Loan capital definition
/What is Loan Capital?
Loan capital is funding that must be repaid. This form of funding is comprised of loans, bonds, and preferred stock that must be paid back to investors. Unlike common stock, loan capital requires some type of periodic interest payment back to investors for use of the funds. However, these investors do not share in the profits earned by the organization, though they have payment preference over shareholders in the event of a business default.
Example of Loan Capital
A manufacturing company plans to expand its operations by building a new production facility. To finance the $5 million construction cost, it secures a long-term loan from a commercial bank, repayable over 10 years at a fixed interest rate of 6% per year. This borrowed amount is considered loan capital, since it provides the company with the necessary funds to invest in capital assets without issuing additional shares. The company uses the facility to increase its production capacity, expecting the higher output to generate enough revenue to cover loan repayments and boost overall profitability. In this case, loan capital supports strategic growth while preserving the existing ownership structure.
Advantages of Loan Capital
The main advantages of loan capital are as follows:
Retention of ownership. Loan capital allows a business to raise funds without issuing additional shares, so existing owners retain their ownership percentages and control over business decisions.
Tax deductibility. Interest payments on loan capital are generally tax deductible, which reduces taxable income and the effective cost of borrowing.
Predictable financing costs. Loan capital with a fixed interest rate provides predictable interest payments, making it easier to prepare budgets and manage cash flows.
Disadvantages of Loan Capital
There are several disadvantages associated with the use of loan capital, which are as follows:
Increased risk of default. An excessive amount of loan capital can present an increased risk of default for a business, since the interest liability associated with the loan capital may exceed the ability of the entity to make these payments on a timely basis.
Not suitable for variable profit situations. The use of loan capital is a particular concern in cases where a business has highly variable profits, since it may not be able to make loan payments during a low-profit year. This is a common concern when product cycles are short and the barriers to entry are low, since both conditions allow low-cost providers to enter the market and undercut your business.
Loan Capital FAQs
What costs are associated with loan capital?
The primary cost of loan capital is interest expense, which compensates lenders for risk and the time value of money. Borrowers may also incur fees such as origination fees, commitment fees, and legal or compliance costs. These costs reduce net returns and must be considered in cash flow planning.