Leverage in Leverage in ProjectsProjects©Dr. B. C. Paul 2001©Dr. B. C. Paul 2001

Use of Debt in ProjectsUse of Debt in Projects

Coal Fuel Purchases 8.2 Million/Year

Coal Plant Construction120 Million Dollars

0 1 ………………………………………………………………..20

Natural Gas Fuel Purchases 34.3 Million/Year

Natural Gas Plant Construction35 Million

0 1 …………………………………………………………………20

-

Study the advantageof choosing coal overNatural Gas(oh yes subtract Preferred- the other thing)

26.1 Million/Year in Fuel Savings

85 Million inAdditional ConstructionCosts

=Cash flow for choosingcoal over natural gas

IRR of this Cash Flow is 30.56%

Change the Financial Change the Financial StructureStructure

$25 Millionadditionalcapital upfront

$26.1 Million Each Year in Fuel Savings

$6.57 Million Each Year in Debt Service

The remaining $60 million dollars wefinance with bank loans over 20 yearsat 9% interest

The IRR of this Cash Flow is78.12%

What Happened???!!What Happened???!!

We applied a principle called leverageWe applied a principle called leverage analogy is to the use of a lever that analogy is to the use of a lever that

magnifies your strengthmagnifies your strength

We use someone else's money at a We use someone else's money at a lower rate of interest than the rate of lower rate of interest than the rate of return in the project and pocket the return in the project and pocket the difference for ourselves difference for ourselves

Use of LeverageUse of Leverage

Most companies will try to sweeten investor Most companies will try to sweeten investor returns by use of leveragereturns by use of leverage

Some People buy stock on “Margin”Some People buy stock on “Margin” if the stock price is growing faster than the interest rate if the stock price is growing faster than the interest rate

it increases your returnit increases your return What makes more money than 400 shares doubling What makes more money than 400 shares doubling

their pricetheir price 4000 shares of stock doubling their price4000 shares of stock doubling their price

May have heard of leveraged buy outs where May have heard of leveraged buy outs where company operators buy the company using debtcompany operators buy the company using debt

How Can You Do That?How Can You Do That?

If the project is so good why doesn't the If the project is so good why doesn't the bank just buy it?bank just buy it? The expertise factor - banks know how to lend The expertise factor - banks know how to lend

money - not necessarily run projectsmoney - not necessarily run projects Banks are more risk adverse - they don’t take Banks are more risk adverse - they don’t take

as many chances and have a lower risk as many chances and have a lower risk premium on investmentpremium on investment

It’s the same project - how can the bank It’s the same project - how can the bank have less risk?have less risk?

Risk deals with Risk deals with Likelihood and Magnitude Likelihood and Magnitude of Lossof Loss

An $85 Million Dollar Investment

Declines in Value to$60 Million Dollars

Our Investors Loose29.5% of theirInvestment

An $85 Million Dollar Investmentis paid for with $25 Million of InvestorMoney and $60 Million with borrowedmoney

Declines in Value to$60 Million Dollars

The Bank Looses Nothing

The Investor Looses

With Leverage - You Pocket the Earnings and the Risk

When Things Were When Things Were RottenRotten

Life Skunk Power and Light Invested anextra $85 Million to build a coal firedpower plant instead of natural gas

Leaving $7.6 Million Per Year in Fuel Savings

The Price of Natural Gas Drops to $2.20/MBTU from $4.50/MBTUThe Gore Worms puta carbon tax on coalto save the world fromGlobal Worming

The IRR on the Project is now6.31%

But Then Larry Leverage Remembers that youcan sweeten projects by using debt financing!

Any More Bright Ideas Any More Bright Ideas Larry?Larry?

Leaving $7.6 Million Per Year in Fuel Savings

The Price of Natural Gas Drops to $2.20/MBTU from $4.50/MBTUThe Gore Worms puta carbon tax on coalto save the world fromGlobal Worming

Life Stuckspends anextra $25Million fora coal plant

The rest is financed at 9% for $6.57 Million per year

The IRR of this Cash Flow is -1.77%(ie - it looses money and has no pay-backperiod)

The Dark Side of The Dark Side of LeverageLeverage

Many people do not understand that if the Many people do not understand that if the return in a project drops below the interest return in a project drops below the interest rate that they will get levered downrate that they will get levered down They take the riskThey take the risk The Bank takes the moneyThe Bank takes the money

Leverage magnifies often improves Leverage magnifies often improves project rate of returnproject rate of return

But it can also increase down-side riskBut it can also increase down-side risk

Use Leverage with Use Leverage with CautionCautionAnd a Generous Helping of And a Generous Helping of UnderstandingUnderstanding