Chapter 05

Intermediate Term Financing

Chapter Contents
 Definitions
 Characteristics
 Types and sources of intermediate term financing
 Cost of intermediate term financing
 Methods of loan repayment
 Repayment schedule
 Balloon Method and
 Capital Recovery Method
 Problem Solutions.

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Definition:
Relating to an investment with an expected holding period somewhere between short-term
and long-term. For bonds, collectibles, and real estate, intermediate-term usually refers to a
holding period that ranges between one and seven years. For stocks, intermediate-term
indicates a somewhat shorter period of six months to several years. For futures and options
contracts, intermediate-term ranges from one month to several months.

Financing required in the maturity stage of a firm where it is stable and steadily growing.
Although largely self-sufficient in cash flows from their operations for internal requirements,
such firms may require large sums of money for acquisitions, initial public offering (IPO),
expansion of facilities or product lines, or to enter new or major foreign markets. Also called
second round funding.

Required amount of fund collected by a business enterprise for meeting up fund requirement
for acquiring important useable items and making investment from different available sources
for more than one year but less than 10 years’ time period is known as intermediate term
financing.

Features/ Characteristics of Intermediate Term Financing:

Normally any finance having maturity of more than one year but less than five years its consider
intermediate/medium/term financing. It has some characteristics which are given bellow:

1) Maturity: The maturity of Intermediate Term Financing is seven to ten years but in
Bangladesh it is three to seven years.
2) Size of Loan: Generally the amount of Intermediate Term Finance is tiny amount and it
should be paid within the 3-7 years.
3) User of the Financing: Small, large and medium all types of company should be use
Intermediate Term Financing. But generally, the company who are not eligible to issue share
and debenture.
4) Objectives of Credit: Generally to meet the current liability, purchases of machinery,
sometimes expansion and development of building are the main objectives of Intermediate
Term Financing.
5) Sources: The commercial bank, Insurance Company, leasing firm and other non bank
financial institution are the sources of Intermediate Term Financing.
6) Intermediate Term Financing should be repayment with installment.
7) Security provisions are available in the Intermediate Term Financing.

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8) Cost of Financing: In Intermediate Term Financing, interest rate is higher than short
term financing but lower than long term financing. But, if anyone wants to use lease then cost
are always higher.
9) Flexibility is offered in an Intermediate Term Financing.
10) Intermediate Term Financing is renewable.

Types of intermediate/medium/term finance:

1. Bank term loan: Normally the commercial banks provides term loan for a period of one year
or more and it is back by repayment schedule.
2. Revolving Credit: Revolving credit has two element of cost. One is regular interest on the
withdrawn portion and another is commitment fees that means undrawn portion.
3. Insurance company’s term loan: Insurance company could also be provides term loan.
4. Equipment financing: Any method of extending capital to businesses for the purpose of
acquiring equipment. Financing methods include equipment leasing, SBA and other
government loans, as well as sale-leaseback wherein the collateralized existing equipment to
raise cash for additional purchases.

Advantages and Disadvantages of Intermediate-Term

Financing
Advantages of intermediate-term financing:
 Flexibility: the borrower can get loan as his/her need.
 Low cost: cost is less than long-term financing.
 Convenience in repayment: the borrower can repay the loan as installment or at a time.
 Renewable: if the borrower fails to repay installment, the loan repayment period can be
expand.
 Maintaining secrecy
 Goodwill for the borrower
 Rapid financing: collecting loan from capital market by selling share or debenture is time
consuming. So business collect intermediate-term credit in a short time.
 Control
 Only source for small business
 Get ownership of asset without capital
 Tax advantage

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Disadvantages of intermediate-term financing
 It is comparatively high cost than short-term financing.
 Inconvenience of installment payment if inflow of cash is decreasing.
 If borrower fails to repay installment, the lender collect money by selling borrower’s
collateral security.
 It is not easy to get loan for financially weak, small and new business. Because banks,
financial institutions give more afford to borrower’s financially solvency when
considering loan.
 Sometimes lenders impose some restrictions over the borrower which limits the
borrower’s power.
 The borrower is required to keep a portion of loan as compensating balance.

