Debt Covenants and Cost of Capital

July 8th, 2010 by hackel Leave a reply »

Debt covenants pertaining to the entity’s most restrictive requirements must be calculated in each reporting period and all covenants that are disclosed must be reviewed for closeness to violation. Each quarter, we determine which debt, income, working capital and other covenants might be exposed over the coming two years.

If the entity might be required to raise capital to reduce leverage to avoid violating a condition, the likelihood of such a raise must be appraised, as should the need for, and probability for success of (including cure resulting from), an asset sale. The violation of a covenant requires the assistance of investors and creditors and thus the relationship with such parties must also be assessed. Although some covenant violations are relatively easier to cure than others, such as a violation caused by a change in an accounting standard, the entity must stand ready to address remedies to any current or future violation.

The effect of, and possibility of, cross-defaults must be explored, including an examination of the entity’s holders of debt securities, should the possibility of breach exist.
Any forbearance issued would result in a large penalty to cost of capital. If the entity is unable to bring its debt payments current, foreclosure and bankruptcy are imminent. Even if the entity can satisfy its creditors, it often comes at a large cost to equity holders.

If the analyst believes it more likely than not a violation will occur and a remedy questionable, the entity’s cost of capital would be marked up at least two percentage points, with the amount dependant on the severity and likelihood of a cure. If a probable violation could result in bankruptcy, the mark up to cost of capital could be in excess of 20 percentage points. At this stage, analysis becomes one of asset and liquidation values and re-organization cost estimates.

Kenneth S. Hackel, C.F.A.
CT Capital LLC


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