BOT (Build Operate Transfer) Question

[touzi]

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.

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Based on the examples, I would come to the conclusion that it is no good to finance an asset using a company's own cash. However from a layman's perspective, I wonder why I should pay interest to the bank if I can use my own cash? Where did my understanding fail ??

[d.o.g.]

Based on the examples, I would come to the conclusion that it is no good to finance an asset using a company's own cash. However from a layman's perspective, I wonder why I should pay interest to the bank if I can use my own cash? Where did my understanding fail ??

You need to take into account the fact that money available to an investor is limited.

If he buys the asset in the examples described using cash, he needs $100m to buy a $100m asset and earn $70m.

If he borrows 70% of the money, he only earns $50m on the deal after paying interest.

However he still has 70% of his cash left to go buy another deal. If he can find more of such deals, then with $100m he can buy $333m ($100m / 30%) of assets to earn 3.33 * $50m = $167m.

Using the property analogy, with $500k you can either buy a HDB flat with cash or make the downpayment on a $2m condominium. With the condominium you have divert some of the rental income towards paying the bank, but you will still earn more than if you own the HDB flat.