Deck 8: Further Issues in Bank Lending

Question 1

The source of income from bank loan is

A)the interest on the loan
B)the repayment of the loan
C)income from fees charged due to lending relationship
D)all of the above
E)a and c only

Answer 1

E

Question 2

With asymmetric information, a bank can earn lower profits on a high risk borrower even though it charges the borrower a higher interest rate.The reason is

A)the high risk borrower has a greater propensity to switch to riskier projects when charged with higher rate
B)the bank's break-even interest rate on a high risk borrower is higher
C)competition forces the bank to charge a higher rate
D)all of the above
E)a and b only

Answer 2

E

Question 3

The variables of interest for determining the prime rate are

A)the term structure of interest rates
B)the rates on non-loan bank assets
C)the rates on bank-acquired liabilities
D)all of the above
E)a and c only.

Answer 3

D

Question 4

Coordination problems due to creditor coalitions generally arise because

A)different creditors have different interest in the borrowing firm.
B)it is hard to ensure that a certain restructuring plan would be accepted by all creditors.
C)the borrowing firm's shareholders can block a restructuring plan which causes the creditors to renegotiate the terms of lending,
D)a and b only.
E)all of the above.

Question 5

After a loan is approved, it will continuously be monitored so that

A)problem loans can be detected early to prevent future liquidity problems
B)regulatory requirements concerning the accuracy of the loan loss reserves are met
C)reserve requirements or deposits can be more accurately estimated
D)a and b only
E)all of the above

Question 6

Rationing in the large means that

A)a borrower is denied credit indiscriminately when the loan amount is large
B)a borrower is denied credit indiscriminately after the bank reached the maximum loan amount it is willing to lend in a given period
C)a borrower is denied credit indiscriminately because it does not have large amount of collateral
D)a borrower is denied credit discriminately because it is not a large, well established company
E)none of the above

Question 7

Rationing in the large may have the following implications):

A)an increase in the upper bound of the loan amount the bank is willing to lend will increase the likelihood of each borrower being rationed
B)an increase in the upper bound of the loan amount the bank is willing to lend will increase aggregate rationing
C)an increase in the upper bound of the loan amount the bank is willing to lend will decrease the likelihood of each borrower being rationed
D)an increase in the upper bound of the loan amount the bank is willing to lend will decrease aggregate rationing
E)only a and b

Question 8

Use the following information for problems
There are two types of borrower, L low risk and H high risk. The bank can distinguish the types but cannot control the borrower’s project choice. The borrower has a choice of two mutually exclusive projects: S safe and R risky. The project requires $250 investment. For borrower L, project S can generate $315 for sure; while project R generates $320 with probability 0.8 and zero with probability 0.2. For borrower H, project S can generate $320 with probability 0.8 and zero with probability 0.2; while project R generates $337 with probability 0.6 and zero with probability 0.4. The riskless interest rate is 6%, and the bank thinks that it can charge an additional 1.5% before a customer switches to another bank.


-What is the net expected payoff to L if S is chosen?

A)$315.00
B)$65.00
C)$60.47
D)$46.25
E)0

Question 9

Credit rationing is a situation whereby

A)there is an excess supply of funds at the going rate
B)the lender refuses to lend at the terms requested by the borrower
C)the lender refuses to lend to a borrower at a price posted by the lender for that borrower class
D)the borrower is denied credit due to a reduction in the interest rate that a bank can charged to that borrower
E)all of the above

Question 10

An advantage of maintaining records of previous borrowers is that

A)the bank can reduce asymmetry information and hence may reduce the costs on future loans
B)the bank can create an economy of scope in the credit application process
C)the bank can reduce monitoring costs
D)a and c only
E)all of the above

Question 11

Use the following information for problems
There are two types of borrower, L low risk and H high risk. The bank can distinguish the types but cannot control the borrower’s project choice. The borrower has a choice of two mutually exclusive projects: S safe and R risky. The project requires $250 investment. For borrower L, project S can generate $315 for sure; while project R generates $320 with probability 0.8 and zero with probability 0.2. For borrower H, project S can generate $320 with probability 0.8 and zero with probability 0.2; while project R generates $337 with probability 0.6 and zero with probability 0.4. The riskless interest rate is 6%, and the bank thinks that it can charge an additional 1.5% before a customer switches to another bank.

