318 Part Two Measuring Risk 21

318 Part Two Measuring Risk

21. Describe how a linear discriminant analysis model works. Identify and dis-
cuss the criticisms which have been made regarding the use of this type of
model to make credit risk evaluations.

22. Suppose that the financial ratios of a potential borrowing firm take the follow-
ing values:
Working capital/total assets ratio (X,) = 0.75
Retained earnings/total assets ratio (X2) = 0.10
Earnings before interest and taxes/total assets ratio (X3) = 0.05
Market value of equity /book value of long-term debt ratio (X,4) = 0.10
Sales /total assets ratio (X5) = 0.65

Calculate the Altman’s Z-score for the borrower in question. How is this num-
ber a sign of the borrower’s default risk?

23. MNO Inc., a publicly traded manufacturing firm in the United States, has
provided the following financial information in its application for a loan. All
numbers are in thousands of dollars.

Assets Liabilities and Equity
Cash $ 20 Accounts payable $ 30
Accounts receivable 90 Notes payable 90
Inventory 90 Accruals 30
Long-term debt 150
Plant and equipment _500 Equity (retained earnings = $22) _400
Total assets $700 Total liabilities and equity $700

Also assume sales = $500,000; cost of goods sold = $360,000; and the market

value of equity is equal to the book value.

a. What is the Altman discriminant function value for MNO Inc.? Recall
that:

Net working capital = Current assets — Current liabilities.

Current assets = Cash + Accounts receivable + Inventories.
Current liabilities = Accounts payable + Accruals + Notes payable.
EBIT = Revenues — Cost of goods sold.

b. Based on the Altman’s Z score only, should you approve MNO Inc.’s appli-
cation to your bank for a $500,000 capital expansion loan?

c. If sales for MNO were $300,000, the market value of equity was only half
of book value, and all other values are unchanged, would your credit deci-
sion change?

d. Would the discriminant function change for firms in different industries?
Would the function be different for manufacturing firms in different geo-
graphic sections of the country? What are the implications for the use of
these types of models by Fls?

24. Consider the coefficients of Altman‘s Z score. Can you tell by the size of the
coefficients which ratio appears most important in assessing creditworthiness
of a loan applicant? Explain.