Describe how a the net present value NPV technique and b the internal rate of return IRR technique are used to make investment capital budgeting decisions. Compare the NPV technique with the IRR technique, and discuss why the two techniques might not always lead to the same investment decisions. Describe how conflicts that might arise between NPV and IRR can be resolved using the modified internal rate of return mirr technique. Describe other capital budgeting techniques 2.
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Students face a bank's decision to enter or not enter the subprime home lending market. The situation is set just prior to the problems that arose in The case provides aggregate economic data available at the end of and asks students to utilize this data in recommending whether or not to enter this market. The case has a difficulty level of three and is designed for a junior level course. Including student presentations, the case is covered in three class hours.
It is expected that students will spend hours outside of class preparing this case. A Senior Vice President for a midsized commercial bank is contemplating getting her bank to move forward in extending subprime loans.
She has observed her competitors' profits rise following their entry into this market. The two percent lending premium on subprime loans is an attractive addition to bank income.
In addition she wants to help those customers who do not qualify for traditional, prime home loans obtain the American dream of home ownership. With financial advice and counseling, the vice president believes that customers who have low credit ratings due to a few late payment, difficulty in documenting their income, or, perhaps, a prior bankruptcy deserve another chance and given the opportunity to move into their own home.
In making recommendations to the bank, the analysis is divided into three parts: a statistical examination of delinquency potential and credit ratings, an examination of aggregate economic implications with statistical analysis for the home loan market, and an evaluation of the ethical aspects of lending to subprime customers.
This case is designed to elicit a discussion on the ethics of lending in the subprime market. Real world data is provided to give substance to the discussion. The case is positioned just prior to the melt down in the subprime market.
We wanted to avoid an ethics discussion that quickly broke down into a reaction to people losing money and a quick conclusion that it must be unethical. The case is structured around the question of entering the subprime market in its early form. Initially the market restricted the risk by requiring, usually, a minimum down payment of at least 10 percent. As financial institutions observed this market's profitability, largely resulting from a rising housing market, they increased their risk exposure.
This reduction came through lower down payments required and granting secondary subprime loans. With lower down payments and secondary loans, the moral hazard problem increases.
With little or no equity in the home, the borrower's incentive to continue making payments is reduced. An interesting discussion topic revolves around how aware the secondary market was of the increase in risk. Data is provided going back sixteen years. A question that should be address is whether or not the market should have been functioning on a seeming belief that housing prices would continue to rise.
The case includes a number of questions that we believe students should address in developing their conclusions on entering or not entering the subprime market. Suggested answers to these questions follow. Mary is concerned over how she should use credit ratings in making these loans. She has gathered sample data on credit rating and loan delinquencies which are provided for your use. Loans delinquent beyond 90 days are likely candidates for foreclosure. Mary believes that the bank is willing to accept a minimum credit score that has an expected foreclosure rate of ten percent.
If Mary used that credit score as a minimum for extending these subprime loans, what proportion of loans to individuals with that score would you expect to be 90 or more days delinquent? Assuming that Mary gets the bank to enter the Subprime market, what minimum credit score would you recommend accepting?
We can use a simple linear regress ion on the credit data to estimate the credit score likely to lead to being 90 days delinquent on a loan. From excel we get:. If we set DDelinq to 90 and solve for the associated credit score we find that a credit score of about is likely to result in being 90 days delinquent on a loan. Since a score of yields an expected delinquency, one-half of the of the loans extended to individuals with a score of would be expected to be 90 days or more delinquent.
This assumes a normal distribution. Ideally we would want information on competitors' decisions in setting our lower limit. Should we set it below the minimum score used by competitors, we would likely get a larger number of lower quality loans and assume greater risk.
A higher selected lower limit would reduce risk at the cost of limiting the loans. Mary is wondering whether or not the success seen by her competitors is the result of recent increases in housing prices.
She has heard rumors that the Federal Reserve is likely to tighten Monetary Policy and wonders what the implications are for her success in this market. Mary has provided you with data on historic home price changes in her area along with data on price level CPI changes, and interest rates.
Using this data, how concerned should Mary be over possible changes in Federal Reserve policy? The only significant evidence is that rising home prices is likely to lead to a reduction in nonperforming loans. It is a suggestion that Mary be concerned over any possible decline in housing prices.
The only significant evidence here is that a rise in interest rates is likely to lead to a reduction in home price changes. If the Federal Reserve moves to a higher interest rate regime, this could generate problems in this lending market. Mary believes that the ten percent required down payment will protect the bank from a loss of principal. However, should the loan default, the funds are likely to be tied up, without interest income for six to nine months.
The funds could have been used to fund a prime loan at around six percent interest with a default rate of well under one percent. Mary is wondering whether or not the two percent premium paid on the performing loans will cover the expected loss from the nonperforming loans.
She expects a potential default rate around percent. Each loan brings in an additional 2 percent in interest payments. Assuming that Mary is correct in assuming that the 10 percent down will protect the principal, one year's payment stream from six loans would maintain the income stream.
The question then is how long will the bank actually suffer the loss in income and does the principal have protection. Additional costs could include: repairs to a damaged property, costs to sell the foreclosed property, and maintenance costs during the holding period.
Planning for a potential ten percent seems very high and, even with the recovery of most of the loan principal, is likely to place the bank in severe difficulty. Mary wants to sell some of these subprime loans on the developing secondary market.
However, she also wants the bank to retain some in their asset portfolio to add income and make the stockholders happy. She wants an evaluation of the associated risks and a recommendation on whether or not to hold or sell. Selling the loans on the secondary market reduces the bank's risk exposure. This needs to be discussed in the light of also removing the potential higher interest income. On the positive side, the bank would usually earn a service fee for collecting and processing the loan payments.
Finally, Mary is concerned over the potential ethical dilemma over lending substantial amounts of funds to customers who have demonstrated an inability to manage their finances or to not lend to them and deny an opportunity to move forward on home ownership.
Is it ethical or not to extend loans in the Subprime market. In making your recommendations it is suggested that you look into the relationships between changes in home price, interest rates and inflation. This case is set in late Subsequently the mortgage market encountered substantial problems. We expect students not to jump to a conclusion that, since some individuals suffered losses in the market, actions to enter that market must have been unethical.
We expect students to cast their ethical analysis of this situation in some model for ethical decision making, such as Utilitarianism.
The relevant stakeholders should be identified and the benefits and costs, short and long term, discussed. The ethics discussion has two significant components. First, are the customers being lured into a situation that they have little hope of surviving?
Second, if the customers are fully informed of potential consequences, should they not be given the opportunity? An interesting point is that, even if five percent of the loans default, 95 percent of the borrowers maintained their payments and it is likely that many actually achieved home ownership.
Chapter 9. Capital Budgeting Techniques
Students face a bank's decision to enter or not enter the subprime home lending market. The situation is set just prior to the problems that arose in The case provides aggregate economic data available at the end of and asks students to utilize this data in recommending whether or not to enter this market. The case has a difficulty level of three and is designed for a junior level course. Including student presentations, the case is covered in three class hours. It is expected that students will spend hours outside of class preparing this case.
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