Debt Financing

Question 1

What is debt? Differentiate between the different types of debt.

Answer 1

Debt is a financial transaction where the borrower receives a principal that it will pay back in a future at a predetermined interest rate.
D = I*(1+r)^T

1. Instalment/Revolving Credit
2. Secured/Unsecured Credit
3. Personal/Corporate Credit

Question 2

What are they key elements of a debt contract? What happens in case of default?

Answer 2

1. Principal
2. Maturity
3. Interest rate (fixed/variable)

Extra:
Fees
Collateral (Recourse/Non-recourse)
Covenants (about liquidity, profitability, business-specific indicators)

In case of default:

a) Declare bankruptcy
b) Renegotiate the loan

Question 3

Examples of Loan contracts

Answer 3

Short-term bullet
Long-term bullet + fee
Interim payments
Revolving credit line

Question 4

What is the cost of debt wrt equity?

Answer 4

Modigliani Miller theorem. The cost of raising Debt and Equity is always the same.

Explain Box of cost of risky debt.

Question 5

What costs are associated with debt contracts vs equity contracts?

Answer 5

1. Transaction cost
2. Incentive cost

Transaction Cost
For Debt, transaction cost involves the initial negotiation and the case of bankruptcy.
For equity, transaction cost involves initial negotiation, structuring an exit and repaying equity.

Debt has less transaction cost for safer companies with low default risk.

Incentive Cost
For Debt, investor has no more incentives when the company value exceeds the debt value.
With Equity, incentives are preserved.

Question 6

Why don’t banks lend to start-ups?

Answer 6

Banks care about three things when giving out loans:

1. Probability of default
2. Recovery in case of default (Collateral)
3. Interest rate they charge

1, 2 are very low for entrepreneurial companies.
3 poses the adverse selection problem. Only companies willing to accept such a high interest rate are the only ones unlikely to succeed.

Question 7

What are alternative types of debt?

Answer 7

1. Personal Loans and Credit Cards (high interest rates).
2. Trade Credit = way of increasing current liabilities, discount for early payment, fee for late.
   With discount it’s like an expensive short term loan.
3. Discounting = borrow using receipts of receivables as collateral
4. Factoring = selling receipts of receivables. (not technically debt). Recourse/Non-recourse factoring.
5. Venture leasing. Lender owns the asset and provides the borrower with the right to use it. Other than the payments, Lessor typically gets some warrants to buy a % “coverage” of the lease value worth of stock at the price of the previous round.

Asset-based loan (secured by an asset) and leasing, the difference is in the ownership of the asset.

6. Venture Debt.
   Can help scale up companies and reach a higher valuation.
   Viable thanks to:
7. Lender risk is not on the success of the venture but on the probability of raising a next round.
8. Relatively high interest rates.
9. Lender obtains strong contractual rights.
10. Warrants increase profitability in case of successful venture.