Loan Covenant Test Before a Debt-Funded Special Dividend
A company reports revenue €1,200,000, gross profit €360,000, operating profit €150,000, finance cost €30,000, profit before tax €120,000, tax €15,000 and dividends €45,000. Its statement of financial position shows non-current assets €650,000, inventory €180,000, receivables €220,000, cash €50,000, ordinary share capital €400,000, share premium €100,000, retained earnings €180,000, 8% debentures €300,000, payables €90,000 and tax payable €30,000. The bank covenant requires interest cover of at least 4 times, gearing as debt/equity of no more than 50%, and dividend cover of at least 2 times. The board proposes raising a further €100,000 of 8% debt and using it to pay a special dividend of €100,000, arguing that cash is available and the loan is cheap. The finance director asks you to test the proposal against the covenants before the board meeting.
1. Calculate interest cover, gearing and dividend cover before and after the proposal. State any assumption you make about tax.
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Before the proposal
Interest cover = €150,000 / €30,000 = 5.00 times.
Gearing = debt / equity = €300,000 / €680,000 = 44.1%.
Dividend cover = profit after tax / dividends = €105,000 / €45,000 = 2.33 times.
All three covenants are met.
After the proposal
New debt = €400,000. Finance cost = €30,000 + €8,000 = €38,000. Assuming tax remains €15,000, profit after tax = €150,000 − €38,000 − €15,000 = €97,000. Dividends become €45,000 + €100,000 = €145,000. Equity falls by the €100,000 dividend to €580,000.
Interest cover = €150,000 / €38,000 = 3.95 times.
Gearing = €400,000 / €580,000 = 69.0%.
Dividend cover = €97,000 / €145,000 = 0.67 times.
All three covenants are breached.
2. Assess whether the board's argument that cash is available and the loan is cheap is sound. Refer to the ratios and to one non-ratio factor.
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The argument is not sound. The 8% coupon may look cheap, but the extra debt pushes interest cover below the covenant minimum and raises gearing well above 50%. Dividend cover falls to 0.67, meaning the dividend is not covered by profit. Paying a special dividend out of borrowed money transfers cash to shareholders while increasing the risk borne by lenders. A non-ratio factor is that a covenant breach can trigger accelerated repayment or prevent further drawdowns, damaging the company's refinancing position. The board should also consider future capital expenditure and the fact that the cash balance of €50,000 is needed for working capital.
3. Suggest an alternative that would keep all three covenants, showing indicative figures.
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One alternative is to finance any new investment with equity rather than debt and to limit the total dividend to the amount supported by profit. With no new debt, interest cover stays at 5.00 and gearing stays at 44.1%. To keep dividend cover at 2 times, maximum total dividend = €105,000 / 2 = €52,500. Existing dividends are €45,000, so a special dividend of no more than €7,500 is possible. If €100,000 of equity is raised, equity becomes €780,000, gearing falls to €300,000 / €780,000 = 38.5%, interest cover remains 5.00, and the same €52,500 dividend limit applies. The board should not pay the €100,000 special dividend under the current covenant.