Aarohi Furniture: Debt or Equity for the Second Production Line
Aarohi Furniture Ltd has 4,00,000 equity shares of Rs 10 each and a term loan of Rs 20,00,000 carrying 10 per cent interest. Earnings before interest and tax last year were Rs 12,00,000. The company needs Rs 20,00,000 to add a second production line, which the finance manager expects to push EBIT up to about Rs 18,00,000 a year; in a recession, however, EBIT could fall to Rs 8,00,000. Two plans are on the table. Plan A: issue 2,00,000 equity shares at Rs 10 each. Plan B: borrow Rs 20,00,000 at 12 per cent, taking total debt to Rs 40,00,000. The tax rate is 30 per cent. The founding family holds 2,40,000 of the existing shares, and the existing lender's covenant caps total debt at 1.5 times net worth. Furniture demand is closely tied to new housing registrations, which have fallen for three quarters. The board meets on Friday and the managing director wants a recommendation, not a lecture.
1. Compute earnings per share under both plans at an expected EBIT of Rs 18,00,000 and at a recession EBIT of Rs 8,00,000. Which plan is better in each case?
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At EBIT Rs 18,00,000
| Plan A (equity) | Plan B (debt) | |
|---|---|---|
| EBIT | 18,00,000 | 18,00,000 |
| Interest (2,00,000 / 4,40,000) | 2,00,000 | 4,40,000 |
| EBT | 16,00,000 | 13,60,000 |
| Tax @ 30% | 4,80,000 | 4,08,000 |
| PAT | 11,20,000 | 9,52,000 |
| Shares | 6,00,000 | 4,00,000 |
| EPS | Rs 1.87 | Rs 2.38 |
At EBIT Rs 8,00,000
| Plan A | Plan B | |
|---|---|---|
| EBT | 6,00,000 | 3,60,000 |
| Tax @ 30% | 1,80,000 | 1,08,000 |
| PAT | 4,20,000 | 2,52,000 |
| EPS | Rs 0.70 | Rs 0.63 |
Reading it: the answer is not 'debt is cheaper'. Debt is better only because EBIT is high enough to cover its fixed charge. Plan B adds Rs 2,40,000 of interest that must be paid whatever the demand for furniture, and in the recession case that fixed charge wipes out the advantage and leaves EPS lower than under equity. The comparison must be made at more than one level of EBIT - a single-point calculation is the trap in this question.
2. Compute the EBIT at which the two plans give the same EPS, and use it to advise the board.
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Set the two EPS expressions equal, cancelling the (1 - 0.30) factor:
(EBIT - 2,00,000) / 6,00,000 = (EBIT - 4,40,000) / 4,00,000 4(EBIT - 2,00,000) = 6(EBIT - 4,40,000) 4 EBIT - 8,00,000 = 6 EBIT - 26,40,000 2 EBIT = 18,40,000, so EBIT = Rs 9,20,000
Check: at Rs 9,20,000 both plans give EPS of Rs 0.84.
What it means: above Rs 9,20,000 of EBIT, debt magnifies EPS because the fixed charge is spread over fewer shares; below it, debt magnifies the loss. This is financial leverage - a lever, not a free lunch.
Advice to the board: expected EBIT of Rs 18,00,000 sits Rs 8,80,000 above the indifference point, which looks comfortable. But the recession case of Rs 8,00,000 sits Rs 1,20,000 below it, and furniture demand is already falling for three quarters. The distance to the downside is short. A defensible recommendation is therefore a hybrid: raise about Rs 12,00,000 by equity and Rs 8,00,000 by debt, which keeps some leverage benefit while keeping interest cover safe in a downturn, or defer the line until housing registrations stabilise. The board should not read the expected-case EPS alone.
3. Besides EPS, what should the board weigh before deciding? Identify the factors that matter here and say which could be decisive.
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Financial risk and cash-flow stability. Interest is a contractual outflow; dividends are not. Furniture revenue follows housing registrations, which have fallen three quarters running, so the firm's cash flows are cyclical - exactly the condition in which a high fixed charge is dangerous. Plan B's interest bill of Rs 4,40,000 is 24 per cent of expected EBIT and 55 per cent of recession EBIT.
Control. This is decisive and is easy to miss. The family holds 2,40,000 shares. Under Plan A the total becomes 6,00,000, so the family falls to 40 per cent and loses its majority; under Plan B it stays at 60 per cent. If control matters more than a few paise of EPS, Plan B wins before any ratio is computed.
Covenant headroom. Net worth is Rs 40,00,000 and Plan B takes debt to Rs 40,00,000 - exactly 1.0 times, inside the 1.5 times cap. But a recession loss would eat net worth and push the ratio up, so headroom is thin.
Flexibility and cost of issue. Equity cannot be repaid; debt can be refinanced or prepaid. Conversely, a Rs 20,00,000 equity issue at Rs 10 is a large float for a small company and may need a discount, raising the effective cost.
Judgement: if the family will not accept 40 per cent, plan B with a shorter tenor or a larger equity slice is the answer; if it will, equity buys the resilience the housing data demands.