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The cash flow approach to assessing debt capacity involves the following steps; arrange these steps in a correct sequence: (A) Specify the tolerance limit on the probability of default. (B) Estimate the probability distribution of cash flows, taking into account the projected performance of the firm. (C) Calculate the fixed charges by way of interest payment and principal repayment associated with various levels of debt. (D) Estimate the debt capacity of the firm as the highest level of debt which is acceptable. Choose the correct answer from the options given below:

The cash flow approach to assessing debt capacity involves the following steps; arrange these steps in a correct sequence: (A) Specify the tolerance limit on the probability of default. (B) Estimate the probability distribution of cash flows, taking into account the projected performance of the firm. (C) Calculate the fixed charges by way of interest payment and principal repayment associated with various levels of debt. (D) Estimate the debt capacity of the firm as the highest level of debt which is acceptable. Choose the correct answer from the options given below: Correct Answer (A), (B), (C), (D)

The correct answer is (A), (B), (C), (D)

Key Points Debt Capacity:

The capacity of a business to take on debt, or the total amount of debt it can accumulate to finance the acquisition of assets, engage in business operations, raise return on investment, increase production, etc., and repay lenders (according to terms of the debt agreement).

Two important metrics to evaluate a company's ability to take on debt are its balance sheet and cash flow statements.

Important Points Cash flow based Debt Capacity:

A method of determining a company's debt capacity is to use cash flow.  The forecast of free cash flows (FCF) and current interest rates serve as the foundation for cash flow-based capacity financing.

Steps to Assess Debt Capacity:

  1. Specify the tolerance limit on the probability of default.
  2. Estimate the probability distribution of cash flows, taking into account the projected performance of the firm.
  3. Calculate the fixed charges by way of interest payment and principal repayment associated with various levels of debt.
  4. Estimate the debt capacity of the firm as the highest level of debt which is acceptable

Hence, Option 2 is correct

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