CHAPTER 16

Week 12 Class Exercise (Qs)

1. The lending function of depository institutions is highly regulated and this chapter gives
some examples of the structure of these regulations for national banks. In this problem you are
asked to apply those regulations to Red Rose National Bank (RRNB). Red Rose has the
following sources of funds: $300 million in capital and surplus, $325 million in demand deposits,
$680 million in time and savings deposits, and $200 million in subordinated debt.

a. What is the maximum dollar amount of real estate loans that RRNB can grant?
$680 million* 70% = $476 million

b. What is the maximum dollar amount RRNB may lend to a single customer?
$300 million* 15% = $45 million

2. Motivation Corporation, seeking renewal of its $12 million credit line, reports the data in
the following table (in millions of dollars) to Hot Springs National Bank’s loan department.
Please calculate the firm’s cash flow as defined earlier in this chapter. What trends do you
observe, and what are their implications for the decision to renew or not renew the firm’s line of
credit?
Projections for
  20X1 20X2 20X3 20X4 Next Year
Costs of Goods Sold $5.1 $5.5 $5.7 $5.8 $6.0
Selling and Admin Exp. $8.0 $8.0 $8.0 $8.1 $8.2
Sales Revenue $7.9 $8.5 $9.2 $9.4 $9.8
Depreciation and other noncash expenses $11.2 $11.2 $11.1 $11.0 $11.0
Taxes Paid in Cash $4.4 $4.6 $4.9 $4.8 $4.8

(Note: Assume the noncash expense is already included in the cost of goods sold.)

Cash flows for a firm can be calculated as:

Sales Revenues - Cost of Goods Sold - Selling and Admin - Taxes Paid in Cash + Non Cash Expenses
Therefore, the cash flows for Motivation Corporation for each year will be:

Year Cash Flow

20X1 $1.60
20X2 $1.60
20X3 $1.70
20X4 $1.70
Projections for Next Year $1.80

16-1
Motivation Corporation’s cash flow have been rising steadily, which indicates that the company
will have less trouble making require loan payments. Therefore, Hot Springs National Bank may
consider renewing loan if the projections for next year is reasonable.
3. Parvis Manufacturing and Service Company holds a sizable inventory of dryers and
washing machines, which it hopes to sell to retail dealers over the next six months. These
appliances have a total estimated market value currently of $30 million. The firm also reports
accounts receivable currently amounting to $24,650,000. Under the guidelines for taking
collateral discussed in this chapter, what is the minimum size loan or credit line Parvis is likely
to receive from its principal lender? What is the maximum size loan or credit line Parvis is likely
to receive?

For advances against accounts receivables, a lender takes a security interest in the form of a
stated percentage usually between 40 to 90 percent of the face amount, depending upon the
perceived quality of the receivables while for advances against inventories, a lender will usually
advance only 30 to 80 percent of the estimated market value of a borrower's inventory to leave a
substantial cushion in case of decline in the inventory's value.

Minimum size loan or credit line: 0.30* $30,000,000 + 0.40* $24,650,000 = $18,860,000

Maximum size loan or credit line: 0.80* $30,000,000 + 0.90* $24,650,000 = $46,185,000

4. Butell Manufacturing has an outstanding $11 million loan with Citicenter Bank for the
current year. As required in the loan agreement, Butell reports selected data items to the bank
each month. Based on the following information, is there any indication of a developing problem
loan? About what dimensions of the firm’s performance should Citicenter Bank be concerned?

One Two Three Four

Current Month Months Months Months
Month Ago Ago Ago Ago
Cash account (millions of dollars) $33 $57 $51 $44 $43
Projected sales (millions of dollars) $298 $295 $294 $291 $288
Stock price per share
(monthly average) $6.60 $6.50 $6.40 $6.25 $6.50
Capital structure (equity/debt ratio
in percent) 32.8% 33.9% 34.6% 34.9% 35.7%
Liquidity ratio (current assets/
current liabilities) 1.10x 1.23x 1.35x 1.39x 1.25x
Earnings before interest and taxes
(EBIT; in millions of dollars) $15 $14 $13 $11 $13
Return on assets (ROA; percent) 3.32% 3.25% 2.98% 3.13% 3.11%
Sales revenue (millions of dollars) $290 $289 $290 $289 $287

16-2
The selected data items reported by Butell to the bank indicate the possible development of a
problem loan situation. The Cash account of Butell in the current month has fallen sharply after
several month of a substantial uptrend. Moreover, Butell’s liquidity ratio of current assets to
current liabilities has decreased significantly since in the last 3 months. It implies that the
decreasing in sales and difficulty in maintaining sufficient cash to meet short-term liabilities.

Furthermore, Citicenter Bank should concern the capital structure of Butell as its ratio of equity
ratio relative to debt is declining. It indicates that creditors provide a greater share of the firm’s
capitalization. So, each creditor is becoming less well secured. However, the changes in the
liquidity and capital structure may not be real problem for the bank as it may only reflect normal
seasonal pressures. The changes of other aspects of its recent performance like stock price, net of
interest and taxes, and return on assets seem to be improving.

Another concern may be the sales revenue falls below its projected sales. The sales revenue of
latest month reached $290 million versus a projected sale of 298 million. Citicenter Bank must
determine the causes of the insufficient sales of Butell to see if the firm is encountering
resistance increase of its product sales. However, even this trend may not be cause for alarm
because sales may be so volatile in Butell’s industry that few analysts put any faith in the
projected sales. Citicenter Bank needs to review the its earlier projected sales and sales revenue
to determine if there is a real cause for concern.

5. Identify which of the following loan covenants are affirmative and which are negative
covenants:

a. Nige Trading Corporation must pay no dividends to its shareholders above $3 per share
without express lender approval.
Restrictions on payment of dividends represent …negative…. loan covenants.

b. HoneySmith Company pledges to fully insure its production line equipment against loss due to
fire, theft, or adverse weather.
A requirement to insure selected assets is an …affirmative…. loan covenant.

c. Soft-Tech Industries cannot take on new debt without notifying its principal lending institution
first.
Restrictions against taking on new debt represent …negative…. loan covenants.

d. PennCost Manufacturing must file comprehensive financial statements each month with its
principal bank.
The requirement of filing periodic financial statements with the bank is an ……
affirmative…… loan covenant.

e. Dolbe King Company must secure lender approval prior to increasing its stock of fixed assets.
A requirement of securing bank approval before adding to a borrower's stock of fixed
assets is considered a ……negative…… loan covenant.

16-3
f. Crestwin Service Industries must keep a minimum current (liquidity) ratio of 1.5× under the
terms of its loan agreement.
Requiring a borrowing customer to maintain a current ratio—a liquidity measure—no
lower than 1 .5× is an ……affirmative…. loan covenant.

g. Dew Dairy Products is considering approaching Selwin Farm Transport Company about a
possible merger but must first receive lender approval.
The stipulation that prior bank approval of a proposed merger must be obtained is a ……
negative……… loan covenant.

16-4