A financial institution is considering a customer’s request for a 12-year $15 million loan, with annual interest payments and the principal due at maturity. The financial institution requires a 17.25% risk adjusted return on capital for this loan. It will use 3.875% as the cost of funds for this loan. Historically, the worst 1% of comparable loans experience an 87.5 basis point increase in the credit risk premium. The financial institution’s typical origination fee for this type of loan is 1.0% and similar loans yield 6.125%.
a. If the financial institution charges its standard origination fee and the uses the yield on similar loans as the coupon rate, what risk adjusted return on capital will the loan generate?
b. Identify three ways, the financial institution could adjust the terms of the loan in order to realize a higher risk adjusted return on capital. For each of those ways, describe how that change will affect the numerator and the denominator of formula used to compute the risk adjusted return on capital.