Nova Plastics: Equity or Debt for the New Line
Nova Plastics has ₹3 crore of equity made up of 3 lakh shares of ₹100 each, no borrowings, and expects EBIT of ₹90 lakh next year. The tax rate is 30%. It needs ₹1.5 crore for a new moulding line and has two options: issue 1 lakh fresh shares at ₹150, or borrow ₹1.5 crore at 12% interest. Sales are cyclical; three years ago EBIT dropped to ₹50 lakh and the bank then refused additional credit. The promoter family holds 1.65 lakh shares and wants to keep control. The loan covenant requires interest cover of at least 3 times, and the bank will test the covenant against a bad year as well as the expected year. The finance manager favours debt because interest is tax deductible.
1. Compute EPS under both options at EBIT of ₹90 lakh and ₹50 lakh.
Read the worked answer
Option 1 - equity: shares become 3,00,000 + 1,00,000 = 4,00,000.
- EBIT ₹90 lakh: tax 30% → PAT ₹63 lakh → EPS = 63,00,000 ÷ 4,00,000 = ₹15.75
- EBIT ₹50 lakh: PAT ₹35 lakh → EPS = ₹8.75
Option 2 - debt: interest = 12% × 1.5 crore = ₹18 lakh; shares stay 3,00,000.
- EBIT ₹90 lakh: EBT ₹72 lakh, tax ₹21.6 lakh, PAT ₹50.4 lakh → EPS = ₹16.80
- EBIT ₹50 lakh: EBT ₹32 lakh, tax ₹9.6 lakh, PAT ₹22.4 lakh → EPS = ₹7.47
So debt adds ₹1.05 per share in the expected year and takes away ₹1.28 in a bad year. Interest cover with debt is 90 ÷ 18 = 5 times in the good year but 50 ÷ 18 = 2.78 times in the bad year, which breaches the 3-time covenant.
2. Find the indifference EBIT between the two options and explain what it means for the decision.
Read the worked answer
Set EPS equal: 0.7E ÷ 4,00,000 = 0.7(E − 18,00,000) ÷ 3,00,000.
Cancel 0.7: 3E = 4(E − 18,00,000) → 3E = 4E − 72,00,000 → E = ₹72 lakh.
Check: at EBIT ₹72 lakh, equity EPS = 50.4 lakh ÷ 4 lakh = ₹12.60; debt EPS = (54 lakh × 0.7) ÷ 3 lakh = ₹12.60.
Above ₹72 lakh, debt gives the higher EPS because the fixed interest is spread over fewer shares. Below ₹72 lakh, equity is better because there is no interest to pay.
Meaning for this firm: expected EBIT of ₹90 lakh is only 25% above the indifference point, while the historical low of ₹50 lakh is 31% below it. A normal downturn, not a catastrophe, puts the company on the wrong side of the line - and breaches the covenant at the same time. The margin of safety is thin.
3. Recommend a financing plan, taking into account promoter control and the loan covenant.
Read the worked answer
Control: the family holds 1.65 lakh of 3 lakh shares = 55%. Issuing 1 lakh shares to outsiders cuts them to 1.65 ÷ 4 = 41.25%, losing majority control. That fact alone makes a plain public equity issue unattractive to the promoters.
Risk: debt wins on EPS (₹16.80 vs ₹15.75) and interest saves ₹5.4 lakh of tax, so the finance manager is right that debt is cheaper - but only in the expected year. At EBIT ₹50 lakh, EPS falls to ₹7.47 and interest cover of 2.78 breaches the covenant, which could freeze credit exactly when it is needed.
Recommendation: a split. Borrow ₹1 crore (interest ₹12 lakh; cover at EBIT ₹50 lakh = 4.17 times, safely inside the covenant) and raise ₹50 lakh through a rights issue to the promoters at ₹150 (33,333 shares). If the family subscribes, they hold 1.98 lakh of 3.33 lakh shares ≈ 59.5%.
This keeps control, keeps the covenant intact in a bad year, and retains most of the tax shield. The debt should be term-matched to the asset's life, not a short working-capital facility.