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12. How Loan Terms Affect Returns
The interest rate, size and duration of the loan affect a investment's returns in different ways. Lending terms can also be a competitive advantage when bidding against competitors.
How loan duration affects project returns
- If a loan increases our rate of return, then the longer the duration of the loan, the better
- For longer loans, we pay more on an absolute basis, but less on a discounted basis
- To gauge the impact of extending the loan duration, run a sensitivity analysis for this variable
How loan amount affects project returns
- If a loan increases our rate of return, then the larger the loan, the better
- For larger loans, we pay more on an absolute basis, but less on a discounted basis
- However, increasing the size of a loan also increases the risk of our investment
How interest rate affects project returns
- The higher the interest rate, the lower the rate of return
- Companies than can achieve better loan terms can have a significant competitive advantage
- This is particularly true for assets that have stable cashflows and are always bought with loans
SHIFT + →: Select next cell
ALT + A , W, T: Create data table
ALT + H , L: Open conditional formatting menu
ALT + A , W, G: Open Goalseek menu
In the previous lesson, we saw our IRR jump from 8.14% to 16.18% when we bought the wind farm with a loan.
Let's now deepen our understanding of investing with loans in this lesson.
Our first step will be to create a sensitivity table to gauge the impact of two loan variables on our model.
I've chosen the loan term and the loan interest rate, although you could’ve chosen loan amount as well.
To run our sensitivity, we'll start by linking the IRR cell in the top left hand corner.
I'll then select the array and press Alt + A, W, T for a data table, and the row input cell will be the interest rate.
And the column input cell will be the loan term.
I'll then press OK to run my sensitivity.
Let's now examine our output.
Unsurprisingly, we experienced the highest IRR's at lower interest rates, but we also observe that the longer the loan term, the greater the IRR.
When you have a longer loan term, you typically pay back more money in total on the loan.
However, the amount you pay each year is less.
Due to the time value of money, the amount we save in the early years by increasing the length of the loan term is greater than the extra money paid in later years on a discounted basis.
So when you have access to cheap money, it’s better to not pay it off very quickly.
However, at very high rates of interest, this saving does not apply because the cost of the loan is so expensive.
In fact, if a bank offered you a loan with a 14% rate of interest for this project, you would turn it down, because the return without any loan at 8.14% is higher than any value in this column.
This table also highlights some strategic implications for a would be buyer.
Let's say the bank offers us a loan at 8% for 8 years, which would provide us with a return of 12.6% on our money.
Unfortunately, there’s another bidder, a large power generation company, which has offered a much better loan by the bank of 6% over 10 years.
With this loan term, our competitor is much more likely to win the bidding war, because he can offer a much higher price for the same return of 12.6%.
If we'd like to calculate that price, we can use goal seek.
I'll return to my assumptions panel, and enter the assumptions for the power generation loan, which will be 6% over 10 years.
I'll then select the internal rate of return cell, and press Alt + A, W, G for goal seek.
And I'll set the value of this cell to 12.6% by changing the sale price.
And then I'll press OK to run the goal seek.
And after a couple of iterations, it tells me that the sale price for the same return for the power generation company would be $5.38 million.
As a percentage, this means that the power generation company can bid 7.2% higher than we can for the exact same return.
For assets such as wind farms, which provide stable cash flows and are always bought with loans, the winning bid on these assets is often the bidder who can obtain the most favorable loan terms from the bank.
Always bear in mind who your competition is when bidding on these types of assets.
If they have access to cheaper debt, then you’re much less likely to win the bid.