I came across the concept of a loan constant the other day and have been doing more digging and am curious all of your opinion on this piece. I’ve always been taught and understood that, ignoring any cash flow concerns, you should always pay off the debt with the lowest interest rate first. In the article below they say the loan constant is better which I have a hard time digesting. Again, assuming the company has strong cash flow, it should not matter what the amortization period is of the loan, only the interest rate, correct? Thoughts?
The rule of thumb is to repay the debt that is the most expensive first, ie with the highest coupon.
But this is subject to quite a few important caveats:
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you also want to repay the nearest maturity first, ie you want to manage the maturity profile of the debt or the refinancing risk.
The idea is, its harder to refinance in an emergency, ie if a maturity is so near that a company is almost forced to accept any term offered to it by the market at thst time. The company wants to refinance on its own terms, ie it should have the option to walk away and wait for better market conditions. -
but also, you want to manage subordination. Subordinated debt is typically more expensive than senior or secured debt. Expensive subordinated debt is regularly refinanced early when a company performs well and replaced by cheaper (ie lower coupon).
This is more relevant in high yield space, where z capital structure might have 4 or 5 layers of subordination. -
typically, the vast majority of financial debt is bullet (all of the principal is repaid at once at maturity). This is because in corporate world an amortising loan rarely matches the risk profile.
Indeed, if a company performs well, ie risk for lenders is lower, you’d rather stay invested longer, since you’re getting paid extra for less risk. If it doesnt perform well, the principal repayment simply increases the cash need of one given tranche at the expense of others.
You see amortising loans on asset finance deals, where the value of the asset decays over time and hence so should a lenders risk.
For these reasons, concepts such as ‘loan constants’ are rarely used in corporate finance.
Typically in practice the aim is to reduce the cash interest while at the same time extending maturities as much as possible (competing objectives).