A manager decides not to lend to any firm in sectors that generate losses in excess of 5% of...

Question:

A manager decides not to lend to any firm in sectors that generate losses in excess of 5% of capital.

a. If the average historical losses in the automobile sector total 8%, what is the maximum loan a manager can lend to a firm in this sector as a percentage of total capital?

b. If the average historical losses in the mining sector total 15%, what is the maximum loan a manager can make to a firm in this sector as a percentage of total capital?

Cost of Capital:

The cost of capital for a firm is used for determining the present value where the prospective cash flows to the firm are discounted by an interest rate which equals the cost of capital. For a firm with both debt and equity capital, the weighted average cost of capital is used for discounting the cash flows.

Answer and Explanation:

Answer to a

The maximum loan amount as a percentage of total capital is given by:

  • {eq}= \dfrac{\text{Maximum losses allowed as a percentage of capital}}{\text{Average historical losses in the automobile sector}} {/eq}
  • {eq}= \dfrac{5\%}{8\%} {/eq}
  • = 62.5%

Answer to b

The maximum loan amount as a percentage of total capital is given by:

  • {eq}= \dfrac{\text{Maximum losses allowed as a percentage of capital}}{\text{Average historical losses in the mining sector}} {/eq}
  • {eq}= \dfrac{5\%}{15\%} {/eq}
  • = 33.33%

Learn more about this topic:

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Cost of Capital: Flotation Cost, NPV & Internal Equity

from Corporate Finance: Help & Review

Chapter 3 / Lesson 18
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