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Lecture8 - raising capital debt equity covenants

asset covenants state what lenders get in default

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Unformatted text preview: ers Bonding covenants specify how covenants are enforced 9 Covenants (cont.) Asset covenants state what lenders get in default – Senior bonds have priority in bankruptcy – Junior bonds have subordinated claims – Secured bonds (specific assets are pledged) – Restrictions on acquisitions Dividend covenants prevent managers from liquidating Dividend the firm, paying out the cash to shareholders, and leave bondholders penniless bondholders Financing covenants restrict new debt issues that would Financing dilute the claim of existing debt holders (unless the firm is financially strong) is 10 Covenants and Financial Ratios Asset and financing covenants are generally Asset written in terms of financial ratios written Minimum net working capital or net worth Minimum interest coverage ratio Minimum ratio of fixed assets to total debt Maximum leverage When the firm cannot meet a financial ratio When condition, it is technically in default even if it has maid the required payments to lenders maid 11 Covenants Affecting the Pattern of Payoffs Sinking funds require that a certain portion of the bonds are retired before maturity. bonds A typical sinking fund on a 30 year bond might typical ensure that 25% of the bonds are retired between years 10 and 20. years The firm makes payments to the trustee, who then The repurchases randomly chosen bonds. repurchases Callable bonds give firms the right to redeem the bond before maturity at a stated price. bond Useful if interest rates are expected to fall. 12 Covenants affecting the pattern of payoffs Convertible bonds give the holder the right to exchange the bond for common stock of the company. The convertible debt contract must specify: The – The security issuable upon conversion (stock in general) – Duration of the conversion period – when can be converted – Conversion price at which the stock can be acquired – Anti-dilution provisions: protect the conversion privilege against Anti-dilution stock splits, stock dividends, or issuance of other convertibles stock – Other details Useful when shareholder-bondholder conflicts make straight Useful debt issues costly (more on this on capital structure section) debt 13 Bonding Covenants Bonding covenants specify a bonding mechanism – a provision ensuring that the borrower will uphold the covenants in the contract covenants They are intended to reduce monitoring costs to debt They holders (and thus bond yields) holders Supply informatio...
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