Debt Capital Markets puzzles, solved step by step

About Rs 296 crore. A 1.3x cover means only 60 divided by 1.3, Rs 46.15 crore a year, can go to interest and principal. A level payment of that size for 10 years at 9% repays a loan equal to its present value: 46.15 times the annuity factor of 6.418, about Rs 296.2 crore. Debt capacity is the present value of the cash the lender lets you spend on debt.

What does the cover ratio actually limit?

Think of a family with Rs 60,000 a month to spare applying for a home loan. The bank will not let the whole Rs 60,000 go to the EMI; it wants a cushion in case a month goes wrong. A debt service cover of 1.3x means every rupee of loan payment must be backed by 1.3 rupees of cash, so the most the project can pay each year is 60 divided by 1.3, Rs 46.15 crore. The remaining Rs 13.85 crore is the lender's buffer against a bad year. It is not money you can borrow against.

How do you turn an allowed payment into a loan amount?

The loan is whatever amount those payments exactly repay with interest. A loan is the present value of the payments that service it, discounted at the loan's own rate. Ten level payments of Rs 46.15 crore at 9% are worth 46.15 times the ten year annuity factorThe present value of receiving 1 a year for a set number of years at a given rate. For 10 years at 9% it is about 6.42.. Look at the green bars: year 1's payment is worth Rs 42.3 crore today, year 10's only Rs 19.5 crore, because money further away is worth less now.

Check it out loud. Rs 296 crore at 9% is Rs 26.7 crore of first year interest, so the first payment of Rs 46.15 crore repays only about Rs 19.5 crore of principal. With a level payment, principal is repaid slowly at first and faster later, because interest takes the biggest bite while the balance is largest. If you can say that, the interviewer knows you understand what the annuity factor is doing rather than reciting it.

What would a lender push back on?

The Rs 60 crore is a forecast, and a forecast is exactly what a sponsor is paid to be optimistic about. The cover protects the lender only if the cash flow it is applied to is honest, so the real negotiation is over which forecast the 1.3x is applied to. Lenders often size on a downside case, shorten the tenor, or ask for a reserve account that holds some months of debt service in cash. Each of those moves the answer more than a quarter point on the rate would. State the limit too: the sum assumes the project runs all ten years and that nothing needs refinancing.

Maximum debt is about Rs 872.7 crore, and the interest cover test binds. Cover of 2.5x on EBITDA of 240 allows interest of 96; at 11% that is Rs 872.7 crore of debt. Leverage of 4.0x would allow Rs 960 crore, but the rate is too high for the business to carry it. The two tests meet at a 10% rate; above that, coverage is the tighter limit.

Why run both tests instead of just the leverage one?

A household can be told it may borrow up to four years of income, but it also has to afford the monthly instalment. When interest rates are high, the instalment test fails first, long before the four-years rule does. Leverage measures how much debt there is; interest cover measures whether the business can pay for it, and the rate decides which one runs out first. A lender sizing debt computes both and lends the lower.

At what rate do the two tests swap?

Set them equal: 96 divided by the rate equals 960, so the rate is 10%. Above 10%, coverage binds; below it, leverage binds. That is the general rule to leave the interviewer with: the crossover rate is one over the leverage multiple times the cover multiple, 1 over 4.0 times 2.5, which is 10%. When rates rise, the same business can borrow less even though its EBITDA has not changed, and lenders who size on leverage alone find their borrowers failing cover tests a year later.

Say the limits. EBITDA interest cover ignores capex and tax, so a lender who worries about cash will also run a fixed charge test, which can bind lower still. And the effective leverage here is 3.64x, not the 4.0x the term sheet headline suggests; quoting 4.0x to the borrower would promise debt the second test will not allow.

Unlevered free cash flow is about Rs 61.8 crore. EBITDA is 18% of Rs 800 crore, Rs 144 crore. Less Rs 30 crore of depreciation gives EBIT of Rs 114 crore, and tax at 25% leaves NOPAT of Rs 85.5 crore. Add back depreciation, which is not cash, to reach Rs 115.5 crore, then take off capex of Rs 45 crore and the working capital build of 12% of the Rs 72.7 crore revenue increase, Rs 8.7 crore.

What order do you walk the lines in?

Think of a shopkeeper's year: sales come in, stock and staff are paid, the taxman takes a share, some money goes on a new fridge, and more stock sits on the shelves because the shop is busier. What is left is what the owner could take out. Unlevered free cash flow follows the same order: operating profit, less tax on that profit, plus non-cash charges, less investment in fixed assets and in working capital. It is unlevered because interest is left out: the cash belongs to lenders and shareholders together.

Why tax EBIT rather than profit after interest?

Unlevered cash flow is the cash the business makes before any financing choice, so tax is charged as if there were no debt: 25% of EBIT, Rs 28.5 crore. Real tax is lower when there is interest to deduct, and that saving is counted elsewhere, in the discount rate or in a separate tax shield line. Taxing profit after interest and then discounting at a rate that already includes the shield counts the same benefit twice.

Where does the cash go between EBITDA and free cash flow?

Of Rs 144 crore of EBITDA, only Rs 61.8 crore, about 43%, becomes unlevered free cash flow: tax takes 28.5, capex 45 and working capital 8.7. Capex is 1.5 times depreciation, so the company is investing to grow, and working capital rises with sales because more revenue means more receivables and stock. A lender sizing debt on EBITDA should look at this conversion, because interest and repayments are paid from the Rs 61.8 crore, not the Rs 144 crore. The limit: one year of cash conversion can mislead when capex is lumpy.

Term loan A has a weighted average life of 3.0 years and term loan B about 6.8 years. Term loan A repays 200 in each of years 1 to 5, so its average is (1 + 2 + 3 + 4 + 5) x 200 / 1,000 = 3.0. Term loan B repays 10 in each of years 1 to 6 and 940 in year 7: (210 + 6,580) / 1,000 = 6.79. Amortisation, not maturity, sets how long the lender's money is out.

What are the two loans, and why do they amortise so differently?

That is the question a candidate reported being asked, and the arithmetic is the best way to answer it. A term loan A is built for banks: it amortises steadily, so the lender's exposure shrinks every year. A term loan B is built for institutional investors such as loan funds: it amortises only nominally and returns almost everything at maturity, which suits investors who want to stay invested. The difference in structure shows up as a difference in weighted average life, and that number drives pricing, investor appetite and how long the credit risk lasts.

How is weighted average life calculated?

Think of lending a friend Rs 1,000 who repays Rs 200 a year: on average your money is out about three years, even though the last rupee comes back in year five. Weighted average life weights each repayment date by the share of principal repaid on it, and ignores interest. For term loan B: six payments of 10 contribute 10 x (1 + 2 + 3 + 4 + 5 + 6) = 210 year-rupees, and the bullet contributes 940 x 7 = 6,580. Total 6,790 over 1,000 is 6.79 years.

Why does the desk care?

A loan's pricing is spread over its weighted average life, not its stated maturity, so an upfront fee or discount is spread over 3 years on term loan A and nearly 7 on term loan B. In practice term loans B are often repaid early from refinancings or cash sweeps: if this one were refinanced in full at year 4, its weighted average life would fall to 3.94 years. Weighted average life is also not duration; it ignores interest and discounting, so it always sits above the loan's duration.