Suppose commercial bank uses an Altman's Z-score model to predict business loan applicants' default probabilities. The...

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Suppose commercial bank uses an Altman's Z-score model to predict business loan applicants' default probabilities. The Altman's Z-score model is specified as follows: Z = 1.2X + 1.4X2 + 3.3X3 + 0.6X4 + 0.999X5 If the Z > 3.0, safe zone as default is unlikely; If 2.7 Z 3.0, we should be on alert; If 1.8 Z 2.7, there is a moderate chance of default (grey area); If Z < 1.8, there is a high chance of default. Suppose that the financial ratios of a particular business loan applicant take the following values: Working capital/total assets (X1) = 0.2 Retained earnings/total assets (X2) = 0 Earnings before interest and taxes/total assets (X3) = -0.2 Market value of equity/book value of liabilities (X4) = 0.1 Sales/total assets (X5) = 2.0 a. Based on the Altman's Z-score analysis, what is the projected probability of default for the loan application? What is the implication of your answer for the bank? (2 marks) b. How could the loan applicant improve its Z-score? (2 marks) c. Explain three key problems of using Altman's Z-score analysis to evaluate credit risk. (6 marks) Suppose commercial bank uses an Altman's Z-score model to predict business loan applicants' default probabilities. The Altman's Z-score model is specified as follows: Z = 1.2X + 1.4X2 + 3.3X3 + 0.6X4 + 0.999X5 If the Z > 3.0, safe zone as default is unlikely; If 2.7 Z 3.0, we should be on alert; If 1.8 Z 2.7, there is a moderate chance of default (grey area); If Z < 1.8, there is a high chance of default. Suppose that the financial ratios of a particular business loan applicant take the following values: Working capital/total assets (X1) = 0.2 Retained earnings/total assets (X2) = 0 Earnings before interest and taxes/total assets (X3) = -0.2 Market value of equity/book value of liabilities (X4) = 0.1 Sales/total assets (X5) = 2.0 a. Based on the Altman's Z-score analysis, what is the projected probability of default for the loan application? What is the implication of your answer for the bank? (2 marks) b. How could the loan applicant improve its Z-score? (2 marks) c. Explain three key problems of using Altman's Z-score analysis to evaluate credit risk. (6 marks)