Case 086Leveraged finance and LBO financingCore

Can debt ever be more expensive than equity? A distressed company is offered a rescue loan at 16% plus a 3% fee plus warrants for 10% of the equity, or a rights issue at a 30% discount. Which money costs more?

TD SecuritiesNew York · 2025

The situation

Velmora Foods, a packaged snacks maker, has lost money for two years after a failed product launch. It needs Rs 300 crore to fund a turnaround plan. Its 20 crore shares trade at Rs 50, a market value of Rs 1,000 crore.

Option one is a three-year rescue loan: 16% interest, a 3% fee deducted upfront, and warrants giving the lender 10% of the equity for a nominal price. Option two is a rights issue at Rs 35 a share, a 30% discount. If the plan works, Velmora's equity is expected to be worth Rs 1,500 crore in three years on the loan route, after repaying the loan. Velmora pays no tax while it is making losses.

Your task

What is the all-in cost of the rescue loan, how does it compare with the rights issue, and in what situations can debt cost more than equity?

Quick check

What is the rescue loan's all-in yearly cost in the plan case, counting the fee and warrants?

Worked solution

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

30-second answerThe answer to give first

Here debt is the dearer money: the rescue loan costs about 30% a year all in, against about 25% for the rights issue in the same plan case. The warrants turn a 16% loan into an equity-priced one, the fee adds more, and a loss-making company gets no tax saving on interest. The loan must also be repaid in three years, adding default risk that the rights issue never carries. Debt costs more than equity when lenders take equity-like risk.

Step 1Why is debt normally cheaper than equity?

Two reasons. Lenders are paid first and have a fixed claim, so they accept a lower return than shareholders, who are paid last. And interest is usually deductible, so the government shares part of its cost. Both reasons weaken in distress: the lender's claim is no longer safe, so it prices like equity, and a company with no taxable profit gets no tax saving. A friend lending to a stable salaried person asks little; the same friend lending to someone whose shop is failing wants a share of the shop too.

Step 2What does the rescue loan really cost?

Count every rupee the lender gets, when it gets it. It hands over Rs 291 crore after the Rs 9 crore fee, receives Rs 48 crore of interest in years one and two, then Rs 348 crore of interest and principal plus warrants worth 10% of Rs 1,500 crore, Rs 150 crore, in year three. That is an all-in yieldThe yearly return a lender earns once fees, discounts and equity add-ons are counted with the coupon, found as an internal rate of return. of about 30.2%: the coupon is 16%, the fee adds 1.4 points and the warrants 12.8. With no tax shield, that is also the after-tax cost.

The relationship
−291+481+r+48(1+r)2+348+150(1+r)3=0  ⇒  r≈30.2%-291 + \frac{48}{1+r} + \frac{48}{(1+r)^2} + \frac{348 + 150}{(1+r)^3} = 0 \;\Rightarrow\; r \approx 30.2\%
291cash Velmora receives: Rs 300 crore less the 3% fee
48yearly interest at 16%
348final interest plus principal
150warrants: 10% of Rs 1,500 crore of equity in year three
What it says in wordsCounting the fee and the warrants, the lender earns, and Velmora pays, about 30% a year if the plan works.
Yearly cost of Rs 300 crore of rescue money, plan caseRescue loan, all in16.012.830.2%Coupon 16.0Fee +1.4Warrants +12.8Rights issue at a 30% discount25.0%return handed to the new sharesThe loan also has to be repaid in three years, whatever happens; the new shares never do.Its failure risk comes on top of the 30% rate, which is why debt is the dearer money here.
The rescue loan's 16% coupon becomes about 30.2% a year once the 3% fee and the warrants are counted, against about 25.0% handed to new shares in a rights issue, and the loan also has to be repaid on a fixed date.
Step 3What does the rights issue cost in the same plan case?

Rs 300 crore at Rs 35 a share is 8.57 crore new shares, 30% of the enlarged company. With no loan to repay, no interest and no fee, equity in year three would be about Rs 1,953 crore, ignoring what the saved cash would earn. The new shares would be worth about Rs 586 crore, a return of about 25% a year: expensive money, but cheaper than the loan. The discount itself costs nothing to a shareholder who takes up the rights; it transfers value only from those who do not, which is why rights issues are priced low to make sure they fill.

Year three of the plan: what today's shareholders keep, Rs croreToday's holders 1,350lender's warrants 1501,500Rescue loan routeToday's holders 1,367new rights shares 5861,953Rights issue routeNearly the samefor today's holders,but only one routecan default
In year three of the plan, today's shareholders keep Rs 1,350 crore on the loan route and about Rs 1,367 crore on the rights route, nearly the same, but only the loan route carries a fixed repayment that could push Velmora into default if the plan slips.

Close with the answer to the general question. Debt can cost more than equity when the borrower is distressed, when lenders demand equity kickers, and when the tax shield is worth nothing. For Velmora the rights issue is cheaper and safer; the loan makes sense only if shareholders cannot or will not put in more money. The limitation: both costs rest on the Rs 1,500 crore plan value, and if the plan fails the lender's warrants are worthless while its claim still ranks ahead of every shareholder.

Where candidates lose it

The common error is adding the warrants to the coupon as if they paid every year, or ignoring them entirely. They are paid once, at the end, and only in the good case, so they belong in an IRR, where they add about 13 points a year here.

The second is quoting the textbook line that debt is always cheaper because of the tax shield. A company making losses has no tax to shield, and that half of the argument disappears.

What the interviewer asks next

  • If the plan fails and Velmora is sold for Rs 250 crore, what does the lender recover, and what do the rights shareholders get?
  • How would an underwriter set the rights issue price?
  • Why might existing shareholders still prefer the loan?
  • What would a convertible bond offer that neither option does?

Asked at TD Securities, Capital Markets, New York, 2025 (Wall Street Oasis): was asked if debt could ever be more expensive than equity and in what scenario?

Company names and figures are illustrative.