Question

Bond covenants restrict firm activities. However, they increase shareholder value. Explain how this is so with your analysis and example, (please to explain with your words and don't just copy-paste from google)

Answer 1

Bond helps is increasing wealth of shareholder's as it tax deductible expense. As long as ROI is greater than interest expense on the bond, it will generate higher returns for shareholder. We shall understand it with help of following example.

Suppose there are two companies A and B. A has raise 100 million frome equity and B has raise 60 million from equity and 40 million from debt with interest rate of 10%. ROI for both the firm is same i.e. 20% The tax rate is 30%. Calculate income after tax for both the firm and calculate Return on Equity.

Equity = 100 Million
ROI = 100*20% = 20 Million
Tax = 20*30% = 6 Million
Total Income after Tax/Net Income = 14 Million

Return on Equity = Net Income/Equity = 14/100 = 0.14 Million

Firm B

Equity = 60 Million
Debt = 40 Million
ROI = 100*20% = 20Million
Interest Expense = 40*10% = 4Million

Profit before Tax = 16 Million
Tax = 16Million*30% = 4.80Million
Profit after tax/Net Income = 11.20 Million

Return on Equity = 11.20/60 = 0.19 Million

Clearly firm B has higher ROE than firm A. Hence, bond covenant restrict firms activities. However, if ROI is greater than interest expense of bond, the wealth of shareholder increases.

If you have any doubt, ask me in the comment section please.