Exhibit Q shows a decision tree about the various alternatives the bank has. The presumed goal is to find the alternative which will maximize the bank’s profit. The basic premise is that if the actual sales’ percentage drop from forecasted sales is greater than the minimum allowable percentage drop, Hampton would not resort to external financing, and instead, default on its loans.(Given the fact that Hampton has a conservative financial policy and has no debt in its balance sheet for 10 years, it seems that Hampton would exhaust all possible means before resorting to external financing, and that Hampton would not want additional obligations from other creditors. ) However, interest payments are assumed to be paid, regardless of whether the principal is paid or not. In cases of default, the bank would incur bad debts expense, which is assumed to be equal to 2% of the principal.(The rate of bad debts is probably small, as Hampton’s customers are large companies and would probably not default; besides, an assumption was made that accounts would be paid within 30 days.
The effects would be the same until the rate of bad debts exceed 6. 34%, in which case, doubling the interest rates would overtake alternative E). The probability that the hypothesized population mean, i??0, (or in this case, the allowable percentage drop in sales) would be greater than the observed sample mean (or in this case, the mean actual deviations in forecasted sales from January to August 1979), which was computed thru the z-test, was used as the probabilities of payment or default in each case. Although the deviations from actual sales would probably be smaller due to seemingly more favorable conditions, the actual sales deviations were used as sample data without adjustments, since this is more reliable and more conservative.Another assumption was that 75% of the time, Hampton would refuse either a shorter credit period or a higher interest rate, which will make Hampton search for banks offering more friendly terms.
(75% was set arbitrarily. As long as the probability of refusal is greater than 50. 78%, the results would not change. ) The usefulness of decision trees is that, the user has some degree of flexibility in dealing with uncertainties. It could give the steps the company probably should take, when the outcome of uncertain events is resolved.
Between granting and rejecting the extension of the $1 Million loan, the bank is better off granting the loan, as the maximum EMV under rejecting the extension is significantly lower. Next, the bank should conduct a more comprehensive study to determine more accurately whether the company would have sufficient cash to retire both obligations or not. If yes, then the company should grant both loans. But if not, the bank has a variety of options aside from agreeing to the terms which Hampton wants, like modifying the credit period, the interest rate, or the payment of interest (as to whether monthly or lump sum).Among these four alternatives, the bank should modify its credit period. And from the decision tree, the extension of the credit period shows a higher EMV than reducing the credit period; thus, the bank should extend the credit period. If the actual sales would insignificantly deviate from the forecast, the bank would earn an interest income of $75,750; otherwise, the company would also incur a bad debts expense of $27,000 aside from the interest income.Another thing to be noticed is that among the alternatives, alternative E appears to be the least risky alternative, since the probability of actual sales percentage drop exceeding the allowable percentage drop in this alternative is the least among the alternatives.
Actually, by doubling the interest rates, the company would earn more interest income; however, Hampton would most likely find another bank offering more friendly terms if this alternative is undertaken. But even if the table effectively shows some of the various means available for the bank, the results are not 100% accurate.Many assumptions were made due to the lack of data. This in turn constrained the list of alternatives which made it non-exhaustive. Other alternatives would involve a mixture of these strategies, or strategies requiring much further data.
One possible alternative is to extend the original Hampton loan with increased debt covenants along with a built in extension option with a rate bump to 2% per month. Under this scenario, Hampton would be required to push back the $350,000 purchase of additional equipment, and would also have to indefinitely push back the $150,000 dividend.The loan will have a built-in extension with a rate bump in the event that Hampton is unable to pay down the loan by the December 1979. However, determining the likelihood that Hampton would indeed defer dividend payment (as its stockholders might pressure the company to pay), the incremental rate in case of default, and the amounts and effects of pledges or debt covenants, is very unlikely and reasonable assumptions could not be made without further study and data.Since the company’s problems are mostly temporary and since the company passed the 5 C’s of Credit, the bank should grant both Hampton’s loan refinancing of the $1,000,000 loan (to be paid on December 31, 1979), and the additional $350,000 that Hampton wants to borrow (payable on January 31, 1980). However, it is very much advisable for St. Louis National Bank to undertake further studies and collect more data, such as industry ratios and data, prevailing interest rates, financial statements from prior years etc.
, to permit a better and more informed decision.