H11CK_August_2022-2023_HWOL_TZ1-TZ2_TOC_24hrs

EDINBURGH BUSINESS SCHOOL

Master of Business Administration

H11CK

LENDING AND CREDIT RISK ANALYSIS

TIMED ONLINE COURSEWORK

August Examination and Assessment Diet 2022-2023

Duration: 24 Hours

This timed online coursework 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.

Attached: A formula sheet and set of statistical tables is provided at the end of
the question paper.
Heriot-Watt University H11CK_August_2022-2023_HWOL_TZ1-TZ2_TOC_24hrs

CASE STUDIES

Question 1 Maximum Word Limit 750 words

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

Patrick is reviewing a business loan application from a small business called Wonderful
Table. Wonderful Table started its operation 3 years ago, its business mainly sells tables
and chairs through online store. It believes that moving the store to online can save
significant operating cost. It also differentiates from its competitors by building a
sophisticated supply-chain management system that allow them to move furniture stock at
much cheaper costs. However, it only act as a sales agent, which means it is not a furniture
producer. Most of its business growth comes from taking market share of competitors, while
the total market size remains unchanged for recent years. IKEA is the leader in this industry,
which sold 40,000 redwood tables with $3K average unit price last year.

Patrick started his review by looking at the accounting information of Wonderful Table. The
company sold 600 sets of its redwood tables, each at $5K. Other products made up $2
million sales. The overall average gross margin is 60%. Compared to the first two years,
sales grew by 30% due to strong economic condition. The company hires 5 staffs to manage
online store, local warehouse and customer service, annual payroll sums up to be $400K, all
cash payments. The only long-term asset is a local warehouse that Wonderful Table
purchased for $500K 3 years ago, the warehouse is expected to have 10-year usable life,
with residual value of $50K, depreciated at straight-line method. Transportation cost is also a
big expense on company tab. It costed $300K last financial year, all in cash. Although it is
close to financial year end, the current period financial statements are not available for
Patrick yet. He only has access to some internal records and financial statements from last
financial year.

Balance Sheet
12/31/2022
Assets Liabilities
Current Assets $ Current Liabilities $
Cash 600,000 Accounts payable 400,000
Accounts Receivable 1,000,000 Small business loan 300,000
Inventory 500,000
Total Current Liabilities 700,000
Total Current Assets 2,100,000
Owner's equity
Long-term Assets Owner's equity
Warehouse 500,000.00 Retained earning 1,000,000
Accumulated
depreciation -90,000.00 410,000 Common stock 810,000

Total Long-term Assets 410,000 Total owner's equity 1,810,000

Total assets 2,510,000 Total equities 2,510,000

Based on internal lodger, new credit sales are 20% of total sales and cash receipt from
debtor is $1.2 million. Wonderful Table purchased $2m worth of supply since last period,

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60% of the purchase are on credit. Payment to supplier summed up to be $600K. The
business loan is interest only, due in 5 years, interest rate at 8%. Tax rate is 30%, all paid in
cash.

Following is the scorecard criteria for Patrick:

Risk Criteria and

Measures W (%) A BBB+ BBB BBB-
12 10 9 8
1. Financial indicators 70%
ROE 30% >23.1 18.1-23.0 13.1-18.0 <13.0
Inventory turnover ratio 30% <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 30%

Life cycle 33% Growth Mature Pioneering Declining
Revenue Market share 33% > 10% 5% - 10% 1% - 5% <1%
counter-
Cyclicality 33% Close to 0 anti-cyclical pro-cyclical cyclical

Required:

(a) Help Patrick build a scorecard based on the updated accounting information this
year. Calculate the overall credit rating and show every calculation step. Round all
results to 0 decimal places for dollar amount and percentage.
(20 marks)

(b) Wonderful Table plans to expand its operation from the capital city to 4 major cities
over the next five years, thus it wishes to borrow $10 million from the bank. The loan
application was made under revolving credit, while Patrick thinks maybe project
finance maybe more appropriate to its purpose. Provide one benefit and one
drawback of each design, and provide an answer on which design you think is more
appropriate for their purpose from an adviser’s perspective?
(5 marks)

(c) At the end, the loan was issued at a rate of 10% with face value $10 million and
maturity 5 years. Given the demand for high return fixed income products in 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 200 6
Class B BBB/Baa 100 8
Class C BB/Ba 50 10
Class R 50

Calculate the thresholds of the underlying loan portfolio for class A investors to lose
interest and capital at the final year. Show your calculation and explanation, round all
results to the closest dollar.
(3 marks)

