Debt Financing

Bank Loan

Debt financing in which a bank lends money to a business, the business agrees to repay the loan with interest over a agreed period

• Banks may require collateral, particularly when the borrower is risky

• Often include covenants (Conditions) such as regular information, limit additional borrowing and restrict disposal or assets

Bank Loan - Pros & Cons

Pros

• Keep 100% Ownership

• No dilution of ownership

• Bank does not receive ownership or voting rights

• interest is often cheaper then giving away equity

Cons

• Loan comes with interest

• Fixed repayments even if low income

• Failure to repay may result in bankruptcy

• Bank may require collateral or covenants

Corporate Bonds

A corporate bond is a type of debt where a company borrows money from investors and agrees to pay interest and repay the borrowed amount at a specified date.

• Debt securities issued by companies to borrow money from many investors.

• Investors are creditors, not owners.

• The company usually pays interest (the coupon) and repays the principal at maturity.

• Advantages: raises finance without diluting ownership.

• Disadvantages: creates repayment obligations and default risk.

• Risk: generally, higher-risk companies must offer higher interest rates to attract investors.

Secured Bonds

Bonds backed by assets as collateral.

• Security: Investors have a claim over specified assets if the company cannot repay.

• Risk: Generally lower risk than unsecured bonds.

• Interest rate: Often lower because investors have greater protection.

• Example: A company issues bonds secured against its buildings or machinery.

Unsecured Bonds

Bonds not backed by specific assets as collateral.

• Security: Investors rely on the issuer’s creditworthiness.

• Risk: Generally higher risk than secured bonds.

• Interest rate: Often higher to compensate investors for the extra risk.

• Default: Investors may have to compete with other creditors to recover their money.

• Example: A company issues bonds based on its reputation and financial strength.

Commercial Paper

Definition: Short-term borrowing through unsecured debt instruments.

• Purpose: Used to finance working capital, inventory and day-to-day expenses.

• Maturity: Usually repaid within a few days to months, typically up to 270 days in the US.

• Interest: Often issued at a discount, with investors receiving the face value at maturity.

• Risk: Generally issued by companies with strong credit ratings because it is unsecured. Rollover can occur when using new commercial paper to pay for old ones

Convertible Bonds

Bonds that can be converted into company shares.

• Interest: Usually pay interest to investors until conversion.

• Benefit to investors: Potential to profit if the company's share price rises.

• Benefit to companies: Often allow companies to borrow at a lower interest rate.

• Risk: If the share price falls, conversion may be unattractive and investors retain bond-related risks.

Credit Rating

An evaluation of a borrower's ability to repay debt.

• Purpose: Helps investors assess the risk of bonds and other debt.

• High rating: Indicates lower default risk and usually lower borrowing costs.

• Low rating: Indicates higher default risk and usually higher interest rates.

• Rating agencies: Examples include Moody's, S&P Global Ratings and Fitch.