Working Capital Financing^363
machinery, and so forth, the loans can be readily secured by the new equipment being
purchased. Occasionally, stocks bonds, real estate, and other assets are also used as
collateral for term loans.
Costs. The interest rate on a term loan is usually higher than the interest rate on short-
term loans. Term loans rates also reflect the credit worthiness of the borrower and the
liquidity and marketability of the collateral used to secure the loan. For a financially
sound borrower, the term loan rate will be about 0.5 per cent higher than the prime
lending rate.
Interest rates on term loans can either remain fixed for the duration of the loan or vary
with changes in the prime rate. If the term loan has a variable interest rate, then the
loan agreement may also specify the ìfloorî and ìceilingî rates. For example, a term
loan agreement may provide that the interest on the unamortised portion of the loan will
be at a prime plus 0.5 per cent rate but in no case will be higher than 10 per cent or
lower than 7 per cent. In this case the 7 and 10 per cent rates are the floor and ceiling
rates, respectively.
In addition to interest expense, term loans may entail other costs. The lending institution
may charge a moderate loan commitment fee. Occasionally, the lending institution may
require that warrants or options to buy common stock at specified prices be provided
by the borrower. This allows the lender to participate in the anticipated growth of the
borrowerís business. Insurance companies providing term loans prefer to use this device
to gain additional returns.
Provisions. Financial institutions making term loans need to assure themñselves that
the borrower continues to have the potential to make interest and principal payments at
the scheduled intervals. This need to secure their financial position leads term lenders
to incorporate a variety of provisions in the lending agreement. These provisions are
designed to provide the lender with timely financial information about the borrower and
to impose certain restrictions on the borrower. For example, the lending arrangement
may require the borrower to maintain a minimum current ratio. If the borrowerís
current ratio falls below the minimum level, then, at its option, the lender may require
immediate payment of the unamortised portion of the term loan.
Another provision regulates the amount of new long-term debt that the borrower can
acquire. This provision typically requires that the borrower must secure the lenderís
approval before the borrower can issue any new long-term debt or sign leases. This
provision allows the lender to exercise control over the borrowerís indebtedness and to
keep the borrower from becoming too indebted.
Another common term loan provision requires the borrower to provide the lender with