Debt Financing

March 24, 2020 12:13 AM

By

Kevin Valley

Lenders are stakeholders to companies in the sense that they have a vested interest in the company for as long as the debt is outstanding; however, pure lenders do not have a formal...

Companies seeking debt financing do so by entering into a debt agreement in exchange for a loan. 

Debt agreements outline repayment terms, including interest, and any security that a borrower must pledge in order for the financier to be willing to provide such a loan. Lenders are stakeholders to companies in the sense that they have a vested interest in the company for as long as the debt is outstanding; however, pure lenders do not have a formal ownership stake in the companies that maintain their loans in good standing. 

Return on Debt Financing

The return on investment to lenders is comprised primarily of interest proceeds, which tend to be either a fixed interest rate agreed upon at inception of a debt agreement, or a variable interest rate linked to a reference interest rate (e.g., commercial prime lending rate in Canada, London Interbank Offered Rate (LIBOR), etc.). 

  • For example, a lender may be willing to grant a 6% fixed interest rate loan to a company or a variable interest rate loan at the prime lending rate + 3%, when the prime rate is equal to 2.5%.
  • In such a case, the lender would receive a lower initial return (5.5% vs. 6%).
  • However, if interest rates rise, the lender may expect to receive 7%+ in the later periods of the loan. 

With regularly contracted payments and a higher ranking in the capital structure, investors view debt as a lower risk, lower returning investment, when compared to equity. Similarly, debt tends to have a lower cost of capital from a company’s perspective.

Why Companies seek Debt Financing?

Companies will seek debt financing so that shareholders can avoid the need to inject further personal funds into a company, and to avoid the expensive equity dilution (reduction in ownership percentage) that is associated with raising equity. 

Examples of initiatives that are commonly financed with debt include: 

  • Company expansion and/or product development and expansion; 
  • Liquidity management, including working capital management; 
  • Mergers and acquisitions; 
  • Dividend recapitalizations – issuing debt as a means to return capital to shareholders; and 
  • Capital structure optimization – getting to the most efficient balance of debt and equity financing for the company.

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