Question

1. Define the following sources of finance and discuss strengths and weakness each one has. In your answer you should also outline the circumstances when they be regarded as a suitable financing instrument.
   1. Corporate Bonds
   2. Term Loan
   3. Mortgage        
   4. Debt servicing risk                             

Use an example to explain the impact of the term to maturity and coupon rate on interest rate risk.                                                                                          

Answer 1

a). Corporate Bonds

Investors considering fixed-income securities might want to research corporate bonds, which some have described as the last safe investment. As the yields of many fixed-income securities declined after the financial crisis, the interest rates paid by corporate bonds made them more appealing. Corporate bonds have their own unique advantages and disadvantages.

1.strengths of Corporate bond.

Liquidity

Many corporate bonds trade in the secondary market, which permits investors to buy and sell these securities after they have been issued. By doing so, investors can potentially benefit from selling bonds that have risen in price or buying bonds after a price decline.

Some corporate bonds are thinly traded. Market participants looking to sell these securities should also know that numerous variables could affect their transactions, including interest rates, the credit rating of their bonds, and the size of their position.

Widespread Options

There are many types of corporate bonds, such as short-term bonds with maturities of five years or less, medium-term bonds that mature in five to 12 years and long-term bonds that mature in more than 12 years.Beyond maturity considerations, corporate bonds may offer many different coupon structures. Bonds that have a zero-coupon rate do not make any interest payments. Instead, governments, government agencies, and companies issue bonds with zero-coupon rates at a discount to their par value. Bonds with a fixed coupon rate pay the same interest rate until they reach maturity, usually on an annual or semiannual basis.

Weaknes of Corporate bond.

One major risk of corporate bonds is a credit risk. If the issuer goes out of business, the investor may not receive interest payments or get his or her principal back. This contrasts with bonds that have been issued by a government with a high credit rating, as this entity could theoretically increase taxes to make payments to bondholders.

Another notable risk is event risk. Companies might face unforeseen circumstances that could undermine their ability to generate cash flow. The interest payments – or repayment of principal – associated with a bond depend on an issuer's ability to generate this cash flow. Corporate bonds can provide a reliable stream of income for investors. These debt-based securities became particularly attractive after the financial crisis, as central bank stimulus helped push the yields lower on many fixed-income securities. Interested investors can choose from many kinds of corporate bonds, and these securities frequently enjoy substantial liquidity. However, corporate bonds have their own unique drawbacks. (For related reading, see "How To Invest In Corporate Bonds")

b) Term loan

Term loan is a medium-term source financed primarily by banks and financial institutions. Such a type of loan is generally used for financing of expansion, diversification and modernization of projects—so this type of financing is also known as project financing. Term loans are repayable in periodic installments.

Features of Term Loans:

Term loan is a part of debt financing obtained from banks and financial institutions.

1. Security:

Term loans are secured loans. Assets which are financed through term loans serve as primary security and the other assets of the company serve as collateral security.

2. Obligation:

Interest payment and repayment of principal on term loans is obligatory on the part of the borrower. Whether the firm is earning a profit or not, term loans are generally repayable over a period of 5 to 10 years in installments.

3. Interest:

Term loans carry a fixed rate of interest but this rate is negotiated between the borrowers and lenders at the time of dispersing of loan.

4. Maturity:

As it is a source of medium-term financing, its maturity period lies between 5 to 10 years and repayment is made in installments.

5. Restrictive Covenants:

Besides asset security, the lender of the term loans imposes other restric­tive covenants to themselves. Lenders ask the borrowers to maintain a minimum asset base, not to raise additional loans or to repay existing loans, etc.

6. Convertibility:

Term loans may be converted into equity at the option and according to the terms and conditions laid down by the financial institutions.

Streangth of Term Loans:

Tax Benefit:

Interest payable on term loan is a tax deductible expenditure and thus taxation benefit is available on interest.

Flexible:

Term loans are negotiable loans between the borrowers and lenders. So terms and condi­tions of such type o

f loans are not rigid and this provides some sort of flexibility.

Control:

Since term loans represent debt financing, the interest of the equity shareholders are not diluted.

ii. From Point of View of the Lender:

Secured:

Term loans are provided by banks and other financial institutions against security—so term loans are secured.

Regular Income:

It is obligatory on the part of the borrower to pay the interest and repayment of principal irrespective of its financial position—hence the lender has a regular and steady income.

Conversion:

Financial institutions may insist the borrower to convert the term loans into equity. Therefore, they can get the right to control the affairs of the company.

