Suppose a new accounting rule causes a company to revalue its inventory, take a one-time hit to earnings and violate an interest coverage covenant. What would you expect its bank lender to do?

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BlackTom AI · Accepted Answer

In evaluating what a bank lender would do when a company revalues its inventory, takes a one-time hit to earnings, and violates an interest coverage covenant, several factors come into play about how lenders manage covenants and credit risk.
Option 1: 'The bank would tell the borrower not to worry about it. In this way the bank preserves its reputation for being cooperative.' This portrayal is unlikely in practice. When a covenant is violated, lenders typically perceive increased credit risk and may take protective actions to safeguard their position. Telling the borrower not to worry would be contradicting standard lending discipline, especially after a covenant breach and an earnings shock from a one-time hit. Banks generally do not publicly downplay a breach or assure smooth, indefinite forbearance without steps.
Option 2: 'A profit-maximizing lender would enforce its rights to declare the loan in default. This means borrower has to repay the loan, or else accept a higher interest rate.' This option aligns more closely with how lenders respond to covenant violations. Covenant breaches, such as violating an interest coverage covenant, give the lender a formal remedy under the loan agreement, often including the right to declare default, accelerate repayment, pursue remedies, or at least demand immediate attention, possible forbearance discussions, or renegotiation. The 'profit-maximizing' framing captures the lender’s incentive to protect value, limit downside, and adjust terms if covenant slack has been breached. 
Additional nuance: while declaration of default is a typical response, many lenders also pursue a staged approach—issuing a waiver, imposing restrictions, or negotiating a remediation period—before outright default. The one-time earnings hit from inventory revaluation may affect earnings quality but is not inherently detrimental to cash flow, whereas the covenant breach directly triggers default pathways unless a waiver or amendment is obtained. 
In sum, the scenario describes risk management that tends toward taking formal protective action (default, acceleration, or renegotiation) rather than a hands-off, laissez-faire stance. The first option underestimates lender discipline and overemphasizes goodwill, whereas the second option captures the conventional lender response to covenant violation and credit risk signals.

IFEPIA7022_001_2025_3 - Economics of Finance EOF Midterm

Suppose a new accounting rule causes a company to revalue its inventory, take a one-time hit to earnings and violate an interest coverage covenant. What would you expect its bank lender to do?

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