# Term Loans - Financial Management

A term loan, or intermediate-term credit, is defined as any debt obligation having an initial maturity between 1 and 10 years. It lacks the permanency characteristic of long -term debt. Term loans are well suited for financing small additions to plant facilities and equipment, such as a new piece of machinery. These loans can also be used to finance a moderate increase in working capital when

• The cost of a public offering of bonds or stock is too high.
• The firm intends to use the term debt only until its earnings are sufficient to amortize the loan.
• The desired increase is relatively long -term but not permanent.

Term loans are often preferable to short -term loans because they provide the borrower with a certain degree of security. Rather than having to be concerned about whether a short-term loan will be renewed, the borrower can have a term loan structured in such a way that the maturity coincides with the economic life of the asset being financed. Thus, the cash flows generated by the asset can service the loan without putting any additional financial strain on the borrower.

Term loans also offer potential cost advantages over long-term sources of financing. Because term loans are privately negotiated between the borrowing firm and the lending institution, they are less expensive than public offerings of common stock or bonds. The issuing firm in a public offering must pay the registration and issue expenses necessary to sell the securities. For small- to moderate -size offerings, these expenses can be large in relation to the funds raised.

Repayment Provisions

A term loan agreement usually requires that the principal be amortized over the life of the loan, which means that the firm is required to pay off the loan in installments, rather than in one lump sum. Amortizing has the effect of reducing the risk to the lender that the borrower will be unable to retire the loan in one lump sum when it comes due.Amortization of principal is also consistent with the idea that term loans are not a permanent part of a firm’s capital structure.

The amortization schedule of a term loan might require the firm to make equal quarterly, semiannual, or annual payments of principal and interest. For example, assume that Arrow Envelope Company borrows $250,000 payable over five years, with an interest rate of 10 percent per annum on the unpaid balance. The repayment schedule calls for five equal annual payments, the first occurring at the end of year 1. Recall from Chapter that the annual payment (PMT) required to pay off a loan can be computed using Equation: PVAN0 = PMT(PVIFAi, n) or PMT =PVAN0/PVIFAi, n In this example, substituting the present value of the annuity (PVAN0) =$250,000, the number of time periods (n) = 5, the interest rate (i) = 10 percent, and the PVIFA0.10, 5 = 3.791 from Table into this equation yields an approximate annual payment of $65,945.66. A more accurate solution, obtained with a financial calculator, is$65,949.37.

By making five annual payments of $65,949.37 to the lender, Arrow will just pay off the loan and provide the lender with a 10 percent return. Panel of Table shows the amortization schedule for this term loan. Over the life of this loan,Arrow will make total payments of$329,746.85. Of this amount, $250,000 is the repayment of the principal, and the other$79,746.85 is interest. It is important to know what proportions of a loan payment are principal and interest because interest payments are tax deductible.

In this example, the repayment schedule calls for equal periodic payments to the lender consisting of both principal and interest. Other types of repayment schedules are also possible, including the following:

• The borrower might be required to make equal reductions in the principal outstanding each period, with the interest being computed on the remaining balance for each period. Panel of Table illustrates such a repayment schedule, where Arrow is required to repay $50,000 of the principal each year. • The borrower might be required to make equal periodic payments over the life of the loan that only partially amortize the loan, leaving a lump sum payment that falls due at the termination of the loan period, called a balloon loan. Panel of Table shows a repayment schedule requiring Arrow to repay one-half ($125,000) of the term loan over the first four years with the balance ($125,000) due at the end of the fifth year. • The borrower might be required to make a single principal payment at maturity while making periodic (usually quarterly) interest payments only over the life of the loan, called a bullet loan. Panel of Table lists the payments required to pay off this loan, given that Arrow is required to make only annual interest payments over the first four years of the loan with the principal ($250,000) plus an annual interest payment due at maturity.

Interest Costs

The interest rate charged on a term loan depends on a number of factors, including the general level of interest rates in the economy, the size of the loan, the maturity of the loan, and the borrower’s credit standing. Generally, interest rates on intermediate -term loans tend to be slightly higher than interest rates on short-term loans because of the higher risk assumed by the lender.

Also, large term loans tend to have lower rates than small term loans because the fixed costs associated with granting and administering a loan do not vary proportionately with the size of the loan. In addition, large borrowers often have better credit standings than small borrowers. An interest rate between 0.25 and 2.5 percentage points above the prime rate is common for term loans obtained from banks.

The interest rate on a small term loan is sometimes the same throughout the loan’s lifetime. In contrast, most larger term loans specify a variable interest rate, which depends on the bank’s prime lending rate. For example, if a loan is initially made at 0.5 percentage points above the prime rate, the loan agreement might specify that the interest charged on the remaining balance will continue to be 0.5 percentage points above the prevailing rate. Thus, whenever the prime rate is increased, the loan rate also increases; if the prime rate declines, so does the interest rate on the loan.

Compensating Balances It is not uncommon for a bank to require a borrowing firm to keep a percentage of its loan balance —for example, 10 percent—on deposit as a compensating balance. If this balance is greater than the amount the firm would normally keep on deposit with the bank, this requirement effectively increases the firm’s cost of the loan.

Equity Participations The interest rate charged on a term loan may also be influenced by a desire on the part of the lending institution to take an equity position (often called a “kicker”) in the company as an additional form of compensation. This is usually accomplished through the issuance of a warrant by the borrower to the lender.

A warrant is an option to purchase a stated number of shares of a company’s common stock at a specified price sometime in the future. If the company prospers, the lending institution shares in this prosperity on an equity basis. The issuance of warrants in conjunction with a term loan is common when the loan has an above -normal level of risk but the lending institution feels the borrower has promising growth potential. Alternatively, the borrower may issue warrants to secure a more favorable lending rate.