Corporate Finance

What determines the rate of interest charged on a new bank loan

The following factors will influence the rate of interest charged on a new bank loan.

Risk of default

The bank providing the loan will make an assessment of the risk that the company might default on its loan commitments and charge an interest rate that reflects this risk. If the borrowing company is listed on a stock exchange, it will be seen as less risky than an unlisted company and will pay a lower interest rate as a result. The period of time that the company has been listed may also be an influential factor.

However, being listed on a stock exchange does not on its own provide a red-carpet treatment. If the company has problems in the way it has managed its operations, this could be a problem. For instance, if the company has expanded sales significantly and relies heavily on overdraft finance, it may be an overtrading situation. This could increase the risk of default and so increase the rate of interest charged on the loan. The bank would need to be convinced through financial information supporting the loan application, such as cash flow forecasts, that the borrowing company would be able to meet future interest payments and repayments of principal.

Security offered

The rate of interest charged on the loan will be lower if the debt is secured against an asset or assets of the company. The loan could carry a fixed charge on particular assets, such as land or buildings. In the event of default by the company, the bank can recover its loan by selling the secured assets.

Duration of loan

The longer the period of the loan taken out by the company, the higher the interest rate that will be charged. This reflects the shape of the normal yield curve.

Yield curve

The normal yield curve is the yield required on debt increases in line with the term to maturity. One reason for this is that loan providers require compensation for deferring their use of the cash they have lent, and the longer the period for which they are deprived of their cash, the more compensation they require. This is described as the liquidity preference explanation for the shape of the normal yield curve. Other explanations for the shape of the normal yield curve are expectations theory and market segmentation theory. Expectations theory suggests that interest rates rise with maturity because rates of interest are expected to rise in the future, for example due to an expected increase in inflation. Market segmentation theory suggests that the market for long-term debt differs from the market for short-term debt.

Amount borrowed

The rate of interest charged on the new loan could be lower if the amount borrowed is not a small sum. It is more convenient from an administrative point of view for a bank to lend a large sum rather than several small amounts.

Conservative, moderate and aggressive funding approaches

Even if the bank provides the new bank loan, a company still needs to determine an approach regarding the relative proportions of long and short-term finance to meet its working capital needs. The different approaches are conservative, moderate and aggressive.

The assets of a business can be divided into current assets and fixed assets, where current assets are used up on a regular basis within a single accounting period and fixed assets benefit a business for several accounting periods. Current assets can be further divided into permanent current assets and fluctuating current assets. Permanent current assets represent the core level of investment in current assets needed for a given level of business activity, and arise from the need for businesses to carry stock and to extend credit. Fluctuating current assets represent a variable need for investment in current assets, arising from either seasonal or unpredictable variations in business activity.

A conservative approach to the financing mix would emphasize long-term finance as the main source of working capital funds. This approach would use long-term finance for fixed assets, permanent current assets and some fluctuating current assets.

To a company, long-term debt finance is less risky than short-term debt finance, since once in place it is not subjected to the dangers of renewal or immediate repayment, but is more expensive in that the rate of interest charged normally increases with maturity. A conservative approach would therefore increase the amount of lower-risk long-term debt finance used by the company, but would also incur higher total interest payments than an approach emphasizing the use of short-term debt, and so would lead to relatively lower profitability. A similar argument can be made with reference to equity finance, which requires a higher return than long-term debt finance.

An aggressive approach to the financing mix would emphasize short-term finance as the main source of working capital funds. This approach uses short-term finance for fluctuating current assets and some permanent current assets, with long-term finance being used for the balance of permanent current assets and fixed assets. This increases the relative amount of higher-risk short-term finance used by the company, but will also incur lower total interest payments than the conservative approach, leading to relatively higher profitability.

Between these two approaches lies a moderate or matching approach. This approach applies the matching principle, whereby the maturity of the funding is matched with life of the assets financed. Here, long-term finance is used for permanent current assets and fixed assets, while short-term finance is used for fluctuating current assets.
For instance, if a company is in an overtrading situation and has an overdraft, the repayment of the overdraft will result in adopting a conservative approach to the mix of long-and short-term finance. This will resolve an overtrading situation, but may reduce profitability more than necessary. If the company continues to expand sales, or reintroduces overdraft finance, the conservative position will only be temporary and a moderate position may arise in the future. The speed with which this happens will depend on the size of the loan taken out, and whether a moderate position is desirable will depend on the company’s attitude to risk and return. It may be preferable to reduce the overdraft to a lower level rather than repaying it completely.