Debt financing is money borrowed to finance a project10 and the investment return for debt holders is limited to the interest earned on the principal. Debt capital can come from many sources and be structured in many ways. However, regardless of its source or structure, debt has a number of distinguishing features that differentiate it from equity:
Maturity - All debt has a maturity date at which time the outstanding amount is paid in full. Long-term debt refers to any debt obligation with a due date of longer than 1 year and short-term debt is defined as any outstanding debt obligations whose due date is less than, or equal to, 1 year.
Repayment Provision - Every debt instrument has a repayment provision which specifies how and when the interest and principal are to be repaid. Depending on the project's cash flow, some lenders may provide a grace period where payments can be delayed until positive cash flow has been achieved.
Seniority - Though the returns for debt holders are limited to the interest, they have a senior claim to income and assets of the company or project. Different rights or claims to cash flow may also exist among different debt holders. Subordinated debt holders are junior to general or senior creditors and will only be paid once they have been satisfied.
Security - When establishing the terms of a debt agreement, the parties must decide if it will be issued on a secured or unsecured basis. A key aspect of project financing is that there is no, or limited, recourse back to the project sponsors and that project loans are secured only by the cash flows and assets of that specific project.
Floating versus Fixed rates - Interest rates on debt instruments will either be stated as a fixed rate or as a floating rate. For example, floating rates may be stated as being 100 basis points, or 1%, above an indicator rate such as a banks prime rate or LIBOR11. The interest rate on a floating rate loan will fluctuate as the indicator rate changes. Fixed rates are set for the term of the loan and are based on prevailing rates for similar term loans.
Voting Rights - Unlike equity holders, lenders are not regarded as owners and therefore do not have any voting powers.
As previously mentioned, debt financing can come from a number of different sources with commercial loans usually ranked as senior debt and all other debt being subordinated debt. However, the priority to assets will depend on a number of factors and will be dealt with in the loan agreement between the parties involved.
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10 See Appendix 2 - Debt Issues for a breakdown of issues that have to be considered when looking to finance with debt.
11 LIBOR - London Interbank Offered Rate