What do you mean by Nominal Interest Rate, Real Interest

Rate, Prime Rate and Effective Interest Rate?
The real rate is the nominal rate minus inflation. In the case of a loan, it is this real interest that
the lender receives as income. If the lender is receiving 8% from a loan and inflation is 8%, then
the real rate of interest is zero, because nominal interest and inflation are equal.

The term “interest rate” is one of the most commonly used phrases in consumer finance and
fixed income investments. Of course, there are several types of interest rates: real, nominal,
effective, annual and so on.

The differences between the various types of rates, such as nominal and real, are based on
several key economic factors. But while these technical variables may seem trivial, lending
institutions and retailers have been taking advantage of the public’s general ignorance of these
distinctions to rake in hundreds of billions of dollars over the years. Those who understand the
difference between nominal and real interest rates have therefore taken a major step toward
becoming smarter consumers and investors.

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Nominal Interest Rate
The nominal interest rate is conceptually the simplest type of interest rate. It is quite simply the
stated interest rate of a given bond or loan. This type of interest rate is referred to as the
coupon rate for fixed income investments, as it is the interest rate guaranteed by the issuer
that was traditionally stamped on the coupons that were redeemed by the bondholders.

The nominal interest rate is in essence the actual monetary price that borrowers pay to lenders
to use their money. If the nominal rate on a loan is 5%, then borrowers can expect to pay $5 of
interest for every $100 loaned to them.

Real Interest Rate

The real interest rate is slightly more complex than the nominal rate but still fairly simple. The
nominal interest rate doesn’t tell the whole story because inflation reduces the lender's or
investor’s purchasing power so that they cannot buy the same amount of goods or services at
payoff or maturity with a given amount of money as they can now.

The real interest rate is so named because it states the “real” rate that the lender or investor
receives after inflation is factored in; that is, the interest rate that exceeds the inflation rate. If a
bond that compounds annually has a 6% nominal yield and the inflation rate is 4%, then the real
rate of interest is only 2%.

The real rate of interest could be said to be the actual mathematical rate at which investors and
lenders are increasing their purchasing power with their bonds and loans. It is actually possible
for real interest rates to be negative if the inflation rate exceeds the nominal rate of an
investment. For example, a bond with a 3% nominal rate will have a real interest rate of -1% if
the inflation rate is 4%. A comparison of real and nominal interest rates can therefore be
summed up in this equation:

Nominal interest rate – Inflation = Real interest rate

Several economic stipulations can be derived from this formula that lenders, borrowers and
investors can use to make more informed financial decisions.
 Real interest rates can not only be positive or negative, but can also be higher or lower
than nominal rates. Nominal interest rates will exceed real rates when the inflation rate
is a positive number (as it usually is). But real rates can also exceed nominal rates during
deflation periods.

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  A hypothesis maintains that the inflation rate moves in tandem with nominal interest
rates over time, which means that real interest rates become stable over longer time
periods. Investors with longer time horizons may, therefore, be able to more accurately
assess their investment returns on an inflation-adjusted basis.

Effective Interest Rate

One other type of interest rate that investors and borrowers should know is called the effective
rate, which takes the power of compounding into account.
For example, if a bond pays 6% on an annual basis and compounds semiannually, then an
investor who invests $1,000 in this bond will receive $30 of interest after the first 6 months
($1,000 x .03), and $30.90 of interest after the next 6 months ($1,030 x .03). The investor
received a total of $60.90 for the year, which means that while the nominal rate was 6%, the
effective rate was 6.09%.
Mathematically speaking, the difference between the nominal and effective rates increases
with the number of compounding periods within a specific time period. Note that the rules
pertaining to how the AER on a financial product is calculated and advertised are less stringent
than for the annual percentage rate (APR).

