Debt or Equity at Aravali Textiles
Aravali Textiles, a Bhilwara fabric processor, earns an EBIT of ₹40 lakh on a turnover of ₹1.2 crore. Its capital today is ₹1 crore of equity, made up of 10 lakh shares of ₹10 each, and it has no borrowings. It needs ₹50 lakh for a stentering machine and is weighing two ways of raising it: issue 2 lakh fresh shares at a market price of ₹25, or borrow ₹50 lakh from the bank at 12 per cent interest. The tax rate is 30 per cent.
The finance manager favours the loan because “equity is expensive and we are already earning well”. The promoter's wife, who holds 18 per cent of the shares, is nervous after a cousin's unit was declared sick. The machine adds 20 per cent capacity and the order book is full for six months, but two buyers are known to shift to Surat suppliers whenever fabric prices soften. Debtors already take 90 days to pay, and the bank wants a working capital note before sanctioning anything.
1. Compute earnings per share under both plans and advise the board, showing why the arithmetic alone does not settle the question.
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| Plan A: Equity | Plan B: 12% Debt | |
|---|---|---|
| EBIT | ₹40.00 lakh | ₹40.00 lakh |
| Interest | - | ₹6.00 lakh |
| PBT | ₹40.00 lakh | ₹34.00 lakh |
| Tax @ 30% | ₹12.00 lakh | ₹10.20 lakh |
| PAT | ₹28.00 lakh | ₹23.80 lakh |
| Shares | 12,00,000 | 10,00,000 |
| EPS | ₹2.33 | ₹2.38 |
The loan looks better - but by 5 paise, about 2 per cent of EPS. The indifference point explains why the gap is so small: EPS is equal when (EBIT × 0.7)/12 = (EBIT − 6) × 0.7/10, which gives EBIT = ₹36 lakh. Since the firm earns ₹40 lakh, it is only ₹4 lakh above the crossover, so the advantage of debt is thin.
What the arithmetic does not price:
- For that 2 per cent the firm takes on a fixed obligation of ₹6 lakh a year that must be paid whatever the order book does.
- Plan A dilutes the promoter family from 18 per cent to 15 per cent - the wife's worry is about control, and on that count debt is better.
- The return on the new ₹50 lakh is 26.7 per cent (EBIT ₹40 lakh on capital employed of ₹1.5 crore), comfortably above the 12 per cent cost of debt, so trading on equity is genuinely working - today.
2. The two large buyers cut orders and EBIT falls 40 per cent. Which plan is safer, and what does this tell you about when trading on equity should be used?
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EBIT at ₹24 lakh:
- Plan A: PAT = 24 × 0.7 = ₹16.80 lakh; EPS = 16.80/12 = ₹1.40.
- Plan B: PBT = 24 − 6 = ₹18 lakh; PAT = ₹12.60 lakh; EPS = ₹1.26.
The ranking reverses: the geared plan now delivers about 10 per cent less to shareholders, because interest is paid before anything reaches them. Interest cover falls from 6.7 times to 4.0 times - still safe. But push EBIT to ₹6 lakh and cover is exactly 1.0, with nothing left for shareholders.
The rule the case teaches. Trading on equity - using borrowed funds to raise the return on owners' funds - benefits shareholders only while the return on the borrowed money exceeds its cost, and it magnifies losses just as readily as gains. It suits firms with stable, predictable earnings.
Application. The full order book is only six months long, and the case says two buyers leave when fabric prices soften. So the test is not the current EBIT but the durability of the earnings.
Recommendation. Take the loan only for the portion of new capacity backed by written minimum-order commitments - say ₹30 lakh of debt against contracted offtake, with the balance from internal accruals or a small equity issue. That captures most of the EPS gain without betting the firm on two buyers.
3. Distinguish the fixed capital requirement from the working capital requirement in this case, and recommend one measure to reduce the working capital burden.
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Fixed capital. The ₹50 lakh stentering machine, its installation and the permanent margin of working capital are long-term needs funded by shares or term loans. They are not recovered in the operating cycle.
Working capital. Day-to-day funds locked in stock and debtors. With turnover of ₹1.2 crore and debtors at 90 days, roughly a quarter of a year's sales - about ₹30 lakh - is sitting with customers at any moment, plus inventory and cash. It is funded by bank cash credit, not by equity. The machine also raises working capital needs, because 20 per cent more fabric means 20 per cent more stock and debtors - a point the finance manager's EPS tables ignore.
Recommended measure. Offer a 2 per cent cash discount for payment within 15 days. The cost of the discount is about 2 per cent for 75 days of earlier cash, roughly 9.7 per cent annualised, against a cash credit rate that is likely above 10 per cent - so the firm saves money and cuts the 90-day cycle. A second, complementary step is bill discounting of the two slow buyers' receivables so that the machine is not financed out of the cash credit limit.