-What is the net expected payoff to L if R is chosen?

A)$320.00
B)$297.68
C)$65.11
D)$52.09
E)$41.00

Question 12

Use the following information for problems
There are two types of borrower, L low risk and H high risk. The bank can distinguish the types but cannot control the borrower’s project choice. The borrower has a choice of two mutually exclusive projects: S safe and R risky. The project requires $250 investment. For borrower L, project S can generate $315 for sure; while project R generates $320 with probability 0.8 and zero with probability 0.2. For borrower H, project S can generate $320 with probability 0.8 and zero with probability 0.2; while project R generates $337 with probability 0.6 and zero with probability 0.4. The riskless interest rate is 6%, and the bank thinks that it can charge an additional 1.5% before a customer switches to another bank.

-If the bank assumes that R will be chosen by H, what interest rate should the bank charge?

A)7.5%
B)15.25%
C)37.88%
D)76.67%
E)122.11%

Question 13

Allowing a firm in a mild financial distress to restructure, instead of forcing it to liquidate,

A)signals the lender's willingness to maintain a long-term relationship with the borrower and improve its reputation in the credit market
B)may make the lender better off in the long run
C)will diminish the borrower's economic value
D)a and b only
E)a and c only

Question 14

A long-term bank-borrower relationship can result in

A)the bank being exploited by the borrower due to a more severe, multi-period asset substitution moral hazard problem
B)the reduction in moral hazard when a binding multi-period contract can be negotiated at the outset
C)the borrower's lesser propensity to switch project because it's being offered a subsidized loan after it repays its first period loan
D)a and c only
E)b and c only

Question 15

A firm in a moderate financial distress

A)will face an imminent default if debt is not restructured
B)has assets whose market value is less than that of its debt repayment obligations
C)has assets whose economic value is less than that of its debt repayment obligations
D)a and b only
E)b and c only

Question 16

When a firm is in a severe financial distress,

A)it should be liquidated to meet the creditors' demand for repayment.
B)it is possible to work out a more efficient debt restructuring plan whereby some lenders help the borrower to pay off some of the debt.
C)it will end up filing for Chapter 11 Bankruptcy,
D)its liquidation value is always less than its going-concern value.
E)a and c only.

Question 17

The reason why a bank would ration credit is that

A)the interest rate has fallen so low that lending to any borrower would not be profitable
B)the increase in the loan rate worsens moral hazard problem between the bank and the borrower
C)the bank's expected profit could be lower at a higher loan rate because of adverse selection problem
D)all of the above
E)b and c only

Question 18

A mild financial distress is a situation whereby

A)a borrower's market value of assets is less than the market value of obligations
B)a borrower faces a temporary shortfall of cash flows but the economic value of its assets still exceeds the economic value of obligations
C)a borrower faces a temporary shortfall of cash flows but the economic value of its assets is less than that of its obligations
D)a borrower cannot repay its debt obligations regardless of the economic conditions
E)none of the above

Question 19

By requiring a borrower to maintain a compensating balance, the bank is

A)giving the borrower the flexibility to withdraw funds as it deems necessary
B)providing the borrower with additional funds when the borrower exceeds its credit limit
C)effectively lowering the interest rate charged to the borrower
D)reducing the amount of funds available to the borrower and hence effectively increasing the loan rate
E)all of the above

Question 20

The prime rate is

A)an interest rate charged during prime time
B)a uniform interest rate that applies to all bank loans
C)an interest rate charged by the Fed for using its facility
D)an interest rate charged by the bank for its most creditworthy customers
E)an interest rate used by the Treasury department to set the coupon rate for T- bonds

Question 21

Use the following information for questions
Dynamic Systems, Inc.is in financial trouble.It has three types of debt: a bank loan of $400 with the highest priority, a senior debt of $100 owned by bondholders with the next highest priority, and a junior debt of $100 owned by bondholders with the lowest priority.These debts are due in one period.The firm has announced its intention to declare bankruptcy.At this stage, the creditors must choose one of two mutually exclusive restructuring plAns.plan A with which the firm's asset next period will be $450 with probability 0.8 and $250 with probability 0.2; or plan B with which the asset's value will be $600 with probability 0.4 or $100 with probability 0.4.Everybody is risk neutral, and the discount rate is zero.