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(d) The return from Wonderful Table’s expansion plan has been growing at a slower rate
than expectation, but management remains confident that the expansion plan will
work out at the end. Two years later, the company EBIT becomes $200K and
Wonderful Table has experienced a shortage in cashflow at the same time. The
company is still capable to repay the loan in full at this stage, but it is difficult to tell
how the situation would change by the time of loan maturity. After the annual review
of this loan, Patrick decided to put it in the watch list, and he plans to prepare for a
situation in which it turns to a real bad debt. Which provision type should he use to
estimate now and why? Identify two restructure strategies he can leverage at the time
of loan becoming bad debt and explain your choices.
(4 marks)

(e) Patrick voices the concern to company owner about loan repayments. The owner
then talks to an Islamic finance provider from his community to arrange loan
remarketing. But before transferring the loan, new funding provider asks Wonderful
Table to restructure the loan to comply with Islamic finance rules. Identify one
method of how the conversion can be done. How is the risk of new lender compared
to previous one and why?
(3 marks)

(f) Patrick is using an internal credit risk model to access credit risk. The credit risk
model is based on a linear regression of key risk measures against default
probability. The model has intercept at -0.08. Beta for quick ratio and gross profit
margin at -0.4 and 0.8. Adjusted R-square is 0.7. Interpret these results and calculate
the default probability when quick ratio is 125% and gross profit margin at 60%. Is
this result reasonable?
(5 marks)

Total 40 marks

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Heriot-Watt University H11CK_August_2022-2023_HWOL_TZ1-TZ2_TOC_24hrs

Question 2 Maximum Word Limit 750 words

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

Naeem is moving to city B for a new job. He really likes this new opportunity and thinks
about starting a new life in city B, including buying a new house. He already has $600K
savings, so he thinks his financial condition is strong enough support his decision. The only
problem is, he already owns a house in the current city. He is not in a hurry to sell his current
property. He would rather wait for a satisfactory offer from the market.

He purchased his current property at $2.5 million exactly three years ago, the maximum LTV
bank offered was 80% for a 30-year mortgage laon, and the annualized effective interest
rate is 5.9364%. He plans to sell his property higher than $2.8 million. The real estate agent
told him that he would need to wait for another 6 months to get a price at that level.

In the meanwhile, he has found a house in city B that fits all his requirements. He decided to
buy the new house before selling the old one. However, he does not have sufficient cash on
hand to make the purchase. The new house is on market for $2 million, the bank has taken a
review on his conditions and pre-approved his 30-year mortgage loan at 70% LTV.

Required:

(a) How much of the first monthly payment of existing loan was made up of the interest
payment and how much the principal repayment? Show all calculations and keep 0
decimal places for dollar amount, 4 decimal places for interest rate in percentage.
(5 marks)

(b) Which year is the first year that principal repayment exceeds interest payment
component? What is the current balance of the loan on existing house?
(5 marks)

(c) Naeem takes out a bridge loan at the same interest rate (i.e., 6.1%) to solve his
problem now. What is the new total balance and monthly repayment after taking the
bridge loan? What would be the new loan balance if he can sell his existing house at
$2.8 million? Evaluate his risk in taking the bridge loan. Assume the interest rate
stays the same, round all dollar amount to 0 decimal places.
(5 marks)

(d) Naeem’s wife wished to maintain the same level of savings for the sake of financial
security. If the market price of the current house is $2.70 million, how much savings
they would have if they sold the existing house immediately at the above price and
buy the new house?
(3 marks)

(e) Bank A which issued Naeem’s mortgage is considering pooling this mortgage with
similar loans. However, after reviewing details, bank A realizes this mortgage has
higher risk than similar products. Explain in terms of Moody’s Analytics Portfolio
Manager Model, which factors can be cause of high risk and why. Considering
Naeem’s mortgage, which factor is the driving factor?
(4 marks)

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(f) Give one advantage and disadvantage of using VaR and Expected shortfall to
measure risk. Which one is more suitable to measure the risk for this mortgage and
explain?
(4 marks)

(g) Explain a typical design of an Islamic house mortgage loan? How the risk profile for
the Islamic mortgage differs from the conventional mortgage and explain the
implication in the typical down payment usually requested by the Islamic bank?
(4 marks)

(h) Naeem’s new company is a property management company. It manages hundreds of

commercial properties in the city. One opportunity comes up for the company to buy
a new apartment building and lease it out to students. The building is close to a
university surrounded by similar student apartments. The company is applying a
commercial real estate loan to fund this project.

(i) Name three attractive investment characteristics of this loan from lender’s
perspective?

There were three recent student apartment transactions in the last 12 months in the
neighbourhood. Student apartment A is right next door but in much worse condition,
it was recently sold at $5 million. Student apartment B is much further away from the
university and in a similar condition were sold last year at $7 million. Apartment C is a
residential apartment with similar condition and location, most of its tenants are
young population, it was sold 3 months ago for $9 million.

