Companies seeking debt financing do so by entering into a debt agreement in exchange for a loan. 

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Debt agreements outline repayment terms, including interest, and any security that a borrower must pledge in order for the financier to be willing to provide such a loan.

Lenders are stakeholders to companies in the sense that they have a vested interest in the company for as long as the debt is outstanding; however, pure lenders do not have a formal ownership stake in the companies that maintain their loans in good standing. 

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Return on Debt Financing

The return on investment to lenders is comprised primarily of interest proceeds, which tend to be either a fixed interest rate agreed upon at inception of a debt agreement, or a variable interest rate linked to a reference interest rate (e.g., commercial prime lending rate in Trinidad and Tobago, London Interbank Offered Rate (LIBOR), etc.). 

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• For example, a lender may be willing to grant a 6% fixed interest rate loan to a company or a variable interest rate loan at the prime lending rate + 3%, when the prime rate is equal to 2.5%.
• In such a case, the lender would receive a lower initial return (5.5% vs. 6%).
• However, if interest rates rise, the lender may expect to receive 7%+ in the later periods of the loan. 

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With regularly contracted payments and a higher ranking in the capital structure, investors view debt as a lower risk, lower returning investment, when compared to equity.

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Similarly, debt tends to have a lower cost of capital from a company’s perspective.

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Why Companies seek Debt Financing?

Companies will seek debt financing so that shareholders can avoid the need to inject further personal funds into a company, and to avoid the expensive equity dilution (reduction in ownership percentage) that is associated with raising equity. 

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Examples of initiatives that are commonly financed with debt include: 

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• Company expansion and/or product development and expansion; 
• Liquidity management, including working capital management; 
• Mergers and acquisitions; 
• Dividend recapitalizations – issuing debt as a means to return capital to shareholders; and 
• Capital structure optimization – getting to the most efficient balance of debt and equity financing for the company.

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