'Prime Rate'
The prime rate is the interest rate that commercial banks charge their most credit-worthy
customers. Generally, a bank's best customers consist of large corporations. The prime interest
rate, or prime lending rate, is largely determined by the federal funds rate, which is the
overnight rate that banks use to lend to one another; the prime rate is also important for
individual borrowers, as the prime rate directly affects the lending rates available for a
mortgage, small business loan or personal loan.

Methods of loan repayment:

Repayment is the act of paying back money previously borrowed from a lender. Repayment
usually takes the form of periodic payments that normally include part principal plus interest in
each payment. Failure to keep up with repayments of debt can force a person to declare
bankruptcy and severely affect his credit rating.
Classes of Loan Repayment Method:
1. Balloon Method
2. Capital Recovery Method

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Balloon Method
A balloon loan is a type of financing with a long term and competitive rate that many borrowers
find attractive. Unlike conventional loans, it doesn't amortize and the principal amount is due at
the end of the term.

Basics
The mortgage amount is the expected or original loan balance while the total payments are the
payments made over the loan term provided that there are no early prepayments. The term
usually ranges from 5 to 7 years, but this varies from issuer to issuer. Issuers that advertise
prepayment options offer different frequencies, from one-time to yearly, monthly, or none.
Prepayments vary in type and are applied to the loan principal.
Balloon Payment
A balloon payment is basically a payment made to cover the outstanding principal. In other
words, the balance is due at maturity. The main benefit to a balloon payment is that borrowers
who don't have a large sum of money for a down payment have an alternative option.

Balloon Loan Example

If the price of the property is $250,000, the term is 10 years, and the interest rate is 4.5
percent, then the balloon payment is $201,490 and the interest payment is $1,266. If the term
is 5 years, however, the balloon payment is $229,161. It will increase to $ 238,603 if the term is
3 years. A longer term of 15 years gives a lump sum payment of $166,852. In this case, the
borrower will pay a total of $393,594 and the total interest is $143,594. In general, if a
borrower applies for a 5-year balloon mortgage to buy some property, equal monthly payments
are distributed over a period of 5 years at a fixed rate. The remainder of the principal or the
balloon payment is due in five years.

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Capital Recovery Method:
Under capital recovery the loan payments are made in several equal installments that includes
interest amount, which can be yearly, monthly, semi-annually and so on. In this method the
amount of installment payment is calculate with the help of the following formula:
P
A=
1 1
−
R R (1+ R)N
Where, P= Principal Loan
A=Amount of Installment
R=Rate of Interest
N=No. of Period/Year

Cost of intermediate term financing:

Generally the cost of intermediate term financing is higher than short term financing but lower
than long term financing.

Problem:
A company needs Tk.30 lakh to finance a capital expenditure. Initially the company arranged for
a revolving credit agreement with Sonali Bank for 3 years on the condition that the agreement
may be converted into another 3 years term loan at the expiration of revolving credit
commitment. The bank charges an interest rate of 2% over the prime rate for revolving credit
and 3% over the prime rate for term loan. The commitment fee for both credit arrangement is
1% of the unused portion. The company plans to borrow Tk.14 lakh at the beginning and Tk. 10
lakh at the very end of the first year. At the exirition of the revolving credit agreement the
company plans to take down the full term loan. At the end of each of the fourth, fifth and sixth
year it plans to make principal payment of Tk. 10 lakh. The prime rate of interest is 9%.
a) What is the total cost of revolving credit for 3 year period? Find out the effective
interest (EIR).
b) What is the cost of bank term loan for the 4th, 5th and 6th? Find out EIR also.

