What is a debt covenant and why is it used in a lending agreement? - Debt covenants are restrictions or undertakings imposed in debt contracts. Debt covenants reduce the risk to the lender, resulting in lower interest costs being imposed on the borrower. Some debt covenants use accounting numbers. For example, a debt covenant may restrict leverage to a maximum of 60 per cent of total assets. By agreeing to debt covenants, managers may be able to borrow funds at lower rates of interest.
- Debt contracts will often restrict investment opportunities of the firm, including mergers and takeovers, to protect themselves against the additional risk arising from asset substitution. Establishing a maximum ratio of debt to tangible assets can also mitigate asset substitution by restricting investment in intangible assets. Restricting higher priority debt is a common method of reducing the risk of claim dilution.
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