Q1) O'Dowell Tool and Machine Company is about to sell $100 million issue of bonds. Covenants on loan need that O'Dowell maintain coverage of its interest plus sinking fund of 2.5 to 1 (remember, sinking fund payment is same as a principle payment). Bonds are to be retired over next 20 years by equal yearly sinking-fund payments and carry an interest rate of 10% per year. Compute the lowest level to which O'Dowell's EBIT can drop in first year the bonds are issued without violating covenants of loan? O'Dowell's tax rate is 40%.
Remember, interest is paid in before-tax dollars where as sinking fund payments are made in after-tax dollars. Each dollar of interest payment needs just one dollar of EBIT to cover it, but to pay dollar in sinking-fund payment in after-tax dollars requires $1.67 of EBIT [before-tax dollars]. After paying 40% tax on $1.67, there will be $1.00 left to cover sinking fund. Hence, to cover one dollar of interest plus one dollar of sinking fund would need $2.67 of EBIT ($1.00 for interest plus $1.00 times 1.67 for sinking fund payment); to cover one dollar of interest plus $0.50 of sinking fund payment would need $1.84 of EBIT.