If a firm issues debt but writes protective and restrictive covenants into the loan contract, then the firm’s debt may be issued at a __ interest rate compared with otherwise similar debt.
A equal
B negative
C lower
D higher
The correct answer and explanation is:
The correct answer is C lower.
When a firm issues debt with protective and restrictive covenants included in the loan contract, the debt typically carries a lower interest rate compared with similar debt without such covenants. These covenants are provisions designed to protect the lender by restricting certain actions the borrower can take and by requiring certain behaviors that reduce the risk of default.
Protective covenants might include limits on the firm’s ability to take on additional debt, restrictions on dividend payments, or requirements to maintain certain financial ratios. Restrictive covenants help ensure the firm manages its operations prudently and maintains financial stability. Because these covenants reduce the lender’s risk by providing mechanisms to monitor and control the borrower’s actions, lenders are more confident in the firm’s ability to repay the loan.
Lower risk means lenders demand less compensation for the loan, which translates to a lower interest rate for the firm. In contrast, if there were no covenants, lenders would face higher uncertainty about the borrower’s behavior and financial health, increasing the risk premium. That would lead to a higher interest rate to compensate lenders for taking on more risk.
In summary, protective and restrictive covenants reduce the lender’s risk exposure. The reduced risk makes the debt less costly for the issuing firm, resulting in a lower interest rate compared to similar debt without such covenants.