Cash flow based debt capacity is more in depth than multiple based Here I've got five cash flows for years 1, 2, 3, 4, 5 I've gone out to a bank and they've said "Yep, we're willing to lend to you based on those five cash flows but not year 6" Okay, they're willing to charge us a cost of debt which after tax costs us 5% And the debt capacity is established by an NPV at the post tax cost of debt I'm going to use those one, two, three, four, five cash flows to repay the debt and interest If I take an NPV (at the interest rate), that gets me the present value that I borrow 479.9 Let's just check what happens over time. That 479.7 becomes my beginning balance at yea 1 It then goes up due to the interest that you owe But then you make a cash payment using all cash (you've got 100) To eventually bring the amount you that you owe down to 403.7 That gradually happens each period, interest increases the amount you owe then you make a big payment By the final period, you've paid it off However what if you want more debt? Well we go onto the next slide and here you've got your original tranche 1 up at the top here But we're now going to add tranche 2 You go to a second bank and they say, "yeh we're willing to lend to you based on years 1-5" You go sorry, we're already with a bank on that one So they say, "what about your year 6 cash flow?" Fantastic! That's available, so we're going to use that to come up with a bullet repayment The first tranche was an amortizing debt. What we're going to have here is a bullet repayment that's going to happen in year 6 Here's the tricky bit, my cash flow in year 6 needs to cover the interest on the amount I borrow (that's 7.2 here) And the principle repayment So what I've done is I've taken the 127, I've split it into repayment of principle and paying off interest How did I get to that principle amount? That was the 127 less one year's interest Or to put it another way, I discount the 127 by one year's interest So that's how much I borrow today (119.8), that goes up by the interest I owe in year 1. But I pay the interest in year 1 Then it goes up again in year 2 by the interest but the I pay the interest So we actually keep an outstanding balance of 119.8 throughout the 5 years And then in year 6, we pay the 119.8 and your interest Here's the tricky bit, because we've now got interest being paid in year 1, 2, 3, 4 and 5 That reduces the cash flows that you did have ear marked for your first tranche of debt (oh dear) So I need to go back to the first bank and say "sorry, I thought I had 100, I've actually now only got 92.8" Because I subtracted the 7.2 And the same for all the remaining years First bank says "yeh no problem, we'll just do the NPV again" I've now got 448 from the first tranche So first bank lends me 448.6 based on the cash flows I've got available after paying the interest on 2 And I get 119.8 from bank two in my second tranche of debt I add the two of them together, that gives me my total debt borrowed So debt tranching allows the issuer to increase the total amount of debt to 568.4 Appealing to investors with different risk profiles in this cash I said we had bank one and bank two