ALL ABOUT DEBT

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DEBT FINANCING: OVERVIEW
Tell the story behind the numbers
London Coffee Co is planning to expand and is exploring the
various debt financing options available. The company is
examining the debt route as it would prefer to avoid diluting its
existing shareholders by raising equity.
In particular the company is looking to acquire another coffee
shop from a competitor. Term loan financing is appropriate for
major asset purchases and acquisitions.
London Coffee Co plans to upgrade its coffee machine for
which a capital lease allows flexibility and manageable
monthly payments to avoid large upfront costs of purchase.
With factoring, the company can strengthen its cash flow
position by releasing cash tied up in invoices issued to clients
who have not yet paid.
Overdrafts and revolving credit facilities are designed to
address financing needs on a short term basis as the company
encounters peaks and troughs in its daily or weekly cash
position.
4 DEBT FINANCING OPTIONS
1
2
3
4
TERM LOAN
OVERDRAFT &
CREDIT FACILITIES
FACTORING
CAPITAL
LEASES
DEBT FINANCING: TERM LOANS
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London Coffee Co is planning to upgrade its coffee
machine to serve premium-quality coffee to its
customers. The machine costs 20,000 and the
company has decided to apply for a loan for the full
amount from the bank.
The bank has offered to lend to London Coffee Co at an
interest rate of 10.0%. The company would like to spread
the payments over 36 months. As a result, the company
must make monthly payments which consist of 645 in
interest and principal for the duration of the loan.
If the company decided to take out a five year loan, they
would be required to make monthly payments of 425 but
the total amount paid in interest would be higher. Similarly
if they were to shop around and obtain a loan
at 5.0% for 36 months, this would reduce the monthly
cost to 599.
London Coffee Co must choose the appropriate
monthly amount they can afford to manage their cash
flows whilst minimising the amount they pay in interest.



Month Beginning Interest Repayment Monthly Ending
1 20,000 167 479 645 19,521
2 19,521 163 483 645 19,039
3 19,039 159 487 645 18,552
4 18,552 155 491 645 18,061
5 18,061 151 495 645 17,566
6 17,566 146 499 645 17,067
7 17,067 142 503 645 16,564
8 16,564 138 507 645 16,057
9 16,057 134 512 645 15,545
10 15,545 130 516 645 15,030
11 15,030 125 520 645 14,510
12 14,510 121 524 645 13,985
24 7,920 66 579 645 7,340
36 640 5 640 645 -
London Coffee Co Bank Loan - Key Terms
Loan Amount: 20,000 Interest Rate: 10.0% Loan Duration: 36 months
1 Year 1,758
3 Years 645
5 Years 425
10 Years 264

5.0% 599
10.0% 645
15.0% 693
20.0% 743

Loan
Duration
Interest
Rate
Monthly
Payment
Monthly
Payment
What is the monthly payment if the
loan duration is:
What is the monthly payment if the
interest rate is:
Loan Repayment Schedule
DEBT FINANCING: INTEREST RATES
Tell the story behind the numbers
London Coffee Co is planning to upgrade its coffee
machine to serve premium-quality coffee to its
customers. The machine costs 20,000 and the
company has decided to apply for a loan for the full
amount from the bank.
The bank has offered to lend to London Coffee Co at an
interest rate of 10.0%. The company would like to spread
the payments over 36 months. As a result, the company
must make monthly payments which consist of 645 in
interest and principal for the duration of the loan.
If the company decided to take out a five year loan, they
would be required to make monthly payments of 425 but
the total amount paid in interest would be higher. Similarly
if they were to shop around and obtain a loan
at 5.0% for 36 months, this would reduce the monthly
cost to 599.
London Coffee Co must choose the appropriate
monthly amount they can afford to manage their cash
flows whilst minimising the amount they pay in interest.



