SCHOOL OF ECONOMICS
DEPARTMENT OF ECONOMIC THEORY
EAE 202: FINANCIAL INSTRUMENTS AND RISK MANAGEMENT
Attempt all the questions.
Time 1 hour ONLY
a) Standard Media Group issued a convertible bond that had a coupon yield of 7%, with a
maturity of 20 years in 2003. An investor purchased a bond with a face value of Kshs.
20,000. The bond can only be converted into 400 shares. If the current prevailing share
price for Standard Media Group is Kshs. 30, should the bondholder convert his bond?
b) Faulu Kenya is drafting a Loan agreement to be used in its corporate lending business. The company Lawyer advices that a contractual clause that places specific operating and financial constraints on the borrower must be inserted in the loan agreement.
Highlight the specific actions that this clause should contain. (15 Marks)
The clause should define what the borrower should do and not do i.e. it should have positive and negative covenants:
Positive covenant – requires the borrower to take a specific action. It specifies things that a borrower must do. The borrower is required to:
- Maintain satisfactory accounting records in accordance with generally accepted accounting principles
- Periodically supply audited financial statements that the lender uses to monitor the firm and enforce debt agreement
- Pay taxes and other liabilities when due
- Maintain all facilities in good working order
- Maintain a minimum level of net working capital. Net working capital below the minimum is considered indicative of inadequate liquidity – a common precursor to default
- Maintain life insurance policies on certain key employees without whom the firm’s future would be in doubt – the policy provides financial resources to hire qualified people quickly in the event that a key person dies or is disabled.
- Avoid any default on any debt. A borrower is considered to be in default on all debts if he/it is in default on any debt. (Cross-default covenant)
- Spend the borrowed funds on a proven financial need
Negative covenant – it specifies what a borrower must not do. It includes the following:
- Borrowers may not sell accounts receivable to generate cash because doing so could cause a long-run cash shortage if the borrower uses the proceeds to meet current obligations
- A long-term borrower faces fixed assets restrictions with respect to liquidation, acquisition and encumbrance of fixed assets.
- Borrowers are prohibited from borrowing additional long-term debt or required that additional borrowing be subordinated to the original loan. (Subordination – all other debt will be paid after the claims of the current (senior) debt are satisfied.
- Borrowers may not enter into certain types of leases to limit additional fixed payment obligations.
- The lender may prohibit business combinations by requiring the borrower to agree not to consolidate, merge or combine in any way with another firm. This may change the borrower’s financial and business risk
- The lender may prohibit or limit salary increases for specified employees.
- The agreement may prohibit the borrower’s cash dividend payments from exceeding 50-70 percent of its net earnings