Capital Budgeting Evaluation Techniques 117

is designed to report events with respect to accounting periods and for profit
centres but not for individual investment.

Debt Service Coverage Ratio

Financial institutions, which provide the bulk of long-term finance for industrial projects,
evaluate the financial viability of a project primarily in terms of the internal rate of
return and the debt service coverage ratio.

PAT +D, +1,)

DSCR=-
a,+LT1)

Debt service coverage ratio (DSCR) is defined as

where PAT, = Profit after tax for year i

D = depreciation for year i
I = interest on long-term loans of financial
institutions for year i
LRI = loan repayment instalment for year i.
n = period over which the loan has be repaid.

Looking at the debt service coverage ratio we find the numerator consists of a mixture
of post-tax and pre-tax figures (profit after tax is a post tax figure and interest is a pre-
tax figure). Likewise, the denominator consists of mixture of post-tax and pre-tax figures
(loan repayment installation is a post-tax figure and interest is a pre-tax figure). It is
difficult to interpret a ratio which is based on a mixture of post-tax and pre-tax figures.
In view of this difficulty, we suggest two alternatives:

Alternative 1:

Earnings before depreciation interest and taxes

DSCR=
Interest + Loan repayment instalment

1-Tax rate

Alternative 2:

Profit after tax + Depreciation

DSCR=
Loan repayment instalment
While alternative 1 is based on pre-ax figures, alternative 2 is based on post-tax figures.