Growth Financing and a Debt Covenant
Dovecote Foods has sales of ₹480 crore, a net profit margin of 6% and a dividend payout of 40%. It operates at 88% of capacity. Management plans 30% sales growth. The balance sheet shows total assets of ₹432 crore, spontaneous current liabilities of ₹72 crore, debt of ₹200 crore and equity of ₹160 crore. A term-loan covenant restricts debt to 1.5 times equity. The finance team assumes assets and spontaneous liabilities move proportionally with sales, and that the current payout is maintained. The bank will fund any external need first with debt, but will waive the covenant only for a 4% arrangement fee on the new debt. The CFO wants to know whether the growth plan is feasible without an equity issue, and if not, what least-cost adjustment is available. Internal accruals are the only source of equity.
1. Calculate external financing need at 30% growth and test the covenant after debt financing. Does the plan fit?
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Projected sales = 480 × 1.30 = ₹624 crore. Assets at 0.90 × sales = ₹561.6 crore; increase = ₹129.6 crore. Spontaneous liabilities at 0.15 × sales = ₹93.6 crore; increase = ₹21.6 crore. Retained earnings = 624 × 6% × 60% = ₹22.464 crore. EFN = 129.6 − 21.6 − 22.464 = ₹85.536 crore.
If financed by debt: debt = 200 + 85.536 = ₹285.536 crore; equity = 160 + 22.464 = ₹182.464 crore; D/E = 1.565. This breaches 1.5. With the 4% fee on new debt (₹3.421 crore) added to debt, D/E = (285.536 + 3.421)/182.464 = 1.583. The plan is not feasible on the stated terms without an equity injection or a dividend cut. Also, 624 exceeds full-capacity sales of 480/0.88 = ₹545.45 crore, so the proportional asset assumption may understate the fixed-asset investment.
2. If the bank refuses the waiver and the CFO wants to cut the dividend payout, what payout is consistent with the covenant at 30% growth? Comment on whether that is sensible.
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Let R be retained earnings. Debt = 200 + (129.6 − 21.6 − R) = 308 − R. Equity = 160 + R. Covenant: (308 − R)/(160 + R) ≤ 1.5. 308 − R ≤ 240 + 1.5R → 68 ≤ 2.5R → R ≥ ₹27.2 crore. Required payout = 1 − 27.2/(624 × 6%) = 1 − 27.2/37.44 = 27.35%. So the payout must fall from 40% to about 27.4%, assuming no fee and no asset-efficiency change. That is a large cut. Before imposing it, the CFO should test whether the 30% growth is worth the financial flexibility lost, whether the asset/sales ratio can be reduced (for example through receivables), and whether the fixed-asset expansion is really required at that scale. A lower growth rate may meet the covenant with a smaller payout cut.