Financing the Axiom precision-forging line
Axiom Components Ltd has 1.2 crore equity shares of ₹10 each and 10% debt of ₹30 crore. Its net worth is ₹60 crore. EBIT is expected to be ₹24 crore next year. It needs ₹50 crore for a new precision-forging line. Three financing plans are being considered: (A) issue 25 lakh equity shares at ₹200 each; (B) raise 12% debt of ₹50 crore; (C) raise ₹25 crore of 12% debt and ₹25 crore of equity at ₹200 per share. The tax rate is 25%. The company’s lenders require interest coverage (EBIT/interest) of at least 3 times and a debt-equity ratio no higher than 1:1 after the project. The board is split: the founder favours debt to avoid dilution, while the independent director warns that demand for forged components is cyclical. The CFO wants an EBIT-EPS analysis plus a risk check before recommending a plan.
1. Compute EPS under each plan at EBIT of ₹24 crore and calculate the indifference EBIT between the all-equity and all-debt plans. Show the formulas.
Read the worked answer
EPS = [(EBIT − interest) × (1 − tax rate)] ÷ number of shares.
Existing interest = 10% × ₹30 crore = ₹3 crore.
Plan A: all equity
- New shares = ₹50 crore ÷ ₹200 = 25 lakh = 0.25 crore; total shares = 1.45 crore.
- Interest = ₹3 crore.
- PAT = (₹24 − ₹3) × 0.75 = ₹15.75 crore.
- EPS = ₹15.75 ÷ 1.45 = ₹10.86.
Plan B: all debt
- Total interest = ₹3 + 12% × ₹50 = ₹9 crore.
- Shares = 1.2 crore.
- PAT = (₹24 − ₹9) × 0.75 = ₹11.25 crore.
- EPS = ₹11.25 ÷ 1.2 = ₹9.38.
Plan C: mixed
- Interest = ₹3 + 12% × ₹25 = ₹6 crore.
- New shares = ₹25 crore ÷ ₹200 = 12.5 lakh; total shares = 1.325 crore.
- PAT = (₹24 − ₹6) × 0.75 = ₹13.50 crore.
- EPS = ₹13.50 ÷ 1.325 = ₹10.19.
Indifference EBIT between A and B: [(EBIT − 3) × 0.75] ÷ 1.45 = [(EBIT − 9) × 0.75] ÷ 1.2 1.2(EBIT − 3) = 1.45(EBIT − 9) 1.2EBIT − 3.6 = 1.45EBIT − 13.05 9.45 = 0.25EBIT EBIT = ₹37.8 crore. Above ₹37.8 crore, debt gives higher EPS; below it, equity gives higher EPS. The same indifference point applies between A and C because C is a linear mix of the two.
2. Using the lender covenants and the cyclicality warning, recommend one plan. Show the covenant calculations and explain the judgement.
Read the worked answer
Covenant check at EBIT ₹24 crore
- Plan A: interest ₹3 crore; coverage = 24/3 = 8.0 times. Net worth after issue = ₹60 + ₹25 = ₹85 crore; debt = ₹30 crore; debt-equity = 0.35. Passes both.
- Plan B: interest ₹9 crore; coverage = 24/9 = 2.67 times. Debt = ₹80 crore; net worth = ₹60 crore; debt-equity = 1.33. Breaches both.
- Plan C: interest ₹6 crore; coverage = 24/6 = 4.0 times. Debt = ₹55 crore; net worth = ₹85 crore; debt-equity = 0.65. Passes both.
At the expected EBIT, Plan A has the highest EPS (₹10.86), followed by C (₹10.19) and B (₹9.38). Plan B only wins above the indifference EBIT of ₹37.8 crore, which is 58% above the current expectation. Given cyclical demand, that is not a prudent margin of safety. Plan B also breaches both lender covenants, so it is not executable without a waiver or equity support.
Recommend Plan A if the promoter can accept dilution, because it preserves financial slack and has the highest EPS at the expected EBIT. If dilution is unacceptable, Plan C is a defensible compromise: it captures some interest tax shield, passes covenants with reasonable headroom, and keeps EPS close to Plan A. Do not choose B on the basis of EPS at a hypothetical higher EBIT. Set a review trigger: if firm orders support EBIT above ₹35 crore with visibility, reconsider debt, but keep coverage above 4 times through the cycle.