How Corporations Raise Money by Acquiring Debt
When a corporation needs money, one of the primary options it has available is to borrow some. Regardless of what the money’s for, when a corporation wants a loan, it starts by putting together a proposal.
For start-up companies, this proposal comes in the form of a business plan, but anytime a corporation receives a loan significant enough to influence the capital structure of the company (not lines of credit), it has to present a proposal for the use of the funds.
This proposal includes financial information about the corporation, including detailed predictions for future financial well-being, called projections, that prove the company could pay back the loan on time and without risk of default.
Ask the right people for money
After the proposal is in place, corporations have a few options for where to go to ask for the money they need:
Commercial banks: Banks are very common sources for corporate debt financing. These loans work very similar to any other loan, wherein your ability and planned use of the funds will both be evaluated in detail before the bank agrees to offer the loan. The findings of their investigation will determine, in part, the interest rate they will charge, the amount they will loan, and the duration of the loan.
Government loans: These loans are frequently available, but they’re often reserved for special types of corporations (usually in a field that the government is trying to promote), corporations with a special role in the nation (such as defense contractors), or especially large companies facing the truth that they’ve been poorly managed for decades and must now resort to begging the government for money.
Issuance of bonds: Bonds, which basically act as IOU’s, are possibly the most popular form of debt financing. A company goes through an underwriter to have bonds issued, and then private investors purchase those bonds. The company keeps the money raised as capital with a promise that it’ll pay back the bondholders’ money with interest.
After a potential moneylender receives the corporation’s loan application, an interview process typically occurs, along with an underwriting process during which the potential lender assesses the borrower for risk, financial ability to repay the loan, credit history, and other variables.
If the lender approves the loan application, the money is deposited in the corporation’s bank account, making it available for use by the corporation in a manner consistent with the original proposal.
Make sure the loan pays off in the long run
The responsibility for making sure a particular loan is beneficial to a company lies with that company. Every loan, except for those rare federally subsidized loans in which the government pays for the interest, incurs interest, meaning you and your company pay more money back to the lender than the lender originally gave you.
Here’s a quick look at how interest works:
B = P(1 + r)t
This equation says that the balance (B) is equal to the principal amount (P) times the rate (r) exponentially multiplied by time (t). So if your company borrowed $100 at an interest rate of 10 percent for one year without making any payments, then the amount of money your company owes at the end of that one year would look like this:
B = 100(1 + 0.1)1
The answer, then, is $110 (because $10 is 10 percent of $100 and interest is accrued annually for only one year).
When accepting a loan, the goal of every company is to make absolutely sure that it can generate more returns from spending the money borrowed than the interest rate being charged. After all, by keeping the loan, the corporation agrees to pay back interest as well as the principal.
Look at loan terms
You have a few different options available when choosing a loan for your company. To make the best choice for your company, you need to be aware of the pros and cons of each loan type. If you’re not sure which one is best for you, ask a professional analyst — not the person trying to sell you the loan. Here are some terms you need to be aware of:
Fixed versus variable rate: When you take out a fixed rate loan, the percentage interest you pay will always be the same.
For example, if you take out a loan with 5 percent APR (annual percentage rate, which is your annual interest rate), then you’ll always be charged 5 percent interest per year. With a variable rate loan, the interest rate you pay will change; the amount of change depends on the type of loan.
Variable rate loans come in many types, changing their rates based on another interest rate, a stock market index, your income, or some other indicator. Some increase gradually over time, while others start low and jump after a period of time (these are called teaser-rates).
Secured versus unsecured: Secured loans are tied to some asset, which becomes collateral. Basically, you tell the bank that if you fail to pay back your loan, the bank can keep and/or sell that particular asset to get its money back.
With unsecured loans, no assets are directly considered to be collateral to which the lender has automatic rights upon the borrower’s default of the loan. However, they can still hurt the credit history of the company, and a lender can still sue to get their money back.
Open-ended versus closed-ended: Closed-ended loans are your standard loans. After your company gets one, it makes periodic payments for a predetermined time period, and then the loan is paid back and you and the lender are both done. Think of a closed-ended loan like a mortgage, except that it’s not used to buy a house.
Open-ended loans are more similar to credit cards. Your company can draw upon an open-ended loan until it reaches a maximum limit, and it just continuously makes payments for as long as it has a balance.
Simple versus compounding interest: Simple interest accrues based only on the principal loan. In other words, if a loan for $100 charges 1 percent interest, the lender will make $1 every period. On the other hand, compounding interest pays interest on interest.
So if the borrower doesn’t make any payments on a loan of $100 with 1 percent interest in the first year, then the loan will charge 1 percent interest on $101 rather than the original $100 the second year. This type of interest is far more common with bank accounts than loans.