Question

C Company’s risk-free interest rate is 6 percent. The standard deviation in the rate of change in the underlying asset's value is percent, and the leverage ratio of C Company is 0.9. C Company has a $350,000 loan that will mature in one year. The value for N(h1) is 0.028, and the value for N(h2) is 0.94.

ALL I NEED ARE PARTS B AND C, WHICH ARE NOT CALCULATIONS

1. What is the current market value of the loan?

b. Briefly discuss what this loan value represents?

c. What is the importance of default risk to loan, give an example.

Answer 1

You have specifically asked answers for part (b) and (c)

Part (b)

Asset = Equity + Debt

Hence, Equity = Asset - Debt

So, equity of a company can be seen and valued as a call option on the assets of the company with loan amount being the strike price. Thus, the loan value represents the strike price of the call option with assets as the underlying.

Part (c)

Default risk can be seen as the probability of an unfavorable outcome that a company, entity or individual will default on its scheduled repayment of the loan or interest payment or both. Thus, default risk is a measure of chance that the borrower is not able to honor its debt or loan obligation.

The default risk associated with the loan is a key determinant of the return expectation of the lender. A borrower with higher default risk will usually get the loan at a higher rate of interest.

Example: A company has borrowed $ 1000 mn at interest rate of 8%. The principal is supposed to be returned in 10 equal annual installment. This year, the company is expecting an annual operating cash flow of $ 150 mn. So, the interest burden this year = 8% x $ 1,000 = $ 80 mn. Scheduled repayment = $ 1,000 / 10 = $ 180 mn. So total amount required to service the debt = Interest + principal repayment = $ 80 + $ 100 = $ 180 mn > expected operating cash flow of $ 150 mn. So, the probability of default is very high and hence the default risk is very high. The lender is subjected to a high default risk on its exposure of $ 1,000 mn in the borrower.