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Solution:
A) Cost of Revolving Credit
Year 1 Year 2 Year 3
a) Actua Tk.14,00,000 Tk.24,00,000 Tk.24,00,000
l amount of
loan taken
b) Unus 16,00,000 6,00,000 6,00,000
ed amount of
loan
c) Intere 14,00,000×0.11=1,54, 24,00,000×0.11=2,64, 24,00,000×0.11=2,64,
st on used 000 000 000
amount @
(9+2)=11%
d) Com 16,00,000×0.01=16,0 6,00,000×0.01=6000 6,00,000×0.01=6000
mitment fee 00
on unused
portion@1%
e) =C+D 1,70,000 2,70,000 2,70,000
f) EIR 1,70,000 2,70,000 2,70,000
EIR= ×100=12.14
EIR=% ×100=11.25
EIR=% ×100=11.25 %
14,00,000 24,00,000 24,00,000
B. Cost of Term Loan:
Year 4 Year 5 Year 6
a) Amount of loan Tk.30,00,000 Tk.20,00,000 Tk.10,00,000
taken
b) Unused 10,00,000 20,00,000
0
amount of loan
c) Interest 14,00,000×0.12 24,00,000×0.11 24,00,000×0.11
on used =3,60,000 =2,40,000 =1,20,000
amount @
(9+3)=12%
d) Commit 6,00,000×0.01 6,00,000×0.01
ment fee on =10,000 =20,000
0
unused
portion@1%
e) =C+D 3,60,000 2,50,000 1,40,000
f) EIR 3,60,000 2,50,000 1 , 40,000
EIR= ×100=12
EIR=
% ×100=12.5
EIR=% × 100=14 %
30,00,000 20,00,000 10 , 00,000

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Problems on Methods of loan repayment
Problem: 1. Apex food Ltd. needs Tk. 500000 to finance for remodeling of food processing
equipment. AB Bank agreed to meet the requirement at 10% interest. The loan should be
repaid in next 3 years with half yearly installment. You are required to show the repayment
schedule under A) Balloon Payment Method and B) Capital Recovery Method.

Problem: 2. BEXIMCO Textile Ltd. needs Tk. 25,00,000 to finance its intermediate term capital
required for expansion purpose. Sonali Bank Ltd. agreed to meet the requirement at 15%
interest p.a. The loan should be repaid in next 6 years.
Requirements:
You are required to show the repayment schedule under:
A) Balloon Payment Method and B) Capital Recovery Method.

Problem: 3. ABX Food Ltd. needs Tk. 6,00,000 to finance its intermediate term capital
requirement for remodeling of food processing equipment. NX bank agreed to meet the
requirement at 14% interest. The loan should be repaid in next 7 years. You are required to
show the repayment schedule under A) Balloon Payment Method and B) Capital Recovery
Method.

Problem: 4. Suppose that you want to borrow 10,00,000 TK at the beginning of January 2015
from Eastern Bank ltd with 2% interest bimonthly to be paid over next 3 years. Payment will be
made in equal installment at the end of June and December for next 3 years.

a. How much should be paid in each installment? You are required to prepare a
repayment schedule using capital recovery method.
Problem: 5. YY café plans to borrow 2,00,000 TK at the beginning of January 2015 from Eastern
Bank ltd with 3% interest compounded quarterly to be paid over next 2 years. Payment will be
made in equal installment at the end of April, June, September and December for next 2 years.
b. How much should be paid in each installment? You are required to prepare a
repayment schedule using Balloon method.

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Cost of Intermediate Financing:
Problem 1:

Café C2 ltd needs 2,00,000 TK to finance its capital expenditure and plans to borrow aforesaid
amount in January 2015. Café C2 come into a revolving credit agreement with BRAC Bank ltd for
2 years with a condition that the agreement may convert into a term loan for next 4 years but
bank agrees to 3 years. The bank will charge interest rate 2% & 3.5% over prime rate for
revolving credit and term loan respectively. Today’s prime rate is 8.5% but will increase by 1.5%
from next month as the Bangladesh Bank plans to reduce money supply by contractionary
monetary policy. The company plans to borrow 100000TK at the beginning and 100000TK at the
ending of 1st year with loan commitment fee is 1.5%. At the expiration of revolving credit
agreement the company will take down the full amount as term loan and will repay the same
amount of borrowed amount within agreed period.

 You are inquired to calculate cost of revolving credit and term loan; also calculate
the Effective Interest Rate(EIR).

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