Backward Integration versus a Fixed-Price Yarn Contract at Meridian Textiles
Meridian Textiles Ltd (revenue ₹2,400 crore, EBITDA margin 11%) exports 60% of its fabric to the EU and US and buys cotton yarn - 48% of raw material cost - on spot terms. Yarn prices ranged between ₹205 and ₹292 per kg over eighteen months. Two options go to the board on 12 April. Option A: a ₹150 crore spinning plant producing 4,800 tonnes a year, the entire requirement, at a cash conversion cost of ₹228 per kg; straight-line depreciation over twelve years to a ₹25 crore salvage; incremental working capital ₹40 crore; tax 25.17%. Option B: a five-year fixed-price supply contract at ₹262 per kg with 85% take-or-pay and a ₹30 crore termination penalty. WACC is 13.5%. Net debt/EBITDA is 2.6x against a covenant of 2.75x, and 60% of any capex would be debt-funded. Treasury notes the rupee depreciated 9% last year. The chairman prefers the plant because it 'removes the vendor from our value chain'.
1. Evaluate the two options on a like-for-like basis and quantify the base-case NPV of Option A. At what alternative yarn price does the plant merely earn its cost of capital?
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First fix comparability. Option B is a five-year price certainty with a re-pricing cliff in year 6 and a ₹30 crore exit penalty; Option A is a twelve-year asset. The relevant cash flow is the avoided purchase cost against the contract price, not the plant's own revenue.
Base case (Option A)
- Annual pre-tax saving = (262 − 228) × 4.8 million kg = ₹16.32 crore
- Depreciation = (150 − 25)/12 = ₹10.42 crore; taxable = ₹5.90 crore; tax @25.17% = ₹1.49 crore
- Operating cash flow = 5.90 − 1.49 + 10.42 = ₹14.83 crore
- Annuity factor, 12 years @13.5% = 5.787; PV of OCF = ₹85.8 crore; PV of salvage = 25 × 0.2187 = ₹5.5 crore
- Working capital: −40 + (40 × 0.2187) = −₹31.3 crore
- NPV = 85.8 + 5.5 − 150.0 − 31.3 ≈ −₹90 crore
A cash conversion margin of ₹34/kg on a ₹150 crore asset is roughly a 10% pre-tax return - below the 13.5% hurdle.
Break-even. Required OCF = (150 + 31.3 − 5.5)/5.787 = ₹30.4 crore. Solving (S − 10.42) × 0.7483 = 30.4 − 10.42 gives S = ₹37.1 crore, i.e. ₹77.3/kg of saving, so the plant only clears the WACC if alternative yarn costs more than about ₹305/kg - above the top of the observed ₹205–292 range.
Judgement. The strategic case (supply security, quality control, a natural hedge between domestic costs and dollar revenues) is real but does not bridge a ₹90 crore gap. Recommend renegotiating Option B with a price collar and a shorter take-or-pay, and revisiting the plant only if the yarn price floor structurally rises.
2. The CFO wants to fund the plant with a seven-year loan at 10.2% and calls the debt covenant a 'bank relationship issue'. Advise the board.
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Quantify the covenant first. Current net debt = 2.6 × EBITDA of ₹264 crore = ₹686 crore. At a 2.75x covenant the ceiling is ₹726 crore - only ₹40 crore of headroom.
Funding 60% of ₹150 crore (₹90 crore) plus ₹40 crore of working capital through debt takes net debt to ₹816 crore. Post-project EBITDA rises by only about ₹16.3 crore to ₹280 crore, giving 816/280 = 2.91x - a breach. On a debt-funded basis the project fails on liquidity before it fails on NPV.
Why 'relationship issue' is wrong. A breach usually triggers a cure period, a margin step-up, a dividend block and, critically, cross-default clauses in other facilities; the 9.5% term loan in any acquisition pipeline would also be at risk. Reporting consequences follow: under Ind AS 1 a loan is classified as current where the lender can demand repayment at the reporting date, and a breach occurring after year-end but before the financial statements are approved is a disclosable non-adjusting event. Concealing it from the board is not an option.
Recommendation. (i) Do not draw the full facility; (ii) test a phased 55–60% capacity build (capex around ₹90 crore) which keeps leverage under 2.75x and preserves the learning curve; (iii) obtain a covenant holiday or an equity cure right before sanction, in writing; (iv) fund the working capital from a rights issue or an asset-backed facility; (v) put Option B in place for the interim so that price volatility is capped while the plant case is re-tested.
3. The treasury head argues the 9% rupee depreciation strengthens the case for the plant. Assess that argument and show how sensitive your conclusion is.
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The argument has a valid core and an offsetting leg.
Valid: Meridian's conversion costs - labour, power, consumables, most cotton lint - are rupee-denominated, while 60% of output is sold in dollars. A weaker rupee widens the export margin and makes domestic conversion structurally more competitive against imported yarn. It also pushes the rupee cost of any dollar-priced imported yarn up, which raises the domestic market price and therefore widens the saving on an in-house plant.
Offsetting: Indian cotton lint itself trades at export parity, so a large part of the raw material basket re-prices upward with the currency. The 9% depreciation is a one-year observation, not a forecast; building a twelve-year irreversible asset on one year's move is precisely the sort of extrapolation that destroys value in cyclical commodity businesses.
Sensitivity. Each ₹10/kg move in the alternative yarn price shifts the annual pre-tax saving by 4.8 × 10 = ₹4.8 crore and the NPV by approximately 4.8 × 0.7483 × 5.787 ≈ ₹21 crore. Even a 15% rise in yarn prices from ₹262 (to about ₹301) leaves the plant at roughly break-even, and that is before any capex overrun or commissioning delay.
Conclusion. Treat the currency as a tailwind for the contract negotiation (argue for a lower collar in a strong-dollar environment), not as the reason to commit ₹150 crore. Present the board with a sensitivity table across yarn price ₹240–₹310 and rupee rates ±10%, and let the decision hinge on whether the ₹305/kg break-even is credible under the strategic view.