Chapter 17 - Lending to Business Firms and Pricing Business Loans

17-1. What special problems does business lending present to the management of a business
lending institution?

While business loans are usually considered among the safest types of lending (their default rate,
for example, is usually well below default rates on most other types of loans), these loans
average much larger in dollar volume than other loans and, therefore, can subject an institution to
excessive risk of loss and, if a substantial number of loans fail, can lead to failure. Moreover,
business loans are usually much more complex financial deals than most other kinds of loans,
requiring larger numbers of personnel with special skills and knowledge. These additional
resources required increase the magnitude of potential losses unless the business loan portfolio is
managed with great care and skill.

17-2. What are the essential differences among working capital loans, open credit lines, asset-
based loans, term loans, revolving credit lines, interim financing, project loans, and acquisition
loans?

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Chapter 17 - Lending to Business Firms and Pricing Business Loans

a. Working Capital Loans -- Loans to fund the current assets of a business, such as
accounts receivable, inventories, or to replenish cash.

b. Open Credit Lines -- A credit agreement allowing a business to borrow up to a

specified maximum amount of credit at any time until the point in time when the credit
line expires.

c. Asset-based Loans -- Credit secured by the shorter-term assets of a firm that are
expected to roll over into cash in the future. Credit whose amount and timing is based
directly upon the value, condition, and maturity of certain assets held by a business firm
(such as accounts receivable or inventory) with those assets usually being pledged as
collateral behind the loan.

d. Term Loans -- Business loans that have an original maturity of more than one year and
normally are used to fund the purchase of new plant and equipment or to provide for a
permanent increase in working capital. Term loans usually look to the flow of future
earnings of a business firm to amortize and retire the credit.

e. Revolving Credit Lines -- Lines of credit that promise the business borrower access to
any amount of borrowed funds up to a specified maximum amount; moreover, the
customer may borrow, repay, and borrow again any number of times until the credit line
reaches its maturity date.

f. Interim Financing -- Bank funding to start construction or to complete construction of a

business project in the form of a short-term loan; once the project is completed, long-term
funding will normally pay off and replace the interim financing.

g. Project Loans -- Credit to support the start up of a new business project, such as the
construction of an offshore drilling platform or the installation of a new warehouse or
assembly line; often such loans are secured by the property or equipment that are part of
the new project.

h. Acquisition Loans--Loans to finance mergers and acquisitions of businesses. Among

the most noteworthy of these acquisition credits are leveraged buyouts of firms by small
groups of investors.

17-3. What aspects of a business firm's financial statements do loan officers and credit analysts
examine carefully?

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Loan officers and credit analysts examine the following aspects of a business firm's financial
statements:
a. Control Over Expenses? Key ratios here include cost of goods sold/net sales; selling,
administrative and other expenses/net sales; wages and salaries/net sales; interest
expenses on borrowed funds/net sales; overhead expenses/net sales; depreciation
expenses/net sales and taxes/net sales.

b. Operating Efficiency? Important ratios here are net sales/total assets, annual cost of
goods sold divided by average inventory levels, net sales/net fixed assets and net
sales/accounts and notes receivable.

c. Marketability of a Product, Service, or Skill? Key ratio measures in this area are the
gross profit margin, or net sales less cost of goods sold to net sales, and the net profit
margin, or net income after taxes to net sales.

d. Coverage? Important measures here include interest coverage (such as income before
interest and taxes divided by total interest payments), coverage of interest and principal
payments (such as earnings before interest and taxes divided by annual interest payments
plus principal payments adjusted for the tax effect), and the coverage of all fixed
payments (such as income before interest, taxes and lease payments divided by interest
payments plus lease payments).

e. Profitability Indicators? Key barometers in this area can include such ratios as before-
tax net income divided by total assets, net worth, or sales, and after-tax net income
divided by total assets (or ROA), net worth (or ROE), or total sales (or ROS) or profit
margin.

f. Liquidity Indicators? Important ratio measures here usually include the current ratio
(current assets divided by current liabilities), and the acid-test ratio (current assets less
inventories divided by current liabilities).

g. Leverage indicators? Ratios indicating trends in this dimension of business

performance usually include the leverage ratio (total liabilities/total assets or net worth),
the capitalization ratio (of long-term debt divided by total long-term liabilities and net
worth), and the debt-to-sales ratio (of total liabilities divided by net sales).

