On 1 July 2019, COVID Supplies Ltd borrowed $30 million to finance an investment in a laboratory for developing and testing surgical supplies. The loan is due on 30 June 2029.

The lender insisted on a debt covenant to the loan agreement, specifying that the ratio of total liabilities to total tangible assets not exceed 65%.

Covid Supplies Ltd met with the requirement in 2020 when the ratio of total liabilities to total tangible assets was 64%.

Covid Supplies Ltd also invested in plant and equipment used exclusively to manufacture latex gloves. However, due to a decline in demand for latex gloves, analysts are predicting that the company may need to write-down some of its plant and equipment.

Required:

Debt covenants or restrictions are commonly used in Australian lending agreements.

(a)Explain why management would choose to enter into a lending agreement that contains a covenant that restricts the leverage of the company. (2marks)

(b)If a company is close to breaching its leverage covenant what actions might it take?

(Refer to Agency theory in your answer). (4 marks)