Which of the following statements best explains why lenders focus more on the downside cases when looking at forecast models?
A. Lenders want to ensure that in the case that the borrower defaults and enters bankruptcy, theres sufficient collateral for them to recover their initial amount.
B. If the lender is issued debt priced at a floating rate, the downside cases will sensitize various interest rate scenarios to ensure their lending hurdle rate yield is net.
C. Theoretically, equity holders have limited upside potential in their investment.
D. Lenders are more concerned with the default risk of the borrower-I.e. the companys ability to make interest expense payments and principal amortization payments on-time.
The correct answer and explanation is:
The correct answer is D. Lenders are more concerned with the default risk of the borrower—i.e., the company’s ability to make interest expense payments and principal amortization payments on time.
Explanation:
Lenders primarily focus on downside cases because their key concern is the borrower’s ability to repay the loan, which includes making regular interest payments and repaying the principal amount. In contrast to equity investors, who may benefit from upside growth in the business, lenders do not participate in the company’s success beyond the fixed interest they are owed. As a result, their interest lies in minimizing the risk of default.
In the case of a borrower defaulting, the lender’s main goal is to ensure they can recover their capital. By considering downside scenarios, such as a downturn in the company’s financial performance, the lender can better assess the risk of non-payment or delayed payments. If the borrower’s cash flows or profits are significantly reduced, it may impact the company’s ability to meet debt obligations. These risks are typically considered through stress tests and scenario analysis, which examine potential negative outcomes like lower revenues, increased costs, or economic downturns.
For lenders, the focus on downside cases helps in setting more conservative loan terms and assessing the collateral needed to secure the loan. It also provides insight into the potential for a borrower to meet future financial commitments, reducing the likelihood of default. Essentially, lenders are not primarily concerned with the company’s growth potential but with its ability to survive adverse conditions and fulfill debt obligations.
In contrast, equity holders are more focused on the potential for upside returns, as they benefit from the company’s growth, which is less of a priority for lenders who prioritize repayment security over profit potential.