Loan capital refers to the borrowed funds a company acquires with the intent to repay at a later date, typically with added interest. It’s an essential source of funding for businesses, especially for those that need capital to finance their operations, growth, or purchase of assets. Loan capital can come from a variety of sources, such as banks, financial institutions, or bond markets.
Unlike equity capital, where investors buy shares in a company and thereby claim ownership, loan capital doesn’t involve any ownership transfer. Instead, it creates a liability for the company, as it’s obligated to repay the borrowed funds under the terms of a loan agreement.
The cost of loan capital is the interest that the company needs to pay to its lenders, which can be fixed or variable, depending on the loan terms. Moreover, loan capital may also require collateral, meaning that if the borrower fails to make repayments, the lender can seize the collateral to recoup the loan amount.
Examples of loan capital include:
- Bank Loans: A company may borrow from a bank, agreeing to pay back the principal along with interest over a specific period. The interest rate could be fixed or variable.
- Bonds: When a company issues bonds, it’s essentially borrowing from the bond purchasers and promising to repay the principal amount (also known as face value or par value) when the bond matures, along with periodic interest payments (known as coupon payments).
- Debentures: These are similar to bonds but are typically unsecured, meaning they don’t have any collateral backing them up. The company’s creditworthiness plays a major role in issuing debentures.
While loan capital can help a company finance its operations and growth, it’s crucial for the company to manage its debt levels carefully. Excessive borrowing can lead to high interest expenses and, in some cases, financial distress if the company is unable to meet its loan obligations.
Example of Loan Capital
Suppose that XYZ Manufacturing Inc., a hypothetical manufacturing company, wants to expand its operations by building a new factory. The estimated cost of this expansion is $5 million. XYZ Manufacturing doesn’t have enough cash on hand for this project, so it decides to raise the necessary funds through loan capital.
XYZ Manufacturing approaches Bank A and negotiates a loan for the full amount. The loan has a term of 10 years and an annual interest rate of 6%. XYZ Manufacturing agrees to these terms, meaning it will have to make regular payments over the next 10 years to repay the principal and the interest.
Let’s assume that the loan is structured to be amortized fully over the term, meaning that by the end of the 10 years, XYZ Manufacturing will have completely repaid the $5 million principal. An amortization calculator shows that the company’s annual loan payments will be about $671,437.
Here’s how it works:
- In the first year, XYZ Manufacturing pays a total of $671,437. Of this amount, $300,000 is interest (6% of $5 million), and the remainder ($371,437) goes toward reducing the principal. This leaves a balance of $4,628,563 ($5 million – $371,437).
- In the second year, XYZ Manufacturing again pays a total of $671,437. However, the interest portion is now only about $277,714 (6% of $4,628,563), and the remainder ($393,723) goes toward reducing the principal. This leaves a balance of $4,234,840.
- This process continues over the 10 years, with the interest portion gradually decreasing and the principal portion gradually increasing until the loan is fully paid off.
Note that in real life, the company might also have to pay loan origination fees, and it might face penalties if it fails to make payments on time or wants to pay off the loan early. These details would all be spelled out in the loan agreement.
This example demonstrates how a company can use loan capital to finance major projects. However, XYZ Manufacturing would also need to consider the risk and cost of taking on debt, including the impact of interest expenses on its net income and the need to maintain steady cash flow to make loan payments.