H11CK_DECEMBER_2023-2024_HWO_TZ1-TZ2_FOA_24HRS

EDINBURGH BUSINESS SCHOOL

H11CK

LENDING AND CREDIT RISK ANALYSIS

FINAL ONLINE ASSESSMENT

December Examination and Assessment Diet 2023-2024

Duration: 24 Hours

This assessment consists of three case studies.

Case Study 1 is worth 40 marks.

Case Study 2 is worth 40 marks.
Case Study 3 is worth 20 marks.

There is no choice in the selection of questions to be answered.

Maximum word limits are provided for all written sections.

Ethical Commitment: By submitting answers to this paper, I declare that the work I have submitted for the assessment is entirely
my own. I have not taken the ideas, writings or inventions of another person and used these as if they were my own. My
submission is expressed in my own words. Any uses made within this work of the ideas, writings or inventions of others, or of
any existing sources of information (books, journals, websites, generative artificial intelligence, etc.) are properly acknowledged
and listed in the references and/or acknowledgements section.

I understand that infringing this statement would represent an academic misconduct offence subject to disciplinary action
according to the University Regulations and Policy regarding Academic Misconduct, with possible significant consequences for
degree progression and final degree outcome.
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CASE STUDIES

Question 1 Maximum Word Limit 750 words

In order to gain full marks, please show full workings step by step.

Farah is reviewing a business loan application from Fish Foods, a small fish food
processing and distributing company established in 2010 in South England. The
company sees much potential to expand north by establishing a storage and
distribution unit in Scotland to facilitate access to new markets. The overall fish market
is relatively stable and mature, with total sales of £436 million. The fish market grows
when the overall economic conditions are favourable. The storage and warehouse
facility is expected to increase Fish Foods’ sales by 25% within the first five years.

Farah has access to the balance sheet of the last financial year (2021) and collected
some internal records of the current financial year (2022):

• The company’s sales stood at £96 million, of which 55% is on credit.

• The company received £18 million from debtors and paid £12 million to
creditors.
• Gross margin is 60% of sales.
• Supplies amount to 38.4 million, of which 60% is on credit.
• Fixed assets were purchased four years ago, which are depreciated at straight-
line method with a residual value of £3.50 million.
• Administrative and operating costs of the current year are £4 million and £9
million, respectively.
• The business loan is interest only, due in 7 years, with an interest rate of 7%.
Tax rate is 35%, all paid in cash in the same financial year.

Balance Sheet
12/31/2021
Assets Liabilities
Current Assets £ Current Liabilities £
Cash 7,150,000 Accounts payable 17,000,000
Accounts Receivable 24,500,000 Small business loan 23,000,000
Inventory 14,000,000
Total Current Liabilities 40,000,000
Total Current Assets 45,650,000
Owner's equity
Long-term Assets Owner's equity
Warehouse 39,000,000.00 Retained earning 14,000,000
Accumulated depreciation -10,650,000.00 28,350,000 Common stock 20,000,000

Total Long-term Assets 28,350,000 Total owner's equity 34,000,000

Total assets 74,000,000 Total equities 74,000,000

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The following is the scorecard criteria for Farah:

Risk Criteria and Measures W (%) A BBB+ BBB BBB-

12 10 9 8
1. Financial indicators 80%
ROE 20% >23.1 18.1-23.0 13.1-18.0 <13.0
Inventory turnover ratio 40% <29 30-35 36-45 >46
Debt-to-equity ratio 20% <40 41-45 46-55 >55
Quick ratio 20% >2.0 1.5-2.0 1.0-1.5 <1.0

2. Economic condition 20%

Life cycle 50% Growth Mature Pioneering Declining
Revenue Market share 20% > 10% 5% - 10% 1% - 5% <1%
Cyclicality 30% Close to 0 anti-cyclical pro-cyclical counter-cyclical

Required:

(a) Conduct a forecast of the company’s financials for FY 2023 (including the
income statement, balance sheet statement and cash flows statement) and
calculate the ratios required to feed into the scorecard to calculate the overall
credit rating. Show every calculation step and round all results to 0 decimal
places for pounds amount and percentage.
(25 marks)

(b) Fish Foods is seeking a new total finance of £12 million to establish the Scottish
unit that will include the following financing needs:

