Managing business finance Essay Example | Topics and Well Written Essays - 1750 words

Managing business finance - Essay Example In a Collateralized Loan Obligation, an investor is entitled to receive periodic debt payments as interests from the underlying loans and at the same time assume the major part of the risks related to the underlying loans in the event of the default of loans. The Collateralized Loan Obligations offers higher benefits and opportunities for the investors by creating the scopes for greater diversity and the chances of returns which are higher than the average returns from other securities. Banks sell these securities with slices and tranches which reflect varied levels of seniority in respect of matching the risk versus rewards profiles of the loans. The following example can be used to understand the working of the Collateralized Loan Obligations. Assume that a corporation is willing to take a debt of USD 100 million to finance its business expansion process and that this corporation has assets which have a valuation of USD 20 million. The cost of debt for the loan is taken to be 5% per annum and the risk free rate of return is 1% per annum. The corporation issues a USD 100 million of debt structures which includes a top trance of USD 40 million and a bottom tranche of USD 60 million. The top tranche would be backed up by the assets of the company so that in the event of credit default, the investors can pay off the loan by selling off the assets to recover the investment. The interest rate in this case is 2.5% per annum. The bottom tranche of USD 60 million does not have any backing even in the event of credit default. For this case, the interest rate per annum would be 6%. For the Collateralized Loan Obligations, the rate of interest would be calculated as follows: This cost of debt is lower than the cost of debt calculated in average. Therefore, it is cost effective and attractive for investment purposes. The