Term Loan as a source of finance

In this article we turn our attention to long term debt. Firms obtain long term debt mainly by raising term loans or issuing debentures.

Historically term loans given by financial institutions and banks have been the primary source of long term, debt for private firms and most public firms. Term loans, also referred to as term finance represent a source of debt finance which is generally repayable in less than 10 years. They are employed to finance acquisition of fixed assets and working capital margin. Term loans differ from short term loans which are employed to finance short term working capital need and tend to be self liquidating over a period of time usually less than one year.

Features of term loans:

The following features of term loans may be discussed.

1. Currency
2. Security
3. Interest payment and principal repayment
4. Restrictive covenants.

Currency: Financial institutions give rupee term loans as well as foreign currency term loans. The most significant form of assistance provided by financial institutions, rupee term loans are given directly to industrial concerns for setting up new projects as well as for expansion modernization, and renovation projects. These funds are provided for incurring expenditure on land, building, plant and machinery, technical know how, miscellaneous fixed assets, preliminary expenses, preoperative expenses, and margin money for working capital.

Financial institutions provided foreign currency term loans for meeting the foreign currency expenditure towards import of plant, machinery and equipment, and payment of foreign technical know-how fees. The periodic liability for interest and principal remains in the currency/currencies of the loan and is translated into rupees at the prevailing rate of exchange for making payments to the financial institutions.

Security: Term loans typically represent secured borrowing. Usually assets, which are financed with the term loan, provide the prime security. Other assets of the firm may serve as collateral security.

All loans provided by financial institutions along with interest, liquidated damages, commitment charges, expenses, etc are secured by way of:

First equitable mortgage of all immovable properties of the borrower, both present and future and

Hypothecation of all movable properties of the borrower both present and future subject to charges in favor of commercial banks for obtaining working capital advance in the normal course of business.

Interest Payment and principal Repayment: The interest and principal repayment on term loans are definite obligations that are payable irrespective of the financial situation of the firm. To the general category of borrowers, financial institutions charge an interest rate that is related to the credit risk of the proposal, subject usually to a certain floor rate. Financial institutions impose a penalty for defaults. In case of default of payment of installments of principal and/or interests, the borrower is liable to pay by way of liquidated damages additional interest calculated a the rate of 2 per cent per annum for the period of default on the amount of principal and/or interest in default. In addition to interests, lending institutions levy a commitment fee on the unutilized loan amount.

The principal amount of a term loan is generally repayable over a period of 4 to 7 years. Typically, term loans provided by financial institutions are repayable in equal semi-annual installments or equal quarterly installments.

Note that the interest burden declines over time, whereas the principal repayment remains constant. This means that the total debt servicing burden (consisting of interest payment and principal repayment) declines over time. This pattern of debt servicing burden, typical in India, differs from the pattern obtaining in western economies where debt is typically amortized in equal periodic installments.

The latter is a relatively more acceptable to borrowers because it does result in heavy debt servicing burden in earlier years. It has also been recommended by the International Bank for Reconstruction and development (popularly called the World Bank). However, presently financial institutions in India do not follow the scheme of equal periodic amortization. Yet they try to ensure, by suitably modifying the debt repayment schedule, within limits, that the debt servicing is not very onerous.

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