Sealex Ltd has a fixed rate term loan of $2 million at an interest rate of 8.75

Question

Sealex Ltd has a fixed rate term loan of $2 million at an interest rate of 8.75 percent per annum. The Company has earnings before interest and tax (EBIT) of $1.4 million per annum. A covenant in the term loan agreement specifies that EBIT must be atleast 3.5 times greater than the total interest paid on the company's debt. The director of Sealex are planning to raise additional debt by borrowing at a variable rate, initially 7.5 percent per annum. what is the maximum amount that Sealex can borrow on these terms?

Explanation / Answer

Their EBIT is 1.4 million, so dividing that by 3.5 gives 400,000, which is the amount of interest they can pay out. They already pay 8.75% on 2 million which is 175,000. Subtracting that amount from the 400,000 gives 225,000, which is the maximum amount of interest they have left to pay out under the covenant. To find out how much they can borrow, you take 225,000 and divide it by the interest rate, currently 7.5%, and you get $3 million for the maximum they can borrow.

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