) Debt covenants or restrictions are commonly used in lending agreements. Discuss how they are used to reduce agency problems that exist in the relationship between management and lenders. b) Why would management choose to enter into a lending agreement that contains a covenant that restricts the company’s leverage? c) How might a write-down of plant and equipment increase the risk of breaching debt contracts?
Apollo Medical Supplies Ltd borrowed $25 million to finance an investment in a laboratory for developing and testing surgical supplies on 1 July 2019. The loan is due 30 June 2029. The lender insisted on a debt covenant in the loan agreement, specifying that the leverage ratio not exceed 60%. Apollo Medical Supplies Ltd complied with the requirement in 2020 when the ratio of total liabilities to total tangible assets was 58%.
Apollo Medical Supplies Ltd also invested in plant and equipment used exclusively to manufacture polyester surgical masks. However, due to a decline in demand for polyester surgical masks, analysts are predicting that the company may need to write-down some of its plant and equipment.
Required
a) Debt covenants or restrictions are commonly used in lending agreements. Discuss how they are used to reduce agency problems that exist in the relationship between management and lenders.
b) Why would management choose to enter into a lending agreement that contains a covenant that restricts the company’s leverage?
c) How might a write-down of plant and equipment increase the risk of breaching debt contracts?
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