Introduction to Corporate Finance

14: Long-Term Debt and Leasing

To prevent liquidation of assets through large salary payments, the lender may prohibit or limit salary

increases for specified employees. A relatively common provision prohibits the company’s annual cash

dividend payments from exceeding 50% to 70% of net earnings or a specified dollar amount.

In the process of negotiating the terms of long-term debt, the borrower and lender must agree to

an acceptable set of covenants. If a borrower violates a covenant, the lender may demand immediate

repayment of the entire loan, waive the violation and continue the loan, or waive the violation but alter

the terms of the original agreement.

14 -1c COST OF LONG-TERM DEBT

In addition to specifying positive and negative covenants, the long-term debt agreement specifies the

interest rate, the timing of interest payments and the size of principal repayment. The major factors

affecting the cost, or interest rate, of long-term debt are loan maturity, loan size, borrower risk and the

underlying cost of money.

Loan Maturity

Generally, the yield curve is upward-sloping, which implies that long-term loans have higher interest rates

than short-term loans. Factors that can cause an upward-sloping yield curve include: (1) the general

expectation of higher future inflation or interest rates; (2) lender preferences for shorter-term, more

liquid loans; and (3) greater demand for long-term rather than short-term loans relative to the supply

of such loans. In a practical sense, the longer the term, the greater the default risk associated with the

loan; therefore, to compensate for all these factors, the lender typically charges a higher interest rate on

long-term loans.

Loan Size

The size of the loan can affect the interest cost of borrowing in an inverse manner because of economies

of scale. Loan administration costs per dollar borrowed are likely to decrease with increasing loan size.

via this usage fee, rather than by charging financial

interest. Interestingly, Islamic finance usage fees

are often pegged to a market interest rate (such

as LIBOR +1%), though the fee is not considered

interest because the entire deal is structured to

meet approval of the appropriate sharia board.

Islamic bonds are known as sukuk, and are often

traded on public markets. The volume of sukuk

issuance has been growing. In the first quarter of

2015, $US17 billion was raised through this type of

financial instrument; this contrasts with $US14 billion

for the whole of 2009. Sukuk are structured so that

the investor is a partial owner in the underlying

asset the bond is used to finance, and the investor’s

return is considered profit sharing.

Many Islamic financial institutions fared better

than Western banks during the 2007–10 global

financial crisis. Western banks got into trouble in

part by buying or selling loans that were originated

elsewhere, and by trading derivative securities.

Both of these practices are forbidden under sharia

(because they are purely financial in nature), and

thus many Islamic financial institutions avoided the

riskiest of the practices that later haunted Western

banks.

Islamic financial markets are likely to grow

rapidly in coming decades, as Islamic nations and

companies continue to grow and seek financial

capital, and as Islamic investors seek to buy

securities that satisfy Islamic law.

Sources: John Burton, ‘Islamic Bond Issues Seen Dropping Further’,

Financial Times. 22 January 2009; Delphine Strauss, ‘Islamic-Style

Turkish Bonds Fail to Appeal’, Financial Times. 29 January 2009; and

http://ifikr.isra.my/documents/10180/16168/Q1%202015%20SUKUK%20

REVIEW08-06-2015-19.pdf (accessed on 6 September 2015).