(ii) On which condition would each of the above three properties be used as
comparable in valuation?

(iii) The student apartment rental market has been volatile for the last year, which
one is most suitable under this situation?
(7 marks)

(i) Which credit portfolio management level correspond to the bank unit that is issuing
the mortgage to Naeem? List two advantage and disadvantages of the CPM level 2
compared to level 3.
(3 marks)

Total 40 marks

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Question 3 Maximum Word Limit 2000 words

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

(a) Letter of credit is a common instrument used in international trade finance. However,
it also composes large risk for the bank due to its non-cancellable, off-balance-sheet
and auto-renewable characteristics. Explain how these three characteristics can
cause potential credit risk concern for lender.
(5 marks)

(b) A financial analyst makes a comment that financial statements from large public
companies are true, and complete, because these companies are audited by famous
accounting firms. They are constantly monitored by regulators and financial market.
Do you agree with this comment? Explain your reason in detail.
(5 marks)

(c) A junior loan reviewer has adopted the statistic approach to analyse credit risk of
loans. She is considering whether to use linear regression model or logit model in her
report to senior management. Which factors should she consider in model selection
process and why?
(5 marks)

(d) Briefly describe how current high inflation and interest rate environment has been
impacting credit risk and why.
(5 marks)

Total 20 marks

END OF PAPER

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Statistical Tables
Normal Distribution Tables for Black–Scholes–Merton Option
Pricing Model
Normal distribution table for N(x) when x ≤ 0
0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09
0.0 0.5000 0.4960 0.4920 0.4880 0.4840 0.4801 0.4761 0.4721 0.4681 0.4641
–0.1 0.4602 0.4562 0.4522 0.4483 0.4443 0.4404 0.4364 0.4325 0.4286 0.4247
–0.2 0.4207 0.4168 0.4129 0.4090 0.4052 0.4013 0.3974 0.3936 0.3897 0.3859
–0.3 0.3821 0.3783 0.3745 0.3707 0.3669 0.3632 0.3594 0.3557 0.3520 0.3483
–0.4 0.3446 0.3409 0.3372 0.3336 0.3300 0.3264 0.3228 0.3192 0.3156 0.3121
–0.5 0.3085 0.3050 0.3015 0.2981 0.2946 0.2912 0.2877 0.2843 0.2810 0.2776
–0.6 0.2743 0.2709 0.2676 0.2643 0.2611 0.2578 0.2546 0.2514 0.2483 0.2451
–0.7 0.2420 0.2389 0.2358 0.2327 0.2296 0.2266 0.2236 0.2206 0.2177 0.2148
–0.8 0.2119 0.2090 0.2061 0.2033 0.2005 0.1977 0.1949 0.1922 0.1894 0.1867
–0.9 0.1841 0.1814 0.1788 0.1762 0.1736 0.1711 0.1685 0.1660 0.1635 0.1611
–1.0 0.1587 0.1562 0.1539 0.1515 0.1492 0.1469 0.1446 0.1423 0.1401 0.1379
–1.1 0.1357 0.1335 0.1314 0.1292 0.1271 0.1251 0.1230 0.1210 0.1190 0.1170
–1.2 0.1151 0.1131 0.1112 0.1093 0.1075 0.1056 0.1038 0.1020 0.1003 0.0985
–1.3 0.0968 0.0951 0.0934 0.0918 0.0901 0.0885 0.0869 0.0853 0.0838 0.0823
–1.4 0.0808 0.0793 0.0778 0.0764 0.0749 0.0735 0.0721 0.0708 0.0694 0.0681
–1.5 0.0668 0.0655 0.0643 0.0630 0.0618 0.0606 0.0594 0.0582 0.0571 0.0559
–1.6 0.0548 0.0537 0.0526 0.0516 0.0505 0.0495 0.0485 0.0475 0.0465 0.0455
–1.7 0.0446 0.0436 0.0427 0.0418 0.0409 0.0401 0.0392 0.0384 0.0375 0.0367
–1.8 0.0359 0.0351 0.0344 0.0336 0.0329 0.0322 0.0314 0.0307 0.0301 0.0294
–1.9 0.0287 0.0281 0.0274 0.0268 0.0262 0.0256 0.0250 0.0244 0.0239 0.0233
–2.0 0.0228 0.0222 0.0217 0.0212 0.0207 0.0202 0.0197 0.0192 0.0188 0.0183
–2.1 0.0179 0.0174 0.0170 0.0166 0.0162 0.0158 0.0154 0.0150 0.0146 0.0143
–2.2 0.0139 0.0136 0.0132 0.0129 0.0125 0.0122 0.0119 0.0116 0.0113 0.0110
–2.3 0.0107 0.0104 0.0102 0.0099 0.0096 0.0094 0.0091 0.0089 0.0087 0.0084
–2.4 0.0082 0.0080 0.0078 0.0075 0.0073 0.0071 0.0069 0.0068 0.0066 0.0064
–2.5 0.0062 0.0060 0.0059 0.0057 0.0055 0.0054 0.0052 0.0051 0.0049 0.0048
–2.6 0.0047 0.0045 0.0044 0.0043 0.0041 0.0040 0.0039 0.0038 0.0037 0.0036
–2.7 0.0035 0.0034 0.0033 0.0032 0.0031 0.0030 0.0029 0.0028 0.0027 0.0026
–2.8 0.0026 0.0025 0.0024 0.0023 0.0023 0.0022 0.0021 0.0021 0.0020 0.0019
–2.9 0.0019 0.0018 0.0018 0.0017 0.0016 0.0016 0.0015 0.0015 0.0014 0.0014
–3.0 0.0013 0.0013 0.0013 0.0012 0.0012 0.0011 0.0011 0.0011 0.0010 0.0010
–3.1 0.0010 0.0009 0.0009 0.0009 0.0008 0.0008 0.0008 0.0008 0.0007 0.0007
–3.2 0.0007 0.0007 0.0006 0.0006 0.0006 0.0006 0.0006 0.0005 0.0005 0.0005
–3.3 0.0005 0.0005 0.0005 0.0004 0.0004 0.0004 0.0004 0.0004 0.0004 0.0003
–3.4 0.0003 0.0003 0.0003 0.0003 0.0003 0.0003 0.0003 0.0003 0.0003 0.0002
–3.5 0.0002 0.0002 0.0002 0.0002 0.0002 0.0002 0.0002 0.0002 0.0002 0.0002
–3.6 0.0002 0.0002 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001
–3.7 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001
–3.8 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001
–3.9 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000
–4.0 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000

