Debt covenants and agency relationships 

On 1 July 2022, Medical Supplies Ltd borrowed \$15 million to finance an investment in a laboratory for developing and testing surgical supplies. The loan is due 30 June 2032. The lender insisted on a debt covenant in the loan agreement, specifying that the ratio of total liabilities to total tangible assets not exceed \(65 \%\). Medical Supplies Ltd complied with the requirement in 2023 when the ratio of total liabilities to total tangible assets was \(64 \%\).

Medical 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 

1. Debt covenants or restrictions are commonly used in Australian lending agreements. Discuss how they are used to reduce agency problems that exist in the relationship between management and lenders.

2. Why would management choose to enter into a lending agreement that contains a covenant that restricts the company's leverage?

3. How might a write-down of plant and equipment increase the risk of breaching debt contracts?

4. If a company is close to breaching its leverage covenant what actions might it take?