Bond covenants

CFA Level I
#1

Shelby Enterprises recently entered into a new $500mil revolving credit facility. The provisions of the facility requires Shelby to repay the facility before other debt can be retired. Also, if the company’s debt to capital ratio is over 1.0 and their net worth falls below $2bil, Shelby will be prohibited from paying dividends. Indicate why Shelby would agree to the above covenants and state whether Shelby management is more likely to use straightline or DDB depreciation in the short run. Covenants Depreciation method A. lower risk to existing bond & share holders, straightline B. lower company’s interest cost straightline C. lower risk to existing bond & share holders DDB D. lower company’s interest cost DDB Ans: B. I get the decpreciation part, but why cant the answer be A?

#2

if you do not pay dividends as per the covenant, aren’t you increasing risk to the shareholders?

#3

the restrictive covenants allow Shelby to get a higher rating so it does reduce the “bondholder” risk. my thought process is more from the financial side, i ask myself if this will hurt the company’s bottom line or not i.e. via interest costs in this case. so that made me choose B.

#4

if repayment needs to be done before any other payment of debt that would mean that the existing bondholders have increased risk + existing shareholders too because of the div payment

#5

Thanks, it makes a lot more sense now!

#6

I don’t know if it’s necessarily to be so complicated, but when would you as a lender write up a covenant so that other creditors of the comp (not you) can benefit from it?.. if I write a covenant, I’d make sure everything is in my favor, which usually means someone else will take a hit as a result

#7

I’d say B.

#8

liaaba Wrote: ------------------------------------------------------- > I don’t know if it’s necessarily to be so > complicated, but when would you as a lender write > up a covenant so that other creditors of the comp > (not you) can benefit from it?.. > Always if you can, but lenders do not usually write bond covenants (although they would write the contract for a credit facility). Anyway, you can’t always jump into the front spot in the cap structure. Just think about taking out a second mortgage. The second mortgage lender can’t ask you to agree to let him jump into first spot because you’ve already given that privilege to someone else. > if I write a covenant, I’d make sure everything is > in my favor, which usually means someone else will > take a hit as a result Except earlier lenders may not let you… Edit: Also as a lender each of those protections is going to cost you money. If you lend money to someone in some subordinated way you will surely get more interest than if you lend in some unsubordinated way.