Long-term debt is a loan or obligation of a company that has a maturity of more than one year. It is usually issued in the form of bonds or notes and can be used to finance a variety of business needs, such as capital expenses, working capital, and acquisitions. Long-term debt also includes any capital leases, obligations under capitalized leases, and any other forms of long-term borrowing that a company has contractual obligation to pay. Management must carefully consider the terms of long-term debts, such as principal amount, interest rate, amortization schedule, and the risk of default, when deciding to take on long-term debt.
Example of long-term debt
- A company may take on long-term debt in the form of a loan or bond. For example, a company may issue a bond with a principal amount of $10 million, an interest rate of 5%, and a maturity of 10 years. The bond proceeds can be used to finance capital expenses or acquisitions.
- A company may also issue notes to borrow money from investors. These notes typically have a shorter term, usually one to three years, and have a higher interest rate than bonds. For example, a company may issue $5 million in notes with an interest rate of 10% and a maturity of three years. The proceeds can be used to finance working capital or other short-term needs.
- A company may also enter into capital leases and other long-term obligations. These leases commit the company to make payments over the course of a certain period of time and usually have a higher interest rate than traditional loans. For example, a company may enter into a capital lease for a piece of equipment with a principal amount of $1 million and an interest rate of 8%. The lease requires the company to make payments over the course of five years.
When to use long-term debt
Long-term debt can be used to finance a variety of business needs, such as:
- Capital expenses, such as upgrading equipment or renovating facilities
- Working capital, such as financing inventory or covering payroll
- Acquisitions, such as purchasing another business or expanding operations
- Refinancing existing debt, such as reducing the interest rate or extending the repayment term
- Funding capital projects, such as building a new factory or expanding a current facility
- Funding research and development, such as launching a new product or entering a new market
- Investing in long-term assets, such as purchasing land or investing in a new venture.
Types of long-term debt
Long-term debt can take many forms, including bonds, notes, and other borrowing instruments. The most common types of long-term debt include:
- Bonds: Bonds are debt securities issued by companies, governments, or other entities to raise capital. Bondholders are entitled to receive interest payments, called coupon payments, at regular intervals, as well as the principal amount at maturity.
- Notes: Notes are debt instruments issued by companies or other entities to raise capital. Unlike bonds, notes do not have a predetermined interest rate. Instead, the interest rate is negotiated between the issuer and investor.
- Mortgages: Mortgages are loans that are secured by real estate. The loan is typically used to purchase the property, and the loan is secured by the property itself. The lender has the right to seize the property if the borrower defaults on the loan.
- Lines of credit: Lines of credit are credit arrangements that allow a borrower to access funds up to a predetermined limit. Interest is only charged on the amount borrowed, and the borrower can repay the loan in full or in part as needed.
- Capital leases: Capital leases are long-term leases that are treated as a form of financing, rather than as operating expenses. The lessee is obligated to make regular payments for the duration of the lease and is usually responsible for any maintenance or repairs.
- Structured finance: Structured finance is a form of financing that involves the securitization of debt instruments such as mortgages and other assets. The debt instruments are packaged together and sold as a security to investors.
Advantages of long-term debt
Long-term debt can offer a number of benefits to a business, including:
- Low-cost financing: Long-term debt typically offers lower interest rates than short-term debt and is often easier to secure.
- Flexibility: Companies can choose from a variety of repayment schedules to match their cash flow needs.
- Tax deductions: Interest payments on long-term debt are tax deductible, which reduces a company’s overall tax burden.
- Leverage: Long-term debt can be used to fund projects and acquisitions without diluting existing shareholders’ ownership.
- Stability: Long-term debt can help to provide a more stable financial structure and reduce the risk of insolvency.
Limitations of long-term debt
Long-term debt has several limitations that must be taken into consideration by management before taking on debt. These include:
- Interest payments on long-term debt can be high, reducing profits and cash flow available for other uses.
- Long-term debt can be difficult to refinance or restructure if the company’s financial situation deteriorates.
- Long-term debt can restrict a company’s ability to take on additional debt, as lenders may be reluctant to offer new financing if the company already has high levels of debt.
- Long-term debt also carries the risk of default, which can be costly to a company’s reputation and creditworthiness.
- Finally, long-term debt can be an expensive source of financing, as the cost of interest payments over time can add up.
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- Alfaro, L., & Kanczuk, F. (2009). Debt Maturity: Is Long‐Term Debt Optimal?. Review of international Economics, 17(5), 890-905.
- Cochrane, J. H. (2001). Long‐term debt and optimal policy in the fiscal theory of the price level. Econometrica, 69(1), 69-116.