-What is the junior debt holders' expected payoff under plan B?

A)$0
B)$20
C)$40
D)$70
E)$100

Question 22

Use the following information for questions
Incredible Inc.currently owes its creditors $300.The manager, Mr.Jack Smith can manage it for a period at a personal cost of $110.It has an asset which will generate $450 with probability 0.7 or $200 with probability 0.3 under Mr.Smith's stewardship.Under any other management, the asset will have a sure liquidation value of $250.Everybody is risk neutral and the riskless rate is zero.
What loan repayment should the creditors offer to Mr.Smith to make him indifferent between continuing and defaulting?

A)$356.75
B)$300.00
C)$298.78
D)$295.74

Question 23

Use the following information for questions
Incredible Inc.currently owes its creditors $300.The manager, Mr.Jack Smith can manage it for a period at a personal cost of $110.It has an asset which will generate $450 with probability 0.7 or $200 with probability 0.3 under Mr.Smith's stewardship.Under any other management, the asset will have a sure liquidation value of $250.Everybody is risk neutral and the riskless rate is zero.
What is the payoff to Mr.Smith if he continues to manage under the current term?

A)-$110.00
B)-$35.00
C)-$5.00
D)$25.00
E)$150.00

Question 24

Use the following information for questions
There are two types of borrowers, low risk L and high risk H.As a lending officer, you cannot distinguish between the two types of borrowers.You believe, however, that there is a 0.5 probability that a randomly chosen borrower is L, and 0.5 that it is H.There are 500 potential loan applicants, each requiring $150.Type L will invest this loan in a single-period project that pays $250 with probability 0.8 or zero with probability 0.2.Type H will invest the loan in a single-period project that pays $275 with probability 0.5 and zero with probability 0.5.Your bank is a monopolist to these borrowers.The riskless interest rate is 6%, and a borrower must have at least $2 of net profit in the successful state in order to apply for the loan.Everybody is risk neutral and suppose that you have $75,000 to lend.

-Suppose that you have decided to charge 65% interest rate.What would be the type H's net profit in the successful state?

A)$10.00
B)$27.50
C)$45.00
D)$67.50
E)$100.00

Question 25

Use the following information for questions
Incredible Inc.currently owes its creditors $300.The manager, Mr.Jack Smith can manage it for a period at a personal cost of $110.It has an asset which will generate $450 with probability 0.7 or $200 with probability 0.3 under Mr.Smith's stewardship.Under any other management, the asset will have a sure liquidation value of $250.Everybody is risk neutral and the riskless rate is zero.
Suppose that the creditors reduce the firm's debt obligation to $290.What is Mr.Smith's payoff if he continues to manage the firm?

A)$0
B)$2
C)$15
D)$68
E)$110

Question 26

Use the following information for questions
Mr.Keith Jones is the manager of State of the Art, Inc.The firm has two kinds of debt: senior debt of $500, and junior debt bank loan) of $1,500.The firm has an asset with a liquidation value of $700.If the firm continues to operate, its asset can generate $1,750 with probability
0.8 and zero with probability 0.2.Mr.Jones suffers a personal cost of $25 from managing the firm for another period.Mr.Jones is the sole equity holder of the firm.
Suppose the bank reduced the repayment obligation to $1,715.What would be the bank's expected payoff if the firm continues to operate?

A)-$378
B)-$250
C)$346
D)$872
E)$1,028

Question 27

Use the following information for questions
Dynamic Systems, Inc.is in financial trouble.It has three types of debt: a bank loan of $400 with the highest priority, a senior debt of $100 owned by bondholders with the next highest priority, and a junior debt of $100 owned by bondholders with the lowest priority.These debts are due in one period.The firm has announced its intention to declare bankruptcy.At this stage, the creditors must choose one of two mutually exclusive restructuring plAns.plan A with which the firm's asset next period will be $450 with probability 0.8 and $250 with probability 0.2; or plan B with which the asset's value will be $600 with probability 0.4 or $100 with probability 0.4.Everybody is risk neutral, and the discount rate is zero.