One problem with employing ratio measures of business performance is that they only reflect
symptoms of a possible problem but usually don't tell us the nature of the problem or its causes.
Management must look much more deeply into the reasons behind any apparent trend in a ratio.
Moreover, any time the value of a ratio changes that change could be due to a shift in the
numerator of the ratio, in the denominator, or both.

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17-4. What aspect of a business firm's operations is reflected in its ratio of cost of goods sold to
net sales? In its ratio of net sales to total assets? In its GPM ratio? In its ratio of income before
interest and to taxes to total interest payments? In its acid-test ratio? In its ratio of before-tax net
income to net worth? In its ratio of total liabilities to net sales? What are the principal limitations
of these ratios?

The ratio of cost of goods sold to net sales is a widely used indicator of a business firm's expense
controls and operating efficiency. The ratio of net sales to total assets reflects activity or
operating efficiency, while the gross profit margin (GPM) measure reflects the marketability of
the customer's products or services. A firm's ratio of income before interest expense and taxes to
total interest payments indicates how effectively a business is covering its interest expenses
through the generation of before-tax income. The acid-test ratio provides a rough measure of a
firm's liquidity position, while the ratio of before-tax income to net worth represents a measure
of profitability. Finally, the ratio of liabilities to sales is an indicator of management's use of
financial leverage. These ratios are affected by changes in the numerator or the denominator or
both; a financial or credit analyst would want to know the source of any change in a ratio's value.
These ratios only measure problem symptoms; you must dig deeper to find the cause.

17-5. What are contingent liabilities, and why might they be important in deciding whether to
approve or disapprove a business loan request?

Contingent liabilities include such pending or possible future obligations as lawsuits against a
business firm, and warranties or guarantees the firm has given to others regarding the quality,
safety, or performance of its product or service. Another example is a credit guaranty in which
the firm may have pledged its assets or credit to back up the borrowings of another business,
such as a subsidiary. Environmental damage caused by a business borrower also has recently
become of great concern as a contingent liability for many banks because a bank foreclosing on
business property for nonpayment of a loan could become liable for cleanup costs, especially if
the bank becomes significantly involved with a customer's business or treats foreclosed property
as an investment rather than a repossessed asset that is quickly liquidated to recover the unpaid
balance on a loan. Loan officers must be aware of all contingent liabilities because any or all of
them could become due and payable claims against the business borrower, weakening the firm's
ability to repay its loan to the bank.

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17-6. What is cash-flow analysis, and what can it tell us about a business borrower’s financial
condition and prospects?

A cash flow statement shows the changes in a business firm's assets and liabilities as well as its
flow of net profit and noncash expenses (such as depreciation) over a specific time period. It
shows where the firm raised its operating capital during the time period under examination and
how it spent or used those funds in acquiring assets or paying down liabilities. From the
perspective of a loan officer the cash flow statement indicates whether the firm is relying heavily
upon borrowed funds and sales of assets. These are two less desirable funding sources from the
point of view of lending money to a business firm. In contrast, loan officers usually prefer to
focus upon cash flow - whether the firm is generating sufficient cash flow (net income plus
noncash expenses) to repay most of its debt. The Statement of Cash Flows shows how cash
receipts and disbursements are generated by operating, investing, and financing activities.

17-7. What is a pro forma statement of cash flows, and what is its purpose?

A pro forma statement of cash flows is useful not only to look at historical data in a Statement of
Cash Flows, but also to estimate the business borrower’s future cash flows and financial
condition and its ability to repay the loan.

17-8. Should a loan officer ever say “no” to a business firm requesting a loan? Please explain
when and where.

Loan officers will inevitably be confronted with some loan requests that will have to be flatly
rejected, particularly in those cases where the borrower has falsified information or has a credit
history of continually "walking away" from debt obligations. Even in these cases, however, the
loan officer should be as polite as possible, suggesting to the customer what needs to be changed
or improved for the future to permit the customer to be seriously considered for a loan.

17-9. What methods are used today to price business loans?

The following methods are in use today to price business loans:

a. Cost-plus pricing d. Customer Profitability Analysis
b. Price leadership pricing model
c. Below-prime market pricing

Cost-plus-profit pricing requires the bank to estimate the total cost involved in making a
loan and then adds to that cost estimate a small margin for profit.

