Forms of Debt Finance

• Debt financing is when a business or individual obtains a loan with the promise to pay back principal plus interest, over a certain period. Secured and unsecured loans are a form of debt financing for both businesses and individuals. In addition to commercial loans, business can also raise capital through debt financing by issuing bonds and commercial paper.

Loans

• Individuals and business who obtain unsecured or uncollateralized loans do not have to pledge any property, plant or equipment in exchange for the loan. If the borrower defaults on the loan, the lender has the right to sue the borrower to recover its financial losses. For secured or collateralized loans, the business or individual has to pledge property, plant or equipment in exchange for a loan. For example, homes, buildings and land secure real estate loans. Business can also use equipment it owns to secure loans. When a borrower defaults on a secured loan, the lender repossess the property and often sells it at auction to recoup its financial losses.

Bonds

• Investors call bonds debt securities because they operate much like a loan. When an investor purchases a corporate bond, the company agrees to pay back the principal at the bond's maturity date, while making interest payments over the term of the bond. The advantage of a corporation issuing a bond instead of obtaining a commercial loan from a bank is because the terms are more flexible and the interest the company pays to its bondholders can often be less than the interest it would pay to a bank on a commercial loan.

Commercial Paper

• When investors refer to commercial paper as a form of debt financing, they are most often referring to promissory notes. Companies use promissory notes as a form of short-term debt financing. Unlike bonds, companies do not have to register promissory notes with the U.S. Securities and Exchange Commission. Companies sell promissory notes to investors at a discount. This means the company sells the note for a stated percentage less than the note's face value. For example, a 10 percent discount on a promissory note with a $100 face value, sells for $90. When the note comes due, the company pays the investor the face value of the note.