“As a leveraged finance analyst, walk me through how you would determine how much debt a company can actually support in an LBO — what are the different constraints (a leverage multiple ceiling, an interest coverage covenant, and a cash flow debt service test) that cap the debt level, and which one typically ends up binding?”
As a leveraged finance analyst, walk me through how you would determine how much debt a company can actually support in an LBO — what are the different constraints (a leverage multiple ceiling, an interest coverage covenant, and a cash flow debt service test) that cap the debt level, and which one typically ends up binding?
Task: test a company's debt capacity against three separate lender constraints, then identify which one actually limits how much debt the company can raise.
A sponsor is sizing the debt package for a leveraged buyout using the following company financials and lender terms.
| Line Item | Value |
|---|---|
| EBITDA | $80.0m |
| Interest Rate on Debt | 8.0% (0.08) |
| Maximum Total Leverage (Lender Guideline) | 5.5x EBITDA |
| Minimum Interest Coverage Ratio (EBITDA / Interest Expense) | 3.0x |
| Mandatory Annual Amortization | 5.0% (0.05) of principal |
| Cash Flow Available for Debt Service (CFADS) | $42.0m |
| Minimum Debt Service Coverage Ratio (DSCR) | 1.2x |
Debt Capacity (Leverage) = EBITDA × Maximum Total Leverage Multiple
Using this formula, compute the debt ceiling implied by the lender's headline leverage multiple.
Maximum Interest Expense = EBITDA / Minimum Interest Coverage Ratio
Debt Capacity (Interest Coverage) = Maximum Interest Expense / Interest Rate
Using this formula, compute the debt ceiling implied by the interest coverage covenant.
Maximum Debt Service = CFADS / Minimum DSCR
Debt Service = Debt × (Interest Rate + Mandatory Amortization Rate)
Debt Capacity (DSCR) = Maximum Debt Service / (Interest Rate + Mandatory Amortization Rate)
Using this formula, compute the debt ceiling implied by the cash flow debt service test.
Think about what happens when three separate tests each produce a different maximum debt figure — which one actually governs how much the company can borrow?
Effective Debt Capacity = MIN(Leverage-Based, Interest Coverage-Based, DSCR-Based)
Using the results from Steps 2–4, determine the effective debt capacity and the leverage multiple it implies.
Try answering out loud first — then reveal the model answer and compare.
No comments yet — be the first to ask a question.