Debt Capital Markets puzzles, solved step by step
- Puzzles
- 100
- Traced to a firm
- 16
- Topics
- 13
- Hard
- 30
022Debt is Rs 500 crore and EBITDA Rs 100 crore, growing 10% a year. Free cash flow is 40% of EBITDA and all of it repays debt. In which year does leverage, debt over EBITDA, first fall below 3.0x?Leveraged financePrivate credit
Try it first
Your first guess: in which year does leverage drop below 3.0x?
Show the worked solution
Year 3, at about 2.66x. EBITDA grows to 110, 121 and 133.1, and 40% of each repays debt: 44, 48.4 and 53.2. Debt falls to 456, 407.6 and 354.4, so leverage runs 4.15x, 3.37x and 2.66x. Deleveraging comes from both ends: repayment shrinks debt while growth enlarges EBITDA, and either lever alone would leave leverage near 3.8x in year 3.
Why do both repayment and growth matter?
A family with a home loan feels less stretched both when it prepays the loan and when its salary rises. Leverage is a ratio, so it falls when the debt on top shrinks and when the EBITDA below grows, and here both happen every year. The growth also feeds the repayment: a bigger EBITDA means more cash, so each year's repayment is larger than the last. That compounding is why the answer arrives sooner than a straight-line guess.
Year EBITDA Cash repaid Debt at year end Debt / EBITDA 0 100.0 500.0 5.00x 1 110.0 44.0 456.0 4.15x 2 121.0 48.4 407.6 3.37x 3 133.1 53.2 354.4 2.66x 4 146.4 58.6 295.8 2.02x Rs crore. EBITDA grows 10% a year and 40% of it repays debt at year end; leverage first drops below 3.0x in year 3, at 2.66x, and reaches 2.02x in year 4. With growth and repayment together leverage falls from 5.0x to 2.66x by year 3, crossing the 3.0x line, while growth alone leaves it at 3.76x and repayment alone at 3.80x in the same year. How do you show the interviewer which lever did the work?
Run each lever on its own. With flat EBITDA and 40 a year of repayment, leverage is 3.80x in year 3 and only reaches 3.0x in year 5; with growth but no repayment it is 3.76x in year 3. Neither alone gets there, and together they reach 2.66x, because each lever makes the other stronger. That split is the follow-up in most leveraged finance interviews, and it is how a lender judges how much of a deleveraging story depends on the growth forecast.
What would a lender worry about in this path?
The growth assumption carries much of the result. If EBITDA stalls, the same repayments leave leverage near 3.8x in year 3, so a covenant set to step down to 3.0x by year 3 would be breached. The model also assumes all free cash flow repays debt, with nothing for dividends, acquisitions or a working capital squeeze. Close with the sensitivity: a lender would size the covenant step-downs on a cash flow case below the base case, and say so.
Where candidates lose it
The common slip is running only one lever: repaying 40 a year against flat EBITDA, which says year 5, or growing EBITDA without increasing the repayment. The question built in 10% growth so that cash flow grows too.
The second is a timing error: dividing year-end debt by the opening year's EBITDA. Match the two: debt at the end of year 3 against year 3 EBITDA.
What the interviewer asks next
- EBITDA grows only 3% a year. When does leverage fall below 3.0x now?
- Half the free cash flow goes to dividends instead. Which year does it cross?
- How would you set covenant step-downs for this borrower?
032The leverage covenant is 4.0x. Debt is Rs 800 crore and EBITDA has dropped to Rs 180 crore, so leverage is 4.44x. The sponsor can inject equity either as a cure counted in EBITDA or as a prepayment of debt. How much does each route need?Leveraged financePrivate credit
Try it first
Which route needs less sponsor cash, and by roughly how much?
Show the worked solution
The EBITDA cure needs Rs 20 crore; the prepayment needs Rs 80 crore. To reach 4.0x with debt of 800, EBITDA must be 200, so the cure adds 20. To reach 4.0x with EBITDA of 180, debt must be 720, so the prepayment is 80. The cure is four times cheaper because each rupee of EBITDA supports four rupees of debt, which is why lenders cap how often and how much a cure can count.
Why does the same covenant give two very different cheque sizes?
A bank lets you borrow up to four times your monthly salary. If you are over the limit, you can either repay some of the loan or show a higher salary. Showing Rs 1,000 more salary makes room for Rs 4,000 of loan, so it takes a quarter as much money to fix. A leverage ratio has debt on top and EBITDA underneath, and at a 4.0x test a rupee added below does the work of four rupees removed above. An equity cureA right in a loan agreement letting the owner inject cash to fix a covenant breach, with the cash treated as if it were extra EBITDA for the test. exploits exactly that.
The relationship800 debt, Rs crore 180 EBITDA after the drop, Rs crore 4.0 the maximum leverage the covenant allows What it says in wordsSolve the ratio for the EBITDA that passes at today's debt, and for the debt that passes at today's EBITDA.Adding Rs 20 crore of cure to EBITDA takes leverage from 4.44x to 4.0x with debt unchanged, while prepayment needs Rs 80 crore of debt repaid to reach the same 4.0x, four times the cash. Why do lenders limit equity cures?
Because the cure is cosmetic for the covenant. Rs 20 crore of one-off equity counted as EBITDA does not make the business earn more; it makes the ratio pass for the test periods it is counted in. The lenders still hold Rs 800 crore against a business earning Rs 180 crore. So documents typically cap how many cures are allowed over the life, forbid them in consecutive quarters, cap the amount at what is needed to pass, and stop the cure cash counting as EBITDA for anything else, such as the room to pay dividends.
One wrinkle is worth saying. Some documents also let the cure cash sit on the balance sheet and be netted against debt. Then you solve 800 minus x over 180 plus x equals 4.0, and x falls to Rs 16 crore. Lenders resist that double count for the same reason: one rupee should not fix both halves of the ratio.
Where candidates lose it
The common answer is Rs 80 crore either way, from candidates who only think about paying down debt. They miss that the question offered a cure counted in EBITDA precisely to see whether you notice the ratio's multiplier.
The second loss is getting Rs 20 crore and stopping. The interviewer wants to hear why lenders cap cures: the business still earns Rs 180 crore, and a cure hides that for a quarter.
What the interviewer asks next
- EBITDA falls again to Rs 170 crore next quarter. What cure is needed, and is a second cure likely to be allowed?
- The cure cash can also be netted from debt. What is the smallest cheque now?
- Why might a sponsor choose to prepay even though the cure is cheaper?