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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.

About the Author(s)

Martin Leibowitz
Martin L. Leibowitz PhD

Martin L. Leibowitz is a managing director on Morgan Stanley's Global Research Strategy team, responsible for producing studies on such topics as beta-based asset allocation, long/short equity strategies and the need for greater fluidity in policy portfolios. Prior to joining Morgan Stanley, Mr. Leibowitz was vice-chairman and chief investment officer of TIAA-CREF from 1995 to 2004, with responsibility for the management of more than $300 billion in equity, fixed income and real estate assets. Previously, he had a 26-year association with Salomon Brothers, where he became director of global research, covering both fixed income and equities. Mr. Leibowitz has written more than 150 articles on various financial and investment analysis topics and has been the most frequently published author in both the Financial Analysts Journal and the Journal of Portfolio Management. Ten of his articles have received the Graham and Dodd Award for excellence in financial writing. He also has written several books: his first, Inside the Yield Book, is considered an investment standard. The CFA Institute has presented him with three of its highest awards. Mr. Leibowitz received an AB and MS from the University of Chicago and a PhD in mathematics from the Courant Institute of New York University.

Stanley Kogelman
Eric B. Lindenberg