Another way of approaching debt capacity analysis, rather than multiples is to take a look at the ability of the firm to service the debt. Fundamentally, the firm is going to pay interest and it's going to repay the debt out of its cash flows. So cash flow based debt capacity analysis tends to be more reliable. It's more complex because you need a forecast of the company's cash flows going forward. It's much simpler to use a multiple based analysis but cash flow based debt capacity analysis means that you won't potentially make the same mistakes that you could make from multiple based debt capacity analysis where you are overestimating the firm's ability to finance the debt. Now, a caveat to that, of course, is that if your cashflow forecast for the company is unrealistic, then your debt capacity using that forecast is going to be unrealistic. At its fundamental, the debt capacity of a company, assuming we use all the free cash flows to repay the loan and pay any interest, is a simple present value calculation. So you can see here we've got a cash flow forecast from year one to year five, and that five year forecast has been present valued using a discount rate, which is equal to the after tax cost of debt. So all these free cash flows have been present valued back to year zero using a 5% after tax cost of debt. Assuming the lender doesn't want any headroom, it probably would do, then the maximum loan this business can support, assuming it has to be repaid over a five year period, is 479.7 million.

We can prove that by doing this little base calculation, and we've got the beginning balance, we add the accrued interest, we subtract the payment and giving our ending balance. We started with the total debt amount based on the present value number, which is 497. That ending balance in year zero becomes the beginning balance in year one. The accrued interest that 24 is calculated by taking the 479.7 times the 5% interest that gets added. The 100 is just the available cash flow in that year and we subtract that. So of that 100, some of it has gone to pay the interest of 24, and some of it has reduced the loan balance. So the loan balance has now dropped to 403.7. That ending balance becomes the beginning balance of the next year, and now the interest has dropped because 403.7 times 5% is only 20.2 because the balance of the loan has dropped. Not only that, but the free cash flow of the company has risen, because perhaps its revenues and earnings have grown. So this means of the 105 million that we have got 20.2 of that is gonna be paid off or used to pay off the interest and the rest is going to start paying off the loan. But the loan repayment is gonna get faster as a function of the free cash flow increasing and the interest expense falling. And you can see that over time. So increasingly what happens is the repayment accelerates. In year one, it was 100, year two 105, year three 110, year four 118, year five 124. And as if by magic, our ending amount is zero. And that's because the present value of the future cash flows using after-tax cost of debt will give us the exact debt capacity of the business.