Debt Finance Flashcards
Definition
When businesses obtain finance by borrowing money.
Types of debt finance
2 types:
1) Loan
2) Debt securities
What they both have in common is the fact that the company borrow money from a bank or an investor which it will then have to repay
Loan - Definition
Where a business borrows money from a bank or another lender such as its owners or its directors or shareholders. 3 types of loan:
1) Bank overdraft
2) Term loan
3) Revolving credit facility
Debt securities - Definition
IOUs which are issued by the company to the investor in return for a cash payment and have to be repaid by the company at an agreed future date
Considerations prior to borrowing
Must check there’s no restriction under constitution. MAs do not place any restrictions. Need to check that the director’s have authority to act on behalf of the company. If they have MA then they have authority under MA 3
Secured loans - Definition
Involves the business giving security to the lender over some or all of its property so that the bank can recover what it is owed more easily if the business defaults on the loan
Unsecured loans - Definition
If the lender does not take security over the borrower’s assets the loan is unsecured. Businesses pay higher rates of interest for unsecured loans
Loans - Overdraft facility - Definition
A contract between the business and its bank which allows the business to go overdrawn on its current account. Type of temporary loan used to cover everyday business expenses where is no other source of money available.
Loans - Overdraft facility - Uncommitted facility
It is known as an uncommitted facility - it will usually be payable on demand. The bank may demand immediate repayment by the business at any time without giving any notice.
Loans - Overdraft facility - Fees
The business will have to pay a fee for the overdraft facility. The bank will also charge interest by reference to its base rate which is the rate at which the bank is prepared to lend to its customers with the best credit rating
Loans - Overdraft facility - Advantages
It is a flexible source of finance and relatively few formalities are required to arrange it
Loans - Overdraft facility - Disadvantages
Repayment may be demanded at any time by the bank. It is also a relatively expensive way to borrow as it is usually unsecured and the banks charge high interest rates in return for offering such flexibility
Loans - Term loans - Definition
In a term loan the business borrows a fixed amount of money, usually from a bank for a specified period at the end of which it must all be repaid. The borrower must pay interest at regular intervals.
Loans - Term loans - Short-term
Short-term loans are usually for up to one year
Loans - Term loans - Medium-term
Usually for 1-5 years
Loans - Term Loans - Long term
5+ years
Loan - Term Loans - When they are used
They are typically used by a business to purchase a capital asset such as land, building or machinery
Loan - Term Loans - Bilateral loan
This is between two parties, the business and the bank
Loan - Term Loans - Syndicated Loan
Between business and a number of different lenders who jointly provide the money the business wants to borrow. These are common when the amount of the loan is high and the risk of lending is shared between a number of banks.
Loan - Term Loans - Advantages
If they take the money in instalments it will reduce their interest payments. It gives greater certainty than an overdraft, the borrower has greater control because the bank can only request repayment under the terms of the contract.
Loan - Term Loans - Disadvantages
Time and expense in negotiating and agreeing all the legal documentation for such a loan and the fact that once repaid the money cannot then be re-borrowed
Loan - Revolving credit facilities - Definition
In a revolving credit facility the bank agrees to make available a max. amount of money to the business throughout the agreed period of the revolving credit facility. During the lifetime of the facility the business can borrow and repay money. Interest is payable at regular intervals. Business is also able to reborrow amounts that it had already repaid so long as it does not exceed the overall max. figure
Loan - Revolving credit facilities - When they will be used
Useful businesses whose income is not evenly distributed throughout the year
Loan - Revolving credit facilities - Advantages
It is a very flexible means of borrowing money and it is possible to reduce the total amount of interest payable by reducing borrowings
Loan - Revolving cred facilities - Disadvantages
Time and expense in negotiating and agreeing all the legal document for the loan and the high fees that are charged
Loan - Facility agreement
This is the contract entered into for a term loan or a revolving credit facilities. It will include repayment and pre-payment and interest rates, express covenants
Debenture - Definition
Gives the lender security over the borrower’s assets
What should be offerred to client
Mix of debt and equity finance
Advantages of debt finance
1) Offers protection of retaining its capital value with no appreciation or depreciation - allows them to retain their investment
2) Monthly repayments are likely to be low and manageable for party repaying
3) Monthly repayments are a deductible expense for the purpose of corporation tax unlike dividends
4) Provides a receipt of income in the form of regular interest payments
5) If they fail to make payment then they might be entitled to enforce terms of debt by appointing a receiver or administrator
6) If they need to realise asset sooner than expected it could be sold
Disadvantages of debt finance
1) Offers no direct measure of shareholder control despite covenants, representations and warranties being included in loan agreement - but then say this is why a mixed solution of debt and equity may be more suitable
2) If they already have a high debt gearing they may struggle with further debt
