What is long term Debt ?
This section, we are going to analyze various sources of long-term debt financing. In general, debt financing is riskier for the issuer as the interest on the loan is payable. Whereas comparing with the equity fiance shareholders have the right to receive dividends only if the company decides to pay them off. Lending, on the other hand, is cheaper than equity because it is less risky than the lender. Therefore, you can learn the following topics throughout this article.
- Term financing methods
- Long term debt (Bonds, Debentures)
- Convertible securities
- International debt finance
- Obtaining debt finance for SMEs
Bank loans
Banks often provide medium to long term finance facilities to the customers. However, there is a long process to obtain a loan from a bank.
Advantages of a term loans
- Comfortable and very quick to negotiate
- A bank loan may be suitable for a small business as well.
- Banks give flexible repayment schedules.
Mezzanine finance
Mezzanine finance is a hybrid type of long-term finance method which includes both debt and equity components. This method is often used in MBOs. However, when the company faced for a liquidation, usually they will settle first the secured loans and then finally they will be looking for unsecured debt to pay. Therefore, Mezzanine finance includes a higher interest due to the higher risk. Above all, there are many factors that many financial institutions will be considering the interest rate for a loan.
- Purpose – What is the purpose of taking the loan
- Amount – Amount of the loan
- Repayment – How to charge the capital payment from the borrower
- Time period – When the period becomes extended, the possibility of a higher rate
- Security – Whether the loan granted is secured by an asset
Types of Long-term debt
Bonds
Bond is instrument forms of long-term debt a company may issue. There are various types of bonds, you should learn as a finance manager/student. These include Redeemable, Irredeemable, Convertible, Floating rate, Zero rate coupon bonds.
Debentures
Debentures are defined as a written acknowledgement of a loan made by a company, which usually includes the provision of interest and repayment of capital. The terms of the bond are set out in a trust deed.
In addition, bonds are secured loans the securities may take the form of a floating charge or fixed charged. The fixed charge would be related to a specific asset ( land, buildings ) whereas floating charge would be associated with certain assets ( Inventory, receivables ). Therefore as an investor, they are likely to expect higher yield ( higher interest ) for an unsecured bond.
Preference shares as a long-term debt
Preference shares are paying a fixed dividend. These shareholders will be prioritized before the equity shareholder in a liquidation. The fixed dividend payment is a must where the company performed well or not.
Convertible securities
These securities are hybrid security which comprises of debt and equity. In this long-term financing method, investors are allowed to invest in the bonds initially. Then they will be given a right to convert their bonds to ordinary shares. If the investors conclude that the converting stock is not profitable, then they can ask for the redemption value from the company.
The issue price and the market price of convertible bonds
Always companies will try to issue the bonds at the highest possible conversion premium. This premium will be charged from the investors will depend on the company’s prospects. However, bonds issued at par will have a lower coupon rate (Interest rate) than the straight bonds. Most companies issuing convertible bonds expect them to be converted. They view the notes as delayed equity.
Advantages of convertibles
- Investors can enjoy the increase prices of shares.
- Bonds will have a lower percentage of interest.
- This will reduce the debt ratio.
- They are issuing equity, ultimately at a higher price than the current market price.
Disadvantages of convertibles
- If the share prices don’t increase as expected, investors will go for debt redemption.
- The borrower may be reluctant to invest due to lower yield.
International debt finance
Large companies with excellent credit ratings use the euro market to borrow from any foreign currency, using unregulated markets organized by trading banks. This market is much larger than the local bond market.
International borrowing
Large companies can borrow money from euro currency (money) markets using the Eurobonds. If the company has its mainstream of income from another currency, they can try to limit the risk of adverse exchange rate movements by matching. It can take out a long-term loan and use the foreign currency receipts to repay that loan. Eurocurrency is a currency which is held by individuals and institutions outside the country of issue of that currency.
Example for international borrowing
Assume there is a business registered in the USA and, they do business with Brazil. If the company receive the income from another currency, it is better to take a loan from that foreign currency. When a company borrows in a foreign currency (Brazil), the loan is known as a eurocurrency loan.
Eurobonds
Eurobonds are typically known as long-term loans raised by international companies. These bonds are issued to several investors in varies countries.
Advantages of Eurobonds
- Euro bonds are bearer instrument.
- It is a cheaper method of financing than a euro loan.
- Most bonds are flexible and fixed-rate, but these help the financial success of the business.
- As you are well aware, Eurobonds are issued by larger companies with good credit rating. Therefore, these bonds are unsecured.
- Typically interest is paid gross, means investors can enjoy tax benefits.
Disadvantages of Eurobonds
- There is an issue cost of approximately 2%. Finance managers will have to think twice if the company’s gearing is high.
- Foreign exchange risk (Company has to invest in the assets in that foreign currency and earn revenue to avoid any foreign exchange risk)
Small and medium sized entities
In any country, SMEs faces problems and high competition when they are going to obtain long term loans. In this competition, they are handicapped by the issue of uncertainty. Let’s look at what are the problems occur when you to obtain finance.
- SMEs have neither the business history nor more extensive track record that larger organizations possess.
- Their accounts are not audited.
- The costs of monitoring small businesses may be high for banks
- Banks face regulatory pressures when lending for SMEs.
However, the bank reluctant to lend if you cannot provide with security. Therefore in some countries, we can see the development of the non-banking sector and some government aid programmes etc.
