A very common way of establishing a company's debt capacity is by using multiples. And there are really two types of multiples that they'll focus on. But in order to calculate the multiple, you need a piece of information first. Firstly, you need to take the multiple. And the two types of multiple will typically be some type of repayment ability, or cash flow or things like EBITDA, or it could be some kind of interest coverage, so EBITDA to interest expense. The amount of the multiple will typically be market driven. And in recent years, we've started to see some of the regulators start to get involved in the levels of leverage that can be undertaken in transactions. For example, the Federal Reserve recently said if a transaction is going to have a debt to EBITDA multiple of more than six times, we want to make sure that there's a lot of more due diligence and careful analysis and ongoing analysis for that transaction than normal. So once we've taken the multiple, which we've got from the marketplace, then what we need to do is take a value driver. And most commonly we will often use EBITDA, or specifically LTM EBITDA. And we usually will use last 12 months EBITDA or LTM EBITDA because it's conservative and it's historical. Now if we're doing total debt to EBITDA, then we'll multiply last 12 months EBITDA. Whereas if we're doing EBITDA to interest coverage, we will divide EBITDA by the interest amount. And that will give us the amount of debt capacity we think that firm will be able to sustain. So let's have a couple of examples looked at.

Before we do that, just remember that in a lot of cases, the debt investors are pretty conservative and they may require some type of haircut to be taken on the multiple before they would agree to lend that amount. The two examples that we've got on the grid below, the first one we've got as total debt to last 12 months EBITDA. So this is a debt to last 12 months EBITDA multiple, and the market is telling us that they're willing to lend the transaction five and a half times LTM EBITDA for those type of businesses in the current marketplace. If the company we're looking at has an EBITDA of 1,200, then what we can do is we can take the five and a half times and multiply it by 1,200. And that will give us the total debt capacity that we can borrow, or an estimated debt capacity of 6,600. Alternatively, if we are doing a forecast and we take the forward year one EBITDA, and the market says, well, we'll agree to lend you money or loan you money on the basis that EBITDA divided by interest expense is going to be three times. So this will allow us to calculate the maximum amount of debt that the business will be able to support, while maintaining EBITDA to interest expense of no less than three times. In other words, we can't have more than about a third of our EBITDA eaten up in interest expense. So if we get that multiple, again, from the market and then take our EBITDA from the firm, which in this case is 1,260, and an interest rate of 6%, what we can then do is we can calculate the maximum interest expense that the business can support. We can take the 1,260 and we can divide by three times, which is the market multiple. And that means that the maximum interest expense that we can afford to support is 420 million. So we take the 420 million and gross it up by the interest rate, which means the maximum that we can afford as our debt number, if the 420 represents the interest expense, it's going to be 7,000. So here we're taking the maximum interest expense, dividing by the interest rate to gross it up to give us the total debt capacity of 7,000. So there are two examples of multiples here, one is a debt to LTM EBITDA multiple and the other is an EBITDA to interest expense multiple. Now the most common here is the debt to EBITDA multiple. This is by far the most common method of establishing a company's debt capacity. There's some dangers to using multiples, and let's take a look at why. Here, we've got two different companies, a media company, Univision, and we've got a manufacturing company, Lockheed Martin. They're very different sizes, but that doesn't matter, 'cause what we're trying to do is we're thinking about the multiples that can be paid of EBITDA in our debt financing. So what is important here is understanding how much EBITDA will convert into cash, because people say that EBITDA is a proxy for cash flow. Well, we're going to actually find out how much it's a proxy for cash flow. And in the case of Univision, our EBITDA is 1,269. The operating profit, which is just the EBITDA minus the depreciation and amortization, is 1077.2. Obviously we've got to pay tax on that. So our net operating profit after tax, which is like an unleveraged net income, is 700.2. Now what we're going to do is we're going to do a little cash flow forecast. Now in the case of Univision, it's a media company. So the cost of fixed assets will typically be a small percentage of the overall cost structure. And in fact, most of the depreciation and amortization is probably amortization. Now in a cash system, we add the depreciation and amortization back. And then we'll add or subtract the operating working capital cash change. Now in a media business, because they're selling subscription products and customers are prepaying for things like their cable subscription, it means actually the business generates cash from its operating working capital. And you can see, here it actually has a fairly small amount of capital expenditure. So this means that the free cash flow number of 771 actually is a fairly high percentage of EBITDA. So if we compare the EBITDA of 1,249 and the free cash flow of 771, this means that 61% of EBITDA converts into cash flow, which is a significantly high percentage, which means that Univision has a high debt capacity because it generates a lot of cash flow which can be used to repay debt and pay interest. Let's compare this to Lockheed Martin. Lockheed Martin has a much large EBITDA, but again, we are really interested in what percentage of that converts to cash flow. Subtracting operating profit, taxing it, we get NOPAT of 3,534.7 We add back the depreciation and amortization. Now in this case, Lockheed Martin is a manufacturing business. So it manufactures the product first, hands it to the customer, and then it has to wait for its money. So it's likely to have to pay their suppliers significantly in advance of receiving money from their customers. So as a consequence, the operating working capital will typically be a cash outflow, and you can see this here. Now Lockheed Martin makes aeronautics, airplanes, and other equipment. So as a consequence, it will have lots of buildings and machinery and capital expenditure, as you can see, is a really significant cost to the business. So the cashflow from the original EBITDA of 62.92 is less than half of the EBITDA, actually it's 40.6%. So this means that the manufacturing business is only converting $1 of EBITDA to 40 cents of cash flow, compared to Univision, which is converting $1 of EBITDA to 61 cents in free cash flow. So this means if we used a simple debt to EBITDA multiple to calculate debt capacity, we will get the same debt capacity for Univision as well as Lockheed Martin. But Lockheed Martin has a much lower or reduced ability to service debt as a multiple of EBITDA than Univision, because a lot less of Lockheed Martin's EBITDA converts to cash flow. So while we can use EBITDA multiples to estimate debt capacity, we need to be careful. EBITDA is a proxy for cash flow, but it's not cash flow in itself. And for some industries, which have high Capex requirements and negative operating working capital, there will be a relatively low cash conversion from EBITDA to free cash flow. So debt to EBITDA multiples, in those industries, should be lower than the debt to EBITDA multiples for other industries where the cash conversion is high. For example, Univision, where it has low capital expenditure needs and its operating working capital generates cash from the business.