The price-leadership model, on the other hand, bases the loan rate upon a national or
international rate (such as prime or LIBOR) posted by major banks and then adds a small
increment on top for profit or risk.

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Chapter 17 - Lending to Business Firms and Pricing Business Loans

The below-prime market prices a loan on the basis of cost of borrowing in the money market
plus a small profit margin. Customer profitability analysis looks at all the revenues and costs
involved in serving a customer and then requires the bank to calculate the net rate of return from
this particular customer.

17-10. Suppose a bank estimates that the marginal cost of raising loanable funds to make a $10
million loan to one of its corporate customers is 4 percent, its nonfunds operating costs to
evaluate and offer this loan are 0.5 percent, the default-risk premium on the loan is 0.375
percent, a term-risk premium of 0.625 percent is to be added, and the bank’s desired profit
margin is 0.25 percent. What loan rate should be quoted this borrower? How much interest will
the borrower pay in a year?

The loan rate quoted for this $10 million corporate loan would be:
Loan Rate = 4 percent loan funds cost + .5 percent nonfunds operating cost
+ .375 percent default-risk premium
+ .625 percent term-risk premium
+ .25 percent profit margin
= 5.75 percent

Based on a $10 million loan this customer will pay in interest in a year:

$10,000,000*.0575 = $575,000.

17-11. What are the principal strengths and weaknesses of the different loan-pricing methods in
use today?

Cost plus pricing is the simplest loan pricing model. However, it assumes that a lending
institution can accurately know what its costs are and often they don’t.

Price leadership overcomes the problems of accurately predicting what the costs of a loan will be
to a lending institution. However, it is still difficult to assign risk premiums to loans. In addition,
using something like the prime rate as the base rate has been challenged by LIBOR and other
market based rates.

Below prime market pricing uses LIBOR as the base rate and includes only a small profit margin
as part of the loan price. This works well for short term loans for large, well known corporations
but is not generally used for small and medium sized companies or longer term loans

Customer profitability analysis is similar to cost plus pricing but differs in that it considers the
whole customer relationship into account when pricing a loan. Customer profitability analysis
has become increasingly sophisticated as computer models have been designed to help with the
analysis.

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17-12. What is customer profitability analysis? What are its advantages for the borrowing
customer and the lender?

Customer profitability analysis is a loan pricing method that takes into account the lender’s entire
relationship (all revenues and expenses associated with a particular Customer) with the customer
when pricing the loan. It is based on the difference between revenues from loans and other
services provided and expenses from providing loans and other services is taken over net
loanable funds. Net loanable funds are those funds used in excess of the customer’s deposits. If
the calculated net rate of return from a customer’s relationship is positive the loan is made and if
it is not, the rate is raised or the loan is not made. Because it takes the entire relationship into
account it gives a better picture of what customer relationships are profitable. The chief problem
with it is that it is a more complex model and takes an accurate picture of all of the relationships
the lender has with the customer. It has also become increasingly complex as computer systems
have put in place to help with the analysis of the total relationship a customer has with a lender.

Problems and Projects

17-1. From the descriptions below please identify what type of business loan is involved.
a. A temporary credit supports construction of homes, apartments, office buildings, and other
permanent structures.
b. A loan is made to an automobile dealer to support the shipment of new cars.
c. Credit extended on the basis of a business’s accounts receivable.
d. The term of an inventory loan is being set to match the length of time needed to generate cash
to repay the loan.
e. Credit extended up to one year to purchase raw materials and cover a seasonal need for cash.
f. A security dealer requires credit to add new government bonds to his security portfolio.
g. Credit granted for more than a year to support purchases of plant and equipment.
h. A group of investors wishes to take over a firm using mainly debt financing.
i. A business firm receives a three-year line of credit against which it can borrow, repay, and
borrow again if necessary during the loan’s term.
j. Credit extended to support the construction of a toll road.

Based upon the descriptions given in the text the type of business loan being discussed is:
A.Interim construction financing.
B. Retailer financing or floor planning loan.
C. Asset-based financing or factoring.
D. Self-liquidating inventory loan.
E. Working capital loan.
F. Security capital loan.
G. Term loan.
H. Acquisition loan or leveraged buyout.
I. Revolving credit line.
J. Project loan.

