Case 072Returns attribution and value creationCore

An adhesives maker can raise prices 3% a year but expects to lose 2% of volume a year as a result. On Rs 400 crore of revenue at a 20% margin, what does that do to EBITDA in year 5 and to the sponsor's return?

The situation

Ekvira Adhesives makes industrial glues and sealants for furniture, footwear and packaging makers. Revenue is Rs 400 crore and EBITDA Rs 80 crore, a 20% margin. Raw materials and freight are 60% of revenue and move with volume; the remaining Rs 80 crore of plant, staff and overhead cost is fixed. Assume input costs per tonne and fixed costs stay flat for five years.

Management believes customers will accept price rises of 3% a year, at the cost of losing 2% of volume a year to cheaper rivals. Without price rises, volume would stay flat. A sponsor would buy at 10x EBITDA with 4x debt at 10%, put 50% of EBITDA towards interest and repayment each year, and exit at 10x in year 5.

Your task

Compare EBITDA in year 5 with and without the price rises, split the difference into price and volume, and work out the sponsor's IRR in each case.

Quick check

Price rises 3% and volume falls 2%, so revenue grows about 1% a year. Roughly how fast does EBITDA grow?

Worked solution

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

30-second answerThe answer to give first

With the price rises, EBITDA reaches about Rs 122 crore in year 5 against Rs 80 crore without, and the sponsor's IRR is about 16% against about 2%. Five years of 3% price adds Rs 57.6 crore of EBITDA, because price has no cost attached. Losing 2% of volume a year costs only the 40% contribution on it, Rs 15.4 crore. That is why pricing power is the first thing a sponsor tests, and why the test is whether costs stay flat.

Step 1Why does a price rise matter so much more than its size suggests?

Because a price rise has no cost attached. Think of a tea stall that raises a cup from Rs 15 to Rs 16: the milk, sugar and gas cost the same, so the extra rupee is all profit, while a lost customer only takes away the margin on his cup. At Ekvira, a 3% price rise on Rs 400 crore of revenue is Rs 12 crore, which is 15% of EBITDA, and losing 2% of volume costs only the 40% contribution on Rs 8 crore of sales, Rs 3.2 crore. The ratio is what matters: price works on revenue, and revenue is five times EBITDA here, so a small price move is a big profit move.

Step 2How far apart are the two paths by year 5?

Compound both effects year by year. With price, revenue grows to Rs 419.2 crore while variable cost falls with volume to Rs 216.9 crore, so EBITDA reaches Rs 122.2 crore; without price, everything stays put and EBITDA is Rs 80 crore. Split the year 5 gap of Rs 42.2 crore into its parts: five years of price on the volume that remains adds Rs 57.6 crore, and the 9.6% of volume lost takes away Rs 15.4 crore of contribution. The margin moves from 20% to 29.2%.

With 3% price rises and 2% volume loss a year, Ekvira's EBITDA climbs from Rs 80 crore to Rs 122.2 crore by year 5, while without price rises it stays at Rs 80 crore; the gap is Rs 57.6 crore from price less Rs 15.4 crore of contribution lost on volume.

Rs crore	With price rises	Without
Year 5 revenue	419.2	400.0
Year 5 EBITDA	122.2	80.0
Entry equity	480	480
Debt at exit	198.4	271.2
Exit equity at 10x	1023.8	528.8
MOIC and IRR	2.13x, 16.4%	1.10x, 2.0%

Bought at 10x with 4x debt and sold at 10x in year 5, Ekvira returns 2.13x and 16.4% a year with the price rises and only 1.10x and 2.0% without them, because flat EBITDA leaves debt paydown as the only source of gain.

Step 3What does this do to the sponsor's return, and what must be true?

It is the difference between a deal and no deal. With the price rises, exit equity is about Rs 1024 crore on Rs 480 crore in, 16.4% a year; without them, flat EBITDA leaves only debt paydown, about 2.0% a year. But the comparison rests on one assumption the interviewer will push on: input costs stay flat. If raw materials and fixed costs inflate 2% a year, the price rises mostly keep pace: EBITDA reaches about Rs 91 crore with price and falls to about Rs 47 crore without. So the real test of pricing powerThe ability to raise prices faster than costs without losing so much volume that profit falls. The cleanest evidence is a history of price rises above input inflation with stable share. is not whether Ekvira can raise prices, but whether it can raise them faster than its costs. Diligence it with five years of price, volume and input cost history by customer group, and ask how much volume was lost after each past increase.

Where candidates lose it

The usual loss is netting price against volume, 3% less 2%, calling it 1% growth, and growing EBITDA at 1%. Price and volume have different costs: price carries none, and lost volume takes only its contribution, so EBITDA grows about 9% a year.

The second is forgetting cost inflation. A price rise that only matches input costs is not pricing power; it is standing still, and the case only works if costs stay below price.

What the interviewer asks next

Volume loss is 4% a year instead of 2%. Is the price rise still worth it?
Where in the customer list would you expect the volume loss to come from, and does that matter?
How would you show pricing power to a buyer at exit?
What is the maximum volume loss at which a 3% price rise still leaves EBITDA flat?

Company names and figures are illustrative.