Sinking fund payments for issue of bonds
O'Dowell Tool and Machine Company is about to sell a $100 million issue of bonds. The covenants on the loan require that O'Dowell maintain a coverage of its interest plus sinking fund of 2.5 to 1 (remember, a sinking fund payment is the same as a principle payment). The bonds are to be retired over the next 20 years by equal yearly sinking-fund payments and carry an interest rate of 10% per year. What is the lowest level to which O'Dowell's EBIT can drop in the first year the bonds are issued without violating the covenants of the loan? O'Dowell's tax rate is 40%.
Remember, interest is paid in before-tax dollars while sinking fund payments are made in after-tax dollars. Each dollar of interest payment requires just one dollar of EBIT to cover it, but to pay a dollar in sinking-fund payment in after-tax dollars requires $1.67 of EBIT [before-tax dollars]. After paying 40% tax on $1.67, there will be $1.00 left to cover the sinking fund. Thus, to cover one dollar of interest plus one dollar of sinking fund would require $2.67 of EBIT ($1.00 for the interest plus $1.00 times 1.67 for the sinking fund payment); to cover one dollar of interest plus $0.50 of sinking fund payment would require $1.84 of EBIT.