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Chapter 17 - Lending to Business Firms and Pricing Business Loans

17-2. As a new credit trainee for Evergreen National Bank, you have been asked to evaluate the
financial position of Hamilton Steel Castings, which has asked for renewal of and an increase in
its six-month credit line. Hamilton now requests a $7 million credit line, and you must draft your
first credit opinion for a senior credit analyst. Unfortunately, Hamilton just changed
management, and its financial report for the last six months was not only late but also garbled.
As best as you can tell, its sales, assets, operating expenses, and liabilities for the six month
period concluded display the following patterns:

Hamilton has a 16-year relationship with the bank and has routinely received and paid off a
credit line of $4 million to $5 million. The department’s senior analyst tells you to prepare
because you will be asked for your opinion of this loan request (though you have been led to
believe the loan will be approved anyway, because Hamilton’s president serves on Evergreen’s
board of directors).
What will you recommend if asked? Is there any reason to question the latest data
supplied by this customer? If this loan request is granted, what do you think the customer will do
with the funds?

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Chapter 17 - Lending to Business Firms and Pricing Business Loans

The figures given in the case as well as the supporting background information suggest several
developing problems. Hamilton has had a recent shakeup in its senior management, which
usually leads to loss in control of the firm until the new management gains sufficient experience.
Among the obvious problems are declines in sales (from $48.1 million to $39.7 million) in the
past six months. Hamilton's cost of goods sold dropped but by less than the decline in sales,
thereby squeezing the firm's margin and net income. We also noted that the firm, faced with
declining cash flows, has been forced to rely more heavily on borrowings which will mean that
the bank's position will be less secure. Current assets have also declined while current liabilities
are on the rise, thus reducing the firm's net liquidity position. The bank's relationship with
Hamilton needs to be reviewed carefully with an eye to gaining additional collateral or reducing
the bank's total credit commitment to the firm.

Additional information that would be desirable and helpful, if not essential, should include:

1) Past financial statements for the last two or three years, preferably on a monthly basis.
This could help us verify seasonality and improvement.

2) Industry outlook for the next six to eighteen months would also help in reinforcing
Hamilton's ability to service the debt from the summer and fall cash flows.

3) Additionally, information about the company's suppliers, other creditors, customers,

and competitors would be helpful.

4) Also, more information about other relationships that Hamilton has with Evergreen
would certainly be helpful.

In summary, the more information we have, the better our analysis and subsequent decisions will
be.

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Chapter 17 - Lending to Business Firms and Pricing Business Loans

17-3. From 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.

* Annual principal payments on bonds and notes payable total $55. The firm’s marginal tax rate
is 35 percent.

Among the many financial ratios that could be computed given the data in this problem are the
following:

Expense Control Ratios Operating Efficiency Measures

Wages and salaries = 58 = .0892 Inventory turnover ratio = 485 = 3.79 x

Net Sales 650 128

Overhead expenses = 29 = .0446 Net sales/ = 650 = .909 x

Net sales 650 Total assets 715

Depreciation expenses = 12 = .0185 Net sales/ = 650 = 2.27 x

Net sales 650 Fixed assets 286

Interest expense = 28 = .0431 Net sales/Accounts = 650 = 4.194 x

Net sales 650 receivable 155

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Chapter 17 - Lending to Business Firms and Pricing Business Loans

Cost of goods sold/ = 485 = .7462 Average = (155) / (650 /360) = 85.85 days
Net sales 650 collection period

Taxes/Net sales = 3 / 650 = .0046

Selling, administrative,
and other expenses/Net
sales =28/650 = .0431
Coverage Ratios Marketability Indicators

GPM = 650 – 485 = .2538

650
Interest coverage = 38 = 1.36 x
28 NPM = 7 = .0108
650
Coverage of principal and
interest payments =

Profitability Measures Liquidity Indicators

Before-tax net income/ = 10 = .014 Current ratio = $333 = 1.549 x

Total assets 715 $215

After-tax net income/ = 7 = .0098 Acid-test ratio = $333 - $128 = .95 x

Total assets 715 $215

Before-tax net income/ = 10 = .0625 Net liquid assets = $333 - $128 -$215
Net worth or equity 160 = - 10
capital
Net working capital= $333 - $215
After-tax net income/= 7 = .0438 = $118
Net worth or equity 160
capital
Leverage Ratios

Before-tax net income/ = 10 = .0154 Total liabilities/Total 555 = .7762

Net sales 650 assets = 715

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Chapter 17 - Lending to Business Firms and Pricing Business Loans

After-tax net income/ = 7 = .0108 Long-term debt = 325 = .6701

Net sales 650 Long-term liabilities 485

Total liabilities = 555 = .8538

Net sales 650

17-4. Pecon 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 is $225 million with $50 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 analyst, loan officer, or both?

