Understanding corporate finance: raising finance: the cost of borrowing: interest
A company that borrows may reward the lender by paying interest. See the Savings and Investment Manual (SAIM2000) for more on the legal meaning of interest.
The rate of interest might be fixed, floating, stepped or linked to some other rate or index.
A fixed rate of interest remains the same for the duration of the loan.
A floating rate of interest fluctuates throughout the period of the loan. Often this rate is linked to a market rate such as LIBOR. The interest rate for the company’s borrowing will rise and fall as LIBOR rises and falls.
The interest rate might be linked to some other rate or index. For example, it could be linked to
- the profit level of the company itself so that if the company’s profits increase, the rate at which interest is paid is increased
- the rate of interest being paid on another debt, such as government debt
- an index such as the retail price index.
A stepped rate of interest is a rate that changes at pre-arranged intervals. The company could negotiate to pay a lower rate of interest (or no interest) at the start and increase the rate of interest in the later years. For example, in the first year interest might be charged at 2%, then 4% in the second year and 6% in the third year.
The company might negotiate to pay all the interest at the end of the term of the loan. In these circumstances it is likely that the interest will be compounded, that is interest will not be paid in the first period and so interest will be charged on that interest in the second period. In the third period interest will be charged on the interest not paid in the first and second period.
Compound interest example
Company borrows £10,000 for 3 years at 10% interest payable annually in arrears.
|Interest charge||Amount owed|
|Year 1 company borrows||10000|
|Year 1 interest charge||10000 x 10% = 1000||11000|
|Year 2 interest charge||11000 x 10% = 1100||12100|
|Year 3 interest charge||12100 x 10% = 1210||13310|
|Year 3 repayment||13310|