Debt Capital Markets puzzles, solved step by step

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100
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All topicsLeverage, coverage and cash flow9Mental maths and numeracy8Estimation and market sizing7Logic and brainteasers8Cost of capital and valuation riddles7Bond pricing and yield7Compounding, PIK and fees6Issuance and refinancing arithmetic8Credit spreads and default probability8Duration and convexity8Capital structure and recovery8Probability and expected value10Yield curve and forward rates6
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  1. 047EBITDA is Rs 150 crore, capex Rs 40 crore, cash taxes Rs 20 crore, interest Rs 30 crore and scheduled principal Rs 20 crore. Compute the fixed charge cover and the interest cover, and say which one a lender trusts more.Leverage, coverage and cash flowWarm upCorporate bankingLeveraged finance

    Try it first

    What is the fixed charge cover?

    Show the worked solution

    Interest cover is 5.0x and fixed charge cover is 1.8x; a lender trusts the fixed charge cover more. Interest cover is EBITDA of 150 over interest of 30. Fixed charge cover takes off capex of 40 and tax of 20, leaving 90, and sets it against interest plus the principal that must be repaid this year, 50. It counts the cash that really has to go out, so it shows how thin the cushion is.

    Why can a company look five times covered and still be tight?

    A salaried person earning Rs 1.5 lakh a month with a Rs 30,000 loan interest bill looks comfortable. But rent and school fees of Rs 60,000 come out first, and the loan also needs Rs 20,000 of principal each month. What is left, Rs 90,000, against Rs 50,000 owed, is the true cushion. Interest cover ignores the cash a business must spend before lenders are paid and ignores the principal it owes, so it flatters the picture. Fixed charge coverCash flow after capex and tax, divided by all the debt payments due in the period, interest and scheduled principal together. fixes both.

    The relationship
    ICR=15030=5.0×FCCR=150−40−2030+20=9050=1.8×\text{ICR} = \frac{150}{30} = 5.0\times \qquad \text{FCCR} = \frac{150 - 40 - 20}{30 + 20} = \frac{90}{50} = 1.8\times
    150EBITDA, Rs crore
    40, 20capex and cash taxes, which must be paid before lenders
    30, 20interest and scheduled principal due this year
    What it says in wordsInterest cover divides earnings by interest; fixed charge cover divides cash left after essential spending by everything owed to lenders this year.
    Same company: 5.0x covered on one test, 1.8x on the one lenders trustInterest coverEBITDA 150Interest 30150 / 30 = 5.0xFixed charge coverCash left 90capex 40tax 20Interest 30Principal 2090 / 50 = 1.8x
    The same company covers its Rs 30 crore of interest 5.0 times from EBITDA of Rs 150 crore, but after Rs 40 crore of capex and Rs 20 crore of tax it covers its Rs 50 crore of interest and principal only 1.8 times.

    Which ratio would you put in a covenant?

    The fixed charge ratio, for a lender who cares about being repaid on schedule. At 1.8x the company has Rs 40 crore of spare cash a year after paying lenders, and a 44% fall in that cash would leave it unable to meet its schedule; at 5.0x interest cover the same fall would still look safe. Interest cover is still useful: it is quick, comparable across companies, and a lender pricing a bullet bond with no amortisation cares less about principal. But for an amortising term loan, fixed charge cover is the test that fails first.

    Say the limits. Definitions vary by document: some deduct only maintenance capex, some add lease payments to the fixed charges, some take tax paid rather than tax charged. Always read the covenant's own definition before comparing a borrower's ratio with a peer's; two companies at 1.8x on different definitions are not equally safe.

    Where candidates lose it

    The common slip is stopping at 5.0x and calling the credit comfortable. The question gave capex, tax and principal because they are the numbers interest cover leaves out.

    The second is putting principal on the wrong side, subtracting it from EBITDA rather than adding it to the charges. Principal is owed to lenders, so it belongs in the denominator with interest.

    What the interviewer asks next

    • Capex rises to Rs 60 crore. What is the fixed charge cover now?
    • Why might a lender deduct only maintenance capex rather than total capex?
    • The company adds a Rs 15 crore lease payment. Where does it go in each ratio?
  2. 073A company has EBITDA of Rs 200 crore, gross debt of Rs 900 crore and cash of Rs 300 crore. It uses Rs 200 crore of its cash to repay debt. What happens to its gross leverage and to its net leverage?Leverage, coverage and cash flowWarm upLeveraged financeCorporate banking

    Try it first

    What happens to net leverage?

    Show the worked solution

    Gross leverage falls from 4.5x to 3.5x; net leverage stays at 3.0x. Gross debt drops from Rs 900 crore to Rs 700 crore against EBITDA of Rs 200 crore. Net debt is 900 minus 300 before and 700 minus 100 after, Rs 600 crore both times, because cash and debt fall together. The repayment cuts interest and tidies the balance sheet, but it does not change what the company owes net of what it holds.

    Why does one ratio move and the other stay put?

    If you owe a friend Rs 9,000 and have Rs 3,000 in your wallet, you are Rs 6,000 in the hole. Hand over Rs 2,000 and you owe Rs 7,000 with Rs 1,000 left: still Rs 6,000 in the hole. Net debt already counts the cash as if it could repay debt, so actually using the cash to repay debt changes nothing in the net figure. Gross debt ignores the cash, so it falls by the full Rs 200 crore.

