Case 056Indian debt market executionWarm up

A tea estate company needs Rs 50 crore for three years. Is a floating bank term loan at 10.2% or a privately placed NCD at 9.6% with Rs 30 lakh of issue costs cheaper, and what else matters?

The situation

Sriharsha Tea Estates wants Rs 50 crore for three years to replant sections of its gardens and upgrade a factory. Its bank offers a term loan at 10.2%, floating: the rate moves with the bank's benchmark.

An arranger suggests a privately placed, rated, listed non-convertible debenture (NCD) with a fixed 9.6% coupon, paid yearly, and the full Rs 50 crore repaid at the end of year 3. Arranger, rating, trustee, listing and legal costs come to Rs 30 lakh in total, paid at issue.

Your task

Which is cheaper all-in, by how much, and what besides cost should Sriharsha weigh?

Quick check

Roughly what does the Rs 30 lakh of issue cost add to the NCD's yearly cost?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

The NCD is cheaper, about 9.84% all-in against 10.20% for the loan, a saving of roughly Rs 18 lakh a year. The Rs 30 lakh of costs add about 0.24% a year to the 9.60% coupon. The margin is thin: below about Rs 20 crore the fixed costs would erase it. The loan's floating rate, prepayment freedom and amortisation matter as much as the price.

Step 1How do you put a one-off cost and a yearly rate on the same footing?

Think of a gym that charges Rs 3,000 to join and Rs 1,000 a month, against one with no joining fee at Rs 1,100 a month. If you stay three years, the joining fee adds about Rs 83 a month and the first gym is cheaper; if you stay three months, it is not. Fixed issue costs work the same way: spread them over the life and the size of the borrowing, then add them to the coupon. The quick version: Rs 30 lakh is 0.6% of Rs 50 crore, 0.2% a year over three years, so about 9.80%. The exact version treats Sriharsha as receiving Rs 49.70 crore and paying 9.6% on Rs 50 crore plus Rs 50 crore back: a yieldThe single yearly rate that makes the present value of all the payments equal to the money actually received. of 9.84%.

The relationship
49.70=4.80(1+y)+4.80(1+y)2+54.80(1+y)3  ⇒  y≈9.84%49.70 = \frac{4.80}{(1+y)} + \frac{4.80}{(1+y)^2} + \frac{54.80}{(1+y)^3} \;\Rightarrow\; y \approx 9.84\%
49.70Rs 50 crore raised less Rs 30 lakh of costs, what Sriharsha actually receives
4.80yearly coupon, 9.6% of Rs 50 crore
54.80the last coupon plus Rs 50 crore repaid
What it says in wordsThe all-in cost is the rate at which the money received equals the present value of everything paid back.
Fixed issue costs are light on a big deal and heavy on a small oneAll-in cost at Rs 50 crore9%10%8%10.20%Bank loanfloating9.84%coupon 9.60%Private NCDfixed+0.24%costsNCD all-in cost by issue sizebank loan 10.20%Breakeven about Rs 20 croreRs 50 crore: 9.84%Rs 10 crore: 10.82%Rs 10 crRs 50 crRs 100 cr10.0%10.5%11.0%Issue size, with Rs 30 lakh of fixed costs
At Rs 50 crore the NCD costs about 9.84% all-in against the loan's 10.20%, but the same Rs 30 lakh of fixed costs on a Rs 10 crore issue would push it to 10.82%, and the two break even at about Rs 20 crore.
Step 2Is the saving worth giving up the loan's features?

The saving is about 0.36% a year, around Rs 18 lakh. Against it, set three things the loan gives that the NCD does not: a rate that falls if benchmark rates fall, the right to prepay, and repayment spread over the life rather than Rs 50 crore due on one day. A tea estate's cash flow depends on weather, auction prices and labour costs; a bullet of Rs 50 crore in year 3 must be refinanced in whatever market exists then, while an amortising loan is paid down from the crop. Rates matter too: if the bank's benchmark rises 0.5%, the loan costs 10.7% and the NCD's fixed 9.6% looks better; if it falls 0.5%, the loan costs 9.7%, below the NCD's all-in figure.

A good answer names the second-order costs as well. An NCD needs a rating that must be kept up each year, a debenture trustee, and listing and disclosure obligations; stamp duty and the yearly fees of the rating agency and trustee vary and should be confirmed at the time of issue rather than assumed. The bank relationship matters: the same bank may provide Sriharsha's seasonal working capital lines. The closing view: the NCD is cheaper by a thin margin and wins if Sriharsha wants fixed-rate certainty and can plan the year-3 refinancing; the loan wins if flexibility is worth more than about Rs 18 lakh a year.

Where candidates lose it

The common error is comparing 9.6% with 10.2% and calling the NCD 0.6% cheaper. That leaves out Rs 30 lakh of costs, which is a third of the gap at this size and all of it at Rs 20 crore.

The opposite error is adding the full 0.6% of costs to one year's rate and concluding the NCD costs 10.2%, a dead heat. The costs buy three years of money, so they are spread across three years.

What the interviewer asks next

  • What issue size would make the two routes cost the same?
  • Would a two-tranche NCD, part 2-year and part 3-year, reduce the refinancing risk?
  • How would a credit enhancement, such as a partial guarantee, change the coupon and the costs?

Company names and figures are illustrative.