Determining a Company's Maximum Debt Capacity

In this post I will first highlight some considerations when taking on additional debt. Next I will detail the process of determining a company's maximum debt capacity.

How much debt maximizes a firm's value? Can you tell me what a company's optimal capital strucure is? You probably might be able to look at industry standards and averages and believe that they must be valid for the company as well. But remember that industry averages are only benchmarks (not necessarily the ideal benchmarks).

Can a company take on more debt? Will you be able to take on additional debt in the future? How will your cost of debt change? How will your relationship with current and prospective lenders change after taking on additional debt? Will you have favorable access to short-term funds to fund net working capital at seasonal peaks? What is the likelihood of insolvency or financial distress? How will your cash flows be affected? Are the marginal benefits from tax shields greater than the costs of financial distress? How will shareholders react? Etc, etc.

The objective of these questions is to determine the point at which a company's borrowing capacity is maximized. After this point, the answers to all of the above questions will be unfavorable. So how do you determine this maximum debt capacity?

Step 1: Determine Earnings Before Interest and Taxes (EBIT)
Step 2: Determine Maximum Interest Payment = EBIT / EBIT Coverage Ratio
Step 3: Implied Maximum Debt Capacity = Maximum Interest Payment / Cost of Debt
Step 4: Compare Current Debt to Implied Maximum Debt Capacity to determine additional
borrowing capabilities

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Sanjeet Parab_____________________________