A chemicals company needs Rs 2,000 crore for an acquisition. Compare all debt, all equity and a 50/50 mix on EPS and on leverage against the rating threshold, and recommend one.

All equity: it dilutes EPS least, 1.7% against 7.5% for all debt, and is the only option that leaves room under the 3.0x rating line. All debt takes leverage to 4.0x and almost certainly costs the rating. The 50/50 mix lands exactly on 3.0x with no headroom and dilutes 4.3%. Equity wins on both counts because Pavak's shares, at 20x earnings, cost less than its debt after tax.

Before any table, compare the yields. New shares cost Pavak its earnings yield, 1 over a P/E of 20, 5.0%; new debt costs 8.5% less the tax shield, 6.375%; and the target earns Rs 90 crore on Rs 2,000 crore, 4.5%. A business earning 4.5% bought with money costing 5.0% or more dilutes every way you fund it, so the question is which currency dilutes least. A family that borrows at 6.4% to buy a fixed deposit paying 4.5% is worse off than one that sells a share of the house at 5%, even though borrowing usually feels cheaper.

Leverage is the constraint the EPS table cannot show. Combined EBITDA is Rs 1,000 crore, so 3.0x allows total net debt of Rs 3,000 crore, only Rs 1,000 crore more than today; all debt overshoots to 4.0x and the 50/50 mix uses every rupee of headroom. A downgradeA rating agency lowering its view of a borrower credit quality, which usually raises the interest rate on new debt and can trigger clauses in existing loans. would raise the cost of all of Pavak's debt, not only the new borrowing, and a 50/50 mix sitting on the line would be one weak quarter away from one.

Say the condition, because that is what the interviewer is really testing. Equity is the cheaper currency only while Pavak's P/E is above about 15.7x, the point where its earnings yield equals the 6.4% after-tax cost of debt; below that, debt dilutes less and the rating becomes the only argument for equity. At 20x Pavak is well above it. The recommendation is to fund with equity, or with mostly equity and a small amount of debt that keeps leverage around 2.5x, so the rating is protected with room to spare. The limits: a share issue usually needs a discount to the market price, which raises dilution; and EPS in year 1 is not value, so the board should also ask whether Rs 2,000 crore for Rs 90 crore of income is a good price at all.