Question

Question 4 EBITDA DZ Plc will be in breach of a covenant in the lending facility if the interest coverage, (interest coverage interest charges re). falls below 2. EBITDA is earnings before interest, taxes, depreciation, and amortization. Compliance with the covenants will be checked at the end of the current quarter. If the covenant is breached, the bank can demand immediate repayment of all borrowings on the facility. That action would probably trigger a liquidity crisis for DZ Plc. With a high degree of confidence, you forecast interest charges of £25 million. Your estimate of EBITDA runs from £40 million on the low end to £60 million on the high end. If the outcomes of EBITDA are equally likely, what is the probability that interest coverage fall below 2, breaching the covenant?

Answer 1

Meaning of interest coverage ratio.

it is used by bank or money lending Organization to know borrower ability to pay interest on its outstanding debt.

calculated as follows

Interest Coverage Ratio= Interest Expense / EBIT​DA

Let as calculate interest coverage ratio for two EBITDA level

If the outcome of EBITDA is £40

Probability that interest coverage fall below 2

Coverage ratio=(EBITDA / Interest Charges )

=£40 / £25

=1.6 Times

If the outcome of EBITDA is £60

Probability that interest coverage fall below 2

Coverage ratio=(EBITDA / Interest Charges )

=£60 / £25

=2.4 Times

Since the probability of occurring outcome is equal, the total probability that coverage ratio fall below 2 is as follow

Outcome Level	Coverage Ratio(A)	Probability(B)	Total Probability(A*B)
£40	1.6 Times	.50	0.80
£60	2.4 Times	.50	1.20
			2.00