# 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.

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%

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% 