The table should be used with interpolation. For example:

N(−0.1234) = N(−0.12) − 0.34[(N(−0.12) − N(−0.13)]

= 0.4522 − 0.34[0.4522 − 0.4483]
= 0.4509
Statistical Tables

Normal distribution table for N(x) when x ≥ 0

0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09
0.0 0.5000 0.5040 0.5080 0.5120 0.5160 0.5199 0.5239 0.5279 0.5319 0.5359
0.1 0.5398 0.5438 0.5478 0.5517 0.5557 0.5596 0.5636 0.5675 0.5714 0.5753
0.2 0.5793 0.5832 0.5871 0.5910 0.5948 0.5987 0.6026 0.6064 0.6103 0.6141
0.3 0.6179 0.6217 0.6255 0.6293 0.6331 0.6368 0.6406 0.6443 0.6480 0.6517
0.4 0.6554 0.6591 0.6628 0.6664 0.6700 0.6736 0.6772 0.6808 0.6844 0.6879
0.5 0.6915 0.6950 0.6985 0.7019 0.7054 0.7088 0.7123 0.7157 0.7190 0.7224
0.6 0.7257 0.7291 0.7324 0.7357 0.7389 0.7422 0.7454 0.7486 0.7517 0.7549
0.7 0.7580 0.7611 0.7642 0.7673 0.7704 0.7734 0.7764 0.7794 0.7823 0.7852
0.8 0.7881 0.7910 0.7939 0.7967 0.7995 0.8023 0.8051 0.8078 0.8106 0.8133
0.9 0.8159 0.8186 0.8212 0.8238 0.8264 0.8289 0.8315 0.8340 0.8365 0.8389
1.0 0.8413 0.8438 0.8461 0.8485 0.8508 0.8531 0.8554 0.8577 0.8599 0.8621
1.1 0.8643 0.8665 0.8686 0.8708 0.8729 0.8749 0.8770 0.8790 0.8810 0.8830
1.2 0.8849 0.8869 0.8888 0.8907 0.8925 0.8944 0.8962 0.8980 0.8997 0.9015
1.3 0.9032 0.9049 0.9066 0.9082 0.9099 0.9115 0.9131 0.9147 0.9162 0.9177
1.4 0.9192 0.9207 0.9222 0.9236 0.9251 0.9265 0.9279 0.9292 0.9306 0.9319
1.5 0.9332 0.9345 0.9357 0.9370 0.9382 0.9394 0.9406 0.9418 0.9429 0.9441
1.6 0.9452 0.9463 0.9474 0.9484 0.9495 0.9505 0.9515 0.9525 0.9535 0.9545
1.7 0.9554 0.9564 0.9573 0.9582 0.9591 0.9599 0.9608 0.9616 0.9625 0.9633
1.8 0.9641 0.9649 0.9656 0.9664 0.9671 0.9678 0.9686 0.9693 0.9699 0.9706
1.9 0.9713 0.9719 0.9726 0.9732 0.9738 0.9744 0.9750 0.9756 0.9761 0.9767
2.0 0.9772 0.9778 0.9783 0.9788 0.9793 0.9798 0.9803 0.9808 0.9812 0.9817
2.1 0.9821 0.9826 0.9830 0.9834 0.9838 0.9842 0.9846 0.9850 0.9854 0.9857
2.2 0.9861 0.9864 0.9868 0.9871 0.9875 0.9878 0.9881 0.9884 0.9887 0.9890
2.3 0.9893 0.9896 0.9898 0.9901 0.9904 0.9906 0.9909 0.9911 0.9913 0.9916
2.4 0.9918 0.9920 0.9922 0.9925 0.9927 0.9929 0.9931 0.9932 0.9934 0.9936
2.5 0.9938 0.9940 0.9941 0.9943 0.9945 0.9946 0.9948 0.9949 0.9951 0.9952
2.6 0.9953 0.9955 0.9956 0.9957 0.9959 0.9960 0.9961 0.9962 0.9963 0.9964
2.7 0.9965 0.9966 0.9967 0.9968 0.9969 0.9970 0.9971 0.9972 0.9973 0.9974
