Meghna Chemicals: Debt or Equity for the Expansion
Meghna Chemicals Ltd has EBIT of ₹40 crore on revenue of ₹320 crore and is entirely equity-financed with 4 crore shares trading at ₹75. The board is considering a ₹120 crore expansion expected to raise EBIT to ₹56 crore. The funding choice is either (A) all equity at ₹75 per share or (B) 12% debt. The tax rate is 25%. The promoter holds 35% and will not accept dilution below 30%. The debt lender requires total debt to be no more than 2.5 times EBITDA; current EBITDA is ₹52 crore and post-expansion EBITDA is expected to be ₹72 crore. The CFO also wants to know how far EBIT can fall before the debt plan's EPS becomes worse than the equity plan's, and whether a 20% EBIT shortfall would breach the interest coverage comfort level of 3 times.
1. Compute EPS under the equity and debt plans at EBIT of ₹56 crore, and the EBIT-EPS indifference point. Interpret the result.
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Equity plan: new shares = 120/75 = 1.6 crore; total 5.6 crore. EPS = 56 × (1 − 0.25)/5.6 = 42/5.6 = ₹7.50.
Debt plan: interest = 12% × 120 = ₹14.4 crore. EPS = (56 − 14.4) × 0.75/4 = 31.2/4 = ₹7.80.
Indifference: E × 0.75/5.6 = (E − 14.4) × 0.75/4 → 4E = 5.6E − 80.64 → E = ₹50.4 crore.
At the expected EBIT of ₹56 crore, debt gives higher EPS by ₹0.30. The margin of safety is (56 − 50.4)/56 = 10%. Below ₹50.4 crore, equity gives higher EPS. The indifference point must be read with the promoter constraint, because the equity plan may not be feasible at all.
2. Assess the promoter dilution and the debt covenant. Which plan should the CFO recommend?
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Promoter holding: equity plan 1.4/5.6 = 25%, below the 30% floor, so the promoter will block it unless the issue price is raised or a rights issue is structured. The debt plan keeps 35%. Covenant: debt/EBITDA = 120/72 = 1.67x, below 2.5x; interest cover = 56/14.4 = 3.89x, above the 3x comfort level. The debt plan meets both financial constraints and gives higher EPS. Recommend the debt plan, but with conditions: preserve headroom under the 2.5x covenant in a downside case, avoid further debt for working capital, and consider a small equity raise later if EBIT growth disappoints. The 10% EBIT margin of safety is thin, so the board should stress-test at ₹44.8 crore before committing.
3. If EBIT falls 20% short of the expected ₹56 crore, what happens to EPS under the debt plan and to interest coverage? What does this imply for the recommendation?
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A 20% shortfall gives EBIT = ₹44.8 crore. Debt-plan EPS = (44.8 − 14.4) × 0.75/4 = 22.8/4 = ₹5.70. Equity-plan EPS = 44.8 × 0.75/5.6 = 33.6/5.6 = ₹6.00. Debt now gives ₹0.30 less EPS because EBIT is below the ₹50.4 crore indifference point. Interest cover = 44.8/14.4 = 3.11x, still just above 3x. If EBITDA also falls 20% to ₹57.6 crore, debt/EBITDA = 120/57.6 = 2.08x, below 2.5x. The debt plan survives but with little cushion. Implication: recommend debt, but stage the capex or arrange a standby equity facility; do not treat the base-case 3.89x cover as comfortable. The promoter constraint still rules out the all-equity plan, so the real choice is debt versus a smaller or deferred project.