What would be the primary reason for a company to agree to a debt covenant limiting the percentage of its long-term debt?
a.To reduce the coupon rate on the bonds being sold.
b.To reduce the risk for existing bondholders.
c.To lower the company's bond rating.
d.To cause the price of the company's stock to rise.
Answer:A
Choice "A" is correct. The primary reason for a company to agree to a debt covenant limiting the percentage of its long-term debt is to reduce the coupon rate on NEW bonds being sold. A debt covenant is a provision in a bond indenture (contract between the bond issuer and the bond holders) that the bond issuer will either do (affirmative covenants) or not do (negative covenants) certain things. In this question, the issuer would agree not to issue bonds in the future over a certain percentage of its long-term debt. Such a provision would be good for the potential bondholders and would probably reduce the coupon rate on the bonds being sold.Choice "d" is incorrect. The primary reason for a company to agree to a debt covenant limiting the percentage of its long-term debt is not to cause the price of the company's stock to rise. Bond covenants affect bonds, not equity (at least not directly).
Choice "c" is incorrect. The primary reason for a company to agree to a debt covenant limiting the percentage of its long-term debt is not to lower the company's bond rating. Such a covenant might raise, not lower, a company's bond rating because there would be less risk. Choice "b" is incorrect. The primary reason for a company to agree to a debt covenant limiting the percentage of its long-term debt is not to reduce the risk of existing bondholders, although a reduction in the risk of the existing bondholders certainly might result from such a covenant. As a general rule, more debt means more risk, less debt means less risk. So less debt would reduce the risk of all bondholders.