Untitled-29

Capital Structure Theories^325

cash flows. However, it too is characterised by the problem of establishing a suitable

norm for judging its adequacy.

Debt Service Coverage Ratio Financial institutions which provide the bulk of long-term

debt finance judge the debt capacity of a firm in terms of its debt service coverage

ratio. This is defined as:

DSCR =

!

, $

 +7 )+ ,&

  

   

+ +

where DSCR = debt service coverage ratio,

PAT, = profit after tax for year i

DEPi, = depreciation for year i

INTi = interest on ions-term loan for year i

LRIi = loan repayment instalment for year i

n = period of the loan

To illustrate the calcularion of debt service coverage ratio, consider a project with the

following financial characteristics.

DSCR = ! %

! %

,& $,

 +7 )+ ,&

  

   = =

+

+ +



=

Normally, financial institutions regard a debt service coverage ratio of 2 as satisfactory.

If this ratio is significantly less than 2 and the project is otherwise desirable, a term loan

of a longer maturity may be provided. By the same token, if this ratio is significantly

more than 2, the maturity period of the loan may he shortened.

Probability of Cash Insolvency

In assessing the debt capacity of a firm the key question is whether the probability of

cash insolvency associated with a certain level of debt is acceptable to the management

and not so much whether a particular coverage norm is satisfied. Gordon Donaldson,

advocating the use of such an approach, has suggested that the analysis of debt capacity

may broadly involve the following steps:

(Rs. in lakhs)

Year 1 2 3 4 5 6 7 8 9 10

Profit after tax -2.0 10.0 20.0 25.0 30.0 40.0 40.0 50.0 55.0 55.0

Depreciation 12.0 10.8 9.72 8.75 7.87 7.09 6.38 5.74 5.17 4.65

Interest on long-

term loan 17.6 17.6 17.05 14.85 12.65 10.45 8.25 6.05 3.85 1.65

Loam repayment

Instalment - - 20 20 20 20 20 20 20 20