Question:
Company is about to sell a $100 million issue of bonds. The covenants on the loan require that Company maintain a coverage of its interest plus sinking fund of 2.5 to 1 (remember a sinking fund payment is the same as a principle payment). The bonds are to be retired over the next 20 years by equal yearly sinking -fund payments and carry on interest rate of 10% per year. What is the lowest level to which Company's EBIT can drop without violating the covenants of the loan? Company's tax rate is 40%.
Remember, interest is paid in before- tax dollars while sinking fund payments are made in after-tax dollars. Each dollar of interest payment requires 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 to cover the sinking fund. Thus to cover one dollar of interest plus one dollar of sinking fund would require $2.67 of EBIT ($1.00 for the interest plus $1.00 times 1.67 for the sinking fund payment); to cover one dollar of interest plus $0.50 of sinking fund payment would require $1.84 of EBIT.