BUSF_A01.qxd

Loan notes and debentures

Methods of issuing loan notes

Loan notes can be issued in several ways, including direct issues to the public by

newspaper advertisement and so on. Quite often, businesses wishing to issue loan

notes will approach an issuing house and ask it to try to place the issue with its clients,

often institutional ones.

Factors for the business to consider on loan notes financing

Issue costs

Issue costs tend to be relatively low; they have been estimated at about 2.5 per cent

of the value of the cash raised on a £2 million issue (Wilson Committee 1980). Lee,

Lockhead, Ritter and Zhao (1996) found that, in the USA, issue costs of loan notes

average 2 per cent of funds raised.

Servicing costs

Since loan notes represent a relatively low-risk investment to investors, expected returns

tend to be low compared with those typically sought by equity holders. Historically,

this has been reflected in actual returns.

Obligation to pay interest

Loan notes holders have the basic right under the law of contract to take action to

enforce payment of interest and repayment of capital on the due dates, should they

not be forthcoming. In many cases, loan notes holders have the contractual right to

take some more direct action (such as effective seizure of an asset on which their loan

is secured), should the borrowing business default on payments.

This clear obligation to pay interest, with potentially dire results for defaulting,

can make servicing the loan notes a considerable millstone around the neck of the

borrowing business.

Obligation to redeem loan notes

Irrespective of whether loan notes are issued as redeemable or not, it is always open

to the business to buy its own loan notes, in the open market, and to cancel what it

buys. Thus loan notes offer a level of flexibility not so readily available with ordinary

and preference shares. On the other hand, if loan notes are issued as redeemable with

a stated redemption date, which will usually be the case, the business is under a con-

tractual obligation to redeem. This could put the business into a difficult cash flow

position as the due date for redemption approaches.

Tax deductibility of loan notes interest

Interest is fully deductible from profit for corporation tax purposes. This has tended

in the past to make loan interest payments cheaper, pound for pound, than ordinary

and preference share dividends. This is a point that we shall return to in Chapter 11.

Effect on control and on freedom of action

The severity of the consequences of failing to meet interest payments and capital

repayments can considerably limit the freedom of action of the business. While con-

trol, in the sense of voting rights, is not usually involved with loan notes financing, the

issuing of loan notes may well seriously erode control in the sense of being able to

manage affairs without impediment.