Introduction to Corporate Finance

PART 4: CAPITAL STRUCTURE AND PAYOUT POLICY

However, the risk to the lender increases, since larger loans result in less diversification. The size of

the loan sought by each borrower must therefore be evaluated to determine the net administrative cost

versus risk trade-off.

Borrower Risk

The higher the company’s operating leverage, the greater the volatility of its operating cash flows. Also,

the higher the borrower’s financial leverage, conveniently reflected in a high financial debt ratio or a low

times interest earned ratio, the greater the volatility of the shareholders’ cash flows. The lender’s main

concern is with the borrower’s ability to fully repay the loan as prescribed in the debt agreement. A lender

uses an overall assessment of the borrower’s operating and financial risk, along with information on past

payment patterns, when setting the interest rate on a loan.

Cost of Money

The cost of money is the basis for determining the actual interest rate charged. Generally, the rate on

Australian government bonds with equivalent maturities is considered the basic (lowest-risk) cost of

money. To determine the actual interest rate to be charged, the lender will add premiums for borrower

risk and other factors to this basic cost of money for the given maturity. Alternatively, some lenders

determine a prospective borrower’s risk class and find the rates charged on loans with similar maturities

and terms to companies in the same risk class. Instead of having to determine a risk premium, the lender

can use the risk premium prevailing in the marketplace for similar loans.

1 What factors should a manager consider when deciding on the amount and type of long-term debt

to be used to finance a business?

2 What factors should a manager consider when negotiating the loan covenants in a long-term debt

agreement?

3 How can managers estimate their companies’ cost of long-term debt before meeting with a

lender?

CONCEPT REVIEW QUESTIONS 14-1

14 -2 CORPORATE LOANS

Corporations can acquire debt financing by borrowing money as a loan from a financial or non-financial

institution, or by selling debt securities (like bonds). Here we describe the two most important types of

corporate borrowing: term loans and syndicated loans.

14 -2a TERM LOANS

A term loan is made by a financial institution to a business, and has an initial maturity of more than one

year, generally three to seven years. Term loans are often made to finance permanent working capital

needs, to pay for machinery and equipment or to liquidate other loans.

Term loans are essentially private placements of debt. Companies typically negotiate term loans

directly with the lender instead of using an investment banker as an intermediary. An advantage of term

term loan
A loan made by an institution
to a business, with an initial
maturity of more than one
year, generally three to seven
years