Bank Debt

Historically, the primary source of borrowed money for all private firms and many publicly traded firms has been the local bank, with the interest rates on the debt based upon the perceived risk of the borrower. Bank debt provides the borrower with several advantages. First, it can be used for borrowing relatively small amounts of money; in contrast, bond issues thrive on economies of scale, with larger issues having lower costs. Second, if the company is neither well known nor widely followed, bank debt provides a convenient mechanism to convey information to the lender that will help in both pricing and evaluating the loan. The presence of hundreds of investors in bond issues makes this both costly and infeasible if bonds are issued as the primary vehicle for debt. Finally, in order to issue bonds, firms have to submit to being rated by ratings agencies and provide them with sufficient information to make this rating Dealing with a rating agency might be much more difficult for many firms, especially smaller firms, than dealing with a lending bank.

Besides being a source of both long term and short term borrowing for firms, banks also often offer them a flexible option to meet unanticipated or seasonal financing needs. This option is a line of credit, which the firm can draw on only if it needs financing. In most cases, a line of credit specifies an amount the firm can borrow and links the interest rate on the borrowing to a market rate, such as the prime rate or treasury rates. The advantage of having a line of credit is that it provides the firm with access to the funds without having to pay interest costs if the funds remain unused. Thus, it is a useful type of financing for firms with volatile working capital needs. In many cases, however, the firm is required to maintain a compensating balance on which it earns either no interest or below-market rates. For instance, a firm that wants a $ 20 million line of credit from a bank might need to maintain a compensating balance of $ 2 million, on which it earns no interest. The opportunity cost of having this compensating balance must be weighed against the higher interest costs that will be incurred by taking on a more conventional loan to cover working capital needs.

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