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10. Investing with Loans Part 1
Investing with loans helps increase your rate of return but also adds additional risk to your investment. As a result, they tend to be used for safer investments.
Investing with loans
- Loans increase the rate of return be reducing the size of the initial investment
- However, loans also increase the risk of our investment
- Loans tend to be used for investments with stable cashflows and collateral
- Amortising loans require the borrower pay back equal amounts every year for duration of the loan
- Each amount is a combination of the interest on the loan and the principal
- To calculate the annual payment on an amortising loan, we use the PMT function
Interest payment as a tax shield
- Interest payments are subtracted from profits before taxes
- This reduces the taxes paid by the investor
- This is a further advantage of investing with loans
When we make certain investments, either personally or for our company, we will often get a loan or a debt from the bank to make the upfront payment.
Loans served increase our rate of return by reducing the amount of cash that we pay upfront.
However, they also add additional risk to our project as we will see later.
Loans tend to be used when the investment that we are making has very stable and consisting cash flows, and has collateral, which is something pledged as security for a payment of the loan in the event of default.
In our wind farm example, the wind farm itself will be collateral, and transferred to the bank if we were unable to repay the loan.
Loans are often used in property and real estate transactions because they tend to exhibit strong cash flows and have substantial collateral.
On the other hand, it will be almost impossible to obtain a loan for a start up investment and three founders and a business plan.
To see the impact of loans on our rate of return, let's return to our wind farm example.
Here I've added a couple of new cells that will allow us to specify the percentage of the total investment that will comprise the loan, the loan term in years, and the interest rate on the loan.
I will assume that the loan is amortizing, which means we make equal payments over the life of the loan, that are a combination of the interest and the principle.
To find the annual loan repayment for an amortizing loan, we use the PMT function.
So I'll write "=PMT" and open the bracket.
And the first variable for the PMT function is the interest rate, which I'll specify as 4%.
Next is the number of periods, which is the number of years, and this will be 8, and the last variable is the loan amount, which is going to be the percentage of the sale price multiplied by the sale price.
I'll then close the bracket and press Enter.
And this tells me that my annual loan repayment will be $519,847.
Now let's adjust our annual cash flows to take account of this new loan, starting with the initial investment.
So the initial investment will no longer be minus the sale price, it will be equal to minus the sale price, multiplied by one, minus the loan as a percentage of the sale price, which is equal to $1,500,000.
Now we need to include the payments for our loan.
Unfortunately, this is not as simple as adding our loan repayments to our existing cash flows.
And this is because our interest repayments act as a tax shield and can affect the cash flows themselves.
To understand this better, let's take a look at how our annual cash flows are currently calculated.
We start at the top with revenues that come from the utility.
Next we have the operating costs.
In this example, I assumed depreciation is equal to zero, so revenues minus operating costs will give us earnings before interest and taxes.
When there's no loans and therefore no interest repayments, we simply subtract taxes at 35% to get the net annual earnings, and in this simplified example, is equal to annual cash flows.
Now let's take a look at what happens when we add in interest repayments.
Again we have revenues minus operating costs equals earnings before interest and taxes, but this time we actually do subtract the interest on our loan.
And this gives us a new value of interest before taxes.
Taxes are now recalculated on this new value, again at 35% to give us a new net earnings.
When we now subtract the principle payments of our loan, we're left with the new annual cash flows.
We now need to repeat these calculations in Excel for our wind farm investment.
I'll do this in the next lesson.