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 benchmark rate such as LIBOR (London inter-bank offered rate). This is not just one rate but a benchmark rate for a defined period such as overnight, three months, six months, 12 months etc. Where the interest rate payable is linked to, say three month LIBOR, the rate resets at the end of each three-month period to the then prevailing rate. The interest payable will typically a margin above the LIBOR rate, expressed in basis points (0.01%). It follows that the interest rate for the company’s borrowing will rise and fall as the applicable LIBOR rate rises and falls. There will be different LIBOR benchmarks for each currency, because interest rates differ according to the currency in which payments have to be made.
There are other benchmarks, though LIBOR has been the most widely used. The LIBOR rates are based on the averages of rates submitted by a panel of banks at a particular time each working day. Even though the extreme ranges of the rates submitted from the averages, evidence of manipulation of the rates in the past has come to light. In the light of these concerns, the British financial regulators have decided that the use of LIBOR should be discontinued and replaced by some other benchmark by the end of 2021.
The interest rate might be linked to some other rate or index. For example, a rate of interest 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. In practice compound interest is more likely to arise in respect of delayed payments or compensation for losses. Where a loan does not bear interest but is issued at a discount to the amount payable on maturity, this is economically equivalent to paying compound interest.
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|
Payment-in-kind (‘PIK’) Notes
In private equity structures, bonds may be issued to investors where interest is ‘paid’ by the issue of further bonds on the same terms as the original - payment-in-kind, or PIK. This has the effect of deferring cash payment to maturity. See CFM11190.