Barbara Carlyle Case Scenario Mock A Morning Session

The most recent bond issue includes a covenant that limits the company’s D/E ratio to 35%. She asks Lee to prepare an analysis for Avignon, using the information in Exhibit 3, to see if the debt covenant will be violated if the company repurchases shares. Info provided:

Book value of equity C$3,600 million

Shares outstanding 200 million

Expected share repurchase price (at market) C$32.00

Cash available for repurchase C$155 million

Debt- to- equity ratio 30.0%

After- tax cost of debt 5.0%

The best answer to Carlyle’s question about the potential violation of the debt covenants is that the covenant:

A will be violated if Avignon uses debt to finance the repurchase.

B will be violated if Avignon uses the surplus cash to finance the repurchase.

C is not violated if Avignon repurchases shares.

A is correct. The debt- financed repurchase increases the debt- to- equity ratio above the 35% threshold and thus violates the debt covenant. Book value of equity (millions) Exhibit 3 C$3,600 Cash available for purchase (millions) Exhibit 3 C$155 Debt- to- equity ratio (D/E) before Exhibit 3 30.0% Book value of debt (millions) 30% × C$3,600 C$1,080 D/E with cash repurchase C$1,080 ÷ (C$3,600 – C$155) 31.3% D/E with debt- financed repurchase (C$1,080 + C$155) ÷ (C$3,600 –C$155)

Typically we use MV’s for corp structure problems. Why are BV’s used for D/E calculation for debt covenants?

For a covenant, the restrictions are based on book values. If you have a restrictive covenant like a D/E ratio, it wouldn’t make sense to use market values since they fluctuate so much. I think where you’re getting confused is that MVs are used in valuation. This problems looks at the changing balance sheet strucuture to see if violations would occur based on certain actions.

Thank you