"How Much Debt Can the Company Support" Question in Growth Capital Modeling Test

Your scenario and logic are plausible and could be reasonable, but again it all comes down to the assets themselves. This is where the logic becomes a bit circular:

• PV of CFADS assumes you discount future cash flows by the cost of debt
• The cost of debt for the underlying company/assets is a function of the underlying asset risk as well as the risk embedded in the capital structure
• As you add more tranches of debt to the capital structure, the cost of debt increases, which reduces the PV of CFADS

So rather than rely too much on straight up CFADS (which is typically used in project finance / bank debt, not so much in mezzanine debt), I would suggest an alternative approach. This may be a bit unorthodox so someone jump in if they disagree. - You may be doing this analysis for an equity LBO, but to size debt you need to put on your lender hat for a moment - Unlike equity investors who want outsized returns, lenders want to make sure they get their money back and are adequately compensated for their risk given their position in the capital structure - Examine your CFADS projections more closely; as you move further in time, there is a larger risk that these projections won't play out due to some downside risk - Determine CFADS under a reasonable downside / "risked" scenario; for example, if the asset is a large industrial park with 60% of cash flows coming from a long-term lease with an A-rated counterparty and the rest are coming from trade sales and other short-term activities, the bank lenders may only be willing to consider the 60% of cash flows that are truly stable while heavily risking the volatile cash flow stream for purposes of CFADS calculation; you may also want to build in higher capex / opex projections to be extra safe - This "PV of downside CFADS" divided by some coverage ratio (something like 1.2x if project is already built and has history of stable cash flows, higher if there is construction or growth built in, even higher if there are other risks like FX / counterparty is not investment grade / etc) will give you a rough idea of how much bank debt the project can support; another way to think about this is collateral value - in a "fire sale" where the market is weak and there are limited buyers, what could you sell the underlying assets for? Banks would probably not want to lend above this value. - To size the remaining debt (let's call it one mezz tranche for now, no need to overcomplicate), go back to your base case cash flow projections; this part is more art than science, but after layering in bank debt servicing (interest + amortization), how much cash flow is available to the mezz and equity? Price the mezz at some interest rate based on underlying asset risk (err on the conservative side, something like 10% - 15% depending on the asset); now when you layer in these interest costs for [$100mm] mezz, what do the various leverage metrics look like over time? How will the mezz get paid out? In the downside scenario you used to size the bank debt, what happens to the mezz? Is there room for dividends in either case? Is cash building on the balance sheet? Study the financial statement projections and determine whether this level of leverage "works" for the business. It probably will not on your first try, so go back and try it with more or less mezz. Keep playing with the numbers and cash flows until you develop a feel for how the financial profile is affected by the different assumptions you are making, and eventually you will find a balanced case that "works". - Finally, run the equity returns - if the equity can't get at least 15% - 20% IRR under a reasonable exit or dividend payout assumption, you may need to refine your debt assumptions until you find a scenario that works for the equity.

This process can be tedious and time consuming, but I've found it's the best way to develop a good feel for a potential investment and whether or not there is a capital structure that would make everyone happy. If you can't find a capital structure that works for everyone (i.e. equity returns are good but debt is too high or vice versa) then that's a warning sign that the deal isn't so good, or perhaps the purchase price is too high.

Apologies for the wall of text but this is a topic where everyone has their own approach and there is a ton of subjectivity involved. Ultimately, as an interviewer I would look for the candidate to have developed some sort of reasonable process in their head for how they are thinking about the actual assets and capital structure. Anyone can use a simple set of formulas / guidelines, but it's the "art", not the "science" part of the process that will make you stand out.