Anand Auto Components: Debentures or Equity?
Anand Auto Components Ltd. has EBIT of ₹1.20 crore and existing debt of ₹3 crore carrying 12 per cent interest. Its equity capital is ₹4 crore, made up of 40 lakh shares of ₹10 each. The company needs ₹2 crore for a new machining line and the board is considering two options: (a) issue 10 per cent debentures of ₹2 crore; (b) issue 20 lakh equity shares at par. The tax rate is 30 per cent and there are no other borrowings. The finance manager favours the debentures: 'Debt is cheap and the equity shareholders will gain.' The chairman is uneasy because the company's sales follow tractor demand, which has fallen 18 per cent over two years and is expected to stay weak for at least another year. The plant would be commissioned in eight months.
1. Compute earnings per share and the interest coverage ratio under both options. State which option gives the higher EPS.
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Existing interest = 12% of ₹3 crore = ₹36 lakh.
Option (a) - 10% debentures of ₹2 crore Interest = 36 + 20 = ₹56 lakh EBT = 120 − 56 = ₹64 lakh PAT = 64 × 0.70 = ₹44.8 lakh Shares = 40 lakh EPS = 44.8 ÷ 40 = ₹1.12 Interest coverage = 120 ÷ 56 = 2.14 times
Option (b) - 20 lakh equity shares at par Interest = ₹36 lakh EBT = 120 − 36 = ₹84 lakh PAT = 84 × 0.70 = ₹58.8 lakh Shares = 40 + 20 = 60 lakh EPS = 58.8 ÷ 60 = ₹0.98 Interest coverage = 120 ÷ 36 = 3.33 times
Conclusion: debentures give the higher EPS (₹1.12 against ₹0.98), but on a thinner interest cushion (2.14 against 3.33 times). Higher EPS here is bought with higher financial risk, and the two figures must be read together - EPS alone is not a verdict.
2. Explain the concept the finance manager is relying on, and test whether it is safe for this company.
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He is relying on trading on equity - using borrowed funds carrying a fixed cost to magnify the return available to equity shareholders. Because interest is fixed, any EBIT earned on the new funds above the after-tax cost of debt belongs to the shareholders.
The arithmetic supports him at present: capital employed under option (a) is ₹9 crore (3 + 4 + 2) against EBIT of ₹1.20 crore, a return of about 13.3 per cent, while debt costs 10 per cent pre-tax, about 7 per cent after tax. Leverage is favourable today.
The safety test is what happens when EBIT falls. Sales follow tractor demand, already down 18 per cent. If EBIT drops 25 per cent to ₹90 lakh:
- Option (a): PAT = (90 − 56) × 0.7 = ₹23.8 lakh; EPS = ₹0.595
- Option (b): PAT = (90 − 36) × 0.7 = ₹37.8 lakh; EPS = ₹0.63
The advantage reverses. Trading on equity magnifies falls exactly as it magnifies rises, and an interest cover of 2.14 leaves very little room before the interest itself is at risk.
3. As a member of the board, which option would you recommend and why? Support your answer with two factors affecting the capital structure decision.
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Recommendation: equity (option b), or a balanced mix of ₹1 crore debentures and ₹1 crore equity.
Factor 1 - Cash flow position. Interest is a contractual outflow payable whether or not sales hold up. Option (a) commits ₹56 lakh of interest annually against a business tied to a cyclical, currently falling demand. A firm must service interest out of cash, not out of hope.
Factor 2 - Risk and existing leverage. The company already pays ₹36 lakh of interest, about 30 per cent of EBIT. Adding debt pushes financial risk up, raises the return future lenders will demand, and removes the flexibility to borrow when tractor demand recovers. Equity keeps borrowing capacity unused for a better year.
Debt would become defensible if the board could reasonably expect EBIT above roughly ₹1.4 crore, or if the new line had assured offtake contracts. Control is a secondary consideration - equity dilutes the promoters' stake - but dilution is a smaller cost than a defaulted interest payment. A 50:50 mix captures part of the EPS advantage while halving the fixed commitment.