= $0.0025m
Required Risk premium or margin for credit risk= 1% = 0.01
Required profit margin= ¼% = 0.0025

We know as per the Cost-plus loan pricing method:

Loan Interest Rate= Marginal cost of raising funds+ Non-fund operating cost + Risk
premium
(or margin) for credit/default risk+ desired profit margin
= [$0.34m+ $0.0025m+($10mx0.01) + ($10mx0.0025)]/$10m
= $0.49m/$10m
=0.049 or 4.9%

So, The Lone Star Bank should a minimum rate of interest against the loan is 4.9
percentage.

8. Many 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 Euro deposits (currently trading
at a rate of 4 percent) plus a one quarter percentage point markup over LIBOR. APEX,
however, wants the loan at a rate of 1.014 times LIBOR. If the bank agrees to this loan
request, what interest rate will attach to the loan if it is made today? How does this
compare with the loan rate the bank wanted to charge? What does this customer’s request
reveal about the borrowing firm’s interest rate forecast for the next 90 days?
8. Answer:

(a). Since Apex Export prefers a Prime Method. Therefore, Interest rate on loan will
be
Loan Interest Rate= 1.014 times LIBOR= 1.014 X 4%= 4.056%

(b). However, if the Eaglewood Bank offers a Prime+ Method, then the interest rates
will be:
Loan Interest Rate= LIBOR Rate+¼ Percentage Points= 4%+0.25%=4.25%

The difference between the Prime Method and Prime+ Method is

= 4.25% (-) 4.056% = 0.194%
It means that If the Eaglewood Bank accepts the offer of the Apex Export, the bank
has to reduce the interest rate of the loan by a 0.194% or 1/5 of a percentage point.

(c). additionally, the Apex Exports preference of Prime Method reflects that it predicts
that LIBOR is supposed to fall in the 90-day period.