The Sources and Uses of Funds Statement for Pecon Corporation would appear as follows:

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Chapter 17 - Lending to Business Firms and Pricing Business Loans

Cash Flows from Operations

Net income 225
Add: Depreciation 100
Subtract: increase in acc/rec (192)
Subtract: increase in inventory (79)
Subtract: increase in other assets (21)
Add: increase in accounts payable 309
Subtract: decrease in taxes payable (111)
Net cash flow from operations 231

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 (50)
Net Cash Flows from Financing Activities 226

Increase (Decrease) in Cash 157

There are several areas of possible concern for a bank loan officer viewing Pecon's projected
figures. First, the firm is relying heavily upon increasing debt of all kinds to finance its growth in
assets. The increase in notes payable of $217 million indicates growing reliance on bank debt
supplemented by sizable increases in supplier-provided credit (accounts payable) and long-term
debt obligations (most likely, bonds) with no change in funds provided by issuing stock. The
bank could experience a serious weakening in the strength of its claim against the firm as other
creditors post a more substantial claim against Conway's assets.

Pecon is projecting a sizable increase in its retained earnings (undivided profits) which suggests
that management is counting on a year of strong earnings. However, both accounts receivable
and inventories (as well as net fixed assets) are growing rapidly, perhaps reflecting troubles in
collecting from the firm's customers and in marketing Pecon's products and services. The bank's
loan officer would want to explore with the company the bases for its projected jump in net
income and why accounts receivable and inventories are expected to rise in such large amounts.

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Chapter 17 - Lending to Business Firms and Pricing Business Loans

17-5 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:

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?

Estimated Revenues:
Interest Income from Loan $10,000,000*.06 = $600,000
Loan Commitment Fee $10,000,000*.0075 = $75,000
Cash Management Fee $15,000,000*.03 = $300,000
Total Revenues $1,125,000

Estimated Expenses:
Interest on Deposit $3,000,000*.0425 = $127,500
Expected Cost of Additional Funds $10,000,000*.04 = $400,000
Labor Costs and Other Operating Costs $10,000,000*.02 = $200,000
Costs of Processing the Loan $10,000,000*.015 = $150,000
Total Expenses $877,500

Net Before Taxes Rate of Return = ($1,125,000 - $877,500)/$7,000,000 = 0.0354 or 3.54 percent

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Chapter 17 - Lending to Business Firms and Pricing Business Loans

a. No, it should not because the bank is earning less than the 4 percent annual before tax rate of
return.

b. The fees that are charged could be made higher and the lender could try and find a way to
reduce the expenses on the loan. Both of these would have the effect of increasing the rate of
return on the loan.

c. In particular, it would be difficult to raise fees for this customer if they can get these same
services from other lenders more cheaply. It would not necessarily cause a direct impact on
expenses but other lenders might already be more efficient in providing these services and they
may already be charging a lower interest rate on this loan based on the customer profitability
analysis.

17-6. 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:

The bank’s credit analysts 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?

The expected revenues and costs from continuing the present relationship between Sun Flower
National Bank and USF Corporation were given in this problem and the reader is asked to
estimate the expected net rate of return if the bank renews its loan to USF.

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Chapter 17 - Lending to Business Firms and Pricing Business Loans

The total of expected revenues and expected costs is:

Expected Revenues Expected Costs

Interest Revenue $300,000 Deposit Interest $ 74,375

Commitment Fees 100,000 Cost of Other Funds 180,000
Raised
Deposit Service 4,500 Wire Transfer Costs 1,300
(Maintenance) Fees Loan Processing Costs 12,400
Wire Transfer Fees 3,500 Record keeping Expenses 4,500
Agency Fees 4,500 Account Activity Cost 5,000
Total Expected Revenues $412,500 Total Expected Costs $ 277,575

Given: Total Expected Revenues = $412,500

Total Expected Costs = $277,575

Net Revenue = $412,500 - $277,575 = $134,925

Net Funds Loaned = $10,000,000 - $2,125,000 = $7,875,000

Expected Net Rate of Return = $134,925/ $7,875,000 = .0171 or 1.71%

Because the estimated net rate of return is positive, the bank should strongly consider approving
the loan as requested because the bank can earn a premium over its costs.