2.8 0.9974 0.9975 0.9976 0.9977 0.9977 0.9978 0.9979 0.9979 0.9980 0.9981
2.9 0.9981 0.9982 0.9982 0.9983 0.9984 0.9984 0.9985 0.9985 0.9986 0.9986
3.0 0.9987 0.9987 0.9987 0.9988 0.9988 0.9989 0.9989 0.9989 0.9990 0.9990
3.1 0.9990 0.9991 0.9991 0.9991 0.9992 0.9992 0.9992 0.9992 0.9993 0.9993
3.2 0.9993 0.9993 0.9994 0.9994 0.9994 0.9994 0.9994 0.9995 0.9995 0.9995
3.3 0.9995 0.9995 0.9995 0.9996 0.9996 0.9996 0.9996 0.9996 0.9996 0.9997
3.4 0.9997 0.9997 0.9997 0.9997 0.9997 0.9997 0.9997 0.9997 0.9997 0.9998
3.5 0.9998 0.9998 0.9998 0.9998 0.9998 0.9998 0.9998 0.9998 0.9998 0.9998
3.6 0.9998 0.9998 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999
3.7 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999
3.8 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999
3.9 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000
4.0 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000

The table should be used with interpolation. For example:

N(0.6278) = N(0.62) + 0.78[(N(0.63) − N(.62)]

= 0.7324 + 0.78[0.7357 − 0.7324]
= 0.7350

12 Edinburgh Business School Credit Risk Management

 Statistical Tables

Poisson Distribution Tables for Insurance Model

Poisson distribution

Number of occurrences given mean value (n) of observations

n 0 1 2 3 4 5 6 7 8 9 10
1 0.36788 0.36788 0.18394 0.06131 0.01533 0.00307 0.00051 0.00007 0.00001 0.00000 0.00000
2 0.13534 0.27067 0.27067 0.18045 0.09022 0.03609 0.01203 0.00344 0.00086 0.00019 0.00004
3 0.04979 0.14936 0.22404 0.22404 0.16803 0.10082 0.05041 0.02160 0.00810 0.00270 0.00081
4 0.01832 0.07326 0.14653 0.19537 0.19537 0.15629 0.10420 0.05954 0.02977 0.01323 0.00529
5 0.00674 0.03369 0.08422 0.14037 0.17547 0.17547 0.14622 0.10444 0.06528 0.03627 0.01813
6 0.00248 0.01487 0.04462 0.08924 0.13385 0.16062 0.16062 0.13768 0.10326 0.06884 0.04130
7 0.00091 0.00638 0.02234 0.05213 0.09123 0.12772 0.14900 0.14900 0.13038 0.10140 0.07098
8 0.00034 0.00268 0.01073 0.02863 0.05725 0.09160 0.12214 0.13959 0.13959 0.12408 0.09926
9 0.00012 0.00111 0.00500 0.01499 0.03374 0.06073 0.09109 0.11712 0.13176 0.13176 0.11858
10 0.00005 0.00045 0.00227 0.00757 0.01892 0.03783 0.06306 0.09008 0.11260 0.12511 0.12511
11 0.00002 0.00018 0.00101 0.00370 0.01019 0.02242 0.04109 0.06458 0.08879 0.10853 0.11938
12 0.00001 0.00007 0.00044 0.00177 0.00531 0.01274 0.02548 0.04368 0.06552 0.08736 0.10484