Weaknes of Term Loans:

Term loans have several disadvantages which are discussed below.

i. From Point of View of the Borrower:

Obligation:

Yearly interest payment and repayment of principal is obligatory on the part of bor­rower. Failure to meet these payments raises a question on the liquidity position of the borrower and its existence will be at stake.

Risk:

Like any other form of debt financing term loans also increases the financial risk of the com­pany. Debt financing is beneficial only if the internal rate of return of the concern is greater than its cost of capital; otherwise it adversely affects the benefit of shareholders.

Interference:

In addition to collateral security, restrictive covenants are also imposed by the lenders which lead to unnecessary interference in the functioning of the concern.

ii. From Point of View of the Lender:

Negotiability:

Terms and conditions of term loans are negotiable between borrower and lenders and thus it sometimes can affect the interest of lenders.

Control:

Like other sources of debt financing, the lenders of term loans do not have any right to control the affairs of the company.

c). Mortgage

A mortgage is a loan from a bank or other financial institution that helps a borrower purchase a home. The collateral for the mortgage is the home itself, meaning that if the borrower doesn't make monthly payments to the lender and defaults on the loan, the bank can sell the home and recoup its money.

Advantages

One of the biggest advantages of using a Commercial Mortgage is that it's a long-term finance agreement which enables you to spread out large expenses over a period of up to 20 years, sparing you the need to remove large quantities of cash from your savings. Plus, although funding typically starts from £50,000, the amount of capital you could borrow is based upon the purpose behind the agreement such as a property purchase, premises refurbishment or a partner buyout. As such, there’s a limit to how much you could borrow other than how much much the lender is willing or able to provide.

In addition, because Mthe product is usually secured against either the property you’re purchasing or one already in your possession, it encourages lenders to offer you a favourable interest rate (depending on your current financial situation). Plus, it’s also worth noting that if you possess the necessary capital, you can choose to pay off the mortgage product early, but there will often be a fee to do this (redemption penalty). Therefore, choosing to explore the advantages of using a Commercial Mortgage could be a great way of supporting and spreading out large expenses, allowing you to focus on other aspects of your business in the meantime.

Disadvantages

However, although it can be prove to be a very useful tool for your business, using a Commercial Mortgage also has its disadvantages as well. Firstly, when applying for a Commercial Mortgage, you’re required to place a portion of your own equity in the agreement. So depending on the purpose, this starts from 20% of either the total purchase price or the full cost of the refurbishment. However, if you’re able to offer up to 40%, it can significantly reduce the amount of capital your business needs to borrow and may earn you a more favourable interest rate too. Therefore, providing equity could, in fact, be seen as being both an advantage and a disadvantage, depending on your perspective.

In addition, Commercial Mortgages use a Fixed Monthly Repayment Scheme that requires you to pay an agreed amount of capital back to the lender every month. Although this could enable you to stay in control of your budget, it may become an issue if you’re unable to keep up with the repayments at any point. Should this occur, the asset that’s being used as collateral could be at risk of repossessed by the lender and, if this was to happen, you would also lose all the capital you’ve already paid into the agreement. Plus, it’s also worth noting that your monthly repayment can vary depending on whether you’ve chosen to use a Fixed Rate or Variable Rate Mortgage. So whilst using a Fixed Rate product will protect you in the event of a market interest rates rise, you may lose out if they decrease. But on the other hand, Variable Rates could enable you to save if market interest rates drop, yet it may cause you to pay more should they rise instead.

d). Debt servicing risk    

The amount of money required to make payments on the principal and interest on outstanding loans, the interest on bonds, or the principal of maturing bonds. An individual or company unable to make such payments is said to be "unable to service one's debt." An example of debt service is a monthly student loan payment

Advantages

• Retain control. When you agree to debt financing from a lending institution, the lender has no say in how you manage your company. You make all the decisions. The business relationship ends once you have repaid the loan in full.
• Tax advantage. The amount you pay in interest is tax deductible, effectively reducing your net obligation.
• Easier planning. You know well in advance exactly how much principal and interest you will pay back each month. This makes it easier to budget and make financial plans.

Disadvantages

Debt financing has its limitations and drawbacks.

• Qualification requirements. You need a good enough credit rating to receive financing.
• Discipline. You’ll need to have the financial discipline to make repayments on time. Exercise restraint and use good financial judgment when you use debt. A business that is overly dependent on debt could be seen as ‘high risk’ by potential investors, and that could limit access to equity financing at some point.
• Collateral. By agreeing to provide collateral to the lender, you could put some business assets at potential risk. You might also be asked to personally guarantee the loan, potentially putting your own assets at risk.