Loans issued by banks with a fixed maturity date by which time all outstanding funds must be repaid are called term loans. There are two distinct ways in which the money borrowed may have to be repaid. If the term loan is an amortizing loan, the initial amount of money borrowed also called the principal will be repaid in stages over the life of the loan. In this example that amounts to 384.7. An amortizing loan is similar to a repayment mortgage where each monthly payment consists of an interest payment for that period with the remainder repaying some of the money initially borrowed. In this example, the company has determined they have a 100 in years one to three and 120 in year four available to make loan payments. If the present value of these cash flows is calculated using the post-tax interest rate of 3.5% based on the interest rate of 5% and the tax rate of 30% then the present value is the 384.7. The post-tax interest rate is used since interest payments are tax deductible and will result in a lower profit before tax and therefore lower tax payments. This means the company could borrow 384.7 today and have sufficient funds to repay the interest and principal on this loan over the next four years. Each year, interest is added based on the opening outstanding loan amount for that year, 384.7 in year one, multiplied by the post-tax interest rate of 3.5% to give an interest cost of 13.5 in year one. The remaining amount of money, from the 100, the company has to service debt in year one is then used to repay some of the outstanding principal, that being 86.5 in year one since 13.5 has been used to meet the interest payment in year one. This means that in year two the opening outstanding principal will be lower than year one, and therefore the interest payment for year two will also be lower: only 10.4 for year two. If we continue these calculations for the four year term of the loan, there'll be a zero balance left owing to the bank at the end of year four, meaning that all of the interest and the initially borrowed principal will have been repaid. An alternative form of loan repayment is a bullet loan where all the money initially borrowed is repaid at the end of the term of the loan. In this example, the company has 500 available to service debt in year four, but will only be able to make interest payments in the previous years. If the 500 is present valued over one year only using the given interest rate of 8% and the tax rate of 30% this gives 472. With the 500 available to service debt in year four, the borrower would be able to meet the post-tax interest cost at 5.6% of the outstanding balance at the beginning of year four, being the 472, as well as the interest of 26.4 from the 500 that we have available in year four. In this example, the borrower would then also have to make the interest payments of 26.4 in each of the previous three years as well. The interest remains constant in this example, since none of the principal has paid off until the end of the term of the loan. Term loans frequently have contractual terms called covenants imposed on the borrower to reduce credit risk for the bank. These covenants can be broken down into maintenance covenants, which are checked regularly such as a maximum debt to EBITDA ratio or a minimum interest coverage ratio, and incurrence covenants which only apply when a specific event such as a takeover or major asset disposal takes place.