11 12 13 14 15 16 17 18 19 20 21
1 0.00000 0.00000 0.00000 0.00000 0.00000 0.00000 0.00000 0.00000 0.00000 0.00000 0.00000
2 0.00001 0.00000 0.00000 0.00000 0.00000 0.00000 0.00000 0.00000 0.00000 0.00000 0.00000
3 0.00022 0.00006 0.00001 0.00000 0.00000 0.00000 0.00000 0.00000 0.00000 0.00000 0.00000
4 0.00192 0.00064 0.00020 0.00006 0.00002 0.00000 0.00000 0.00000 0.00000 0.00000 0.00000
5 0.00824 0.00343 0.00132 0.00047 0.00016 0.00005 0.00001 0.00000 0.00000 0.00000 0.00000
6 0.02253 0.01126 0.00520 0.00223 0.00089 0.00033 0.00012 0.00004 0.00001 0.00000 0.00000
7 0.04517 0.02635 0.01419 0.00709 0.00331 0.00145 0.00060 0.00023 0.00009 0.00003 0.00001
8 0.07219 0.04813 0.02962 0.01692 0.00903 0.00451 0.00212 0.00094 0.00040 0.00016 0.00006
9 0.09702 0.07277 0.05038 0.03238 0.01943 0.01093 0.00579 0.00289 0.00137 0.00062 0.00026
10 0.11374 0.09478 0.07291 0.05208 0.03472 0.02170 0.01276 0.00709 0.00373 0.00187 0.00089
11 0.11938 0.10943 0.09259 0.07275 0.05335 0.03668 0.02373 0.01450 0.00840 0.00462 0.00242
12 0.11437 0.11437 0.10557 0.09049 0.07239 0.05429 0.03832 0.02555 0.01614 0.00968 0.00553

Credit Risk Management Edinburgh Business School 13

Statistical Tables

Cumulative distribution

Number of occurrences given mean value (n) of observations

n 0 1 2 3 4 5 6 7 8 9 10
1 0.36788 0.73576 0.91970 0.98101 0.99634 0.99941 0.99992 0.99999 1.00000 1.00000 1.00000
2 0.13534 0.40601 0.67668 0.85712 0.94735 0.98344 0.99547 0.99890 0.99976 0.99995 0.99999
3 0.04979 0.19915 0.42319 0.64723 0.81526 0.91608 0.96649 0.98810 0.99620 0.99890 0.99971
4 0.01832 0.09158 0.23810 0.43347 0.62884 0.78513 0.88933 0.94887 0.97864 0.99187 0.99716
5 0.00674 0.04043 0.12465 0.26503 0.44049 0.61596 0.76218 0.86663 0.93191 0.96817 0.98630
6 0.00248 0.01735 0.06197 0.15120 0.28506 0.44568 0.60630 0.74398 0.84724 0.91608 0.95738
7 0.00091 0.00730 0.02964 0.08177 0.17299 0.30071 0.44971 0.59871 0.72909 0.83050 0.90148
8 0.00034 0.00302 0.01375 0.04238 0.09963 0.19124 0.31337 0.45296 0.59255 0.71662 0.81589
9 0.00012 0.00123 0.00623 0.02123 0.05496 0.11569 0.20678 0.32390 0.45565 0.58741 0.70599
10 0.00005 0.00050 0.00277 0.01034 0.02925 0.06709 0.13014 0.22022 0.33282 0.45793 0.58304
11 0.00002 0.00020 0.00121 0.00492 0.01510 0.03752 0.07861 0.14319 0.23199 0.34051 0.45989
12 0.00001 0.00008 0.00052 0.00229 0.00760 0.02034 0.04582 0.08950 0.15503 0.24239 0.34723

