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Term loans are a fundamental source of long-term debt financing for businesses, allowing them to fund significant investments like fixed assets and working capital. Unlike short-term bank loans designed for immediate operational needs, term loans are structured for repayment over several years, typically less than a decade. Understanding their features and application process is crucial for firms seeking substantial capital.
What is a Term Loan?
Historically, term loans provided by financial institutions and banks have been a primary source of long-term debt for both private and public firms. Also known as term finance, these loans are a form of debt that is generally repayable within 10 years. They are specifically used to finance the acquisition of fixed assets and to provide working capital margins for projects.
Key Features of Term Loans
Term loans come with several distinct features that define their structure and utility:
- Currency: Financial institutions in India offer both local currency (rupee) term loans and foreign currency term loans. Rupee term loans are a significant form of assistance, directly provided to industrial concerns for new projects, expansion, modernization, and renovation. These funds cover expenses for land, buildings, plant and machinery, technical know-how, various fixed assets, and preliminary/pre-operative costs. Foreign currency term loans help meet expenses for importing plant and machinery or paying foreign technical know-how fees, with liabilities translated into rupees at prevailing exchange rates for payment.
- Security: Term loans typically represent secured borrowing, often requiring prime security of assets. This usually involves an equitable mortgage of all immovable properties of the borrower and hypothecation of all movable properties. This is subject to any prior charges in favor of commercial banks for obtaining working capital advances in the normal course of business.
- Negotiated Terms: The specific details of term loans are negotiated directly between the borrower and the lender, similar to a private placement of debentures rather than a public offering to investors.
- Interest and Principal Repayment: Both interest and principal repayment on term loans are definite obligations that must be met regardless of the firm's financial situation. Financial institutions typically charge an interest rate that is related to the credit risk of the proposal, subject to a certain floor rate. Lenders may impose a penalty, such as additional interest, for the period of default on the amount of principal in default. In addition to interest, lending institutions typically levy an upfront fee on the sanctioned loan amount. The principal amount is generally repayable over a period of 4 to 7 years after an initial grace period of 1 to 2 years, often in equal semi-annual or quarterly installments. It's worth noting that the interest burden usually declines over time, while principal repayment remains constant.
- Restrictive Covenants: To protect their interests, financial institutions often impose restrictive conditions on borrowers. While specific covenants vary based on the project and the borrower's financial situation, loan contracts frequently require the borrowing firm to:
- Broaden its board of directors and finalize its management structure in consultation with, and to the satisfaction of, the financial institutions.
- Arrange for additional funds in the form of unsecured loans.
- Refrain from undertaking any new project, expansion, or making investments without prior approval from the financial institutions.
- Obtain necessary licenses from various government agencies.
- Abstain from additional borrowings.
The Term Loan Application Process
The procedure for obtaining a term loan typically involves several key steps:
Submitting Your Application
The borrower submits an application form requesting comprehensive information about the project. This includes details on the promoters' background, particulars of the industrial concern and the project itself, project cost, means of financing, marketing and selling arrangements, projected profitability and cash flow, economic considerations, and required government consents.
Initial Review
Upon receipt, an officer from the financial institution reviews the application for completeness. Once deemed complete, a 'flash report'—a summary of the application—is prepared. This report helps determine if the project warrants a detailed appraisal.
Project Appraisal
A detailed appraisal of the proposed project covers marketing, technical, financial, managerial, and economic aspects. An appraisal memorandum is usually prepared within two months, often after a site inspection. Based on this memorandum, a decision is made to accept or reject the project.
Receiving the Letter of Sanction
If the project is approved, a letter of sanction is issued to the borrower. This document communicates the sanctioned assistance and all related terms and conditions.
Accepting Terms and Conditions
Upon receiving the letter of sanction, the borrowing unit convenes a board meeting to formally accept the terms and conditions. An appropriate resolution is passed and conveyed to the financial institution within a stipulated period.
Executing the Loan Agreement
After receiving the acceptance letter, the financial institution sends a draft of the loan agreement to the borrower. This agreement must be executed by authorized persons and properly stamped as per the Indian Stamp Act, 1899. Once the executed and stamped agreement, along with other required documents, is returned and signed by the institution, it becomes effective.
Establishing Security
Term loans and deferred payment assistance are typically secured through a first mortgage, often by depositing title deeds of immovable properties, and hypothecation of movable properties.
Loan Disbursement
Periodically, the borrower must submit information on the project's physical progress, financial status, financial resources, promoters' contribution, estimated funds flow statement, compliance with statutory requirements, and fulfillment of pre-disbursement conditions before funds are released.
Ongoing Monitoring
The project is monitored throughout its implementation and operational stages. During implementation, monitoring involves regular reports, periodic site visits, dialogue with promoters, bankers, and suppliers, and observation of trial production. During the operational stage, monitoring relies on quarterly progress reports, site inspections, reports from nominee directors, and a comparison of actual performance against initial projections.
Understanding Repayment Schedules and Amortization
Term loans are amortized according to a predetermined schedule, which includes two main components:
Interest Component
The interest component is a legally enforceable contractual obligation. Interest on term loans is typically subject to a minimum prime lending rate.
Principal Repayment
The principal is usually repayable over a period of 6 to 10 years, following an initial grace period of 1 to 2 years. While institutional borrowings often feature equal semi-annual installments, term loans from banks may be repayable in equal quarterly installments.
Advantages and Disadvantages of Term Loans
Term loans offer both benefits and drawbacks for borrowers and lenders. From the borrower's perspective, they share many advantages and disadvantages with debenture financing. An additional drawback for borrowers is that term loan contracts often include restrictive covenants that can limit managerial freedom. The right of lenders to nominate directors to the borrowing company's board can further restrict managerial discretion.
For lending institutions, term loans provide the advantages and disadvantages of debenture financing, with the added benefit of restrictive covenants to protect their interests. However, term loans typically do not involve negotiable securities. In summary, term loans often carry a lower cost of capital but involve higher risk for lenders if not adequately secured. While they generally do not adversely affect company control, they can impose moderate restraints on managerial freedom.
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