Case 059Capital structure decisionsHard

A consumer company can target a AA rating with less debt or an A rating with more. Compute the WACC under each and decide which target to adopt, allowing for a downturn.

The situation

Hovera Consumer makes kitchen appliances and has EBITDA of Rs 1,000 crore. Its board is choosing a long-term rating target. Target AA: debt about 2.0x EBITDA, 25% of capital at market value, costing 8.0%, with a cost of equity of 13.0%. Target A: debt about 3.0x EBITDA, 35% of capital, costing 8.9%, with a cost of equity of 13.5%. Tax is 25%.

Appliance demand is cyclical: in the last downturn the industry's EBITDA fell about 30%. For this illustration, assume the agency's guidance is that leverage sustained above 2.5x is inconsistent with AA and above 3.5x with A, and that a BBB-rated Hovera would pay about 10.0% on its debt.

Your task

What is the WACC at each target, how much value does the cheaper one add, and which target would you advise once a downturn is allowed for?

Quick check

Which target gives the lower WACC, and by roughly how much?

Worked solution

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

30-second answerThe answer to give first

The A target has the lower WACC, 11.11% against 11.25%, worth only about Rs 161 crore of value, and a 30% downturn would push it to 4.29x and towards BBB. The AA structure would reach 2.86x, a notch at worst. For a cyclical appliance maker, target AA: a 0.14% saving does not pay for losing the rating in a bad year.

Step 1How much does the extra debt really save?

Borrowing more replaces expensive equity with cheaper, tax-deductible debt, but both costs rise as you borrow. That is why moving from 25% to 35% debt lowers WACCWeighted average cost of capital: the blended yearly return required by all the company’s funders, with debt counted after its tax saving. by only 0.14%, not by anything like the full gap between equity and debt. Think of a family deciding whether to take a bigger home loan to keep more savings invested: the loan is cheaper than the return on savings, but the bank charges more for a bigger loan and the family's own risk rises, so the net gain is smaller than it first looks.

The relationship
WACCAA=0.75(13.0)+0.25(8.0)(0.75)=11.25%WACCA=0.65(13.5)+0.35(8.9)(0.75)=11.11%\text{WACC}_{AA} = 0.75(13.0) + 0.25(8.0)(0.75) = 11.25\% \qquad \text{WACC}_{A} = 0.65(13.5) + 0.35(8.9)(0.75) = 11.11\%
0.75, 0.65equity weights at each target
13.0, 13.5cost of equity, higher with more debt
8.0, 8.9pre-tax cost of debt at AA and at A
0.75one minus the 25% tax rate
What it says in wordsEach WACC is the equity cost times its weight plus the after-tax debt cost times its weight.
More debt lowers WACC, but only a littleAA target: 25% debtequity 9.750%debt 1.50%11.25%A target: 35% debtequity 8.775%debt 2.34%11.11%0%4%8%12%Equity weight x cost of equity, plus debt weight x cost of debt x (1 - 25% tax).The A target is cheaper by 0.14%: worth about Rs 161 crore of valueon Rs 600 crore of free cash flow growing 4% a year. Small, and only if nothing goes wrong.
The AA structure costs 11.25% and the A structure 11.11%, a saving of 0.14% that is worth about Rs 161 crore on Rs 600 crore of free cash flow growing 4% a year.
Step 2What happens to each structure in a bad year?

Cut EBITDA 30% to Rs 700 crore. At the AA target, Rs 2,000 crore of debt becomes 2.86x, just past the illustrative AA guide, and interest cover falls from 6.25x to 4.4x: an agency might lower the rating a notch, and the company still borrows easily. At the A target, Rs 3,000 crore becomes 4.29x, well past the 3.5x guide, and cover falls from 3.75x to 2.6x. In fact the A structure crosses 3.5x once EBITDA falls just 14%. The A structure is the one most likely to lose its rating exactly when it most needs to borrow. At BBB, repricing Rs 3,000 crore from 8.9% to 10.0% costs about Rs 33 crore a year, and the cost of equity rises too.

The cheaper structure is the one that breaks in a bad yearAA target2.0x today2.86x if EBITDA falls 30%2.5x guideA target3.0x today4.29x if EBITDA falls 30%3.5x guide0x1x2x3x4x5xAA: 2.86x, a notch at worst, cover still 4.4x.A: 4.29x, into BBB territory, cover 2.6x and about Rs 33 crore more interest a year.
In a 30% EBITDA downturn the AA structure's leverage rises from 2.0x to 2.86x, just past its illustrative 2.5x guide, while the A structure's rises from 3.0x to 4.29x, far past its 3.5x guide and into BBB territory.
Step 3So which target would you advise?

Weigh a small, certain gain against a large, conditional loss. The A target adds about Rs 161 crore of value on paper, around 2% of the business, but only if the cash flows are never tested. For a cyclical appliance maker, at least one downturn in the life of the structure is likely, and in it the A structure faces a downgrade, costlier debt and pressure to cut dividends or capex. The view: target AA, keeping leverage near 2.0x through the cycle and letting it rise temporarily only for a good acquisition. A steadier business, say a utility with contracted revenue, could take the A target, because its EBITDA would not fall 30%. Say that condition too; it shows the answer depends on the cash flows, not on the WACC formula. The rating guides here are illustrative: each agency publishes its own, and they vary by sector, so confirm the current ones.

Where candidates lose it

Candidates compute the two WACCs, see that A is lower, and advise A. That treats WACC as the whole answer and ignores what happens to the cheaper structure in a downturn, which is what the question is really about.

The other error is holding the cost of equity and the cost of debt constant as leverage rises, which exaggerates the saving from extra debt several times over.

What the interviewer asks next

  • At what EBITDA decline does the A structure breach its 3.5x guide?
  • How would you use a share buyback to move from AA to A gradually?
  • Would your answer change if Hovera had a large acquisition planned in two years?

Company names and figures are illustrative.