Case 047Capital allocation and corporate actionsCore

Pallanza Hospitals raises Rs 1,000 crore through a placement at a 5% discount, adding about 8.8% to its share count, to build three hospitals that break even in year three. When does the deal start adding to EPS?

The situation

Pallanza Hospitals runs 18 hospitals and earns Rs 400 crore after tax on 40 crore shares, EPS of Rs 10.00. The shares trade at Rs 300, and the existing business grows profit about 12% a year. It sells Rs 1,000 crore of new shares to institutions at Rs 285, a 5% discount, which adds 3.51 crore shares, 8.8% of the count.

The money builds three hospitals. Management guides that, net of interest earned on cash not yet spent, they will add to profit after tax Rs -10 crore in year 1, Rs -25 crore in year 2, zero in year 3, Rs 60 crore in year 4 and Rs 120 crore in year 5.

Your task

Year by year, is the placement dilutive or accretive to EPS, and what does breakeven in year 3 really mean for shareholders?

Quick check

The hospitals break even in year 3. When does the placement stop diluting EPS?

Worked solution

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

30-second answerThe answer to give first

The placement dilutes EPS for three years and turns accretive in year 4, one year after the hospitals break even. The new shares need the hospitals to earn about 8.8% of the existing profit just to hold EPS level: Rs 49 crore in year 3, Rs 55 crore in year 4. The hospitals deliver zero, then Rs 60 crore. EPS is about 13% lower in year 2, 0.7% higher in year 4 and 7.6% higher in year 5.

Step 1Why is breakeven not the point where the deal pays off?

Three friends who own a shop let a fourth buy in to fund a second branch. Until the branch earns a quarter of the combined profit, each of the original three takes home less than before, even if the branch is not losing money. New shares take their share of every rupee the company earns from day one, so the new project must earn at least that share just to leave EPS where it was. For Pallanza that bar is 3.51 over 40, about 8.8% of the existing profit, which grows with the base business.

Growth capital dilutes first and pays later: EPS, Rs1012141618Without the raiseWith the raise: -13% in year 2Year 4: +0.7%+7.6%TodayYear 1Year 2Year 3Year 4Year 5Breakeven in year 3 is not accretion: the new shares still need their share of profit
Pallanza's EPS with the placement trails the no-raise path by 10% in year 1 and 13% in year 2, is still 8% lower at the year-3 breakeven, and moves ahead only in year 4, by 0.7%.
Step 2How do you find the crossover year?

Compare what the hospitals add with what the new shares need. The deal is accretive in any year when incremental profit exceeds the old profit times new shares over old shares: Rs 629 crore times 3.51 over 40 is Rs 55.2 crore in year 4. The hospitals add Rs 60 crore that year, so EPS moves ahead, but only just. In year 5 they add Rs 120 crore against Rs 62 crore needed and the gap opens up.

The relationship
Accretive when ΔPAT>PATold×nnewnold=629×3.5140≈55 in year 4\text{Accretive when}\ \Delta\text{PAT} > \text{PAT}_{\text{old}} \times \frac{n_{\text{new}}}{n_{\text{old}}} = 629 \times \frac{3.51}{40} \approx 55 \ \text{in year 4}
Delta PATprofit the new hospitals add, net of interest on unspent cash
PAT oldprofit of the existing business that year, Rs crore
n new / n old3.51 crore new shares over 40 crore existing
What it says in wordsA share issue adds to EPS only once the new profit beats the slice of old profit handed to the new shareholders.
What the new shares need against what the hospitals deliver, Rs crore39-10Year 144-25Year 2490Year 355+60Year 462+120Year 5Needed: 8.8% of the base profitDelivered, clears the barDelivered, short
The new hospitals must add Rs 39 to 62 crore a year just to hold Pallanza's EPS level; they deliver -10, -25 and 0 in the first three years and first clear the bar in year 4 with Rs 60 crore.
Step 3Is a dilutive deal a bad deal?

No, and this is the point to finish on. EPS dilution in the early years is the normal price of growth capital; the question is whether the hospitals earn more than the capital costs over their life. If they mature to Rs 150 crore or more of profit a year on Rs 1,000 crore, a 15% return, the deal creates value even though EPS suffers for three years. The discount has a cost too: selling 3.51 crore shares Rs 15 below market hands about Rs 53 crore of value to the placement buyers, which is why investors ask why the raise was needed now.

Where candidates lose it

The common loss is saying the deal adds to EPS in year 3 because that is when the hospitals break even. Breakeven means zero profit, and zero is less than the share of profit the new shareholders take.

The second is judging the raise on EPS alone. A capital raise is justified by the return on the capital, and a candidate who calls it bad because of three years of dilution has missed the question behind the question.

What the interviewer asks next

  • What if the hospitals take one more year to ramp up? When does the deal turn accretive then?
  • Would debt funding have been better for EPS, and what would it cost the balance sheet?
  • How would you value the three hospitals separately in a sum of the parts?

Company names and figures are illustrative.