Case 021Credit and leveraged financeWarm up

A middle-market plastics company wants the biggest term loan the bank's policy allows. Size it on leverage and on fixed charge cover, and set covenants with 25% headroom.

Deutsche BankNew York · 2024

The situation

Kaivan Plastics, a family-owned maker of moulded containers, has EBITDA of Rs 40 crore. It spends Rs 8 crore a year on maintenance capex and pays about Rs 5 crore of cash tax. It has no debt today and wants a term loan to fund a payout to family shareholders.

The bank lends at 11%, repaid in equal instalments over seven years. Policy says total debt may be at most 3.0x EBITDA, and the fixed charge cover, EBITDA less maintenance capex and cash tax, divided by interest plus scheduled principal, must be at least 1.5x in the first year.

Your task

What is the largest loan the policy allows, which test binds, and where would you set the two covenants with 25% headroom to the base case?

Quick check

Leverage of 3.0x allows Rs 120 crore. Is that the answer?

Worked solution

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

30-second answerThe answer to give first

The largest loan is about Rs 71 crore, set by fixed charge cover, not the Rs 120 crore leverage allows. Kaivan has Rs 27 crore of cash for debt service, and each rupee of a seven-year loan at 11% costs about 25 paise in year 1, so 1.5x cover caps the loan at Rs 71.2 crore, 1.78x EBITDA. With 25% headroom, set leverage at 2.22x and cover at 1.20x.

Step 1Why can a loan pass on leverage and still fail?

Because leverage looks at the size of the debt, and cover looks at what the debt costs this year. When a loan amortises over a short period, the principal instalments, not the interest, are the biggest fixed charge, and cash cover becomes the binding test. A fixed charge coverCash available after maintenance capex and tax, divided by the interest and scheduled principal due in the period. of 1.5x means the company earns one and a half times what it must pay. A family can afford a big home loan on paper, three years of income, yet fail the bank's EMI-to-salary test if the loan must be cleared in seven years.

Step 2What does each test allow?

Leverage: 3.0x Rs 40 crore is Rs 120 crore. Cover: cash for debt service is Rs 40 crore less Rs 8 crore less Rs 5 crore, Rs 27 crore. Year-1 cost per rupee of loan is 11 paise of interest plus one-seventh of principal, about 14.3 paise, together about 25.3 paise. To keep cover at 1.5x, debt service can be at most Rs 18 crore, so the loan can be at most Rs 18 crore over 0.253, about Rs 71.2 crore. At the leverage limit of Rs 120 crore, cover would be only 0.89x: Kaivan could not pay its instalments from its own cash.

The relationship
Lmax=40−8−51.5×(0.11+1/7)=270.379≈71.2L_{max} = \frac{40 - 8 - 5}{1.5 \times (0.11 + 1/7)} = \frac{27}{0.379} \approx 71.2
40 - 8 - 5EBITDA less maintenance capex less cash tax, Rs 27 crore
1.5required fixed charge cover
0.11 + 1/7year-1 interest plus principal per rupee lent
What it says in wordsThe largest loan is the cash available for debt service divided by the cover required times the year-one cost of each rupee borrowed.
Two tests, one loan: the lower answer wins, Rs croreLeverage test: 3.0x EBITDA120Cover test: 1.5x fixed charges71 bindsHow far EBITDA can fall before each covenant tripsLeverage covenant 2.22x20% (EBITDA to 32.0)Cover covenant 1.20x13.5% (EBITDA to 34.6)a 25% EBITDA fall25% headroom on a ratio is not 25% headroom on EBITDA: capex, tax anddebt service do not fall when EBITDA does.
Leverage of 3.0x would allow Kaivan Rs 120 crore, but 1.5x fixed charge cover allows only about Rs 71 crore, so cover binds; covenants set 25% beyond the base case trip after an EBITDA fall of 20% on leverage but only 13.5% on cover.
Step 3Where do you set the covenants, and how much room do they really give?

Set each covenant 25% looser than where the loan starts. Opening leverage is 1.78x, so the leverage covenant sits at 2.22x; opening cover is 1.5x, so the cover covenant sits at 1.20x. Then translate both into EBITDA, because that is what moves. Leverage trips if EBITDA falls to about Rs 32 crore, a 20% fall. Cover trips at about Rs 34.6 crore, a fall of only 13.5%, because capex, tax and the instalment stay put while EBITDA drops.

TestBase caseCovenantEBITDA at which it tripsEBITDA cushion
Leverage, debt / EBITDA1.78x2.22x32.020.0%
Fixed charge cover1.50x1.20x34.613.5%
Rs crore. With covenants set 25% beyond the base case, Kaivan can lose 20% of EBITDA before the leverage covenant trips but only 13.5% before the cover covenant does, because its fixed charges do not shrink.

Close with what you would tell the credit committee: lend about Rs 70 crore, accept that the cover covenant is tight in year 1 and loosens as interest falls with each instalment, and ask for a longer tenor or a cash sweep if the family wants more. A payout to shareholders is also a reason for caution, since the bank's money leaves the business on day one.

Where candidates lose it

Candidates size the loan at 3.0x EBITDA, Rs 120 crore, because leverage is the first ratio they learn. On a seven-year amortising loan that cannot be serviced: year-1 debt service exceeds the company's cash.

The second miss is assuming 25% covenant headroom means EBITDA can fall 25%. On the cover test it can fall barely half that, and saying so is what marks a credit answer.

What the interviewer asks next

  • How large could the loan be if it repaid over ten years instead of seven?
  • Why do lenders test cover on maintenance capex rather than total capex?
  • The family wants Rs 100 crore. What structure would you offer?

Asked at Deutsche Bank, Sales and Trading, New York, 2024 (Wall Street Oasis): The case study was relatively simple, focused on lending to a middle-market corporate.

Company names and figures are illustrative.