Term loan | Characteristics of Term Loan | Advantages and Disadvantages | Corporate Finance
The term loan is a type of loan in which repayment is made on a periodic installment basis which includes principals and interests that have a maturity period of more than 1 year but generally less than 10 years. It is a formal loan that means a loan arranged from formal negotiation with banks and financial institutions.
Formal negotiation includes a formal contract having required information and term and conditions like; maturity period, interest rate, collateral, and payment process along with the date. A series of payments are made periodically on this type of loan until the loan is fully amortized. Term loan funds are normally used for purchasing fixed assets or discharging other loans.
Term loans are advantageous for the firm because of lower cost than the cost of equity, lower processing cost, flexible negotiation, etc. Here we are going to analyze from the borrower’s perspective not via the lender perspective.
Advantages of Term loan
- Term loans can be obtained easily on mutual understanding of lender and borrower.
- Terms and conditions can be revised considering mutual benefit and convenience.
- Firms can reduce costs like underwriting commission, advertisement cost, and certificate printing charge, and so on.
- Interest on the term loan is tax-deductible.
- Term loan does not affect the control position and operation of the firm.
Disadvantages of Term loan
- A firm should pay fixed interest expenses on the basis of fixed interest rate, whether the firm is in profit or loss.
- It firm defaults on an installment payment that may lead to seizure of property and bankruptcy.
- Timely payment of an installment is most.
- Term loans long-term financial burden in the sense that installment payment takes a long time.
- Term loans are difficult to obtain since trustworthiness organization is most.
- Term loan/ debt financing contains a restrictive covenant that may limit the flexibility of operation in the future.
Characteristics of term loan
Key features of term loans are as follows;
It is the fixed amount over which interest is calculated. The principal amount gradually decreases with the installment payment. It is the original amount, that borrower receives or mentioned in the contract.
The maturity period is the life of the term. A loan should be repaid fully with interest at the end of the maturity period. Generally, term loans have a life of more than one year but less than 10 years.
Interest is a charge for using the funds which are considered as a cost of capital. An interest rate should be fixed at the time of negotiation based on the prevailing market price. The interest rate can be changed if the market price loan has been changed.
It is the table of payments made of interest and principal on the respective period. It shows the interest and principal amount that should be paid each period.
Any activities that probably cause loss and likely to unable to pay the debt is often restricted by lender to keep their investment secure and safe. Sometimes loan contract states the procedure if a firm is going to do any activity which probably causes loss.
Formal and direct negotiation
The term loan is made with formal and direct negotiation between the lender and borrower. There are no intermediaries as in security issuance and trading.
Tie up with collateral
Term loans always include the collateral provision. If the borrower fails to repay the loan, collateral can be seized and sold to recoup the losses of the lender. Generally, the loan amount is less than the collateral value since there is a safety margin.
Amortization of Loan
The term loan is repaid in a periodic equal installment that contains interest and principal. In the beginning, installment contains higher interest and lower principal amount but in the time close to maturity time installment amount contains the higher principal amount and lower interest amount. A repayment schedule can be generated to show the periodic payment amount and time to be paid along with the proportion of interest and loan amount. Periodic installment can be paid in two ways; either at the beginning of the period or end of the period.
Security Provisions and Protective Covenants
There are two parties in the loan agreement, lender and borrower. A lender gives borrower funds up maturity period. During that period loss can occur and the borrower may not be unable to repay the debt so, the lender restricts the activities that likely cause loss. These restrictions are called covenants. The covenants that can be imposed on the borrower are categorized into three categories although there is no hard and fast rule of classifying the covenants and provisions;
A. General provisions
The General Provisions are those provisions that are used in most of the loan agreements. General provisions are variable in nature which means situations can be different for different term loans. Some general provisions are as follows.
a. The net-working capital requirement provision: In most loan agreements working capital requirement is imposed to ensure that the firm is capable of paying the loan. The minimum working capital requirement is probably the most commonly used and most comprehensive provision in a loan agreement. The amount of minimum working capital that a company must maintain is determined based on future and present working capital allowing some fluctuations.
b. The cash dividend and repurchase of common stock restriction: The cash dividend and repurchase of common stock outflows the cash from the business and decreases the current assets and also leads to liquidity problem in repayment of the loan. A certain percentage of dividend and repurchase of common stock of the company is determined to limit the decline in the liquidity of the company.
c. The capital expenditures limitation: The excessive investment into fixed assets and new plants can be prohibited from the lenders to the borrowers if they are being financed internally. It is because capital expenditures are normally financed from long-term debt and share capital.
d. A limitation on other indebtedness: The lenders may limit the borrowers from taking additional debt because there is the chance of being the default of debt if the debt amount is large. Sometimes claim on the same assets could occur at the time of liquidation.
B. Routine Provisions
The routine provisions are the provisions that are used for most of the loan agreement and are not variable to the situation.
- To furnish the bank with financial statements and to maintain adequate insurance.
- Forbidding of future pledging and mortgaging of any of the assets of borrowers.
- A Prohibition of entering into any leasing agreement of the property.
- Restriction on the acquisition and merger of the other companies.
- A prohibition from making or guaranteeing loans to others would impair the lenders’ insecurity.
C. Special Provisions
Those provisions which are used in specific situations are categorized under specific provisions.
- No diversion of funds purpose
- Default provisions that permit the lender to insist that the borrower repay the entire loan immediately under certain conditions.
- Limitations on the level of salaries, bonuses, and advances firm may give to employees.