Let us consider the following loan proposal:

Funding | |||

Loan | 100 | Interbank debt | 94 |

Equity | 6 |

$100 million two-years-to-maturity fixed-rate loan (interest paid at the end of the year and principal at maturity).

Corporate tax rate: 40%.

Shareholders’ opportunity return (cost of equity): 13.2%.

Fixed interbank rate: 10% for the first year and 10% for the second year.

Equity funding (economic capital): 6%.

Interbank funding: 94%.

Probability of default in Year One: 0%.

Probability of default in Year Two: 3%.

Recovery of 60 in case of default (or loss-given default) = 40.

As we learned in Stage 7 (loan pricing), the break-even loan interest rate R is such that the discounted value of expected after-tax cash flows is equal to the initial equity ...

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