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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.