Case 046Capital structure decisionsWarm up
Sarvagya Pipes has Rs 400 crore of surplus cash. It can pay a special dividend or repay a 9.5% term loan. What does each do to leverage and earnings, and which would a lender prefer?
1The situation
Sarvagya Pipes makes ductile iron and plastic pipes for water projects. EBITDA is Rs 500 crore and depreciation Rs 100 crore. Debt is Rs 1,200 crore: a Rs 400 crore term loan at 9.5%, prepayable without penalty, and Rs 800 crore of bonds at 8.5%. Cash is Rs 600 crore, earning about 6%, of which Rs 400 crore is surplus to operating needs. Tax is 25%.
The board is choosing between a Rs 400 crore special dividend and repaying the term loan.
2Your task
Show what each option does to gross and net leverage, interest cover and net profit, and say which a lender would prefer and why.
Quick check
Repaying the loan changes net leverage by how much?
Worked solution
Try it on paper, then open one step at a time.
30-second answerThe answer to give first
Repaying the loan leaves net leverage at 1.2x, cuts gross leverage to 1.6x and raises net profit by about Rs 10.5 crore; the dividend lifts net leverage to 2.0x and cuts profit by Rs 18 crore. A lender prefers repayment. Retiring a 9.5% loan earns its after-tax cost, 7.13%, with certainty, against 4.5% after tax on idle cash.
Step 1What does each option do to the balance sheet?
A household with a fixed deposit and a personal loan can either spend the deposit on a holiday or close the loan; only one leaves the household better placed for a bad year. Paying a dividend sends cash to shareholders and leaves the debt; repaying the loan cancels debt against cash and leaves net debtBorrowings minus cash and liquid investments: what would remain owed if all cash were used to repay debt. unchanged. After the dividend, net debt rises to Rs 1,000 crore, 2.0x. After repayment, gross debt falls to Rs 800 crore, 1.6x, and net debt stays Rs 600 crore, 1.2x.
Step 2Why does repayment raise earnings?
The loan costs 9.5% and the cash earns 6%. Repaying debt is a certain return equal to its after-tax cost: 7.125% here, against 4.5% after tax on the cash, a gap of 2.625% on Rs 400 crore, about Rs 10.5 crore a year. Interest falls from Rs 106 crore to Rs 68 crore and interest cover rises from 4.72x to 7.35x. The dividend removes Rs 24 crore of interest income and costs about Rs 18 crore of net profit.
| 9.5% | interest saved on the loan |
| 6.0% | interest given up on the cash |
| 25% | tax |
Step 3Which would a lender prefer, and is the dividend ever right?
A lender prefers repayment, obviously for the lender being repaid and also for the bondholders, who now rank alongside Rs 400 crore less of debt. The dividend is value-neutral in theory, cash simply moves to owners, but it spends the cushion that protects creditors in a downturn, and pipe makers depend on government water spending that can pause. That is why bond documents often cap dividends with a restricted payments test. The view: repay the loan; if shareholders want cash returned, do it from future free cash flow once net leverage is well inside the company's target.
Where candidates lose it
The usual slip is saying repayment cuts net leverage. It cuts gross leverage; net debt was already counting the cash against the debt, so it does not move.
The second is comparing 9.5% with 6% pre-tax and stopping. Both interest paid and interest earned are taxed, so the true gain is the after-tax gap, about 2.6% a year, and that is the number to quote.
What the interviewer asks next
- The term loan carries a 2% prepayment fee. Does repayment still pay?
- Why might shareholders prefer the dividend even though it lowers profit?
- What restricted payments test would you put in a bond to control dividends?
Company names and figures are illustrative.