Chapter 8 • Sources of long-term finance
It is common for those who lend money to impose conditions or covenantson the
business. Failure to meet these covenants could, depending on the precise contract
between the lenders and the business, give the lenders the right to immediate repay-
ment of the loan.
Typical covenants include:l a restriction on dividend levels;
l maintenance of a minimum current asset/current liability ratio;
l a restriction on the right of the business to dispose of its non-current assets; and
l a restriction on the level of financial (capital) gearing.
The Rank Group plc, the bingo (Mecca) and gaming (Blue Square) business, had to
miss paying its normal dividend to shareholders in 2007 to avoid breaching its loan
covenants.
In its 2007 annual report the rail maintenance business Jarvis plcsaid of a new
loan that it had taken out: ‘The facilities are subject to certain financial covenants and
events of default. Breaches of financial covenants or events of default can be waived
or consented to by the lenders but such waivers or consents may require the payment
of fees and costs to the lenders.’
We shall go more fully in Chapter 11 into the effect on the position of the ordinary
shareholders as borrowings increase.Factors for the potential investor to consider on loan notes
Level of returns
The returns from loan notes tend to be low compared with those expected from equ-
ities and preference shares.Riskiness of returns
Although the level of risk associated with default by the borrowing business tends to
be low, the loan notes holder is usually exposed to another risk, namely interest rate risk.
This is the risk of capital losses caused by changes in the general level of interest rates.‘
An investor has £100 nominal value of perpetual (irredeemable) loan notes, which have a
coupon rate (the rate that the borrowing business is contracted to pay on the nominal value
of the notes) of 6 per cent. The prevailing interest rates and the level of risk attaching to the
particular loan notes cause the capital market to seek a 6 per cent return from them. Since
the loan notes’ return on their nominal value is 6 per cent, the capital market would value the
holding at £100 (the nominal value).
If the general level of interest rates were to increase so that the capital market now sought
a 7.5 per cent return from these loan notes, their value would fall to £80 (that is, the amount
on which the 6 per cent interest on £100 represents a 7.5 per cent return). Thus our loan
notes holder would be poorer by £20.
If the loan notes were not perpetual but redeemable at £100 at some date in the future,
the price would probably not drop as low as £80 on the interest rate change. The closer the
redemption date, the smaller the fall; but irrespective of the redemption position some loss
of value would occur. Clearly, the investor would gain similarly from a general fall in prevail-
ing interest rates, but a risk-averse investor (and most investors seem to be risk-averse)
would be more concerned with the potential loss than with the potential gain.Example 8.4‘