10-07-2011, 11:49 PM
(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.
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 ??