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).