Mod 3- Debt as a source of financing Flashcards
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What are debt agreements?
“Debt agreements outline repayment terms, including interest, and any security that a borrower must pledge in order for the financier to be willing to provide such a
loan.”
Advantages and Disadvantages of debt financing?
“Advantages:
-Low cost of capital.
-No ownership dilution.
-Tax destructibility of interest.
-Corporate governance and strategic decision making
is usually not impacted significantly
-Less costly and time-consuming to raise
capital, compared to raising equity.
-Can better optimize a company’s weighted
average cost of capital.
Disadvantages:
-Use of funds can be restricted and/or limited
by covenant
- Bankruptcy and default risk is heightened
when companies take out too much debt
financing.
- Regular financial reporting requirements.
- Rigid, inflexible payment requirements.
- Onerous penalties associated with financial
covenant breach or late payments.
- Less alignment of interest between lender and
investor, compared to equity financing.”
Types of debt investors
“1) Bank and credit unions
2) Private credit providers: family offices, credit funds(middle market), asset based lending.
3) Institutional investors: pension funds, insurance, endowment funds
4) pubic debt markets
* company size increases with forms above.”
Rights and Features of debt
”- Right to principal repayment / recovery.
• Right to interest payment.
• Right to financial reporting: test covenants
• Right to call the loan: demand loans although many agreements still carry provision
• Right to default remedies:
• Right to seize assets: secured vs. non secured and general claim”
Debt classifications?
”- Loan vs. bond: Bond from public bondholders while loans are private debt obligations
- Secured vs. unsecured: secured often referred to as Asset backed loans have collateral. General security agreements for all assets.
- Senior debt vs. junior debt:
- Cash flow lending vs. Asset based lending: ABL loan mechanisms are tied to the underlying assets
- Specialized forms of financing: For specific needs such as factoring, floor plan, leasing, vendor take back.
“
Common debt financing instruments?
"- Operating Line of Credit - Term Loan - Factoring - Floor plan financing - Leasing - Vendor Take back loan - Mezzanine Debt - Convertible debt "
Operating line of credit
“-A short term loan that extends cash to cover short term expenses. Interest is paid on the actual amount loaned.
- Very flexible and used for business with cyclical business cycles.
- commonly secured by assets such as AR and inventory.
- Rates are floating based on prime and range from prime -.5 to prime +3”
Term Loan
”- As known as commercial loan. Borrower borrows amount of $ and agrees to pay back plus interest over set period.
- Amortizing can be bullet or zero (principal due at maturity), or paid back equally each year.
- used by business for expansion, acquisition, succession, or other.
- Assets secured are long term -land, property, plant, equip
- Rates an be fixed or variable (prime 0-5%), or ratcheting based on leverage.
- Loans can be issued as asset based on cash flow based.
“
Factoring
”- Factoring similar to ABL of AR, loan based on sale of AR.
- Non-recourse buyer of AR responsible for collection, recourse seller repurchase the receivable and collects
- cost typically 80% of AR, balance less fee(3-5%) collected on payment.
“
Floor plan financing
”- Form of inventory financing where large ticket inventory is purchased from supplier, lender forwards payments establishing line of credit with purchaser. Purchased inventory forms security.
- used by business largely with main supplier
- interest similar to LOC and items are paid as sold “
Leasing
Common form of asset based lending is a lease agreement. These may accounted as operating or capital. Asset forms security for loan.
Vendor take back loan
“-Arise during the acquisition of a company by a 3rd party. Previous owner receive loan from the acquirer as part of purchase consideration.
- Rates vary between 0-10% although purchases want lower to ensure return.”
Mezzanine Debt/ Subordinated debt
”- Mezzanine capital is a general term which refers to the capital in-between senior debt and equity within a business. It typically takes the form of subordinated debt and may include other forms of capital, such as convertible debentures. Largely, this debt has a general security over the agreement, but is lower priority than the senior debt.
Subordinated debt: all debts ranked below senior secured debt.
- Mezzanine capital /subordinated debt is largely used in situations where the senior lenders are not willing to extend
further debt, and the company wishes to avoid diluting its shareholders.
- Interest high single digits to teens”
Forms of Mezzanine Debt/ Subordinated debt
”- senior subordinated debt
- convertible subordinated debt
- redeemable preferred stock”
Flexible features commonly associated with mezzanine debt:
“• Principal deferment;
• Paid-in-kind interest; forgo interest payments until maturity
• Equity participation: through warrants or conversion”
