Chapter 24 The Many Different Kinds of Debt 637
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Commitment
Companies sometimes wait until they need the money before they apply for a bank loan, but
about 90% of commercial loans by U.S. banks are made under commitment. In this case the
company establishes a line of credit that allows it to borrow up to an established limit from the
bank. This line of credit may be an evergreen credit with no fixed maturity, but more com-
monly it is a revolving credit (revolver) with a fixed maturity. One other common arrange-
ment is a 364-day facility that allows the company, over the next year, to borrow, repay, and
re-borrow as its need for cash varies.^42
Credit lines are relatively expensive; in addition to paying interest on any borrowings, the
company must pay a commitment fee of around .25% on the unused amount. In exchange
for this extra cost, the firm receives a valuable option: it has guaranteed access to the bank’s
money at a fixed spread over the general level of interest rates.
The growth in the use of credit lines has changed the role of banks. They are no longer
simply lenders; they are also in the business of providing companies with liquidity insurance.
Maturity
Many bank loans are for only a few months. For example, a company may need a short-term
bridge loan to finance the purchase of new equipment or the acquisition of another firm. In
this case the loan serves as interim financing until the purchase is completed and long-term
financing arranged. Often a short-term loan is needed to finance a temporary increase in
inventory. Such a loan is described as self-liquidating; in other words, the sale of goods pro-
vides the cash to repay the loan.
Banks also provide longer-maturity loans, known as term loans. A term loan typically has
a maturity of four to five years. Usually the loan is repaid in level amounts over this period,
though there is sometimes a large final balloon payment or just a single bullet payment at
maturity. Banks can accommodate the precise repayment pattern to the anticipated cash flows
of the borrower. For example, the first repayment might be delayed a year until the new fac-
tory is completed. Term loans are often renegotiated before maturity. Banks are willing to do
this if the borrower is an established customer, remains creditworthy, and has a sound busi-
ness reason for making the change.^43
Rate of Interest
Most short-term bank loans are made at a fixed rate of interest, which is often quoted as a
discount. For example, if the interest rate on a one-year loan is stated as a discount of 5%, the
borrower receives $100 – $5 = $95 and undertakes to pay $100 at the end of the year. The
return on such a loan is not 5%, but 5/95 = .0526, or 5.26%.
For longer-term bank loans the interest rate is usually linked to the general level of interest
rates. The most common benchmarks are LIBOR, the federal funds rate,^44 or the bank’s prime
rate. Thus, if the rate is set at “1% over LIBOR,” the borrower may pay 5% in the first three
months when LIBOR is 4%, 6% in the next three months when LIBOR is 5%, and so on. The
nearby box describes how LIBOR is set and its relationship to the Treasury bill rate.
Syndicated Loans
Some bank loans and credit lines are too large for a single lender. In these cases the borrower
may pay an arrangement fee to one or more lead banks, which then parcel out the loan or
BEYOND THE PAGEmhhe.com/brealey12eThe LIBOR
scandal(^42) Banks originally promoted 364-day facilities because they did not need to set aside capital for commitments of less than a year.
(^43) One study of private debt agreements found that over 90% are renegotiated before maturity. In most cases this is not because of
financial distress. See M. R. Roberts and A. Sufi, “Renegotiation of Financial Contracts: Evidence from Private Credit Agreements,”
Journal of Financial Economics 93 (2009), pp.159–184.
(^44) The federal funds rate is the rate at which banks lend excess reserves to each other.