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Unformatted text preview: (4) maintain all facilities in good working order.
Restrictive Provisions Bond indentures also normally include certain
restrictive covenants, which place operating and financial constraints on the
borrower. These provisions help protect the bondholder against increases in borrower risk. Without them, the borrower could increase the firm’s risk but not
have to pay increased interest to compensate for the increased risk.
The most common restrictive covenants do the following:
1. Require a minimum level of liquidity, to ensure against loan default.
2. Prohibit the sale of accounts receivable to generate cash. Selling receivables
could cause a long-run cash shortage if proceeds were used to meet current
3. Impose fixed-asset restrictions. The borrower must maintain a specified level
of fixed assets to guarantee its ability to repay the bonds. subordination
In a bond indenture, the stipulation that subsequent creditors
agree to wait until all claims of
the senior debt are satisfied. 4. Constrain subsequent borrowing. Additional long-term debt may be prohibited, or additional borrowing may be subordinated to the original loan.
Subordination means that subsequent creditors agree to wait until all claims
of the senior debt are satisfied.
5. Limit the firm’s annual cash dividend payments to a specified percentage or
Other restrictive covenants are sometimes included in bond indentures.
The violation of any standard or restrictive provision by the borrower gives
the bondholders the right to demand immediate repayment of the debt. Generally, bondholders evaluate any violation to determine whether it jeopardizes the
loan. They may then decide to demand immediate repayment, continue the loan,
or alter the terms of the bond indenture. sinking-fund requirement
A restrictive provision often
included in a bond indenture,
providing for the systematic
retirement of bonds prior to their
maturity. Sinking-Fund Requirements Another common restrictive provision is a
sinking-fund requirement. Its objective is to provide for the sy...
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