The Refinancing Window That Closes Early
Kestrel Engineering Ltd has a BDT 40 crore term loan at 11.5% fixed, repayable in equal annual instalments over the remaining six years. The CFO can refinance now at 9.8% fixed for five years, but the lender charges a 2.0% arrangement fee on the new principal and a 1.5% prepayment penalty on the outstanding balance. The company's effective tax rate is 25%. Free cash flow last year was BDT 3.2 crore after debt service, and the covenant requires a debt-service coverage ratio of at least 1.30 in every year. The CFO argues the 170 basis point saving is obviously worth it; the treasurer worries the fee load and a tighter amortisation profile will breach the covenant in year one. The board wants a decision at Friday's meeting.
1. Quantify whether the refinancing is value-accretive on a present-value basis before any covenant test. What discount rate is defensible and why?
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Frame the cash flows. The relevant comparison is not the coupon differential but the incremental cash flows of refinancing versus staying.
- Old loan: BDT 40 crore at 11.5%, six equal instalments of about BDT 6.67 crore principal plus declining interest.
- New loan: refinance the outstanding balance, pay the 1.5% prepayment penalty (about BDT 0.60 crore), and borrow the balance plus the 2.0% fee so the principal rises to roughly BDT 41.2 crore at 9.8% over five years.
- Interest tax shield: interest is deductible, so the effective cost of each loan is the coupon times (1 − 0.25). The 170 bp saving is worth about 128 bp after tax on the outstanding balance each year.
Discount rate. Use the after-tax cost of debt on the new facility (9.8% × 0.75 ≈ 7.35%), not the WACC. Refinancing changes only the debt side of the capital structure, so discounting at WACC would misprice the decision and smuggle in an assumption that the project risk equals firm risk. A case could be made for the pre-tax cost of debt if you are consistent, but mixing pre-tax flows with an after-tax rate is the classic error here.
Verdict. The annual after-tax saving on roughly BDT 40 crore is about BDT 0.51 crore, giving a five-year annuity of about BDT 2.1 crore discounted at 7.35%, versus upfront costs of about BDT 1.4 crore (penalty plus fee). The net present value is modestly positive but thin - perhaps BDT 0.5–0.7 crore - and highly sensitive to the shorter five-year amortisation. The treasurer is right that the headline 170 bp overstates the prize; the CFO is right that it is probably still positive. The decision should turn on the covenant, not the NPV.
2. Test the year-one debt-service coverage ratio under the new facility and advise the board.
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Build the year-one debt service. Under the new five-year facility, principal repayment is about BDT 41.2 crore ÷ 5 ≈ BDT 8.24 crore. Year-one interest at 9.8% is roughly BDT 4.0 crore, so total debt service is about BDT 12.2 crore.
Compare with cash available. Last year's free cash flow after debt service was BDT 3.2 crore, meaning cash available for debt service was roughly BDT 3.2 crore plus the old year's debt service. The old year-one service was about BDT 6.67 crore principal plus BDT 4.6 crore interest, roughly BDT 11.3 crore, so cash available is around BDT 14.5 crore.
DSCR. 14.5 ÷ 12.2 ≈ 1.19, below the 1.30 covenant. The old facility's DSCR was about 14.5 ÷ 11.3 ≈ 1.28 - already only marginally compliant. The refinancing compresses the amortisation into five years instead of six and adds fee-driven principal, so the covenant is breached in year one even though the interest cost falls.
Advice to the board. Do not sign on the current terms. Options: (a) negotiate a five-year facility with a one-year interest-only or balloon structure to cut year-one principal to about BDT 5 crore, lifting DSCR to roughly 1.4; (b) extend amortisation to seven years; (c) roll the arrangement fee into year two or pay it from cash rather than capitalising it; (d) seek a covenant waiver for year one as a condition of closing. The economically correct answer is not 'refinance' or 'don't' but 'refinance only on a structure that preserves the covenant headroom', because a breach triggers cross-default and removes the very flexibility the deal was meant to buy.