Capital Rationing, the 45% Covenant and a Director's Favourite Project
Bahari Holdings Ltd can raise only KES 60 million of new finance for the coming year without breaching a 45% debt covenant. The finance director has produced the following (all KES million, cash flows discounted at the company's current WACC of 13%):
- Project X: outlay 40, NPV 8.0, IRR 16.5%
- Project Y: outlay 30, NPV 6.6, IRR 18.2%
- Project Z: outlay 25, NPV 4.0, IRR 15.4%
The projects are independent and indivisible. Existing capital is 40% debt and 60% equity; the pre-tax cost of debt is 12% and shareholders require 16%. Corporation tax is 30%. One director proposes funding Project X alone because it has the largest absolute NPV; the finance director prefers a combination.
1. Verify the discount rate, determine which project or combination should be selected, and explain why the director's argument fails.
Read the worked answer
Verify the WACC
WACC = 0.40 × 12% × (1 − 0.30) + 0.60 × 16% = 3.36% + 9.60% = 12.96%, say 13% - so the 13% used is consistent.
Rank on profitability index (NPV per shilling of scarce capital), PI = (NPV + outlay)/outlay:
- X: 48/40 = 1.20
- Y: 36.6/30 = 1.22
- Z: 29/25 = 1.16
Test the feasible combinations against the 60m budget
- Y + Z = 55m → NPV 10.6
- X alone = 40m → NPV 8.0
- X + Z = 65m → over budget
- X + Y = 70m → over budget
Select Y and Z. They consume KES 55m and deliver KES 10.6m of NPV, against KES 8.0m from spending 40m on X alone.
Why the director is wrong
Under capital rationing the objective is to maximise NPV per shilling of the scarce resource, not absolute NPV. X looks bigger only because it absorbs more capital; on that logic the company should always buy the most expensive project. Note also that IRR ranking (Y 18.2% > X 16.5% > Z 15.4%) happens to point the same way here, but IRR alone cannot rank projects of different scale - it must be read alongside the PI and the budget.
Nuance: KES 5m is left idle. If any part-investment were possible, KES 5m of X at PI 1.20 would add KES 1.0m, taking the total to KES 11.6m - worth asking whether the outlay can be staged.
2. Assess how sensitive the recommendation is to (a) a rise in the cost of capital and (b) cost overruns, and state the fallback position.
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(a) Cost of capital
Z is the marginal project and has the lowest IRR at 15.4%. The recommendation only fails if NPV(Y + Z) falls below NPV(X alone) = 8.0. Since Y contributes 6.6, that requires Z's NPV to fall from 4.0 to 1.4 - a fall of 2.6, i.e. 65%. Z's NPV reaches zero at a discount rate of about 15.4%.
So the choice is robust: WACC would have to rise by roughly 240 basis points before the ranking is threatened. At that point Z drops out and the fallback is X alone (8.0) rather than Y alone (6.6), because X's IRR of 16.5% holds while Y's larger relative NPV advantage erodes with the higher discount rate. That is the sensitivity case the board should be told about, and it should be re-run if the covenant forces equity funding.
(b) Cost overruns
The Y + Z package has 5m of headroom: Z could overrun from 25 to 30, or Y from 30 to 35, before the combination breaches the 60m budget. Beyond 5m of overrun, Y + Z becomes infeasible and the fallback is X alone at 8.0, a loss of 2.6m of NPV.
Practical response: procure on fixed-price terms, hold a 10% contingency inside the budget, and stage the commitment of the second project so that an overrun on the first is absorbed before the second is drawn.
What the board should minute: the decision rule (maximise NPV subject to a 60m budget), the sensitivity, the fallback and the trigger for revisiting it.
3. The board asks whether the 60 million can simply be borrowed. Advise on the interaction between the covenant, the financing mix and the project decision.
Read the worked answer
The covenant is a constraint on the decision, not a detail
Existing debt is 40% of capital against a 45% covenant. A further KES 60m of debt pushes average gearing through the ceiling and, more importantly, the marginal gearing of the new money is 100% debt. Covenants are usually tested on total debt to total capital or on net debt to EBITDA, either of which would be breached, allowing the lender to freeze facilities or demand early repayment - a far larger loss than the 2.6m of NPV that distinguishes the projects.
Options, in order of preference
- Stage the investment. Y costs 30m, is the highest-ranked project, and is quick to generate cash; part-fund Z from Y's inflows in the following year. This stays inside the covenant and keeps the ranking intact.
- Equity for the balance. Issue 25–30m of equity (issue costs typically 3–5%). Dilution is real, and the appraisal must then be re-run at a higher WACC - if the overall cost of capital moves above about 15.4%, Z ceases to be viable and Y alone is funded.
- Project-specific finance. Non-recourse or lease-based funding for specific assets, if the covenant definition permits it, but check the substance - a lease that is in effect borrowing will be treated as debt.
- Talk to the bank first. Most lenders will grant a waiver or reset the covenant on a credible plan. Discovering the breach after drawdown destroys the relationship and the company's pricing.
Recommendation: stage Y then Z, raise only what the covenant allows, and do not trade a hard financing constraint for a 2.6m NPV improvement. Report the covenant headroom to the board monthly.