Debt finance Flashcards
Types of debt finance
- loan facilites
- debt securities
What is a loan facility?
An agreement between a borrower and a lender which gives the borrower the right to borrow money on the terms set out in the agreement.
Types of loan facilities:
- overdraft
- term loan
- revolving credit facility
Overdraft
An on-demand facility which means that the bank can call for all of the money owed to it at any point in time and demand that it is repaid immediately.
Unsuitable for long-term borrowing. Interest is paid to the bank on the amount that the customer is overdrawn.
Term loan
Loan of money for a fixed period of time, repayable on a certain date.
The lender cannot demand early repayment unless the borrower is in breach of the agreement. The lender will receive interest on the loan throughout the period.
Term loans which are repayable in a single lump sum at the end of the agreement are referred to having a ‘bullet repayment’.
The loan may be repayable in instalments in which case it is referred to as ‘amortising’.
Revolving credit facility
A loan of money for a specified period of time, but unlike a term loan the borrower can repeatedly borrow and re-pay loans up to the agreed maximum overall amount when it chooses.
This helps the borrower keep interest payments down by borrowing only when it needs funds and repaying loans when it has available cash.
Debt securities
- Bond
Promise to pay the value of the bond to the holder of that bond at maturity.
Company also pays interest at particular periods usually biannually.
Bonds can be issued with a view to be traded on the capital market.
Private companies can only issue bonds to targeted investors and not to the public indiscriminately.
Convertible bonds
Bonds which can be converted into shares in the issuer.
On conversion the issuer issues shares to the bondholder in return for its agreement to give up its rights to receive interest and repayment of the principal amount invested.
Bond is essentially swapped for shares.
Preference shares
Commonly has no voting rights and will usually get a definite amount of dividend ahead of other shareholders.
If preference has a fixed maturity date on which company must purchase or redeem the share and/or such preference is fixed - looks more like a debt/
If no maturity date and preference is only paid if there is a dividend - looks more like equity.
Term sheet
Statement of the key terms of the transaction agreed by the lender and borrower.
Like the heads of terms in other transactions.
Not intended to be a legally binding document rather a statement of the understanding on which the parties agree to enter into the transaction.
Common terms:
- loan amount
- interest rate
- fees
- key representations
- undertakings
- events of default
- terms and conditions
Loan agreement
Sets out the main commercial terms of the loan such as amount of interest, dates on which interest will be paid, dates on which principal needs to be repaid and any fees due.
Will also include most of the other information from the term sheet but in much more detail.
Loan agreement is one of the most heavily negotiated documents in a debt finance transaction.
Security document
If a loan is secured, a separate security document will be negotiated and entered into.
Debenture
two meanings:
1) Covers any form of debt security issued by a company including debenture stock, bonds and any other securities of the company.
2) A type of security document which sets out the details of the security for the loan. It is sent to Companies House for registration purposes.
Representations
Statements of fact as to legal and commercial matters made on signing of the loan agreement and repeated periodically during the life of the loan.
Undertakings
Or covenants
Promises to do or not to do something or to procure that something is done.
Events of default
Breaches of representations or undertakings may give rise to an event of default.
Vital in terms of giving the bank the power to call in its money early if the borrower shows signs of becoming an enhanced credit risk.
Pledge
Security provider gives possession of the asset to the creditor until the debt is paid back (e.g. pawning)
Lien
Creditor retains possession of the asset until the debt is paid back.
e.g. mechanic keeps the care until bill is paid
Mortgage
Security provider (borrower) retains possession of the asset but transfers ownership to the creditor (lender).
Subject to:
- creditors right to take possession of the asset and sell it if the security provider defaults; and
- the security provider’s right to require the creditor to transfer the asset back when the debt is paid
Right is known as the ‘equity of redemption’.
Charge
Security provider retains possession of the asset. However, rather than transferring ownership a charge simply involves the creation of an equitable proprietary interest in the asset in favour of the creditor.
Charge document will also give lender certain rights over the asset - right to appoint a receiver or administrator to take possession of it, if the debt is not paid when it should be.
Two types:
- fixed
- floating
Fixed charge
- common over machinery and vehicles
- creditor can control what the security provider can do with the fixed charge assets
- usually cannot dispose
- create further charges over asset
without consent
Bank can appoint a receiver to sell and use money to pay it back for the loan
Floating charge
‘Floats’ over the whole of a class of circulating assets. Common to take one out over stock - where company needs to be able to dispose of it freely.
Crystallisation
Means floating charge stops floating and fixes to the assets which are owned by the provider at the time of crystallisation.
May occur by law or triggered by evens which are contractually agreed such as insolvency.
Disadvantages of a floating charge (creditors POV)
- hard to keep track of value of the class of assets
- ranks below a fixed charge on the statutory order of priority (if term prohibiting later fixed charges and the company does it anyway the new fixed charge will rank below the floating charge)
- Subject to the prescribed part fund (part of the assets proceeds being set aside)
- Capable of being avoided (voidable transaction)
- Administrator is free to deal with floating charge without reference to charge holder or the court and pay their remuneration out of those assets
Guarantees
Not security in that there are no assets involved.
However, their commercial effect is similar to that of a security.
Registration of charges
MUST be registered within 21 days beginning on the day after the day on which the charge is created.
- Form MR01 detailing:
- company creating the charge
- date of creation
- persons entitled to the charge
- short description of fixed assets charged - Certified copy of the charge
- fee
Order of priority is date of the creation of the charge
Who registers the charge
Usually it will be the lender’s solicitors
Effect of failure to register the charge
- charge is void against liquidator, administrator or creditor
- debt becomes immediately payable
Records to be kept by company
Company must keep a copy of every charge and every instrument that amends of varies any charge.
Must be kept at registered office for inspection. Free for member or creditor, fee for public. Court order if they refuse.
Effect of equity on the balance sheet
Both net asset value and total equity will change
- both halves of the balance sheet
Effect of debt on the balance sheet
Net asset value will not change and equity will not change.
Earnings per share
Commonly used ratio that can be measured by the financial performance of a company.
An increase in the number of shares in issue will result in a dilution of the earnings per share figure.
Divide profit after tax by number of ordinary shares in issue while profit was generated.
Effect of debt finance
liabilities are increased and assets (cash) increase. but net is the same.
What is gearing?
Ratio of debt to equity.
Higher ratio more highly a company is geared.
long term debt/equity x100
High gearing
Seen as more of a credit risk by banks and other lenders.
Also has less equity to protect creditors so there is a higher risk.
A higher geared company will need to make more profits before interest and tax in order to meet the demands for interest payments.
Advantages of gearing
By borrowing money, the company can make a far bigger investment than a company could have made if it was just using its own resources.
May also be more advantageous to shareholders because raising money through debt finance does not require share dilution though the issue of new shares.
A higher loan level improves earnings per share.
