496 Part 6 Working Capital Management, Forecasting, and Multinational Financial Management
demand payment unless the borrower’s creditworthiness has deteriorated,
some “short-term loans” remain outstanding for years, with the interest rate
" oating with rates in the economy.- Interest rate. The interest rate can be! xed or " oating. For larger loans, it is typi-
cally indexed to the bank’s prime rate, to the T-bill rate, or to the London
Interbank Offer Rate (LIBOR). The note will also indicate whether the bank
uses a 360- or 365-day year for purposes of calculating interest. The indicated
rate is a nominal rate, and the effective annual rate is generally higher. - Interest only versus amortized. Loans are either interest only, meaning that only
interest is paid during the life of the loan, with all principal repaid when the
loan matures, or amortized, meaning that some of the principal is repaid on
each payment date. Amortized loans are also called installment loans. - Frequency of interest payments. If the note is on an interest-only basis, it will
indicate how frequently interest must be paid. Interest is typically calculated daily
but paid monthly. - Discount interest. Most loans call for interest to be paid only after it has been
earned; but banks also lend on a discount basis, where interest is paid in
advance. On a discount loan, the borrower actually receives less than the face
amount of the loan; and this increases its effective cost. We discuss discount
loans in Web Appendix 15B. - Add-on loans. Auto loans and other consumer installment loans are generally
set up on an “add-on basis,” which means that interest charges over the life of
the loan are calculated and then added to the face amount of the loan. Thus,
the borrower signs a promissory note calling for payment of the funds received
plus all interest that must be paid over the life of the loan. The add-on feature
raises the effective cost of a loan. - Collateral. If a loan is secured by equipment, buildings, accounts receivable, or
inventories, this fact is indicated in the note. Security for loans is discussed in
more detail in Section 15-13. - Restrictive covenants. The note may also specify that the borrower must main-
tain certain ratios at or better than speci! ed levels, and it spells out what hap-
pens if the borrower defaults on those covenants. Default provisions often
allow the lender to demand immediate payment of the entire loan balance.
Also, the interest rate on the loan might be increased. - Loan guarantees. If the borrower is a small corporation, the bank will probably
insist that its larger stockholders personally guarantee the loan. Troubled
companies’ owners have been known to divert assets from the company to
relatives or other entities they own, so banks protect themselves by obtaining
personal guarantees.
15-10b Line of Credit
A line of credit is an agreement between a bank and a borrower indicating the
maximum amount of credit the bank will extend to the borrower. For example,
in December, a bank loan of! cer might indicate to a! nancial manager that the
bank regards the! rm as being “good for” up to $80,000 during the coming year,
provided the borrower ’s! nancial condition does not deteriorate. If on January
10 the! nancial manager signs a promissory note for $15,000 for 90 days, this
would be called “taking down” $15,000 of the credit line. The $15,000 would be
credited to the! rm’s checking account; and before it was repaid, the! rm could
borrow an additional $65,000 for a total of $80,000. Such a line of credit would be
informal and nonbinding; but formal and binding lines are available, as dis-
cussed next.Line of Credit
An arrangement in which
a bank agrees to lend up
to a specified maximum
amount of funds during a
designated period.Line of Credit
An arrangement in which
a bank agrees to lend up
to a specified maximum
amount of funds during a
designated period.