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Chapter 7

Example 5

Grass Co has a debt covenant that requires its gearing ratio (measured as
debt/(debt + equity) using market values) to be less than 40%, and its interest
cover to be greater than 2.

Extracts from its recent financial statements show that it has 100,000 $1
shares in issue and it has a 10% interest bank borrowing of $60,000. It made
a profit before interest and tax last year of $15,000.

The current share price is $1.40 per share.

The directors of Grass Co are considering borrowing an extra $20,000 from
the bank as a secured borrowing at an interest rate of 6% per annum.

Annual profits are expected to stay constant, but the share price is expected to
fall to $1.35 per share to reflect the shareholders' perception of increased
financial risk.

Assuming the new finance is raised, which of the following shows Grass
Co's position with regard to its debt covenant:

A Gearing: MET, Interest cover: MET

B Gearing: FAILED, Interest cover: MET

C Gearing: FAILED, Interest cover: FAILED

D Gearing: MET, Interest cover: FAILED

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