Possible Violation of Debt/Asset Covenant
Assume you have just conducted a preliminary analysis of your firm’s 1999 financial statements. The firm has not prospered in recent years, and you are particularly concerned about violating a provision of a loan agreement you have with a local bank. Your firm has a $200,000, nine percent bank loan due in 2001. One provision of the loan agreement is that your firm’s debt-to-total assets ratio does not exceed 50 percent. Your review of the 1999 financial statements indicates a ratio of 58 percent.
You are very confident that violation would result in a renegotiated interest rate of about 10.5 percent. Your firm would find meeting this higher interest charge to be quite difficult.
The only alternative to violating this provision that you can think of is to change depreciation methods. Currently, your firm uses double-declining-balance.
You have calculated that changing to the straight-line method would reduce your debt-to-total assets ratio to 49 percent.
Required
a. How much additional interest expense would be incurred if the loan agreement is violated?
b. What are the ethical implications of this decision?
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