Valuation for Mergers, Buyouts, and Restructuring, Second Edition

Chapter 7

Debt Capacity for Acquisition Financing

7.1 FINANCIAL INTERDEPENDENCIES

The ability to finance a cash acquisition usually depends on the debt capacity of the merged company or, in the case of a leveraged buyout (LBO), of the target itself. This chapter presents a review and some extensions of financial concepts and techniques that are used in practice to assess the debt capacity of a company. We begin by examining financial requirements in relation to growth with the purpose of understanding the way the financial system of a company works. After that, we deal with the determination of sustainable debt and its expression in terms of target interest coverage ratios and debt ratios. The chapter concludes with an examination of the debt capacity of LBOs and recapitalizations.

Basically, a firm's cash flow determines its internal capacity to finance growth. In addition, the firm can take advantage of the debt capacity created by the expansion of its assets. Under normal circumstances, the firm is able to increase its debt maintaining a target interest coverage ratio [earnings before interest, taxes, depreciation, and amortization (EBITDA) to interest expense] without shifting to a higher risk class. The debt policy of the firm, represented here by its target coverage ratio (or, equivalently, by its target debt ratio), determines equity requirements for a given growth rate. How the firm finances its equity requirements, how much via retained earnings and how much via new equity ...