BOT (Build Operate Transfer) Question

mrEngineer Wrote:depreciation of asset can be seen as repayment of debt in a certain way

Depreciation is meant to take into account the need to replace an asset. It has nothing to do with debt. Whether you buy an asset with cash or debt, if it has a limited life you depreciate it.

However, as depreciation is a non-cash charge (because the cash has already been spent to buy the asset), it "creates cash" because the cash generated exceeds the reported profits by the same amount i.e. if a company reports $1m profit after depreciation of $200k, it actually generated $1.2m of cash (ignoring capital expenditure).

The confusion probably arose because some entities e.g. PST use the cash "generated" from depreciation to pay down debt. It must be understood that depreciation and debt repayment are totally separate issues. Depreciation is a P&L item while debt repayment is a cash flow item. Using cash from depreciation to repay debt is simply a matter of convenience since otherwise cash would build up in the bank account while there was still outstanding debt that needed to be paid down.

(06-07-2011, 11:10 PM)d.o.g. Wrote:

mrEngineer Wrote:depreciation of asset can be seen as repayment of debt in a certain way

Depreciation is meant to take into account the need to replace an asset. It has nothing to do with debt. Whether you buy an asset with cash or debt, if it has a limited life you depreciate it.

However, as depreciation is a non-cash charge (because the cash has already been spent to buy the asset), it "creates cash" because the cash generated exceeds the reported profits by the same amount i.e. if a company reports $1m profit after depreciation of $200k, it actually generated $1.2m of cash (ignoring capital expenditure).

The confusion probably arose because some entities e.g. PST use the cash "generated" from depreciation to pay down debt. It must be understood that depreciation and debt repayment are totally separate issues. Depreciation is a P&L item while debt repayment is a cash flow item. Using cash from depreciation to repay debt is simply a matter of convenience since otherwise cash would build up in the bank account while there was still outstanding debt that needed to be paid down.

Hi d.o.g,

This is my understanding - cash-flow from depreciation retained over the years of useful life will be sufficient to repay both the loans and regenerate the original equity used to fund the purchase.

Asset XYZ was acquired for $100 million and debt funded entirely. It has lifespan of 10 years.

Depreciation: $10 mil X 10 years = $100 mil
Debt Repayment: $10 mil X 10 years = $100 mil

If all of the cash-flow from depreciation is used to repay the debt annually, after 10 years, all the debt would have been repaid. Since no equity was used to acquire the asset, no equity was re-generated.

Asset XYZ was acquired for $100 million and debt funded 50% and equity funded 50%. It has lifespan of 10 years.

Depreciation: $10 mil X 10 years = $100 mil
Debt Repayment: $10 mil X 5 years = $50 mil
Cash in Bank: $10 mil X 5 years = $50 mil

If cash-flow from depreciation is used to repay debt, after 5 years, all the debt is repaid. At the end of the asset life-span, it would be debt-free and the original equity will be regenerated.

In the case of PST (which uses this strategy), its book value would have remained stagnant since while the asset is depreciated, the liabilities are being reduced. Though a couple of years ago, it decided to retain 30% of the net profit so the book value has grown due to retained earnings.

Please correct my misunderstandings or errors

(Not Vested in PST)

(07-07-2011, 12:04 AM)Nick Wrote: cash-flow from depreciation

There is no such thing. Depreciation does not throw out cash. Revenue when collected generates cash. The cash will pay for expenses and borrowings. Otherwise, you got to borrow more, sell assets or raise equity.

The devil is in the details.

A company who has a lax depreciation policy is best avoided, a company MUST at least write down true to market value or
corresponding portion of usable lifespan.

A company who aggressively re-value its assets(think property companies) higher to make themselves look good are to be avoided as well.

These are the subtle details that separates the great from the ordinary. All these clues will give guidance on the company's investment merit.
All the talk on their prospects and their vision is plain crap, unless of course, they have proven time and again they are able to walk the talk. More often than not, they are not even close to what they want you to believe they are.

(06-07-2011, 11:10 PM)d.o.g. Wrote: Depreciation is meant to take into account the need to replace an asset. It has nothing to do with debt. Whether you buy an asset with cash or debt, if it has a limited life you depreciate it.

However, as depreciation is a non-cash charge (because the cash has already been spent to buy the asset), it "creates cash" because the cash generated exceeds the reported profits by the same amount i.e. if a company reports $1m profit after depreciation of $200k, it actually generated $1.2m of cash (ignoring capital expenditure).

The confusion probably arose because some entities e.g. PST use the cash "generated" from depreciation to pay down debt. It must be understood that depreciation and debt repayment are totally separate issues. Depreciation is a P&L item while debt repayment is a cash flow item. Using cash from depreciation to repay debt is simply a matter of convenience since otherwise cash would build up in the bank account while there was still outstanding debt that needed to be paid down.