1. The purchase of a warehouse building for £3 million,

2. The purchase of new equipment for £7,
3. Financing the working capital requirement of £2 million.

If Farah decided to deal with the above three financing needs separately, what
types of loan(s) would be most appropriate for each financing need? What
collaterals can Farah use to secure the loans?
(6 marks)

(c) Farah’s bank offers conventional and Islamic loans depending on its clients’
preferences. What will be the appropriate Islamic product or products that can
be used to meet each of the above three financing needs? Explain how the risk
profile of these Islamic loans differs from conventional loans.
(6 marks)

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(d) At the end, the loan was issued at a rate of 9% with a face value of £12 million
and a maturity of ten years. Given the demand for high return fixed income
products in the current market, the bank plans to bundle it up with all identical
products and issue an ABS security. Following is the structure of ABS product
design:

Tranches Rating Principal (£ mil) % Return

Class A AAA/AAA 100 7%
Class B BBB/Baa 80 9%
Class C BB/Ba 40 11%
Class R 30

What are the thresholds for class A, B and C to lose interest and capital in the
final year? Show your calculations and explanation, and round all results to
the closest pounds.
(3 marks)

Total 40 marks

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Question 2 Maximum Word Limit 750 words

In order to gain full marks, please show full workings step by step.

Adam is a young professional who has been working in a leading financial institution
for three years as a real estate credit analyst. Adam’s annual salary is £100,000, and
he has already saved £90,000, hoping these savings will enable him to get on the
housing ladder. His parents also gifted him a check for £10,000 for the same purpose.
Adam has found his dream house with an asking price of £600,000. He has an
agreement in principle for a 30-year mortgage loan with 85% LTV and a maximum
loan to income of 6 times at a 6% interest rate.

Required:

(a) Calculate the monthly mortgage payment. How much of the first monthly
mortgage will be the interest payment, and how much is the principal
repayment? Show all calculations and keep 0 decimal places for pounds
amount and four decimal places for interest rate in percentage.
(8 marks)

(b) In which month the principal repayment exceeds the interest payment
component? What will be the outstanding balance of the loan for that month?
(5 marks)

(c) Adam has received an application from a real estate developer seeking finance
for constructing a new commercial building in a prime retail location. Adam is
considering two types of loans for this real-estate development transaction:
corporate loans and project finance. Explain how each loan can be structured,
showing the common factors between them. Which type of loan do you
recommend to Adam?
(10 marks)

(d) Explain how commercial real estate credit gives investors attractive investment
characteristics.
(7 marks)

(e) A local bank in the UK is worrying that the rising inflation and interest rate
environment will cause systemic credit risk in its major financial institutions. It
sends five teams of auditors to check how the financial institutions are operating
and whether they are reporting the true credit risk assessment to regulators.

1. A medium-sized local bank is reporting £1.5 billion in assets and £1.3 billion
in liabilities. Among the assets, there are £400 million worth of financial
assets measured at market price. What are the losses to debt holders if the
market value of those financial assets drops to 50% of value? What about
75%? Show all workings.
(5 marks)

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2. For this medium bank, a high-quality asset size is £0.5 billion, with an
available stable funding size of £0.75 billion and a total net cash flow over
30 days of £0.3 billion. The required stable funding is £0.65 billion. What is
the Net stable funding ratio? Is this ratio satisfactory, and why? Show all
workings.
(5 marks)

Total 40 marks

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Question 3 Maximum Word Limit 2000 words

(a) In your words, describe how the option pricing theory affects the measurement
of credit risk.
(5 marks)

(b) Credit portfolio management (CPM) is typically divided into three levels.
What is transfer pricing? How does it work and what are the advantages? How
may a poor implementation lead to potential moral hazard?
(5 marks)

(c) One of your local banks is considering adopting a portfolio management system
to manage commercial loans. The bank intends to add the first batch of 20 loans
into a portfolio. The loan portfolio manager selects 20 loans of similar size and
similar rating into this portfolio. One employee believes that if a loan is positively
correlated to other loans, it does not benefit from diversification. Is this correct?
What do you consider the diversification effect? Answer this question according
to the Credit Portfolio Management (CPM) framework.
(5 marks)

(d) Name two advantages and disadvantages of using Monte Carlo simulation for
backtesting. Give an example of how this would work.
(5 marks)

Total 20 marks

END OF PAPER

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