-What

A)is the bank's expected payoff under plan A? $450
B)$370
C)$290
D)$200
E)$120

Question 28

Use the following information for questions
There are two types of borrowers, low risk L and high risk H.As a lending officer, you cannot distinguish between the two types of borrowers.You believe, however, that there is a 0.5 probability that a randomly chosen borrower is L, and 0.5 that it is H.There are 500 potential loan applicants, each requiring $150.Type L will invest this loan in a single-period project that pays $250 with probability 0.8 or zero with probability 0.2.Type H will invest the loan in a single-period project that pays $275 with probability 0.5 and zero with probability 0.5.Your bank is a monopolist to these borrowers.The riskless interest rate is 6%, and a borrower must have at least $2 of net profit in the successful state in order to apply for the loan.Everybody is risk neutral and suppose that you have $75,000 to lend.

-Suppose that you have decided to charge 65% interest rate.What would be the type L's net profit in the successful state?

A)$0
B)$2.50
C)$7.50
D)$25.00
E)$37.50

Question 29

Use the following information for questions
There are two types of borrowers, low risk L and high risk H.As a lending officer, you cannot distinguish between the two types of borrowers.You believe, however, that there is a 0.5 probability that a randomly chosen borrower is L, and 0.5 that it is H.There are 500 potential loan applicants, each requiring $150.Type L will invest this loan in a single-period project that pays $250 with probability 0.8 or zero with probability 0.2.Type H will invest the loan in a single-period project that pays $275 with probability 0.5 and zero with probability 0.5.Your bank is a monopolist to these borrowers.The riskless interest rate is 6%, and a borrower must have at least $2 of net profit in the successful state in order to apply for the loan.Everybody is risk neutral and suppose that you have $75,000 to lend.

-Suppose you assume that an applicant is of type L.What is the loan rate that you should charge?

A)100%
B)75%
C)65%
D)25%
E)6%

Question 30

Use the following information for problems
There are two types of borrower, L low risk and H high risk. The bank can distinguish the types but cannot control the borrower’s project choice. The borrower has a choice of two mutually exclusive projects: S safe and R risky. The project requires $250 investment. For borrower L, project S can generate $315 for sure; while project R generates $320 with probability 0.8 and zero with probability 0.2. For borrower H, project S can generate $320 with probability 0.8 and zero with probability 0.2; while project R generates $337 with probability 0.6 and zero with probability 0.4. The riskless interest rate is 6%, and the bank thinks that it can charge an additional 1.5% before a customer switches to another bank.

-For H to prefer S to R, what interest rate should the bank charge?

A)78.89%
B)37.88%
C)16.75%
D)13.5%
E)7.6%

Question 31

Use the following information for questions
Mr.Keith Jones is the manager of State of the Art, Inc.The firm has two kinds of debt: senior debt of $500, and junior debt bank loan) of $1,500.The firm has an asset with a liquidation value of $700.If the firm continues to operate, its asset can generate $1,750 with probability
0.8 and zero with probability 0.2.Mr.Jones suffers a personal cost of $25 from managing the firm for another period.Mr.Jones is the sole equity holder of the firm.
Would Mr.Jones continue to manage the firm for another period?

A)No, his net expected payoff is -$25.
B)No, his net expected payoff is -$75.
C)No, his net expected payoff is -$125.
D)Yes, his net expected payoff is $45.
E)Yes, his net expected payoff is $75.

