What is the debt capacity of a corporation? How much leverage should a corporation have?
The complexity of the leveraging decision reflects, to a great extent, the myriad interrelated factors managers and creditors must consider. One useful approach to the problem, however, may be to break down the leveraging decision into some of its basic elements. This article addresses the debt-capacity decision primarily from the creditor’s point of view, specifically dealing with the narrow question of the adequacy of a firm’s cash flows to support various levels of debt financing.
The goal in this case is to see how the level and riskiness of a firm’s cash flows influence the amount of debt a creditor would be willing to supply. The specification of a minimum threshold return and maximum shortfall probability can be used to define the maximum amount of leverage the firm’s cash flows will support.