    Repaying debt with cash cuts gross leverage and leaves net leverage alone4.5xbefore3.5xafterGross debt / EBITDA3.0xbefore3.0xafterNet debt / EBITDARs croreBeforedebt 900cash 300After repaying 200debt 700cash 100net debt 600 both times
    Repaying Rs 200 crore of debt from cash takes gross leverage from 4.5x to 3.5x, but debt and cash fall together, so net debt stays at Rs 600 crore and net leverage stays at 3.0x.
    The relationship
    Gross: 900200=4.5×→700200=3.5×Net: 900−300200=700−100200=3.0×\text{Gross: } \frac{900}{200} = 4.5\times \to \frac{700}{200} = 3.5\times \qquad \text{Net: } \frac{900-300}{200} = \frac{700-100}{200} = 3.0\times
    900, 700gross debt before and after, Rs crore
    300, 100cash before and after, Rs crore
    200EBITDA, Rs crore, unchanged by the repayment
    What it says in wordsGross leverage sees only the debt; net leverage sees debt less cash, and both fall by the same amount.

    Why would a company repay debt with cash at all?

    Because the money still changes: interest on Rs 200 crore of debt usually costs more than the same cash earns on deposit. If the debt costs 9% and the cash earns 6%, repaying saves about Rs 6 crore a year of net interest. It also matters where covenants are written on gross debt, as some loan documents are, and where the cash sits in a subsidiary or abroad and could not easily reach lenders in a crisis. That is why credit analysts ask whether cash is truly available before netting it.

    Now look at the other side. Spending the cash also removes a cushion: a company with Rs 100 crore of cash has less room to absorb a bad quarter than one with Rs 300 crore, at the same net leverage. Lenders and rating analysts look at liquidity alongside leverage for this reason. The limit: this assumes EBITDA is untouched by the repayment, which holds, because interest sits below EBITDA.

    Where candidates lose it

    The fast wrong answer is that both ratios improve, because repaying debt sounds like deleveraging. Net leverage already assumed the cash could repay debt, so doing it changes nothing on that measure.

    The opposite slip is saying the repayment achieved nothing. It lowers gross leverage, cuts net interest cost and spends liquidity; name all three.

    What the interviewer asks next

    • The company instead raises Rs 200 crore of new debt and holds it as cash. What happens to each ratio?
    • Which leverage figure would you write into a covenant, and why?
    • When is it risky to net cash against debt?
  3. 095A company has EBITDA of Rs 300 crore and Rs 1,000 crore of debt, all floating at 10%. The benchmark rate rises by 150 basis points. What happens to its interest cover?Leverage, coverage and cash flowWarm upCorporate bankingLeveraged finance

    Try it first

    Where does interest cover land?

    Show the worked solution

    Interest cover falls from 3.0x to about 2.61x. All the debt is floating, so the rate goes from 10% to 11.5% and interest from Rs 100 crore to Rs 115 crore. EBITDA is unchanged at Rs 300 crore, so cover is 300 / 115 = 2.61x. A 15% rise in the interest bill cuts cover by about 13%, with no change in the business at all.

    Why does a small rate move matter so much?

    A household on a floating home loan feels a rate rise in the very next EMI, even though nothing about its salary has changed. Companies with floating debt feel it the same way. Floating rate debt passes a benchmark rise straight into the interest bill, so coverage falls even when the business is doing exactly as well as before. Here 150 basis points on Rs 1,000 crore is Rs 15 crore a year, a 15% rise in interest.

    Floating debt passes a rate rise straight into coverageInterest, Rs crore100Rate 10.0%115Rate 11.5%Interest cover, EBITDA / interest3.00xBefore2.61xAfter +150 bp2.0xEBITDA stays at Rs 300 crore; only the interest line moves
    A 150 basis point rise lifts interest on Rs 1,000 crore of floating debt from Rs 100 crore to Rs 115 crore, and with EBITDA unchanged at Rs 300 crore, interest cover falls from 3.0x to 2.61x.
    The relationship
    Cover=EBITDAD×r:3001,000×10%=3.0×  →  3001,000×11.5%=2.61×\text{Cover} = \frac{EBITDA}{D \times r}: \quad \frac{300}{1{,}000 \times 10\%} = 3.0\times \;\to\; \frac{300}{1{,}000 \times 11.5\%} = 2.61\times
    EBITDAearnings before interest, tax, depreciation and amortisation, Rs 300 crore
    Dfloating rate debt, Rs 1,000 crore
    rthe all-in floating rate, 10% before and 11.5% after
    What it says in wordsCoverage is earnings over the interest bill, and on floating debt the bill moves with the benchmark.

    What would a lender ask next?

    Two questions: how much headroom is left, and how much is hedged. Cover would reach 2.0x only if interest rose to Rs 150 crore, a rate of 15%, so the benchmark would need to climb another 350 basis points from here. Hedging changes the answer more than anything else: if 60% of the debt were swapped to fixed, the same rise would add only Rs 6 crore of interest and cover would fall only to 2.83x. A banker who sees all-floating debt at 3.0x cover asks about hedging before anything else.

    Where candidates lose it

    The common slip is saying cover is unchanged because EBITDA did not move. The ratio has two sides, and floating debt makes the bottom one move.

    The second is reporting 2.6x without the cause: interest up 15%, from Rs 100 crore to Rs 115 crore. The interviewer wants to hear that the business is unchanged and the capital structure did the damage.

    What the interviewer asks next

    • If covenants require cover of at least 2.5x, how far can the benchmark rise before the breach?
    • What share of the debt would need to be fixed to keep cover above 2.8x after the rise?
    • Why might EBITDA also fall when rates rise, and what does that do to the answer?