Case 081M&A strategyHard

An Indian parts maker wants to buy a German drivetrain firm for EUR 300 million. It can borrow in euros at 5% or rupees at 9%, and the rupee is expected to weaken about 3% a year. Which currency should fund the deal, and what risk does each choice carry?

The situation

Vaikhari Auto, an Indian maker of engine and transmission parts, has agreed to buy Hessler Antriebe, a German drivetrain company, for EUR 300 million, 7.5x Hessler's EBITDA of EUR 40 million. At EUR 1 to Rs 90, the price is Rs 2,700 crore. Vaikhari plans to borrow EUR 160 million, Rs 1,440 crore, and fund the rest from its own cash.

It can borrow in euros at 5% or in rupees at 9%. The rupee is expected to weaken by about 3% a year against the euro, though nobody can promise that path. Hessler's revenue and costs are almost all in euros.

Your task

Compare the cost of the two loans in rupees, say which currency you would borrow in and how much, and name the risk Vaikhari takes either way.

Quick check

Measured in rupees, roughly what does the 5% euro loan cost a year if the rupee weakens 3% a year?

Worked solution

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

30-second answerThe answer to give first

Borrow in euros, sized to what Hessler's euro cash flow can carry, and fund the rest in rupees. The 5% coupon costs about 8.2% in rupees if the rupee weakens 3% a year, so the expected saving over 9% is small, about Rs 12 crore a year. The real reason is the hedge: euro debt is repaid from euro earnings, so a currency move shifts the asset and the debt together.

Step 1Is the euro loan as cheap as it looks?

Convert both loans into the currency Vaikhari reports in. A borrower in a foreign currency pays the coupon plus whatever its own currency loses, so 5% in euros with a 3% yearly rupee fall costs about 8.15% in rupees. Think of a student in Pune who borrows from an aunt in Frankfurt: the interest is low, but every year the euros she must send back cost more rupees. The euro loan breaks even with rupee debt if the rupee falls 3.81% a year, the ratio 1.09 over 1.05 less one. That gap between interest rates is roughly what currency markets already expect, which is why the carryThe interest saved by borrowing in a low rate currency, which is exposed to that currency rising against your own. rarely comes free.

In rupee terms the 5% euro loan costs about 8.15% if the rupee weakens 3% a year, against 9% for rupee debt, and it costs more than rupee debt only if the rupee falls faster than 3.81% a year.

Step 2Why does the currency of Hessler's earnings decide the answer?

Because the debt is repaid from Hessler's cash, not from a forecast. Euro debt serviced by euro earnings is a natural hedgeMatching a liability to an asset or income stream in the same currency, so a currency move changes both by the same proportion.: if the rupee falls, Hessler is worth more rupees and so is the loan, and the two moves offset. Interest of EUR 8 million against EUR 40 million of EBITDA is cover of 5.0x whatever the exchange rate. With rupee debt, Hessler's rupee earnings move with the euro while the loan does not: debt to EBITDA would be 4.50x at Rs 80 and 3.45x at Rs 104, against a constant 4.00x with euro debt.

With euro debt, Vaikhari's equity in Hessler moves from Rs 1,120 crore to Rs 1,461 crore as the euro goes from Rs 80 to Rs 104; with rupee debt it swings from Rs 960 crore to Rs 1,690 crore, more than twice as much.

Rs per euro	Equity, euro debt	Equity, rupee debt	Debt / EBITDA, rupee debt
80	1,120	960	4.50x
90	1,260	1,260	4.00x
104.3	1,461	1,690	3.45x

Holding Hessler at EUR 300 million, rupee funding makes Vaikhari's equity and its leverage ratio swing with the exchange rate, while euro funding keeps leverage at 4.00x and narrows the equity swing to Rs 341 crore.

Step 3What risk is Vaikhari taking either way?

Name both, because neither choice is risk free. With rupee debt, the risk is a stronger rupee: Hessler's earnings shrink in rupees while the loan does not, so a fall to Rs 80 cuts the equity from Rs 1,260 crore to Rs 960 crore. With euro debt, the risk is a mismatch of size or time: if Vaikhari borrows more euros than Hessler's cash can service, the excess is repaid from rupee profits and the full depreciation bites. Expected interest saving, about Rs 12 crore a year on Rs 1,440 crore, is not the reason to choose euros; the matched balance sheet is.

Close with the recommendation for the board and its limits. Borrow in euros up to a level Hessler's own cash flow covers comfortably, keep the rest of the funding in rupees, and check that lenders measure covenants in a way that does not create a mismatch. The forecast of 3% a year is an assumption, not a promise, and the case for euros should survive the rupee moving either way. It does here, because the hedge does the work; the coupon saving is a bonus, not the argument.

Where candidates lose it

The common miss is comparing 5% with 9% and choosing euros because they are cheaper. The coupon is not the cost to a rupee borrower; the currency move is part of the price, and on these numbers it closes most of the gap.

The opposite miss is choosing rupees to avoid currency risk. The currency risk already sits in Hessler's euro earnings; rupee debt leaves it unhedged rather than removing it.

What the interviewer asks next

Vaikhari's Indian business also exports to Europe and earns EUR 15 million a year. How much euro debt can it carry now?
Why do lenders and rating agencies care whether leverage covenants are measured at the current or the average exchange rate?
Could Vaikhari borrow in rupees and swap into euros instead? What changes?
The rupee strengthens 10% in year 1. Walk through what happens to group leverage under each funding choice.

Company names and figures are illustrative.