Let us consider the following loan proposal:
$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 ...