Research Paper on "Financial Implications of a Loan for the Lender and the Borrower"

Research Paper 10 pages (4687 words) Sources: 10

[EXCERPT] . . . .

199754 (Yahoo Finance, 2016). The input calculation it is not possible to assess the expected rate of return. The calculation is as follows;

Risk free rate

Market return

Beta

Expected return

0.62

7

0.19975

2.018278

This indicates that an expected rate of return for the lender would be 2.018278%, which can be rounded to 2.02%. However, it may be argued that this be through a lender, as it is based on a very low level of volatility associated share price, which may not give a true representation of the risk associated with the loan, or the risk inherent in the company's business operations (Fernandez, 2015). Therefore, it is possible a higher rate would be required.

With a long-term rate, and interest rates currently low, expected to rise, it is highly unlikely that borrower would be able to gain a loan a fixed rate for a 10-year period. Offering a loan at this rate would be unwise for lenders, as rises in interest rates could result in depositors requiring a higher return, which may leave little, or even a potential negative returns for the bank for the net interest received (Watson, 2014). Therefore, it is also assumed that the loan is a variable rate loan, with changes in interest rates being implemented to reflect the changing market conditions. This paper, it is assumed that the interest rate for the loan remains at 2.02%, and there are no additional transaction costs.

5. Impact on Lender

A loan of this type will have both positive and negative impact on the lender. Firstly, the lender in the business of making loans, therefore, the loan will result in an increased level of revenue generated for the firm. The bigger interest the bank the net interest inflow, this is the amount of interest that is received after they have paid interest on the deposits used to fund the loan (Bridges et al., 2014; Morais, Peydro, & Ortega, 2015). Current deposit rates will vary for different consumers and businesses, with some deposits attracting a zero rate, others may attract a more positive way, but they will remain low. Therefore, it is assumed that the average deposit rate paid out by the lender in 0.5%. Using the assumption, the calculation for the net interest received per annum is shown below.

Loan amount

15,000,000

Interest rate paid by borrower

2.02%

Gross interest received

303,000

Less interest paid to depositors

75,000

Net interest received

228,000

Therefore, the Bank of America will receive a net interest payment every year of $228,000, over a period of 10 years. This results in inflows of $2.28 million over a ten-year period. However, the time value of money will erode the value of that inflow during the forthcoming decade.

By making this loan the organisation maintains a piece of administrative efficiency. While transaction costs are not considered within the assessment, it is fair to assume that commending a similar amount of money to a number of other borrowers, would involve a higher level of associated overheads (Kevin, 2015). Therefore, the potential for increased efficiency in the lending process were the Bank of America makes a single large loan, rather than multiple smaller loans.

When a bank makes a loan, it also impact on the overall capital adequacy. Capital adequacy is determined through the application of the Basal Accords, with new levels under the Basel III agreement being implemented by 2019, as well as requirements issued by the Federal Reserve (Bridges et al., 2014). In order to protect the financial system and relevant stakeholders, banks have limits on how much money they can lend based on the amount of assets they hold. The implemented tighten the ability of companies such as the Bank Of America to expand lending, for example, the minimum common equity requirement is being increased by 2.5%, from 2% to 4.5% of assets (Ghosh, Sugawara and Zalduendo, 2012). In addition, the regulations create a conservation buffer which is 2.5% of assets, resulting in a core tier 1 capital requirement of 7% (Gosh et al., 2012; Harle et al., 2010). The broader tier 1 requirement is 8.5%, with a 1.5% minimum for additional noncore tier 1 capital (Harle et al., 2010). Additional requirements were also introduced in terms of the standards set for short-term funding and long-term funding (Harle et al., 2010). The increase in capital requirements is significant, with the initial implementation date of 2015 being extended to 2019 (Yan et al., 2012). This means that a single loan of $15 million may present a significant opportunity cost to the organisation (Nellis & Parker, 2006), preventing lending undertaken elsewhere., The Bank of America has tier 1 risk-weighted assets of $1,602 billion, and a common equity tier ratio of 10.2% (Bank of America, 2016). Therefore, the bank is already in compliance with forthcoming requirements. However, increasing lending by 15% will inevitably impact on this ratio, but the size of the current loan book, means that the impact will not be significant.

The main impact on the supplier may be the opportunity cost associated with lending to American Water. With a very low level of risk, the loan attracts a relatively low level of interest. It is possible that the company could gain a better return, even allowing for additional overhead, if money was lent to organisations, or individuals, where there is a greater premium. This is particularly pertinent in the case of this low, due to the calculation of the interest rate using a significantly lower than average beta. For example, the current interest rate on SBA 7A loans in the United States, for amounts above $50,000 is 5.75%. This can be used to assess the potential opportunity cost if the organisation chooses to lend to American Water, rather than to lend to a more lucrative set of borrowers.

American Water

SBA 7A

Loan amount

15,000,000

15,000,000

Interest rate paid by borrower

2.02%

5.75%

Gross interest received

303,000

862,500

Less interest paid to depositors

75,000

75,000

Net interest received

228,000

787,500

Difference

559,500

This calculation shows that if the bank chose to lend to other borrowers that interest receipts could be approximately $559,500 more per annum, or $5.5 million over the term of the loan. However, this would also increase overall risk, not only do the higher risk borrowers, even if they are assessed to be standard with, but the diversity within the portfolio spread of numerous loans.

This potential for risk also highlights the way in which the bank may require some type of security so that the capital may be recovered in case of a default (Morais et al., 2015). It is usual for firms to offer some type of security, this may be in form of equity holdings for the bank, but it is more frequently a charge over some type of asset (Richards, Palmer, & Boganiva, 2008). The type of security will depend on the type of loan, and its purpose. For example, working capital financing may result on a floating lien on inventories, which may be seized if the borrower defaults (Clarkson, Miller, & Cross, 2010). For larger loans, such as that are being made to American Water, waited for the creation of assets, such as buildings, a charge may be taken on the real estate which is created/enhanced (Clarkson et al., 2010). This ensures that the organisation has first claim on a specific asset if there is a default. Therefore, it is highly recommended that the bank ensure that they have sufficient security to cover the loan, as well as facilitate a potential decrease in value of the underlying asset.

In addition to security, the bank may also wish to protect his position by implementing terms and conditions into the loan agreement (Clarkson et al., 2010). For example, in order to ensure the organisation is able to continue to repay its existing debts, and reduce the risk to the firm, a term regarding a limit on the level of debt the organisation can acquire may be inflated. This is usually implemented through a debt ratio agreement, where the organisation does not exceed a specific level of debt to equity, or debt to assets. The loan will not impact on the firm's own debt-to-equity ratio, as this is an operational transaction, with the loan being made out of current liabilities in the tender deposit, and the debt itself being an asset. The ratio for times interest earned will see a positive return. As interest is seen as a general operating expense, deducted from the revenue before it interest is declared, it is not possible to calculate the impact of the loan on times interest ratios (Elliott & Elliott, 2013). Likewise, the bank deals in the, rather than inventories, the level of impact are working capital will be minimal. However, making the loan may impact on the return on assets, as the loan itself is an asset. Currently, the return on assets 0.68%, as the net return gained in excess of 1.5% loan, the return on assets will increase,… READ MORE

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