Question 32

Use the following information for questions
There are two types of borrowers, low risk L and high risk H.As a lending officer, you cannot distinguish between the two types of borrowers.You believe, however, that there is a 0.5 probability that a randomly chosen borrower is L, and 0.5 that it is H.There are 500 potential loan applicants, each requiring $150.Type L will invest this loan in a single-period project that pays $250 with probability 0.8 or zero with probability 0.2.Type H will invest the loan in a single-period project that pays $275 with probability 0.5 and zero with probability 0.5.Your bank is a monopolist to these borrowers.The riskless interest rate is 6%, and a borrower must have at least $2 of net profit in the successful state in order to apply for the loan.Everybody is risk neutral and suppose that you have $75,000 to lend.

-What would be the bank's expected profit if the bank charge 65% rate?

A)-$1,025
B)-$876.66
C)$344.78
D)$754.65
E)$884.43

Question 33

Use the following information for questions
Mr.Keith Jones is the manager of State of the Art, Inc.The firm has two kinds of debt: senior debt of $500, and junior debt bank loan) of $1,500.The firm has an asset with a liquidation value of $700.If the firm continues to operate, its asset can generate $1,750 with probability
0.8 and zero with probability 0.2.Mr.Jones suffers a personal cost of $25 from managing the firm for another period.Mr.Jones is the sole equity holder of the firm.
Suppose the bank buys out the senior debt, and agrees to restructure the debt.What loan repayment would make Mr.Jones indifferent between defaulting and continuing?

A)$2,000
B)$1,987.50
C)$1,875.75
D)$1,767.85
E)$1,718.75

Question 34

Use the following information for problems
There are two types of borrower, L low risk and H high risk. The bank can distinguish the types but cannot control the borrower’s project choice. The borrower has a choice of two mutually exclusive projects: S safe and R risky. The project requires $250 investment. For borrower L, project S can generate $315 for sure; while project R generates $320 with probability 0.8 and zero with probability 0.2. For borrower H, project S can generate $320 with probability 0.8 and zero with probability 0.2; while project R generates $337 with probability 0.6 and zero with probability 0.4. The riskless interest rate is 6%, and the bank thinks that it can charge an additional 1.5% before a customer switches to another bank.

-Suppose that the bank charges 7.593%.What is the bank's expected profit to L? What is the expected profit to H?

A)$35.75, $12.50
B)$3.75, -$49.81
C)-$5.85, $16.55
D)$12.65, -$38.75
E)-$2.80, -$5.75

Question 35

Use the following information for questions
There are two types of borrowers, low risk L and high risk H.As a lending officer, you cannot distinguish between the two types of borrowers.You believe, however, that there is a 0.5 probability that a randomly chosen borrower is L, and 0.5 that it is H.There are 500 potential loan applicants, each requiring $150.Type L will invest this loan in a single-period project that pays $250 with probability 0.8 or zero with probability 0.2.Type H will invest the loan in a single-period project that pays $275 with probability 0.5 and zero with probability 0.5.Your bank is a monopolist to these borrowers.The riskless interest rate is 6%, and a borrower must have at least $2 of net profit in the successful state in order to apply for the loan.Everybody is risk neutral and suppose that you have $75,000 to lend.

-Suppose that you have decided to charge 80.67%.What would be the type H's net profit in the successful state?

A)-$37.50
B)-$21.00
C)$0
D)$4.00
E)$15.00

Question 36

Use the following information for questions
Incredible Inc.currently owes its creditors $300.The manager, Mr.Jack Smith can manage it for a period at a personal cost of $110.It has an asset which will generate $450 with probability 0.7 or $200 with probability 0.3 under Mr.Smith's stewardship.Under any other management, the asset will have a sure liquidation value of $250.Everybody is risk neutral and the riskless rate is zero.
If the debt obligation is reduced

A)$296
B)$290
C)$275
D)$263
E)$250

Question 37

Use the following information for questions
Dynamic Systems, Inc.is in financial trouble.It has three types of debt: a bank loan of $400 with the highest priority, a senior debt of $100 owned by bondholders with the next highest priority, and a junior debt of $100 owned by bondholders with the lowest priority.These debts are due in one period.The firm has announced its intention to declare bankruptcy.At this stage, the creditors must choose one of two mutually exclusive restructuring plAns.plan A with which the firm's asset next period will be $450 with probability 0.8 and $250 with probability 0.2; or plan B with which the asset's value will be $600 with probability 0.4 or $100 with probability 0.4.Everybody is risk neutral, and the discount rate is zero.

