Question

When you are negotiating the borrowing contract with the bank, the bank proposes a restriction that, during the borrowing period, the annual dividend per share paid by the firm can not be higher than the earnings per share in the previous year. What is the terminology in corporate finance for this restriction? And explain why the bank proposes this restriction

Answer 1

Loan Covenant is a condition in a commercial loan or bond issue that will require the borrower to fulfill certain conditions and that will be forbidding the borrower from undertaking any kind of certain action which will possibly restrict certain activities to circumstances when other conditions are met and these are undertakings which are given by the borrower is a part of term loan agreement.

Bank is proposing these restriction because it wants to ensure itself that the risk attached to the loan does not unexpectedly deteriorate prior to the maturity and this will be helpful in recovery of the loan in the longer period of time because of having higher cash on hand of the firm as when the firm will be distributing lesser dividend, it will help the firm in retaining more of the cash and having a higher amount of solvency in their hand and it will help the bank in order to recover then loan without the risk in the longer period of time before maturity.