Loan financing (Debentures & Term loans)
Hi guyz, how has your week been? Today we would be taking a look at the different types of loan capital for business. I hope you enjoy. Let’s start with debentures and types of debentures.
Debentures: Debentures are written acknowledgement of debt incurred by a limited liability company. The thing about debentures is that unlike normal loans that are backed by a collateral, i.e. physical asset of the business, land certificates etc, debentures are generally not secured by any physical asset (except a fixed charge/secured debenture). Instead, they are backed by the general creditworthiness or reputation of the issuer. Due to this, a debenture is generally considered more risky than an asset backed loan. A debenture like any normal loan provides for repayment of the underlying debt in the future and with interest.
Now let’s look at the various types of debentures classified into four groups which are:
- Debentures based on security
- Debentures based on convertibility
- Debentures based on redemption/ tenure
- Debentures based on the mode of redemption
Debentures based on security:
There are three types of debentures based on security. They are:
1)A simple unsecured or “Noted” debenture: This is a type of debenture issued solely on the credit worthiness and reputation of the issuer. It is not backed by any physical asset or collateral. In simple terms, it is a debenture in which the holder has no lien or pledge on any asset of the issuer.
In terms of liquidation (i.e winding up of a firm and selling of its assets in order to settle debts and obligations due), the simple unsecured debenture holder ranks after secured creditors for repayment.
2) A fixed charge debenture / Secured debenture: As the name implies, there is a fixed charge on specific assets of the issuer. The debenture stockholder is also entitled to interest payments as well as the repayment of the debt out of the liquidated assets of the issuer if the need arises. Due to the volume of debenture stocks sold, the specific assets the debenture is secured with are held by a trustee as the assets cannot be assigned to thousands, if not millions of people holding units of the that debenture stock.
3) A floating charge debenture: This type of debenture carries characteristics of both the simple unsecured and the fixed charge/ secured debenture. It is similar to the simple unsecured debenture in the sense that it is not backed by specific assets, while it is also similar to a fixed charge debenture in the sense that there is a general charge on the unpledged assets of the issuer.
Debentures based on convertibility:
There are two types of debentures based on convertibility, they are:
1 Convertible debenture: This type of debenture holder has an option of converting their debenture stock to common stock. In the indenture of a convertible debenture, the rate at which the debenture will be converted, and the period after which it can be converted would have been agreed upon and stated. So regardless of the current market price, the rate agreed on the indenture would take effect. Note: an indenture is a legal and binding contract between a bonds (debt) issuer and the bondholders.
2) Non-convertible debenture: They are simple or ordinary debentures that do not have the embedded option of converting the debenture stock to common stock (equity)
Debentures based on redemption or tenure:
There are two types of debentures based on redemption, they are:
1)Redeemable debenture: Redeemable debenture allows for the redemption of the debenture stock at specific date by the issuer. The company is legally bound to repay the principal amount of the debenture stock to the debenture holder at the date agreed upon in the indenture, or specified on the certificate.
2) Irredeemable debenture: Irredeemable debentures are also called perpetual debentures, meaning that they are expected to go on perpetually without any specific date of redemption. It should be noted that during the liquidation process, irredeemable debenture holders have the right to seek the repayment of the debt.
Debentures based on the mode of redemption:
There are two types of debentures based on the mode of redemption, they are:
1)Callable debentures: Callable debenture stock has embedded options for the issuer to buy back stock and repay investors at a predetermined rate.
2)Putable debentures: Putable debenture stock on the other hand has embedded option too, but for the debenture holder this time around. The debenture holder (buyer) can request redemption of the stock from the issuer, with the issuer paying the buyer back the principal amount of the debenture stock.
A term loan is a monetary loan provided by financial institutions with maturities ranging from 5 years to 15 years (though they are some ranging as long as 30 years), and a specified repayment schedule with a fixed or floating interest rate. A term loan is a very good source of small business finance, but before you rush to get a term loan, you should take into consideration these four factors:
1)Interest rates: Term loans usually tend to have a higher interest rate than short term loans. This is because of the inability of the lender to predict the future behaviour of interest rates accurately. Also because of the high risk of default of payments, getting a term loan is usually a rigorous and arduous process. Hence to compensate for not only the uncertainty of future interest rates but also the higher probability of default, lenders generally tend to charge higher interest rates on term loans.
2) Size of loan: The size of the loan and the interest cost of borrowing have an inverse relationship. This means that the larger the size of the loan, the lower the cost of borrowing. Why is this so? you ask. The simple answer is that administration cost per dollar of the loan decreases with an increase in its size. The administration cost refers to the cost of a loan’s credit analysis an execution.
3) Basic cost of money: The cost of money is the opportunity cost of holding money instead of investing it. It is measured with the interest rate on government securities of equivalent maturities, which are assumed to be virtually risk-free. The cost of money may be used as the basis for determining the actual interest rate to be charged on a prospective buyer. If the basic cost of money is high then interest rates would also be high. The basic cost of money is adjusted for certain specific factors such as the maturity of the loan, its size, business and financial risk, etc in order to determine the actual rate of interest charged.
4) Business and financial risk: A typical lender analyzes the financial statement of the business before deciding on whether to give out the loan or not. Through the use of financial ratios , the lender can determine the operating leverage of the business, and the higher the operating leverage, the less stable are the borrower’s earnings and costs. This implies that there is a higher level of business risk.
Advantage of term loan financing
- Tax deductibility of interest expenses. This makes it cheaper than equity financing.
- It can be raised without any dilution in the ordinary shareholder voting power and control.
Disadvantages of term loan financing
- Every firm has a maximum or optimal debt-equity beyond which the burden of debt servicing becomes too heavy, the risk of default increases and future borrowing is restricted.
- Higher coupon may have to be offered ifd the debt ratio is high or increasing , particularly if there is continuing inflation.