5.0% 599
10.0% 645
15.0% 693
20.0% 743

UK Interest Rate
Loan amount
Collateral
Credit History
Capacity to Repay
Loan Duration
Deposit
Which factors influence the 10% interest rate?
The bank asked London Coffee Co to secure the loan against the companys
property and equipment, its collateral. If the company cannot keep up with its
monthly loan payments, the bank will be claim ownership of its property and
equipment. London Coffee Co did not offer any collateral on the loan, which increased
the risk of lending and therefore, increased the interest rate at which the bank was
willing to lend at.
The banks also looked at London Coffee Cos capacity to repay the loan. It deemed
that the amount of cash flow the company is generating is sufficient to meet its
monthly interest and principal, which reduced the loans interest rate.
The company requested a loan with a 3-year term. For the bank, a longer loan duration
means a higher risk that the loan will not be repaid. By increasing the loans term,
London Coffee Co would have to pay a higher interest rate than a shorter-term loan.
Similar to collateral, London Coffee has not put down a cash deposit for the loan,
which has increased its borrowing rate. By securing the loan against the deposit, the
bank would have a level of protection should London Coffee Co fail to meet its
payments.
London Coffee Co borrowed a similar loan amount when it first started up. As a
long-standing customer of the bank and with a clean track record of making loan
payments in a timely manner, London Coffee Co has a good credit history. This has
contributed to reduction in the loans interest rate.
DEBT FINANCING: OVERDRAFTS & REVOLVING
CREDIT FACILITIES Tell the story behind the numbers
OVERDRAFTS & REVOLVER FACILITIES
OVERDRAFTS
The bank has offered London Coffee Co a 1,000 overdraft facility. It is
an uncommitted facility which means the bank can choose whether to
lend or terminate the facility at its discretion. The amount drawn from
the facility is repayable on demand, which makes it unsuitable for
certain purposes, such as funding a business acquisition. It is
straightforward setup process although the interest rate on the
overdraft is high and only this limited amount can be borrowed.
REVOLVING CREDIT FACILITY
The bank has also offered a committed facility that provides a 10,000
maximum that can be borrowed over a fixed term of 3 years. London
Coffee Co can draw down as much or as little money as it requires at
any time, and repay outstanding advances that are no longer required.
Any amounts that are repaid can also be re-borrowed. The company
can select an interest period and fix the interest rate it pays over that
period for each advance it draws. At the end of an interest period, the
company can decide whether to repay or "rollover" the advance into a
new interest period.
To arrange this flexible facility, the commitment fees are higher than an
overdraft. There is also a minimum notice period of 1 week before an
advance can be received and a 2,000 limit on the amount that may
be drawn at any one time.
SOURCES OF FUNDS
Current liabilities
Short-term debt 0 0 0
Accounts payable 3,000 4,800 5,600
Income taxes payable 2,000 4,598 7,475
Long-term liabilities
Long-term debt 15,000 14,000 13,000
Provisions 500 750 1,000
Equity
Common stock 100 100 100
Share premium 11,000 11,000 11,000
Retained earnings 5,300 13,978 19,598
Total Equity 21,400 25,078 31,058
2013 2014 2015
Actual Forecast Forecast
Total Liabilities 21,500 24,148 27,075
LONDON COFFEE CO - BALANCE SHEET SNAPSHOT
According to the companys balance sheet, the company
is not expected to encounter cash flow deficits as it is
forecast to have positive cash balances. However London
Coffee Co is looking at options to manage any short-term
cash flow problems during quiet months. The bank
has offered two solutions which the company is weighing
up:
(i) an overdraft or
(ii) Revolving Credit Facility.
DEBT FINANCING: FACTORING
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USES OF FUNDS
Current assets
Cash and cash equivalents 500 6,926 15,733
Accounts Receivable 400 600 800
Inventories 1,000 1,200 1,400
Other Current Assets 2,000 3,000 4,000
Long-term assets
Deferred taxes 1,000 1,500 2,000
Goodwill 2,000 2,000 2,000
Property, plant and equipment 30,000 28,000 26,200
2013 2014 2015
Actual Forecast Forecast
London Coffee Co also makes outside of its store by delivering
coffees to local businesses. The company invoices these clients,
requesting payment within 30 days and books them in the
accounts receivable. At the end of December 2013, London
Coffee Co had 400 in invoice value that is awaiting payment.
Sometimes, these payments are received after 30 days. On other
occasions, the company can be running low on cash for
operations and cannot wait until for these payments are made.
To free up cash for use in the business, London Coffee Co
decides to use invoice factoring which offers the company a
cash advance in exchange for the value of these invoices. The
Factor offers 70% (280) cash advance for the invoice value
immediately.
The remaining 120, the reserve minus the factors commission
and other charges are paid to London Coffee Co once the local
businesses have transferred the 400 they owe to the factor. The
emphasis is on the value of the invoice which is essentially a
financial asset. The seller is borrowing against its debtors.
By selling these invoices to a factor, London Coffee Co can
quickly release cash which is tied up. The company also avoids
the risk of non-paying clients as factor takes ownership of the
invoice.
LONDON COFFEE CO - BALANCE SHEET SNAPSHOT
London Coffee
Co
The Factor
London Coffee
Co Clients
5. Factor transfers remaining funds
less commission fee
HOW FACTORING WORKS
DEBT FINANCING: CAPITAL LEASES
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London Coffee Co is planning to upgrade its coffee machine
to serve premium-quality coffee to its customers. Instead of
buying the machine outright for 10,000 in cash, the company
wants to lease the equipment over a fixed term. The company will
make monthly payments at an interest rate of 6% to the manufacturer
over 36 months in exchange for ownership of the equipment. At the
end of the lease term, the machine is expected have residual value
of 2,000. Using present value calculations, London Coffee Co
will need to make monthly lease payments of 365 over the period.
The company benefits as the lease frees up a significant amount of
capital and spreads the cost over its useful working life. As a result,
London Coffee co can now lease the most advanced coffee
machine which it would otherwise have not been able to procure
if it were to make an outright purchase. In the lease contract,
there is also an option to upgrade to a newer machine during
the lease period so the company can adapt to new
technologies.
As a capital lease, London Coffee Co assumes some of the
risks of ownership - the lease is recognized as both a
non-current asset and liability (the lease payments) on the
balance sheet. The company can claim depreciation each year
on the asset and also deducts the interest expense from the
lease payment each year which will offset against its pre-tax
profits.
Example
Coffee Machine Lease Value: 10,000
Residual Value: 2,000
Lease Duration: 36 months
Interest Rate: 6.0%
Monthly Lease Payment: 365