BUS307 Commercial Banking|Borrower

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BUS307 Commercial Banking

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QUESTION 1a Suppose a borrower knows at time t = 0 that it will have available at time t = 1 an opportunity to invest $340 in a risky project that will pay off at time t = 2. The borrower knows that it will be able to invest in one of two mutually exclusive projects, S or R, each requiring a $340 investment. If the borrower invests in S at time t = 1, the project will yield a gross payoff of $615 with a probability of 0.8 and $180 with a probability of 0.2 at time t = 2. If the borrower invests in R at time t = 1, the project will yield a gross payoff of $685 with a probability of 0.6 and $100 with a probability of 0.4 at time t = 2. The borrower’s project choice is not observable to the bank. The riskless, single-period interest rate at time t = 0 is 3%. It is not known at time t = 0 what the riskless, single period interest rate at time t = 1 will be, but it is common knowledge that this rate will be 4% (with probability 0.65) or 10% (with probability 0.35). Assume universal risk neutrality and that the borrower has no assets than the project on which you (as the lender) can have a claim. Suppose you are this borrower’s bank and both you and the borrower recognize that this borrower has two choices: (1) it can do nothing at time t = 0 and simply borrow at the spot market at interest rate prevailing for it at time t = 1, or (2) it can negotiate at time t = 0 with you (or some other bank) for a loan commitment that will permit it to borrow at predetermined terms at time t = 1. What advice should you give this borrower? Assume a competitive loan market in which each bank is constrained to earn zero expected profit. Determine the NPV of the alternative(s) that you recommend. QUESTION 1a [15 Marks] (continued) QUESTION Lee Ltd and Ng Corporation negotiate a $15 million, 5-year interest-rate swap in in which Lee will pay 4.25% fixed rate to Ng and Ng will pay Libor to Lee (there is no swap dealer involved). The firms will net payments half-yearly. Lee generally pays Libor plus 20 basis points for borrowing and Ng borrows at 4.10%. Determine the “all-in-cost” for Lee and Ng. It may be useful to create a diagram showing the payment responsibilities of each firm. Suppose after two years the market is offering a swap rate of 3.25% against Libor. A swap dealer offers to take the swap off Lee’s hands. How much will Lee have to pay the dealer?

QUESTION 2 The market value of the assets of a corporation is currently $290.0 million but the owners wish to only use as collateral a value that will result in an interest rate of about 10%. The firm has on issue a debt outstanding that has a par value of $35.0 million and a due date of exactly five years. No intermediate interest payments are required. The risk-free (continuous) rate is 3.25% and the standard deviation of returns of the firm’s assets is 60%. What is the value of the assets required by the debt holders to permit a fair interest rate of approximately10% (your answer should ensure that the fair interest rate is in the range of >9% and <11%)? State any simplifying assumptions made in your calculations.

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