MenuItem 10: (Topic 10) Medium- to long-term debt
Question 1: Manufacturer Limited is seeking a five-year term loan from its bank. The bank manager has indicated that a loan can be provided and will be priced at the bank’s base rate, plus a margin. Which of the following is not a determinant of the margin to be paid by the company? A: the debt to equity ratio of the borrower
B: the borrower’s past loan-repayment performance
C*: the term structure of interest rates
D: the assets available to be pledged as security
Feedback: The margin added to the bank’s base rate will reflect the credit risk of the individual borrower. In assessing the risk and hence the margin, the bank is likely to consider factors such as the debt to equity ratio of the borrower and its past loan repayment performance. The term structure of interest rates is a market-wide factor and is likely to influence the base rate, but it should not influence the margin that applies to a borrower, so C is the correct answer. MORE: Financial Institutions, Instruments and Markets 5/e, pp. 390–391. The interest rate charged on a term loan will also depend on the following: • The credit risk of the borrower. This is the perceived creditworthiness of the borrower. A lender will analyse factors such as the total debt-to-equity ratio of the firm, projected cash flows, the financial strength of the borrower, past loan repayment performance, the projected performance of the industry and the economy generally, forecast interest rates, the management of the firm and the life cycle of the firm’s products.
• The term of the loan. Under normal circumstances a long-term loan will attract a higher rate of interest than a short-term loan. However, from time to time it is possible that a long-term loan may attract a lower rate. Ultimately, the cost to the borrower will reflect the cost that the lender encounters in funding the loan. If, for example, the rates on short-term-to-maturity deposits are higher than those on long-term deposits, the cost to the lender of the relatively short-term funds would be higher than the cost of longer-term funds. The interest charged on loans should reflect these funding costs. Short-term interest rates might be higher because the central bank has implemented monetary policy that pushes up short-term interest rates. (The implementation and purpose of monetary policy is discussed in Chapter 12.)
• The repayment schedule. The frequency of loan repayments and the form of repayment may influence the interest rate applied to a loan. For example, the rate for a borrower who has a loan which requires monthly repayments may be different from that of a borrower who makes quarterly loan repayments. Also differences may occur for an amortised loan compared with an interest-only loan.
Question 2: A term loan agreement will usually specify an indicator rate. Which of the following most accurately describes an indicator rate?
A: the interest rate payable by the borrower
B: an average rate published daily
C: the prime rate set by a bank.
D*: an interest rate used as a benchmark for pricing loans
Feedback: Answer A is incorrect because the interest rate payable by a borrower will be equal to an indicator rate, plus a margin. The descriptions in B and C are accurate, but incomplete; so, D which is more complete is the correct answer.
MORE: Financial Institutions, Instruments and Markets 5/e, p. 391. MaxMark t/a Financial Institutions, Instruments and Markets 5e by Viney
A loan agreement will normally specify a reference or an indicator interest rate that will apply at each interest rate reset date of a term loan. Indicator rates vary from country to country. For example:
• the US commercial paper rate (USCP)
• the London interbank offered rate (LIBOR)
• the Singapore interbank offered rate (SIBOR)
• the Australian bank bill swap rate (BBSW).
The majority of indicator rates are calculated as an average of an interest rate relating to a...
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