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Debt Financing

Debt Financing

Author: James Howard

This lesson discusses debt financing.

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Hello, and welcome to this tutorial on debt financing. Now as always with these tutorials, please feel free to fast forward, pause, or rewind as many times as you need in order to get the most out of the time that you're going to spend here. Now let me ask you a question. What are some different ways you think a company might get money for its long term needs? Now we've covered short term financing pretty well, but what about long term needs?

Well, during this tutorial, what we're going to be looking at are loans and bonds. We'll also be looking at long term loans, corporate bonds, and finally, we'll be comparing the two-- bonds and loans. The key terms for this lesson are going to be debt financing, bond, and maturity date.

So let's go ahead and define what debt financing is. Debt financing is an arrangement in financing where a company takes a loan and agrees to pay the loan back at a specified point in time. Now businesses will use financial leverage to borrow funds that they need to try to increase the return on their owner's equity in these long term plans or long term goals that they have.

Now this is true as far as return on that owner's equity as long as the businesses' earnings are going to be greater than the interest that's charged for that particular loan. And this could be beneficial and true as long as the earnings are going to be solid for a company. If something unexpected happens, however, then it can fail because it has to make up that interest payment along the way. For small businesses, long term financing is typically only loans.

So let's take a look at what we mean here. Now here you'll see the blue area is earnings for a company and the red area is the interest that's going to be charged for a particular type of long term or debt financing. And you'll notice that the company is making $12,000-- up to about $13,500 a year from 2010 up to 2015. And the interest along the way is going, of course, go down along the maturity of the loan in this case. So as long as we have that gap there between earnings of interest, then we're going to be OK for this particular financing. What we have to watch out for, especially at the beginning, is unexpected occurrences or unexpected outlays that we're going to have to make where our earnings may not make up the difference between the earnings and the interest. In that case, well, we'll be in some trouble.

So, long term loans. Now long term loans are typically offered by banks. Now also, manufacturers and suppliers may provide long term credit, which functions as a type of long term loan as well. Now businesses when getting loans for more than a year have to have a term loan agreement, and this is a promissory note that details a repayment process for that particular loan.

Now these are typically really, really long and really complicated, so I've found this older type of promissory note to pay back a loan, and this is from the Imperial Bank of India in Rangoon. They've loaned this particular person 20,000 rupees, and they've agreed to pay it back on order at an interest rate of 6 and 1/2% every single year. So the interest is going to build every single year at 6 and 1/2%. And if I'm not making any payments on that particular loan, then whenever they come back and say, hey, I want this money back, I have to pay the 20,000 initial rupees plus that 6 and 1/2% that's matured over the life of the long term loan.

Now corporate bonds are a little bit different type of long term finance and long term loans, And a bond is a financial instrument where the organization, a company, or the government offers an IOU to the holder of the bond. The organization promises to repay the IOU with specified interest by a specific date. Now with corporate bonds, this is a great way to raise money long term for a company as well as loans.

Now typically you'll see this done in addition to any loans a company may have through a bank, and basically it's a promise by the corporation or the government to repay the money by the maturity date. The maturity date is the final payment due date for a loan or other monetary instrument such as a bond. Now, with bonds, all the legal information you need to know about the bond is going to be in something called the bond indenture. And typically what's going to happen is a corporation will appoint someone called a trustee. And this is an independent person or a firm that serves as the representative for the bond owner.

Now typically, this is going to be a bank. Someone who is independent from the bond holder or the bond issuer, and they're going to be responsible for communication between the corporation and the bond owners. Now there's some different types of corporate bonds out there. The first one we're going to look at is called a debenture bond.

Now a debenture bond is unsecured. Typically it's only issued by financially strong companies because the only thing that's securing in this thing is the company's word that they're going to pay this bond back. And let's think about it. If the company wasn't strong and trustworthy, nobody would buy this bond or own this bond because you wouldn't be sure that the bond would actually be paid back.

Another title corporate bond is a mortgage bond. So a mortgage bond is made up of pool property that's used as collateral against the face value of the bond. So if for some reason the corporation defaults or doesn't pay back the bond in accordance with the bond indenture, then this pool's property then is sold and that is used to pay back the bond.

So let's take a look at bonds versus loans and see how they kind of compare to each other. Now with long term loans, typically what we're looking at is there's a limited number of parties involved. Typically just the person taking the loan and person or the institution issuing the loan.

There's also typically no public disclosure about the financial information involved within the long term loan. No one else needs to know what the terms of the loan are. It's quick-- relatively quick-- and the payback times for long term loans are usually between three to seven years. And what you'll see as far as an interest rate is anywhere from 6% to 12% depending on how creditworthy the business is.

Now with bonds on the other hand, these take much longer time to arrange. Because you have to arrange for buyers, you have to arrange for financing, and find the trustees, and get the bond indenture together. There's also a lot more people involved with this type of financing instrument. Now typically, the term on a bond is anywhere from 10 to 30 years. So it really takes a long time to pay back and the bonds are hanging over the business for this entire 10 to 30 year term.

Bonds typically will pay an interest rate of somewhere between 5% and 10%, and there's a higher cost for these to sell and administer. And as a result, if I issue a bond, say, for $1,000, because of this high sell and administration cost, I'm only going to give maybe about $900 or so against that $1,000 promise to pay back. So I'm not going to get the full face value being the one who issues the bond.

However, if I buy this bond, I can be assured that I'm going to get that face value back. And I'm also going to get that 5% to 10% interest rate every year for the life of the bond.

So what have we talked about today? Well, we looked at loans and bonds. We also looked at long term loans and corporate bonds. And lastly, we compared the two-- bonds and loans-- to see how they kind of compare to stack up to each other. Now as always, I want to thank you for spending some time with me today, and have a great day.

Terms to Know

A financial instrument where the organization (A company or the government) offers an IOU to the holder of the bond where the organization promises to repay the IOU with specified interest by a specific date.

Debt Financing

An arrangement in financing where a company takes a loan and agrees to pay the loan back at a specific point in time.

Maturity Date

The final payment due date for a loan or other monetary instrument, such as a bond.