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Long Term Debt Finance

Where possible, a business should match the maturity and repayment schedule of its debt with the cash flow patterns of its investments that are being financed through debt. For investments of a medium-to-longer-term nature, the debt should be of a similar term. There are numerous arrangements and instruments of medium-to-longer-term debt. Such debt may be intermediated finance provided by financial institutions, or it may be direct finance obtained from either the domestic or international capital markets.

The simplest form is the term loan facility, available through banks and money market corporations. The structures and terms of the loans vary considerably. The loans may have interest-only repayment schedules, with the principal repaid in full at maturity; they may be credit foncier loans (amortised); or they may be loans with reduced-payment or deferred-payment schedules for the first year or two of the loan. During the term of the loan, the interest rate will be periodically reset in relation to changes in a specified reference rate.

A feature common to merchant bank loans is the inclusions of a bill option clause, which has the effect of converting the funded loan into a liquid asset. A term loan lender will often seek to protect its total financial risk exposure to a borrower by including debt covenants in the loan contract. These restrict the business and financial activities of the borrower.

Another form of loan is one that is secured by the lender (the mortgagee) taking a mortgage over the property being acquired by the borrower (the mortgagor). The introduction of mortgagor insurance, the development of the secondary mortgage market and the significant increase in the securitisation of mortgage-backed assets has encouraged the availability of mortgage finance.

The issuance of mortgage-backed securities or other asset-backed securities, through the process of securitisation, is a form of finance whereby a special-purpose vehicle (SPV) to support the issuance of negotiable securities. The trustee of the SPV issues securities, such as bonds or commercial paper, to institutional investors, and thus generate the finance required to purchase the assets from the originator.

The corporate bond market has experienced a dramatic upsurge in prominence. The instruments issued in the market include debentures, unsecured notes, and subordinated debt. Each of the instruments has in common a contract, between the borrower and the lender, that specifies that the lender will receive regular specified interest payments during the life of the loan, and that the instrument will be redeemed at face value on maturity. The distinction between the instruments is primarily on the basis of the security offered to the borrower. A further distinction is the instruments’ ranking in a claim on the assets of the borrower in the event of the failure of the business. Certain types of subordinated debt issued by banks are deemed to be equity for the purposes of calculating a bank’s capital adequacy.

Lease finance has grown in importance as a form of longer-term finance, and the main providers have been finance companies and banks. The various types of leases can be distinguished on the basis of the term of the lease contract, and on the basis of which party bears the risk of obsolescence of the leased asset at the end of the agreement. Operating leases tend to be relatively short-term arrangements, at the end of which the possession of the leased asset reverts to the lessor. Finance leases, whether direct or leveraged, are generally longer-term relationships, and normally, at the end of the agreement, the lessee obtains ownership of the asset. The latter feature transfers the residual of obsolescence risk from the lessor to the lessee. From the lessor’s point of view, on of the key components of its return from the lease arrangement is the tax deductions associated with the arrangement. These are derived from the lessor’s ownership of the asset (depreciation) and, in the case of leveraged leases, from the tax deductions that the lessor receives for the interest payments made to the debt parties to the arrangement.

The most complex form of long-term finance is project finance. One major distinction between project finance and other forms of long-term finance is that lenders assess their investment in terms of the prospective cash flows of the project that is to be funded. Lenders have only limited recourse to the cash flows and assets of the project sponsors, and that the recourse ceases once the project reaches completion. Given the significance of the completion date, project finance documentation is most specific in its definition of the events that constitute completion. Typically, in project finance a project company is formed as a legal entity, which is separate from the existing businesses of the sponsors. The sponsors may contribute as little as 25% of the total capital of the project company. Syndicated lenders provide the rest of the funding in the form of debt. In addition to the sponsors and debt parties, there is a large group of participants whoa re employed because of their experience in law, accounting, finance, engineering, and project evaluation and management.

The final form of longer-term debt introduced in the chapter is the direct credit substitute, in particular, the stand by letter of credit, and guarantees. These instruments are an undertaking by a financial institution to meet certain financial obligations of their clients. Under the current capital adequacy guidelines, such commitments are to be supported by the appropriate amount of capital. The capital requirement has added to the cost of providing the commitment.