If you decide to turn down this request, under what assumptions regarding revenues, expenses,
and customer-maintained deposit balances would you make this loan?

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.

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17-7. 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 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 this cases. What loan rate would it charge?

Lone Star Bank has sold negotiable CDs in the amount of $6 million at a yield of 3.50% and
purchased $4 million in federal funds at a rate of 3.25%. 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

On a $10 million loan this is an average annual interest cost of $340,000/$10,000,000 or 0.034
which is 3.4 %. There was also $25,000 in noninterest costs or 0.25% of the loan total of $10
million. With a one percent risk premium and a 0.25% minimal profit margin, 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%.

To break even we take out the profit margin, thus the loan rate would be 4.90 -.25 = 4.65%

Interest Cost = Loan rate -Non-interest cost - risk premium

Interest cost = 4.90 – 0.25 – 1.00 = 3.65%

17-8. 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?

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At today’s prevailing LIBOR rate the customer's requested loan-rate formula would generate a
loan interest rate of 1.014 * 4.0% = 4.056%. The bank wanted to charge a rate of 4.0% + 0.25%
= 4.25%. 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.

17-9. Five weeks ago, Robin Corporation borrowed from the commercial finance company that
employs you as a loan officer. At that time, the decision was made (at your personal urging) to
base the loan rate on below-prime market pricing, using the average weekly Federal funds
interest rate as the money market borrowing cost. The loan was quoted to Robin at the Federal
funds rate plus three-eighths percentage point markup for risk and profit.
Today, this five-week loan is due, and Robin is asking for renewal at money market
borrowing cost plus one-fourth of a point. You must assess whether the finance company did as
well on this account using the Federal funds rate as the index of borrowing cost as it would have
done by quoting Robin the prevailing CD rate, the commercial paper rate, the Eurodollar deposit
rate or possibly the prevailing rate on U.S. Treasury bills plus a small margin for risk and
probability. To assess what would have happened (and might happen over the next five weeks if
the loan is renewed at a small margin over any of the money market rates listed above), you have
assembled these data from the Federal Reserve Statistical Releases H15
What conclusion do you draw from studying the behavior of these common money
market base rates for business loans? Should the Robin loan be renewed as

requested, or should the lender press for a different loan pricing arrangement? Please explain
your reasoning. If you conclude that a change is needed, how would you explain the necessity for
this change to the customer?

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Chapter 17 - Lending to Business Firms and Pricing Business Loans

Robin Corporation was quoted a loan rate equal to the prevailing federal funds interest rate plus
3/8 of a percentage point (or 0.375%). Robin wanted the loan renewed at money-market
borrowing cost plus 0.25%. If the base rate is set at the federal funds rate the loan rate as
requested by Robin would be:

Week 1 Week 2 Week 3 Week 4 Week 5

Fed Funds 1.99% 2.04% 1.98% 2.06% 2.02%
Margin 0.25% 0.25% 0.25% 0.25% 0.25%
Loan Rate 2.24% 2.29% 2.23% 2.31% 2.27%

Clearly the other money-market interest rates would have generated somewhat lower loan rates,
especially the CP and Treasury bill rates. However, interest rates fell over the period examined,
resulting in lower loan revenues for the bank. The bank would have been better off to offer its
customer a fixed interest rate over the next five weeks.

17-10. Wren Corporation has posted an average deposit balance this past month of $265,500.
Float included in this one-month average balance has been estimated at $50,000. Required legal
reserves are 3 percent of net collected funds. What is the amount of net investable (usable) funds
available to the bank holding the deposit?
Suppose Wren’s bank agrees to give the firm credit for an annual interest return of 2.25
percent on the net investable funds the company provides the bank. Measured in total dollars,
how much of an earnings credit from the bank will Wren earn?

Net investable funds = 265,500 – 50,000 – (3% x 215,500) = $209,035

Earnings credit =2.25% x 1/12 x 209,035 = $391.94

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