11 12 13 14 15 16 17 18 19 20 21
1 1.00000 1.00000 1.00000 1.00000 1.00000 1.00000 1.00000 1.00000 1.00000 1.00000 1.00000
2 1.00000 1.00000 1.00000 1.00000 1.00000 1.00000 1.00000 1.00000 1.00000 1.00000 1.00000
3 0.99993 0.99998 1.00000 1.00000 1.00000 1.00000 1.00000 1.00000 1.00000 1.00000 1.00000
4 0.99908 0.99973 0.99992 0.99998 1.00000 1.00000 1.00000 1.00000 1.00000 1.00000 1.00000
5 0.99455 0.99798 0.99930 0.99977 0.99993 0.99998 0.99999 1.00000 1.00000 1.00000 1.00000
6 0.97991 0.99117 0.99637 0.99860 0.99949 0.99983 0.99994 0.99999 0.99999 1.00000 1.00000
7 0.94665 0.97300 0.98719 0.99428 0.99759 0.99904 0.99964 0.99987 0.99996 0.99999 1.00000
8 0.88808 0.93620 0.96582 0.98274 0.99177 0.99628 0.99841 0.99935 0.99975 0.99991 0.99997
9 0.80301 0.87577 0.92615 0.95853 0.97796 0.98889 0.99468 0.99757 0.99894 0.99956 0.99983
10 0.69678 0.79156 0.86446 0.91654 0.95126 0.97296 0.98572 0.99281 0.99655 0.99841 0.99930
11 0.57927 0.68870 0.78129 0.85404 0.90740 0.94408 0.96781 0.98231 0.99071 0.99533 0.99775
12 0.46160 0.57597 0.68154 0.77202 0.84442 0.89871 0.93703 0.96258 0.97872 0.98840 0.99393

14 Edinburgh Business School Credit Risk Management

Appendix 2

Formula Sheet for Credit Risk

Management
1. Ratio Analysis

Average collection period

Average collection period

Stock (inventory) turnover

Stock inventory turnover

Non-current (fixed) asset turnover

Non˗current asset turnover
˗

Total asset turnover

Total asset turnover

Current ratio
Current ratio

Quick ratio
Quick ratio

Gross profit margin

Gross profit margin

Net profit margin

Net profit margin

Credit Risk Management Edinburgh Business School A2/1

Appendix 2 / Formula Sheet for Credit Risk Management

Free cash flow from the business

FCF
Net profit Interest payment
Depreciation and other non‐ cash items Change in networking capital
Capital expenditure

Return on capital employed

Return on capital employed ROCE

Return on assets
Return on assets ROA

Return on equity
Return on equity ROE
’

Debt ratio
Debt ratio

Debt-to-equity ratio
Debt˗to˗equity ratio

Interest cover
Interest cover times

Fixed charge cover

Fixed charge cover times

Earnings per share

Earnings per share EPS

Price/earnings ratio
P/E PER

A2/2 Edinburgh Business School Credit Risk Management

 Appendix 2 / Formula Sheet for Credit Risk Management

Price-to-book ratio
P/BV

Net asset value

’
Net asset value NAV

Accounts receivable turnover

Accounts receivable turnover

Days sales outstanding collection period

Payables turnover
Payables turnover

Days payable outstanding

2. DuPont Model

Return on assets
ROA

Return on equity
ROE

3. Credit Scoring and Modelling Default

Expected loss from extending credit, good and bad attributes

∈
/ ∈
/
or equivalently:
∈
/ ∈
/

Decision rule to minimise loss

A / / /
or equivalently:
/
A /
/

Credit Risk Management Edinburgh Business School A2/3

Appendix 2 / Formula Sheet for Credit Risk Management

Linear regression

Multiple regression

∑ ∑ ∑ ∑

∑ ∑ ∑

∑ ∑ ∑ ∑

∑ ∑ ∑

Altman’s Z–score for private firms

1.2 1.4

’
3.3 0.6 1.0

Taffler and Tishaw’s Z-score

3.3 1.0 0.6

1.4 1.2

4. Market-Based Credit Models

Probability of default on a bond

1
1
1

The present value of the loss from default at time t

, G BR ⋅ 1

A2/4 Edinburgh Business School Credit Risk Management

 Appendix 2 / Formula Sheet for Credit Risk Management

The total present value of the losses given on the jth bond
G B ,

Probability of loss for the jth bond

Spot (zero-coupon) interest rate

1
⋅

Mean of distributions
∑

Variance of distributions

Portfolio return
∑

Portfolio standard deviation

Probability of default
Pr Default Pr

Portfolio value at risk

VaR VaR VaR 2 VaR VaR

Credit Risk Management Edinburgh Business School A2/5

Appendix 2 / Formula Sheet for Credit Risk Management

Binomial option pricing model

√ 1⁄

⋅ 1

Delta (in binomial option pricing model)

Black–Scholes–Merton option pricing model, default put

1 1

√ √
√

The Black–Scholes–Merton equation for a call option

Default spread
ln 1

Value of put in terms of the likelihood of default

1

Expected loss if default takes place

Expected loss 1 1

Expected loss, yield spread

ln

Expected loss, yield spread, derived from option pricing equation

ln 1
Short˗term debt Long˗term debt

A2/6 Edinburgh Business School Credit Risk Management

 Appendix 2 / Formula Sheet for Credit Risk Management

Marginal Mortality Rate (MMR)

MMR
,

Standard error

Probability of n default

Pr defaults
!

