Nova Textiles' Loom Expansion: Marginal WACC and Covenant Headroom
Faisalabad-based Nova Textiles (NT) is evaluating a PKR 1.5 billion air-jet loom expansion. NT has PKR 2.4 billion of existing debt priced at KIBOR + 350 bps; six-month KIBOR is 11.0%. Its equity market value is PKR 3.6 billion, equity beta 1.2, risk-free rate 10.0%, and market risk premium 6.0%. The company tax rate is 29%. The expansion will be funded 60% by new debt at KIBOR + 450 bps and 40% by retained earnings. Existing covenants require net debt/EBITDA below 3.0x. Current EBITDA is PKR 900 million and net debt is PKR 2.4 billion. The project is expected to add PKR 260 million EBITDA, but the sponsor family wants a PKR 120 million dividend next year. NT's treasurer favours a fixed-rate loan; the bank offers a floating facility with an optional interest-rate swap at 15.8% fixed.
1. Calculate NT's marginal after-tax WACC for the expansion and explain whether the marginal or existing WACC should be used for appraisal.
Read the worked answer
Cost of equity = 10.0% + 1.2(6.0%) = 17.2%. New debt pre-tax = 11.0% + 4.5% = 15.5%; after-tax = 15.5% × (1 − 0.29) = 11.005%. Marginal weights: debt 60%, equity 40%. Marginal WACC = 0.60 × 11.005% + 0.40 × 17.2% = 6.603% + 6.88% = 13.48%.
The existing WACC, using existing debt at 14.5% pre-tax and 40% debt/60% equity, is 0.40 × 10.295% + 0.60 × 17.2% = 14.44%. Use the marginal WACC because it reflects the incremental financing and current market costs for this project. Use the existing WACC only if the project has the same risk and the financing mix is unchanged. If the project risk differs, adjust the discount rate for that risk. Material flotation costs would raise the hurdle rate further.
2. Assess covenant headroom after the project and stress-test the position if only 60% of the expected EBITDA increase materialises.
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Post-deal net debt = 2.4 + 0.9 = PKR 3.3bn; EBITDA = 0.9 + 0.26 = PKR 1.16bn; ratio = 3.3 / 1.16 = 2.84x. Headroom = 3.0 × 1.16 − 3.3 = PKR 0.18bn of EBITDA (about 0.16x).
If only 60% of the EBITDA increase appears, EBITDA = 0.9 + 0.156 = PKR 1.056bn and the ratio = 3.3 / 1.056 = 3.13x - a breach. The PKR 120m dividend would further reduce cash; if funded by a revolver, net debt rises to PKR 3.42bn and the ratio is 3.24x even at full synergy. Mitigants include funding more with equity, phasing the project, deferring the dividend, negotiating a covenant holiday, or escrowing cash. A breach can trigger acceleration or restrict distributions, so it is not merely a technical issue.
3. Recommend a financing structure and whether NT should use the fixed-rate swap.
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Recommend a mix that preserves at least 0.3x headroom. At 50% debt (PKR 0.75bn), net debt is PKR 3.15bn, ratio 2.72x at full EBITDA; if synergy is only 60%, ratio is 2.98x - still tight. At 40% debt, net debt is PKR 3.0bn, ratio 2.59x, and 2.84x stressed. Retain the dividend only if headroom remains above 0.3x.
On the swap: floating new debt costs 15.5%; fixed swap at 15.8% costs 30 bps more today. Paying 30 bps for certainty is defensible if treasury expects KIBOR to rise by more than 30 bps or if the covenant cannot tolerate floating-rate stress. A partial hedge of 50–70% of the new debt balances cost and protection; full hedging is expensive and reduces flexibility. Decide from sensitivity analysis, not a directional view.