Hi d.o.g,

I understand your point on depreciation and debt repayments are actually separate issues all together. I was trying to understand better why do we not perform any adjustments to the income statement when we reduce our debt. It is clear that the accounting rules state that, it was more of the reason that I would like to know. I think we should not account debt payments in income statement as the capex has already accounted for it (irregardless of whether it is expensed immediately or accurally) and further adjustments for debt payment would lead to double counting in the income statement.

Also I realized that income statement is solely for income and expenses and it actually understates the operations as the payment of debt does not come under income statement. This means that part of the retained earnings belongs to debt repayment and which leads to less organic growth in the company cash or equity/net asset. Only a lowly leveraged firm would mean the full retention of earnings and contribute to the growth of NAV.

---

Ok I think I am confused. My first point contradicts 2nd point. Haha. If we take debt for cash for the fun of it and have to pay back e debt every year, the income statement still does not show any capex or depreciation but just the interest and not e repayments

Nick Wrote:This is my understanding - cash-flow from depreciation retained over the years of useful life will be sufficient to repay both the loans and regenerate the original equity used to fund the purchase.

This is incorrect. Depreciation does NOT generate cash flow. What depreciation does is that it reduces reported income. Actual cash inflow exceeds reported income because the revenues are reduced by depreciation.

Quote:Asset XYZ was acquired for $100 million and debt funded entirely. It has lifespan of 10 years.

Depreciation: $10 mil X 10 years = $100 mil
Debt Repayment: $10 mil X 10 years = $100 mil

If all of the cash-flow from depreciation is used to repay the debt annually, after 10 years, all the debt would have been repaid. Since no equity was used to acquire the asset, no equity was re-generated.

This picture is too simple. You have to put in the revenues and expenses.

Let's pretend you can indeed buy the asset with 100% debt (which does not happen except in exceptional circumstances). Let's just say interest will cost a bit more since the bank is taking a higher risk in lending 100%.

Example 1:

Over 10 year life ($0 residual value):

Initial Cost = $100m (all debt)
Revenue = $200m
Depreciation = $100m
Cash Expenses = $65m

Net Income
= $200m - $100m - $65m
= $35m

What was the total net income? $35m. What was the total cash generated? $135m. How much of the cash belongs to the bank? $100m. How much belongs to the owner? $35m. Did the owner do well? He turned $0 of equity into $35m, an infinite rate of return.

Did the owner create money from thin air? No - the bank was dumb enough to take 100% of the risk but take less than 100% of the profits. The owner got a free ride. Everyone should aim for this type of deal. Unfortunately for them (and fortunately for bank shareholders) the banks are not usually so stupid. During the US housing bubble you could borrow more than 100% of the house value so yes, the banks WERE being stupid and their shareholders suffered accordingly.

A more realistic case is when the asset is financed with part cash, part debt e.g. 30/70. Let's say the interest savings are $15m.

Example 2:

Over 10 year life ($0 residual value):

Initial Cost = $100m ($30m cash, $70m debt)
Revenue = $200m
Depreciation = $100m
Cash Expenses = $50m

Net Income
= $200m - $100m - $50m
= $50m

What was the total net income? $50m. What was the total cash generated? $150m. How much of the cash belongs to the bank? $70m. How much belongs to the owner? $80m. Did the owner do well? He turned $30m of equity into $80m, a 166% return. But he took 10 years to earn this, so his IRR was closer to 10% (2.66 ^ 0.1 = 1.103).

Now let's consider the same deal on an all-cash basis. Suppose he saved another $20m on interest.

Example 3:

Over 10 year life ($0 residual value):

Initial Cost = $100m (all cash)
Revenue = $200m
Depreciation = $100m
Cash Expenses = $30m

Net Income
= $200m - $100m - $30m
= $70m

What was the total net income? $70m. What was the total cash generated? $170m. Did the owner do well? He turned $100m of equity into $170m, a 70% return. Over 10 years, his IRR was closer to 5% (1.7 ^ 0.1 = 1.054). So, he did not do so well without the leverage i.e. it was not really a great deal.

mrEngineer Wrote:I was trying to understand better why do we not perform any adjustments to the income statement when we reduce our debt.

When you reduce your debt you are merely netting off cash (an asset) against debt (a liability). There is no change in your net worth i.e. your equity is the same. There is no gain or loss so nothing appears in the income statement. See the following before/after scenarios:

Before:

Cash in Bank $10m
Bank Borrowings $5m
Equity $5m

After:

Cash in Bank $5m
Bank Borrowings $0
Equity $5m

So when you pay the bank back, there is no change in your financial position. If you happen to EARN money and use that to repay the bank, there are actually 2 independent events: you earn money (recognized in the income statement, and equity increases) and you repay the bank (recognized in the cash flow statement, no further change in equity).