5. Managing Credit Risk in a Corporate Environment

Net present value of a new credit policy

NPV

VCR 1 Sales

Net present value of existing credit policy

NPV

VCR Sales

6. Binomial Option Pricing Model

Replicating portfolio
Loss from default at 1
Loss from default at 1

Credit Risk Management Edinburgh Business School A2/7

Appendix 2 / Formula Sheet for Credit Risk Management

Fractional holding in the company’s assets

Amount of lending/borrowing at risk-free rate

A2/8 Edinburgh Business School Credit Risk Management

7. Extra formulae
Depreciation Expense
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 – 𝑅𝑒𝑠𝑖𝑑𝑢𝑎𝑙 𝑣𝑎𝑙𝑢𝑒
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 =
𝑈𝑠𝑒𝑓𝑢𝑙 𝑙𝑖𝑓𝑒 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡

EBIT
𝐸𝐵𝐼𝑇 = 𝐺𝑟𝑜𝑠𝑠 𝑝𝑟𝑜𝑓𝑖𝑡 − 𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠

Accounts Receivable
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 = 𝑝𝑟𝑒𝑣𝑖𝑜𝑢𝑠 𝑏𝑎𝑙𝑎𝑛𝑐𝑒 + 𝑐𝑟𝑒𝑑𝑖𝑡 𝑠𝑎𝑙𝑒𝑠 – 𝑟𝑒𝑐𝑒𝑖𝑝𝑡 𝑓𝑟𝑜𝑚 𝑑𝑒𝑏𝑡𝑜𝑟𝑠

Accounts Payable
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒 = 𝑝𝑟𝑒𝑣𝑖𝑜𝑢𝑠 𝑏𝑎𝑙𝑎𝑛𝑐𝑒 + 𝑐𝑟𝑒𝑑𝑖𝑡 𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒 – 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 𝑡𝑜 𝑠𝑢𝑝𝑝𝑙𝑖𝑒𝑟𝑠

Inventory
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 = 𝑝𝑟𝑒𝑣𝑖𝑜𝑢𝑠 𝑏𝑎𝑙𝑎𝑛𝑐𝑒 + 𝑠𝑡𝑜𝑐𝑘 𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒 – 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑 𝑠𝑜𝑙𝑑

Cash
𝐶𝑎𝑠ℎ = 𝑝𝑟𝑒𝑣𝑖𝑜𝑢𝑠 𝑏𝑎𝑙𝑎𝑛𝑐𝑒 + 𝑐𝑎𝑠ℎ 𝑟𝑒𝑐𝑒𝑖𝑝𝑡 𝑓𝑟𝑜𝑚 𝑠𝑎𝑙𝑒𝑠

+ 𝑟𝑒𝑐𝑒𝑖𝑝𝑡 𝑓𝑟𝑜𝑚 𝑑𝑒𝑏𝑡𝑜𝑟𝑠 – 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 𝑡𝑜 𝑠𝑢𝑝𝑝𝑙𝑖𝑒𝑟𝑠 – 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 𝑡𝑜 𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑠𝑡𝑜𝑐𝑘

– 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 𝑡𝑜 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑒𝑠 – 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 𝑡𝑜 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠 – 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 – 𝑡𝑎𝑥 𝑝𝑎𝑦𝑚𝑒𝑛𝑡

Quick ratio (adjusted)

𝑐𝑎𝑠ℎ + 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
𝑄𝑢𝑖𝑐𝑘 𝑟𝑎𝑡𝑖𝑜 =
𝑡𝑜𝑡𝑎𝑙 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

Moody’s Analytics Portfolio Manager Model

𝑅𝑖 = 𝐴𝐼𝑆𝑖 − 𝐸(𝐿𝑖 ) = 𝐴𝐼𝑆𝑖 − [𝐸𝐷𝐹𝑖 ⋅ 𝐿𝐺𝐷𝑖 ]

Loan monthly repayment calculation

1 − (1 + 𝑖)−𝑝𝑒𝑟𝑖𝑜𝑑
𝑀𝑜𝑟𝑡𝑔𝑎𝑔𝑒 𝑠𝑖𝑧𝑒 = 𝑀𝑜𝑛𝑡ℎ𝑙𝑦 𝑟𝑒𝑝𝑎𝑦𝑚𝑒𝑛𝑡 ∗
𝑖
Maximum loan size
𝐿𝑜𝑎𝑛 𝑠𝑖𝑧𝑒 = ℎ𝑜𝑢𝑠𝑒 𝑣𝑎𝑙𝑢𝑒 ∗ 𝐿𝑇𝑉