Introduction to Corporate Finance

PART 4: CAPITAL STRUCTURE AND PAYOUT POLICY

6 The borrower must maintain life insurance policies on certain key employees without whom the

company’s future would be in doubt (so-called ‘key-man insurance’).

7 The borrower is often considered to be in default on all debts if it is in default on any debt to any

lender. This is known as a cross-default covenant.

8 Occasionally, a covenant specifically requires the borrower to spend the borrowed funds on a specific

project or financial need.

Negative Covenants

Negative covenants specify what a borrower must not do. Common negative covenants include the

following:

1 Borrowers may not sell receivables, because doing so could cause a long-run cash shortage if the

borrower uses the proceeds to meet current obligations.

2 Long-term lenders often impose fixed asset restrictions. These constrain the company with respect

to the liquidation, acquisition and encumbrance of fixed assets, because any of these actions could

damage the company’s ability to repay its debt.

3 Many debt agreements prohibit borrowing additional long-term debt or require that additional

borrowing be subordinated to the original loan. Subordination means that junior creditors must wait

until all claims of the senior debt are satisfied in full before having their own claims satisfied.

4 Borrowers are prohibited from entering into certain types of leases to limit their additional fixed-

payment obligations.

5 Occasionally, the lender prohibits business combinations by requiring the borrower to agree not

to consolidate, merge or combine in any way with another company, because such action could

significantly change the borrower’s operating and financial risk.

cross-default covenant

A positive debt covenant

in which the borrower is

considered to be in default on

all debts if it is in default on

any debt

What are negative covenants,

and how do they benefit lenders?

thinking cap
question

subordination

Agreement by all subsequent

or more junior creditors to

wait until all claims of the

senior debt are satisfied in

full before having their own

claims satisfied

finance in practice

ISLAMIC FINANCE: HOW DO YOU SELL BONDS WHEN YOU CANNOT CHARGE

INTEREST?

The past two decades have witnessed a dramatic

increase in the issuance of financial securities that

fulfil the principles of Islamic law, or sharia. While

there are many nuances, three fundamental features

of compliance with sharia stand out. First, interest

cannot be charged or earned. In place of interest,

loans are structured as investment partnerships

• where the bank’s or bondholder’s return comes
  in the form of a share of profits – or by structuring
  loan payments as fees or dividends rather than
  interest. Second, to earn a return, lenders (such as
  banks) must bear ownership risk in real assets (that
  is, not purely financial assets). Ownership risk means
  that the lender cannot just benefit on the upside,

but must also be exposed to risk that an asset can

decline in value. Third, Islamic loans cannot be used

to fund prohibited activities, such as gambling or

adult entertainment.

In the Western world, when a company wants to

buy a machine or other asset, it often first borrows

the needed funds from a bank in a purely financial

transaction, paying interest on the loan. Under the

rules of Islamic finance, rather than charge interest,

the bank would instead (at least partially) own the

machine, and charge the company to use it. This

approach is akin to leasing, where a lender (lessor)

buys an asset and allows a lessee to use the asset in

exchange for a rental fee. The lessor earns a return

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