2.1Bank Loans

Although bank loans remain a major part of the total amount of debt that firms take

on, the volume of bank financing has shrunk drastically since the 1960s when loans,

2

along with bonds, made up about half of the corporate debt outstanding.Today, bank

loans account for about 20 percent of the debt outstanding. Major corporations with

good credit ratings have found that commercial paper, a short-term debt security, and

nonbank loans from syndicates of wealthy private investors and institutions, such as

insurance companies, are less expensive than bank debt as a way to raise funds.

Types of Bank Loans

Exhibit 2.1 shows the two general types of bank loans: lines of credit and loan com-

mitments. Harman, described in the opening vignette, now has a type of loan commit-

ment known as a revolver.

Lines of credit do not in a practical sense commit the bank to lend money because

the bank is free to quote any interest rate it wishes at the time the borrowing firm

requests funds. If the interest rate is too high, the firm will decline the available line of

credit. The more formal contract, the loan commitment, specifies a preset interest rate.

To understand the terms of a bank loan you need to have a thorough understanding of

the floating interest rates that are generally used for these loans. We turn to this topic next.

Floating Rates

Floating ratesare interest rates that change over time. Both lines of credit and loan

commitments (revolver and nonrevolver) are floating-rate loans, priced as a fixed

spread over a prevailing benchmark rate, which is the floating interest rate specified

²Many features of bank loans—for example, the description of floating rates and debt covenants—

also apply to corporate debt securities such as bonds that are held by the investing public.

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Strategy, Second Edition

32Part IFinancial Markets and Financial Instruments

EXHIBIT2.2Benchmark Rates forFloating-Rate Loans

Treasury rate

The yields on U.S. Treasury securities for various maturities ranging from 1 month to 30 years.3These yields are computed from the on-the-run Treasuries, that is, from the most recently auctioned Treasury issues which have the greatest liquidity.

•	Treasury billsare the zero-coupon Treasury issues with maturities that range from one month to one yearat issue. The bill rates for one-month, three-month, and six-month maturities are the most popular Treasury-based benchmark rates.
•	Treasury notesare the coupon-paying issues with maturities from 1 year to 10 years at their initial issue date.
•	Treasury bondsare the coupon-paying issues with maturities greater than 10 years at their issue date. Their maximum maturity is 30 years.

Fed	funds	rate	Federal funds are overnight loans between two financial
			institutions. For example, one commercial bank may be
			short of reserves, requiring it to borrow excess reserves
			from another bank or a federal agency that has a surplus.
			The Fed funds rate, which is strongly affected by the
			actions of the Federal Reserve, is the rate at which banks
			can borrow and lend these excess reserves.

LIBOR

As noted in Chapter 1, the London interbank offered rate is a set of rates for different time deposits offered to major international banks by major banks in the Eurodollar market. One-month, three-month, or six-month LIBOR are the most common maturities for benchmark rates. There also is LIBID, the bid rate for interbank deposits.

Commercial paperrate	The yields on short-term, zero-coupon notes issued by
	major corporations.

Prime	rate	This is a benchmark rate used by banks for some floating-
		rate loans. Traditionally, the prime rate was charged by
		banks to their most credit-worthy customers. The prime rate
		means less now than it did in previous years because many
		floating-rate loans are now linked either to the Treasury bill
		rate, a commercial paper rate, or LIBOR.

in the contract. The spread usually depends on the default risk of the borrower. We

will discuss default risk in detail after describing some commonly used benchmark

rates below.

Benchmark Rates.Exhibit 2.2 describes commonly used benchmark rates. Exhibit

2.3 displays the benchmark rates that prevailed in mid-January 2001 in order of increas-

ing interest rates.

3

As of 2001, the U.S. Treasury issues only securities with up to a 10-year maturity.

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Markets and Corporate	Financial Instruments		Companies, 2002
Strategy, Second Edition

Chapter 2

Debt Financing

33

EXHIBIT2.3Benchmark Rates, mid-January 2001

Benchmark Instrument

Maturity

Rate

Treasury bills		6 months	4.84%
Constant-maturity Treasury	note	10 years	4.94
Treasury bills		3 months	5.06
LIBOR		6 months	5.34
AAcommercial paper		3 months	5.50
LIBOR		3 months	5.52
AAcommercial paper		1 month	5.71
Fed funds rate		1 day	5.98
AAAcorporate bond rate		Long term	7.07
Bank prime rate		Short-term floating	9.00

Source: Federal Reserve, Jan. 2001.

Creditworthiness and Spreads.Spreads to these benchmark rates are quoted in terms

of basis points, where 100 basis points equals 1 percent. For example, the spread of a

borrower with almost no default risk might be LIBOR plus 20 basis points, which

means that if LIBOR is at 8 percent per year, the borrower pays 8.2 percent per year.

The creditworthiness of the borrower determines the spread over the benchmark rate.

For example, a firm with outstanding credit risk such as Harman International,

described in the opening vignette, was able to borrow at 20 basis points above LIBOR.

By contrast, highly leveraged companies with substantial default risk may end up bor-

rowing at a rate between 150 basis points and 400 basis points above LIBOR.

Caps, Floors, and Collars.Floating-rate lending agreements often have a cap(max-

imum interest rate) or a floor(minimum interest rate). If a loan has a spread of 50

basis points to LIBOR, and LIBOR is at 7 percent but the cap is set at 7.25 percent,

the interest rate charged on the loan over the period will be the cap interest rate, 7.25

percent, instead of the benchmark rate plus the spread, which would be 7.5 percent. A

collared floating-rate loanhas both a cap and a floor on the interest rate.

Loan Covenants

Lending agreements contain loan covenants, which are contractual restrictions imposed

on the behavior of the borrowing firm.⁴For instance, managers of the borrowing com-

pany may be required to meet minimum net worth constraints on a quarterly basis.⁵

They may face restrictions on dividend payouts or restrictions on the extent to which

they can borrow from other sources. Alternatively, they may be asked to pledge cer-

tain assets such as accounts receivable or inventory as collateral. If the firm defaults

on the loan, the bank can claim the accounts receivable or the inventory in lieu of the

forgone loan repayment.

4

Covenants will be studied in greater depth later in this chapter when we focus on bonds.

⁵Anet worth constraint requires book assets to exceed book liabilities by a threshold amount.

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Markets and Corporate	Financial Instruments		Companies, 2002
Strategy, Second Edition

34Part IFinancial Markets and Financial Instruments

EXHIBIT2.4Types of Leases

Operating lease

An agreement, usually short term, allowing the lessee to retain the right to cancel the lease and return the asset to the lessor.

Financial	lease	(or	capital	lease)	An agreement that generally extends over the life
					of the asset and indicates that the lessee cannot
					return the asset except with substantial penalties.
					Financial leases include the leveraged lease(asset
					purchase financed by a third party), direct lease
					(asset purchase financed by the manufacturer of the
					asset), and sale and leaseback(asset purchased from
					the lessee by the lessor).