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13. Downside of Investing with Loans
Loans can cost a huge amount if future cashflows don't go as planned. In this lesson, we examine the downside of investing with loans, and how much it cost investors.
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Example of a Loan Gone Wrong (00:04)
If you are unable to make the repayments on a loan, then you can lose the full investment amount. This generally happens if investors take on a loan that is too large, or if the cash flows from the investment are volatile.
To illustrate this principle, we consider an example of a wind farm purchased using a large loan. After the purchase, a recession significantly reduces the annual earnings from the project. After loan repayments, the annual cash flows are all negative. This means that investors need to make up these losses themselves in order to maintain ownership of the wind farm. The investors would hope that the economy turns around and that these extra payments will be earned back later on. If investors cannot pay back the loan, then the bank may take the wind farm, meaning the investors would have lost their entire investment.
The Impact of Guarantees (01:58)
Some loans may include guarantees. A loan guarantee is a promise that the loan will be repaid in full. In these loans, investors can lose more than their initial investment. If a bank takes over the collateral asset and sells it, but the sale proceeds do not cover the initial loan amount, then the investor must pay the difference. This ensures that the bank receives the full loan amount. The investor loses their initial investment and has to make an additional payment in order to pay off the loan.
Generally, larger companies can obtain better loan terms. This is because they are more likely to have the cash on hand to withstand difficulties like this. As a result, it is less risky for the bank to give a loan to a large company, as they are more likely to get their money back.
As we’ve seen in previous lessons, loans can dramatically increase the return on investment.
However, if the cash flows from your asset don't turn out as planned and you are unable to make the loan repayments, you may lose your full investment amount.
This tends to happen when investors take on too big a loan, and the cash flows needed to serve that loan are too volatile.
To understand the downside of investing with loans, let's take the example of another wind farm which also has 10 years life remaining on the asset.
This wind farm has a sale price of $5 million and annual earnings before interest and tax of $1 million.
In this example, we’re eager to get a large return on our investment, so we’ve taken out a big loan which corresponds to 90% of the total selling price.
There is currently a boom in wind farm asset prices and the bank gives us a very competitive loan rate of 4% over 10 years.
Although the loan repayments are very high, the cash flows from the utility still result in a positive cash flow every year and will deliver a 26% IRR.
Unfortunately, the economy encounters a recession and the utility company that buys the electricity from our wind farm goes bust.
We must now sell our electricity into the open market at a much lower price, which reduces Ebit by 30%.
So I'll make this adjustment in the Ebit cell.
This means that our project now has negative cash flows.
To maintain full ownership of the asset, the investors will need to make up the difference in the annual cash flows every year.
If our investors are cash rich, they can continue to make these repayments in the hope that electricity prices recover in the coming years.
Unfortunately, if the investors cannot pay back the loan, then the bank may take over the wind farm and the investors would lose all of their investment.
But it often gets worse.
If the bank negotiated guarantees from the investors as part of the loan, then the full loan must also be repaid by the investors if the sale of the wind farm does not cover the bank's original loan.
Say for example the bank takes over the asset and sells it for $3,000,000.
In this case, the investors would need to pay the remaining $1,500,000 as well.
This means that the investors will lose the initial $500,000 investment, and have to pay an addition $1,500,000 to service the loan.
In this scenario, the larger the loan, the bigger the problem for the investor.
In the previous lesson, we saw a large power generation company could obtain better loan terms than a small individual investor.
And this is because the large power gen company has the cash on hand to withstand difficulties like this, if they emerge.
Although loans will increase your returns, and should be used in certain cases, it’s critical that you account for future uncertainty when taking out loans for investment.