Debt Capacity Calculations
- 05:26
Calculating the debt capacity for Smithy
Transcript
Right, we're going to calculate now the debt capacity for Smithy using the three methodologies just explained. And we're gonna start, of course, with calculating the unlevered free cash flow and that's been done here in the file. Let's just have a look at what that was again. We start with our EBIT number, so that's an unlevered number. We take away taxes, add back depreciation, amortization, deal with changes in operating working capital and then in the end, take away the capital expenditure. This would be our unlevered free cash flow. So this 61.6, and going forward, this is gonna be our starting point. When we eyeball that number, we see that it's dropping off and that's an important factor here. It goes from 61-ish all the way down to 32, 28, et cetera.
So we know that that might be a problem. Anyway, those are our unlevered free cash flows. Right, we go down here to the calculations and we'll see that we will be using this debt service coverage ratio, and think of that debt service coverage ratio as a buffer. The greater the risk in our forecast, in this case, our unlevered free cash flows, the greater the debt service coverage ratio will have to be because that is the buffer between our forecasted cash flows and what we expect to be able to use to service debt. This DSCR will be set according to industry and there will be certain standards here. We've decided to put 1.4 times, which is a reflection of this intermediate risk that we see here. So the first thing we do is we calculate the cash available for debt after considering the debt service coverage ratio.
So that's, of course, now a lower number because that's after that buffer. We're gonna copy that across all the way to the right.
And now we have a starting point here. The first calculation we're gonna do is to think of the debt service coverage ratio and look at one cash flow, the projected year one cash flow, and assume that that is representative for the future. We're gonna assume that the maturity of the new debt is seven years, so let's think of that seven years, one divided by seven, that's 14%. It means that 14.3% of the loan will have to be repaid every year. Of course, the loan also carries interest, so we're gonna add the interest portion of 3% post-tax there. That gives us an all-in debt service coverage cost of 17.2%.
What we simply do then is we take that one-year cash flow and we divide it by that 17.2%, and we get our implied debt capacity using the DSCR, and a one-year cash flow estimate. Remember, this 255.2 does not take into account that the fact that cash flows are going to be falling in the future. Secondly, we use the implied debt capacity using the NPV.
So we're gonna do NPV, NPV and the interest rate here, of course, is the post-tax 3% and the cash flows are seven years' worth of cash flows two, three, four, five, six, seven, and close the bracket, and that gives us a debt capacity of only 184.4. Why is this? Well, now we're looking at the full forecast, seven years of cash flow, which, of course, reflects the fact that cash flows are falling. The calculation above does not reflect the falling cash flows, but it is still looking at real cash flows. Why do I say that? Well, because our last methodology here is just saying what if our max debt to EBITDA multiple is five times? Well, five times is the multiple. Go up in the model and find the EBITDA and you'll see that the implied debt capacity using a maximum EBITDA multiple is 668.5.
I think this shows us clearly the weaknesses here of just using the debt to EBITDA multiple. Why? Well, of course, this multiple does not reflect the cash conversion of the business. It just uses EBITDA as a proxy for cash flows, and secondly, it's also not reflective of the fact that cash flows might be falling in the future. Anyway, there we have our three calculations for maximum debt capacity.