Credit Risk Management Discussion
QUESTION 1
Oban is a small building products firm in the construction industry. Conditions have been very poor in the sector, but in the past year there has been an improvement and sales in the industry have been moving forward again.
Up to this point Oban has had a credit policy of ‘Net 25 with 1.5% discount’ and only 30% of their customers were taking the discount. The average payment for those who were not taking the discount was 50 days. However, sales at rival companies have been
improving at a quicker pace than at Oban’s. The directors have put this down to the fact that the other firms have started to lengthen their credit terms and offer discounts.
The directors have decided to change their credit policy. They will instigate a policy of ‘Net 45 with a 2.5% discount’. Analysts at the firm estimate that 50% of their customers will take up the discount. For those who do not take the discount, payment is expected after 90 days.
Oban’s existing policy is expected to raise bad debts from 5% to 7%. Industry figures show that the level of bad debts experienced with lengthened credit policies is running at 8%. Oban is confident that their sales will rise by 10% with the new credit policy, which is slightly more generous than rival firms. Current sales are £10m (annually).
The variable cost ratio is 0.50 and the administrative expenses incurred from the new credit policy are expected to be 3.0% of the value of unit sales, as opposed to 1.5% with the existing policy. The opportunity cost of capital is 8%.
Required:
- Should Oban’s adopt the new trade credit policy? Is it profitable? Show all yourworkings. (15 marks)
- Explain in detail how a company would determine what line of credit to offer to acustomer if there were financial statements available on the customer. (10 marks)
- What other non-financial factors should be considered when determining the lineof credit offered to a customer? (5 marks)
- You have the following information on the Oban’s bonds as well as government bonds with the same maturity:
The recovery rate in the event that Oban defaults on its bonds is conservatively estimated at 60% given its realisable assets if the firm is liquidated.
What is the market in corporate bonds saying about the likelihood of Oban defaulting over the next five years? What are the five- year cumulative default rate and the default probability and hazard rate for Year 5? (10 marks)
QUESTION 3
Levine plc is a Scottish based company that has been growing fast and is looking to expand operations overseas. Levine had up until this point in time been a UK only
trading company with no overseas sales or contracts. They had operated in the real estate office construction market, which had been a reasonably good business in the UK. Now they felt it was time to seek some overseas contracts. They planned to move into North Africa and the Middle East to participate in the growing markets in those regions. Levine needs extra capital to embark on this expansion. Levine has been a good customer of your bank for a number of years and now they have come to the bank seeking a loan of £50m to fund its overseas expansion plans, which is considerably large for a single customer. Your bank has set a limitation on its credit exposure to the real estate sector.
In its loan application, Levine stated that the repayment of this loan will be made using the cashflows generated from its overseas activities. You have been asked to conduct a credit risk assessment on Levine’s loan application.
Required:
- What are the additional factors that need to be taken into account when assessing the credit quality related to this loan? (7 marks)
- What methods can a bank use to control credit risk? Describe and discuss each method and apply them to Levine’s loan. (8 marks)
- Describe in detail four firm-specific causes of financial distress. (5 marks)