-Which plan would the senior debt holders prefer?

A)A since the expected payoff is $100 vs.B with expected payoff $40.
B)A since the expected payoff is $60 vs.B with expected payoff $30.
C)B since the expected payoff is $60 vs.A with expected payoff $30.
D)B since the expected payoff is $100 vs.A with expected payoff $40.
E)Indifferent since both plans have expected payoff $40.

Question 38

Use the following information for questions
Mr.Keith Jones is the manager of State of the Art, Inc.The firm has two kinds of debt: senior debt of $500, and junior debt bank loan) of $1,500.The firm has an asset with a liquidation value of $700.If the firm continues to operate, its asset can generate $1,750 with probability
0.8 and zero with probability 0.2.Mr.Jones suffers a personal cost of $25 from managing the firm for another period.Mr.Jones is the sole equity holder of the firm.
If the firm continues for another period, what will be the senior debt holder's net expected payoff?

A)$500
B)$400
C)$300
D)$200
E)$100

Question 39

Use the following information for questions
Mr.Keith Jones is the manager of State of the Art, Inc.The firm has two kinds of debt: senior debt of $500, and junior debt bank loan) of $1,500.The firm has an asset with a liquidation value of $700.If the firm continues to operate, its asset can generate $1,750 with probability
0.8 and zero with probability 0.2.Mr.Jones suffers a personal cost of $25 from managing the firm for another period.Mr.Jones is the sole equity holder of the firm.
If the firm continues for another period, what would be the bank's net expected payoff?

A)$1,000
B)$1,200
C)$1,500
D)$1,600
E)$1,750

Question 40

Use the following information for questions
Incredible Inc.currently owes its creditors $300.The manager, Mr.Jack Smith can manage it for a period at a personal cost of $110.It has an asset which will generate $450 with probability 0.7 or $200 with probability 0.3 under Mr.Smith's stewardship.Under any other management, the asset will have a sure liquidation value of $250.Everybody is risk neutral and the riskless rate is zero.
What

A)is the creditors' payoff if the firm is continued to be managed by Mr.Smith? $0
B)$250
C)$270
D)$300
E)$450

Question 41

Use the following information for questions
Dynamic Systems, Inc.is in financial trouble.It has three types of debt: a bank loan of $400 with the highest priority, a senior debt of $100 owned by bondholders with the next highest priority, and a junior debt of $100 owned by bondholders with the lowest priority.These debts are due in one period.The firm has announced its intention to declare bankruptcy.At this stage, the creditors must choose one of two mutually exclusive restructuring plAns.plan A with which the firm's asset next period will be $450 with probability 0.8 and $250 with probability 0.2; or plan B with which the asset's value will be $600 with probability 0.4 or $100 with probability 0.4.Everybody is risk neutral, and the discount rate is zero.

-Which plan would the bank prefer?

A)A since the expected payoff is $400 vs.B with expected payoff $250.
B)A since the expected payoff is $370 vs.B with expected payoff $220.
C)B since the expected payoff is $370 vs.A with expected payoff $220.
D)B since the expected payoff is $400 vs.A with expected payoff $250.
E)Indifferent since both plans have expected payoff $400.

Question 42

Use the following information for questions
Dynamic Systems, Inc.is in financial trouble.It has three types of debt: a bank loan of $400 with the highest priority, a senior debt of $100 owned by bondholders with the next highest priority, and a junior debt of $100 owned by bondholders with the lowest priority.These debts are due in one period.The firm has announced its intention to declare bankruptcy.At this stage, the creditors must choose one of two mutually exclusive restructuring plAns.plan A with which the firm's asset next period will be $450 with probability 0.8 and $250 with probability 0.2; or plan B with which the asset's value will be $600 with probability 0.4 or $100 with probability 0.4.Everybody is risk neutral, and the discount rate is zero.

-Suppose that the bank buys out the junior debt at face value.What would be the bank's net expected payoff?

A)$300
B)$270
C)$220
D)$150
E)$0