Financing a New Line: Equity Dilution versus Debenture Leverage
Nirmal Precision Ltd, a Nashik auto-component maker, has 80 lakh equity shares of ₹10 each and ₹4 crore of 12% term debt. Promoters hold 60% and have told the board they will not accept dilution below 30%. The company needs ₹12 crore for a new machining line. Proposal A is a further equity issue of 1.2 crore shares at ₹10. Proposal B is ₹6 crore of 11% debentures plus 60 lakh equity shares at ₹10. Expected EBIT after the expansion is ₹4.8 crore; current EBIT is ₹3.2 crore. Corporate tax is 25%. The lending bank requires interest coverage of at least 3 times. Equity issue expenses are 5% of gross proceeds; debenture issue expenses are 2%. The managing director wants the higher EPS option, while the finance director is worried about fixed charges. No other debt is outstanding.
1. Compute EPS and interest coverage under Proposal A and Proposal B at the expected EBIT of ₹4.8 crore. Present the calculations clearly.
Read the worked answer
Base figures
- Existing shares = 80 lakh; existing interest = ₹4 crore × 12% = ₹0.48 crore.
- Tax = 25%, so PAT = PBT × 0.75.
| Item | A: all equity | B: debt + equity |
|---|---|---|
| New shares | 1.20 crore | 0.60 crore |
| Total shares | 2.00 crore | 1.40 crore |
| Interest | ₹0.48 crore | ₹1.14 crore |
| EBIT | ₹4.80 crore | ₹4.80 crore |
| PBT | ₹4.32 crore | ₹3.66 crore |
| PAT | ₹3.24 crore | ₹2.745 crore |
| EPS | ₹1.62 | ₹1.96 |
| Interest coverage | 10.0× | 4.21× |
At the expected EBIT, B gives higher EPS and still satisfies the 3× covenant. A has safer coverage but lower EPS. Flotation costs are not in the EPS table; on a net-proceeds basis the equity issue would need a larger gross issue, so A's EPS would be slightly lower still.
2. Calculate the EBIT indifference point between the two proposals and explain what it means for the board's decision.
Read the worked answer
Set the two EPS expressions equal:
(EBIT - 0.48)(0.75) / 2.00 = (EBIT - 1.14)(0.75) / 1.40
Cancel 0.75:
(EBIT - 0.48) / 2 = (EBIT - 1.14) / 1.4 1.4(EBIT - 0.48) = 2(EBIT - 1.14) 1.4EBIT - 0.672 = 2EBIT - 2.28 0.6EBIT = 1.608 EBIT = ₹2.68 crore.
Above ₹2.68 crore, B gives higher EPS; below it, A gives higher EPS. Expected EBIT of ₹4.8 crore is well above the indifference point, so the EPS case favours B. But B's fixed charge is ₹1.14 crore: if EBIT falls 30% to ₹3.36 crore, coverage becomes 2.95×, breaching the bank covenant. The EPS advantage is therefore sensitive to a demand downturn.
3. Recommend which proposal the board should adopt, taking into account promoter control, flotation costs, and the bank covenant.
Read the worked answer
Control test
- Promoters hold 48 lakh shares.
- Under A: 48/200 = 24%, below the 30% floor.
- Under B: 48/140 = 34.29%, above the floor.
A is not acceptable unless promoters subscribe more or the issue is structured as a rights issue. B meets the control floor, has lower flotation cost (₹0.24 crore versus ₹0.60 crore), and gives higher EPS at expected EBIT.
Recommendation: choose B, but with a covenant cushion. A 30% EBIT fall breaches 3×, so the board should negotiate a lower debenture amount (say ₹4 crore), arrange a standby facility, or use a rights issue so promoters can maintain 30% without adding fixed charges. Do not choose A merely because coverage is safer; it fails the stated control constraint.