Understanding Debt Capacity Bargains

The complexity of Debt Capacity Bargains made it very difficult for me to understand the concept. Thus, for my own understanding I tried to give a shot and try explaining in words. I hope some of the readers may find it useful.

In the Security Analysis, Benjamin Graham said

"A senior issue cannot be worth, intrinsically, any more than a common stock would be worth if it occupied the position of that senior issue, with no junior securities outstanding."

Better known as the "Rule of Maximum valuation for senior issues", it states that the value of the common stock of a company (here, the common stock is the only issue of the company) cannot be less than the value of the senior issues(had they been there) of the company. 

To make it more clear, let us use an example similar to what Graham used in Security Analysis:

Consider a company which has issued both senior issues and common stock. If now, the company is recapitalized in a way that the common stock is eliminated and the senior issues are converted into new common stock, what will be the price of the new common. Earlier, the senior issues had a limited claim on the assets of the company (a characteristic of senior issues), and let us assume that they were selling at a price x. Now the new common has the overall claim i.e. the claim of the old senior issues (selling at x) in addition to the claim of the old common stock. 

Looking from the perspective of an investor, we would like to pay more for more claim in the company. As we saw, the new common has more claim on the company than the previous senior issues, so it should sell at a higher price. This is precisely the Rule of Maximum Valuation for Senior Issues.

To understand Debt Capacity Bargains, we will have to follow the above process in the reverse order. Suppose a company has only issued common stock (a debt free company), so applying the above stated rule, the price of the common should not be less than the value of the senior issues of the company. But the company does not have any senior issues, so we have to find out the possible value of senior issues that this company can issue. In other words, we have to find out the maximum amount of debt this company can raise comfortably and this is what we call the debt capacity of the company. To calculate the debt capacity, we have to see what is the amount of debt which the company can comfortably service with its earnings.

With regard to the calculation of the debt capacity, different people may end up getting different values because of the difference of the assumptions they make. Assumptions like the Cost of Capital, a suitable Interest Coverage Ratio will affect the value of the debt capacity for the company. Instead of Interest Coverage Ratio, some people might want to consider the coverage of both the interest and the principal repayment, but I believe these things are more of personal decision while making calculation. You might end up getting a value, which is somewhat different from the debt capacity but as Warren Buffet says "I'd rather be approximately right than precisely wrong".

Further, according to Graham, a debt free company which is selling at a price less than its debt capacity, should be considered a debt capacity bargain. 

In my previous posts, you might have noticed that I had used a process longer than the one described above to conclude a stock to be a debt capacity bargain. This additional approach is one followed by some of the new Era investors like Prof. Sanjay Bakshi. The new approach suggests that for a credit-worthy borrower (which the company must be in order to raise debt), there should be present a collateral value in excess of the debt capacity. Thus, the value of the new common should be more than the debt capacity. So while calculating the total value of the common, we should add the surplus cash and a suitable value for the equity (which Graham suggests is more than 75% of the debt capacity) to the debt capacity. The value thus calculated should be used as the value below which the company should be treated as a bargain.