How would you go about determining debt capacity of a business?

Talk to capital market (DCM) who will probably just use past transaction comps.

TM Capital posts a monthly report on DCM. Debt Capacity & Pricing are on page 2. 

Start with the lowest priced senior debt then go deeper in the capital structure. 

Beyond comps, think about what life/growth cycle and business/industry cycle the company is currently in. High growth, more equity type financing, high cash flow visibility and stability, more debt type financing. Under current environment, cruise companies can hardly raise pure equity, but short-term debt secured by their massive asset bases.

Many times, comps could be misleading because cap structure of company are rarely optimized, and many folks in the corp finance/treasury teams don't know what they are doing.

Be happy to chat in more specifics if you wish.

Talking with DCM team and looking at precedents of peers of course.
 

With regards to how DCM bankers size up quantum to begin with, it comes down to a number of things including capital intensity, defensibility / cyclicality of cash flow generation, sustainability of growth / margins to name a few. Cash flow based debt sizing (NPV of CFADS over tenure at fixed post-tax rate) is very helpful to understand the theoretical maximum amount a company could borrow if cash flows were 100% guaranteed i.e. not a single dollar less of cash was generated.

From there, there is a great deal of downside analysis conducted, the extent of which depends on the above factors such as cash flow cyclicality. Does a snacking brands business have more defensible cash flows than a high growth tech start up? Absolutely- therefore the ultimate debt quantum will be closer to the maximum amount determined under CF based sizing than the tech start up. Clearly this analysis is used hand in hand with turns of EBITDA.

With regards to the nature of the debt instrument, it’s a case by case basis. Unitranche is becoming increasingly popular for example. Typically any instrument with an equity kicker will be used to squeeze that last bit of leverage in after tapping out the senior financing. PIYC is used when you’re expecting to be short on cash in the early years and want the option to defer interest payments.