90 4 Debt
The borrower’s investment project might include an estimate of capital cost.
However, the firm might incur large additional capital cost. If that cost has not
been included in the original finance plan for the project, the firm might not have
any immediate funds available to pay for it. The question arises how that addi-
tional capital cost can be funded.
The firm would normally deal with additional capital costs by raising additional
funding. Raising new funding may nevertheless face various difficulties. First, ex-
isting lenders might not be willing to provide any additional funding. Second, they
might also not be willing to allow new lenders to do so. If the raising of new fund-
ing requires lender approval, existing lenders have plenty of bargaining power.
This would put the firm at a disadvantage in negotiations with the lenders.^15
Interest rate risk. Interest rates may change. The borrower can mitigate interest
rate risk through: fixed or variable interest rates; prepayment options; and the
length of the interest period.
When interest rates rise, the firm may benefit from a fixed interest rate or a
prepayment option. When interest rates fall, the firm may benefit from a variable
interest rate.
This can be illustrated by consumer mortgages. (a) Danish consumer mortgages typically
provide for the combination of fixed interest rates and an option to repay the loan early.
Danish mortgages thus shield borrowers from interest-rate risks. If rates rise after they buy
a home, they are protected by the fixed interest rate. If rates fall, they can take out a new
mortgage at a lower rate and prepay the old one. The prepayment option, like bond issuers'
options to call some bonds before they mature, transfers interest rate risk to the lender.^16 (b)
In the US, mortgage rates are usually fixed, but borrowers can remortgage easily when rates
drop. (c) In England, however, mortgage rates are usually variable and borrowers face the
risk of rising interest rates. If the mortgage rate is fixed, the borrower must often pay hefty
fees to get out of the contract.
In so-called Eurocurrency lending,^17 one of the basic assumptions is that each
bank will fund its loan to the borrower by taking a deposit from another financial
institution in the same amount as the funds advanced to the borrower (matched
funding). Because it is difficult for banks to obtain deposits in the interbank mar-
ket for periods of more than 12 months, most Eurocurrency loans are broken into
interest periods of a shorter duration, and banks take matching deposits only for
each interest period as it begins. The result is that the interbank reference rate will
change for each successive interest period as it begins. In addition, the lender
wants any increased costs (such as withholding taxes or unexpected reserve re-
(^15) Yescombe ER, Principles of Project Finance. Academic Press, San Diego London
(2002) § 10.6.1.
(^16) A Danish model in Aztec dress, The Economist, January 2007.
(^17) Eurocurrency is the term used to describe loans or deposits residing in banks that are lo-
cated outside the borders of the country that issues the currency the loan or deposit is
denominated in. For example, a deposit denominated in US dollars residing in a Japa-
nese bank is a Eurocurrency deposit (a Eurodollar deposit).