Question

(cost of restrictive covenant) peachtree construction has a restrictive covenant in a loan contract that essentially prohibits the expansion of the firm into a new line of business that it is considering. the cost of this restriction is estimated to be $20 million. The debt can be called off and paid early by paying a $5 million penalty. What should peachtree do?  

Answer 1

First of all we have to know about the Restrictive Covenant.

A restrictive covenant between a Bank and an Company( in this question, assume the loan is provided by the Bank), is ussualy to safegaurd the loan given by the bank. Banks issue Restrictive Covenant so that the company is unable to sell its assets. there are varieties of Restrictive Covenant which deals with selling of fixed assets and it may prohibit the company even at appointing Independent directors. From the banks point of View this Restrictive Covenant is to safegaurd the loan they have provided. but from the companies poit of view it restricts the powers of the board.

In the case above Peachtree constructions have bought a loan with Restrictive Covenant which prohibits the company from expanding its business into a new stream.

Cost of Restriction : $ 20 Million

Penalty if loan called of early: $ 5 Million

Total possibility of cost : $ 25 Million

If Peachtree Construction's new business line has a scope of profiting the company with more than $25 million as early as possible, Peachtree constructions can call off the debt and incur an expense of $25 Million.

If Peachtree Construction's Future goal doesn't match up with the expenses they can wait for the loan period to end or can send a requisition stating the profitability of the new business stream to the lenders, as they hold the power of relaxing the Restrictive Covenant.