Describe how a linear discriminant analysis model works

Question

1.MNO, Inc., a publicly traded manufacturing firm in the United States, has provided the following financial information in its application for a loan. All numbers are in thousands of dollars.

 

         Assets                                                                 Liabilities and Equity

         Cash                                                $ 20            Accounts payable                         $ 30

         Accounts receivables                        90            Notes payable                                90

         Inventory                                          90            Accruals                                         30

                                                                                    Long-term debt                             150

         Plant and equipment                        500            Equity (ret. earnings = $0)            400

         Total assets                                     $700            Total liabilities and equity           $700

          Also assume sales = $500,000, cost of goods sold = $360,000, taxes = $56,000, interest payments = $40,000, net income = $44,000, the dividend payout ratio is 50 percent, and the market value of equity is equal to the book value.

a.What is the Altman discriminant function value for MNO, Inc.? Recall that:

b.  Should you approve MNO, Inc.'s application to your bank for a $500,000 capital expansion loan?

c. If sales for MNO were $300,000, the market value of equity was only half of book value, and the cost of goods sold, interest, and tax rate were unchanged, what would be the net income for MNO? Assume the tax credit can be used to offset other tax liabilities incurred by other divisions of the firm. Would your credit decision change? 

d.   Would the discriminant function change for firms in different industries? Would the function be different for manufacturing firms in different geographic sections of the country? What are the implications for the use of these types of models by FIs?

2.Describe how a linear discriminant analysis model works. Identify and discuss the criticisms which have been made regarding the use of this type of model to make credit risk evaluations.

3.Suppose the estimated linear probability model used by an FI to predict business loan applicant default probabilities is PD = .03X₁ + .02X₂ - .05X₃ + error, where X₁ is the borrower's debt/equity ratio, X₂ is the volatility of borrower earnings, and X₃ = 0.10 is the borrower’s profit ratio. For a particular loan applicant, X₁ = 0.75, X₂ = 0.25, and X₃ = 0.10. 

a.   What is the projected probability of default for the borrower?

b.   What is the projected probability of repayment if the debt/equity ratio is 2.5?

c.   What is a major weakness of the linear probability model?

4.What are covenants in a loan agreement? What are the objectives of covenants?  How can these covenants be negative? Positive?

5.Why could a lender’s expected return be lower when the risk premium is increased on a loan? In addition to the risk premium, how can a lender increase the expected return on a wholesale loan? A retail loan?