Question: Assume that The Gap Inc. has credit agreements that require a long-term liability to EBITDA ratio that does not exceed 3:1. Financial requirements such as this are called loan or credit covenants. The violation of a loan or credit covenant can result in the debt becoming due immediately, as well as requirements to pay additional interest and penalties. The long-term liabilities of The Gap Inc. at the end of 2005 and 2004 were $2,870 and $3,518 respectively.
1. Based upon your answer to Case, determine whether The Gap Inc. is in compliance with the loan covenant for 2005 and 2004. Round to one decimal place.
2. Assume that long-term debt does not change during 2006. Also, assume the following operating data for 2006:
Interest expense $200
Depreciation and amortization 650
Income before income taxes 300
Given this information, will The Gap Inc. violate its loan covenant in 2006? Show your computations. Round to one decimal place.
3. Assuming that during 2006 the long-term debt does not change, how much would EBITDA have to decline before The Gap Inc. would violate the covenant?