Debt Finance - Types of Debt Finance Flashcards
What is debt finance and what are the two main types?
1) Debt finance is when businesses obtain finance by borrowing money
2) Two main types
2a) Loans – a business borrows money from a bank or other lender. Examples:
- Bank overdraft
- Term loan
- Revolving credit facility
2b) Debt securities – company may issue these to investors in return for a cash payment and they must be repaid by an agreed future date
What are some of the main issues a company should consider before borrowing money?
MAs don’t place any restrictions on borrowing
If the company has its own articles and wishes to borrow, it must change them via special resolution
Directors must also have the authority to act on behalf of the company, so check if there are restrictions on the amount they can borrow
Partnership agreement should be checked for same; can be changed with unanimous consent
Debt finance largely governed by contract law
Businesses will often have to offer lenders security over its property in return for the money
- Allows lender to take possession to sell it if they default to recover their money
Give an overview of loans
Business will negotiate the terms of the loan contract
- Secured loans allow the lender security over the businesses property
- Unsecured loans (no security taken by lender) usually require the business to pay higher rates of interest
Three main types of loan – overdraft, term loan, revolving credit facility; all governed by contract law
What is an overdraft facility and how does it work?
Contract between the business and bank that allows the business to go overdrawn on its current account
- Maximum amount agreed in advance
- Common for small and medium businesses
Bank may demand immediate repayment at any time, without notice, but they usually wait until the business is in financial difficulties
Business pays a fee for the facility + pays interest on a compound basis (interest added to amount borrowed and charged on whole amount)
- Usually high interest rates, but offers businesses flexibility
What is a term loan and how do they work?
Business borrows a fixed amount for a specified period, and it must be repaid by the end of this term
- Borrower pays interest regularly
Length of term
- Short term = up to 1 year
- Medium term – 1-5 years
- Long term = over 5 years
Usually secured, but can be unsecured
Bilateral or syndicated loan
- Bilateral – between 2 parties, business and bank
- Syndicated – between business and various lenders; common for high amounts as risk splits between lenders
Contract for a term loan is a loan/credit/facility agreement
Term loan may allow business to take out the loan in one go or in instalments on agreed dates
What is a revolving credit facility and how does it work?
Bank agrees to make a max amount of money available throughout an agreed period
- During the lifetime of this period (the facility), the business can borrow and repay money
- Interest is payable at regular intervals
The business can borrow amounts it has already repaid, so long as it doesn’t exceed the maximum figure
Usually secured, but can be unsecured; can be bilateral or syndicated; contract usually called a facility agreement
Term loans and revolving credit facilities involve complex contracts and have various important clauses.
How will payment to the borrower be outlined in the contract terms?
Initial clauses of facility agreement will set out:
- (a) the amount of the loan;
- (b) the currency
- (c) the type of loan; and
- (d) the availability period(s) during which the loan can be taken (for a revolving credit facility, this is almost the entire length of the facility)
Terms loans and RCFs are committed facilities, so when the agreement is signed, the bank must provide the loan monies when the business requests them
How will repayment and pre-payment be outlined in the contract terms?
Bank can only ask for repayment in accordance with the terms of the facility agreement
May be able to repay:
- The whole loan at once at the end of the term
- In equal instalments over the term
- In unequal instalments, with the final instalment being the largest
How will interest rates be outlined in the contract terms?
The rate payable will be agreed and must be expressly stated
- May be fixed for the term or variable to maintain lender’s profit
Often default interest if scheduled payments are missed
What express covenants will the business give to the bank in the facility agreement?
- Business to pay all debts as they fall due
- Dividends do not exceed a specified percentage of net profits
- Minimum capital requirements
- Business must not dispose of assets without lender’s consent or change nature/scope of business
- Business must not create any further security without lender’s consent (negative pledge clause)
- Provision of information on the business
What implied covenants will be included in the facility agreement?
A contractual term will only be implied if necessary to give business efficacy to the contract or if the term ‘goes without saying’
No term can be implied that is inconsistent with an express one
How will the facility agreement address ‘events of default?’
If the business breaches any ‘events of default’ terms, the lender can terminate the agreement
- Failure to pay sums due
- Commencement of insolvency procedure
- Breach of other obligations under the facility agreement
What are ‘debentures?’
Not a separate type of debt finance – generally describes a written loan agreement that is registered at Companies House
Gives lender security over borrower’s assets
Only companies and LLPs can enter debentures; sole traders and partnerships cannot
What is the main difference between secured and unsecured debt?
A lender with security is in a much stronger position if the business becomes insolvent, as unsecured debts are governed by the pari passu principle
- This means that unsecured debts are all reduced pro rata if there are insufficient funds to pay all the business’ debts
Debt finance is generally preferred by companies, owing to various factors.
How does the relative risk of the investment differ between debt and equity finance?
Equity finance – riskier, as may not get a dividend if there are financial difficulties and shareholders’ shares are worthless if company is insolvent
Debt finance – interest payments paid before dividends + security means a lender is more likely to be repaid on insolvency
How does the involvement in the company differ between debt and equity finance?
Equity finance – shareholders have rights and influence the direction of the company
Debt finance – lenders have no say
How does the repayment of capital differ between debt and equity finance?
Equity finance – shareholders’ capital won’t be repaid unless company wound up or they sell shares to a 3rd party
Debt finance – loan capital repaid according to agreement
How does the restrictions on sale differ between debt and equity finance?
Equity finance – transfer of shares is governed by articles and directors may refuse to register a new shareholder
Debt finance – lender may sell its debenture to a 3rd party earlier than the repayment date
How does the capital value of the investment differ between debt and equity finance?
Equity finance – share value changes based on company’s success
Debt finance – capital value of a facility agreement remains constant
How does the degree of statutory control differ between debt and equity finance?
Equity finance – tightly controlled by CA 2006
Debt finance – mainly a contract law matter
How does the payment of income differ between debt and equity finance?
Equity finance – company can only pay dividends if there are available profits and directors might refuse to pay dividends too
Debt finance – interest must be paid according to agreement’s terms
How does the tax treatment of income payments differ between debt and equity finance?
Equity finance – payment of a dividend is not a deductible expense for the company
Debt finance – payment of debenture interest is a normal trading expense and is deductible before corporation tax is assessed
How does the cost differ between debt and equity finance?
Equity finance – share of future dividends or capital growth is decreased by presence of extra shareholders
Debt finance – cost of debt is the interest charged by lenders + tax savings should be considered, as interest is tax deductible
How does the existing capital structure differ between debt and equity finance?
Equity finance – if the company has a lot of debt, it might be good to issue fresh shares
- Gearing is the ratio of borrowings to shareholder funds and high gearing means more borrowings and greater risk of insolvency
Debt finance – N/A