(07-07-2011, 03:49 PM)d.o.g. Wrote: Let's pretend you can indeed buy the asset with 100% debt (which does not happen except in exceptional circumstances). Let's just say interest will cost a bit more since the bank is taking a higher risk in lending 100%.

Example 1:

Over 10 year life ($0 residual value):

Initial Cost = $100m (all debt)
Revenue = $200m
Depreciation = $100m
Cash Expenses = $65m

Net Income
= $200m - $100m - $65m
= $35m

What was the total net income? $35m. What was the total cash generated? $135m. How much of the cash belongs to the bank? $100m. How much belongs to the owner? $35m. Did the owner do well? He turned $0 of equity into $35m, an infinite rate of return.

Did the owner create money from thin air? No - the bank was dumb enough to take 100% of the risk but take less than 100% of the profits. The owner got a free ride. Everyone should aim for this type of deal. Unfortunately for them (and fortunately for bank shareholders) the banks are not usually so stupid. During the US housing bubble you could borrow more than 100% of the house value so yes, the banks WERE being stupid and their shareholders suffered accordingly.

Cityspring/Basslink?

The lenders were "stupid" because the asset is in their land and the parent is rich.

Usually, a borrower has to guarantee the debt but in this case it paid a third party to do so. Pretty clever.

A few years later, the lenders realized that they don't want to hold depreciated assets as security and the rating agencies become the messenger. Very interesting to watch how the events unfold.

Some local telco companies are also funded that way. Equity holders get cheap/free rides.

D.o.g can i say that with technolgical advances some capital replacements now is cheaper and longer lasting that it was ago and therefore certain companies benefit from it?

Year 0
Cash $10
Asset $10
Debt $15 (Assume 100% $10 loan to Asset)
Equity $5

Assuming asset lifetime of 2 years
---------------------------------------------------
Year 1
Revenue $20
Depreciation $5
Expenses $5
Net Income $10

Cashflow
Operating CF $15 (NI + Dep)
Financing CF -$5 (Repay debt)
Add Cash $10

Note: Net Income = Additional Cashflow (no working capital or capex or dividends)
Therefore if we look at cashflow analysis, we will somewhat view depreciation as a form of repayment of debt.

Balance sheet
Cash $20
Asset $5
Debt $10
Equity $15

-----------------------------------------------------
Year 2
Revenue $20
Depreciation $5
Expenses $5
Net Income $10

Cashflow
Operating CF $15 (NI + Dep)
Financing CF -$5 (Repay debt)
Add Cash $10

Balance sheet
Cash $30
Asset $0
Debt $5
Equity $25

However when there is no financing, depreciation cannot be used as form of debt repayment but solely reduction of asset.

Year 0
Cash $0
Asset $10
Debt $5
Equity $5

Assuming asset lifetime of 2 years
---------------------------------------------------
Year 1
Revenue $20
Depreciation $5
Expenses $5
Net Income $10

Cashflow
Operating CF $15 (NI + Dep)
Financing CF $0
Add Cash $15

Note: Net Income < Additional Cashflow as the depreciation is used to depreciate the asset. Here we see that adjustment of Equity from Additional cashflow comes after reduction in asset.

Balance sheet
Cash $15
Asset $5
Debt $5
Equity $15

-----------------------------------------------------
Year 2
Revenue $20
Depreciation $5
Expenses $5
Net Income $10

Cashflow
Operating CF $15 (NI + Dep)
Financing CF $0
Add Cash $15

Balance sheet
Cash $30
Asset $0
Debt $5
Equity $25

Therefore d.o.g is right to say depreciation should be seen separately to reduce assets only and financing should be seen coming from the cash account only.

Drizzt Wrote:D.o.g can i say that with technolgical advances some capital replacements now is cheaper and longer lasting that it was ago and therefore certain companies benefit from it?

Yes, but the converse can also be said to be true i.e. some capital equipment now costs more and has a shorter life.

Wafer foundry equipment is one example where equipment has gotten more expensive over the years, yet the obsolescence rate has gotten faster so the useful life is actually shorter. Foundry companies have struggled to create value for their shareholders.

On the other hand some of our consumer electronics now costs much less than before and can be used for a lot longer without breaking down e.g. computers, TVs, DVD players etc. Compared with black and white CRT TVs of 20 years ago, an LCD TV delivers color, costs a fraction as much and is more reliable.

Anecdotally, it seems that consumers have benefitted greatly from technological advances, while the picture is more mixed for businesses.