The Cooperative's Expansion and the Loan Covenant
A dairy cooperative with annual sales of Tk 400 million is considering a Tk 150 million pasteurisation plant. Its current balance sheet shows total debt of Tk 120 million and equity of Tk 180 million. The plant is expected to add Tk 60 million in annual revenue at a 25% operating margin, with depreciation of Tk 15 million and additional interest of Tk 18 million. The cooperative's bank loan covenant requires a debt-to-equity ratio no higher than 1.0 and interest cover of at least 2.5 times. The bank has offered a 10-year loan at 12%, repayable in equal annual instalments. Members are divided: some want higher milk prices now, others want growth. The cooperative's effective tax rate is 25%.
1. Compute the post-project debt-to-equity ratio and interest cover, and assess covenant compliance.
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Debt-to-equity. New debt is Tk 150 million, taking total debt to Tk 120 + 150 = Tk 270 million. Equity stays at Tk 180 million unless retained earnings are added. Post-project D/E = 270 / 180 = 1.5, well above the 1.0 covenant. Even if first-year retained earnings of roughly Tk 20 million are added, D/E is about 270 / 200 = 1.35, still non-compliant.
Interest cover. New interest is Tk 18 million; existing interest is not given, so state the assumption. If existing interest is, say, Tk 12 million, total interest is Tk 30 million. Incremental operating profit is 25% of Tk 60 million = Tk 15 million. Existing operating profit must be added; if it is Tk 45 million, total EBIT is Tk 60 million. Interest cover = 60 / 30 = 2.0 times, below the 2.5 covenant.
Conclusion. On the stated figures the project breaches both covenants unless the bank grants a waiver, equity is injected, or the loan is structured with a grace period. The cooperative should negotiate before drawing down, not after.
2. Recommend a financing structure that preserves member returns while restoring covenant compliance.
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The cooperative needs to reduce leverage or increase the equity base. Options:
- Member equity contribution. If members subscribe Tk 90 million, debt stays at Tk 270 million and equity rises to Tk 270 million, giving D/E of 1.0. The cost is reduced immediate milk prices, which is the political trade-off members must debate.
- Phased investment. Build a smaller plant first (say Tk 90 million), deferring the balance. This lowers debt to Tk 210 million and equity to Tk 180 million, giving D/E of 1.17 - closer but still above 1.0.
- Longer tenor or grace period. A 15-year loan with two years' grace reduces early principal and interest, improving interest cover in the critical years.
- Blended finance. A government or donor concessional tranche of Tk 50 million as quasi-equity would lower senior debt and improve both ratios.
- Retained earnings policy. Temporarily retaining a larger share of surplus builds equity organically.
The recommended package is a phased plant plus a member equity tranche plus a grace period, because it addresses both ratios simultaneously and keeps the growth option alive. The cooperative should model downside scenarios (milk price falls, margin drops to 15%) before committing.