RES exam question on Financing: Lim Holdings owns a small office building producing net operating income of $120,000…
Lim Holdings owns a small office building producing net operating income of $120,000 a year. Its bank loan costs $60,000 a year in interest and $30,000 a year in principal repayments. The bank reviews the loan against its covenants. (i) The interest cover ratio is 2.0 times, net operating income divided by the interest alone. (ii) The debt service coverage ratio is about 1.33 times, as principal repayments are added to the interest. (iii) The debt service coverage ratio is higher than the interest cover ratio, because it leaves principal out. (iv) A covenant requiring a debt service coverage ratio of at least 1.5 times is met. Which of the statements above is/are correct?
- A(i) and (ii) only
- B(i), (ii) and (iv) only
- C(ii) and (iii) only
- D(i), (iii) and (iv) only
Show answer & explanation
Answer
A. (i) and (ii) only
Explanation
Answer: (i) and (ii) only. DSCR adds principal to interest, so at about 1.33 times it sits below the 2.0 times ICR and fails a 1.5 covenant.(i) True. $120,000 / $60,000 = 2.0 times.(ii) True. $120,000 / $90,000 = about 1.33 times.Rule: ICR is net operating income divided by interest. DSCR divides it by interest plus principal, so for an amortising loan DSCR is always the lower.
Why the other options are wrong
- (iii) False. DSCR includes principal, which is why it is lower than ICR.
- (iv) False. 1.33 is below 1.5, so the covenant is not met.
Study the concept behind this question: Home Loan Rate Types & Refinancing (fixed, floating, SORA)
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