A company has a covenant on its 5% long-term bond, stipulating that its retained earnings must not fall below...

Step 1: Dividend per share next year

0.045×1.04=0.04680.045 \times 1.04 = 0.04680.045×1.04=0.0468

Step 2: Total dividend payment

0.0468×100 million=4.68 million0.0468 \times 100\ \text{million} = 4.68\ \text{million}0.0468×100 million=4.68 million

Step 3: Interest expense

Bond nominal = 60m

Coupon = 5%

Interest=60×0.05=3.0 million\text{Interest} = 60 \times 0.05 = 3.0\ \text{million}Interest=60×0.05=3.0 million

(Market value is irrelevant for covenant calculations — CIMA F3 rule)

Step 4: Profit after tax

EBIT=11.25\text{EBIT} = 11.25EBIT=11.25 EBT=11.25−3.0=8.25\text{EBT} = 11.25 - 3.0 = 8.25EBT=11.25−3.0=8.25 \text{Tax (20%)} = 1.65 Profit after tax=6.60 million\text{Profit after tax} = 6.60\ \text{million}Profit after tax=6.60 million

Step 5: Retained earnings

6.60−4.68=1.92 million6.60 - 4.68 = 1.92\ \text{million}6.60−4.68=1.92 million

Step 6: Covenant test

Required minimum retained earnings = $2 million

1.92<2.001.92 < 2.001.92<2.00

❌ Covenant breached

✅ Correct Option:

C. Covenant is breached as retained earnings = $1.92 million\boxed{\textbf{C. Covenant is breached as retained earnings = \$1.92 million}}C. Covenant is breached as retained earnings = $1.92 million​