Debt is good!

…Well it can be anyway. The important idea is what you’re going to use the capital for!

There’s a basic concept in finance, an investment banking staple, called the leveraged buyout. A savvy investor will find a company with strong cashflows, borrow a big chunk of cash, and then buy the prospective company. With the cashflows from the purchased company, the investor can make the payment on his loan, which may only be interest in some cases, and still have a cashflow leftover for himself as a profit.

If a company is valued at $10 million and has an annual cashflow of about $1.2 million, an investor could buy it with cash realizing an annual return of about 12%.

If that same investor borrows $8 million to buy the same company, he might have to pay $480 thousand back on the loan each year. That payment comes out of the $1.2 million cashflow from the purchased company leaving $720 thousand in profit per year for the investor. Your initial thought might be that $720 thousand is less than $1.2 million; however, remember that with leverage, the investor only had to spend $2 million. While the total profit is less, his return on investment is 36%; by using leverage, he tripled his return!

Let’s take it a step further. If the investor has $10 million and uses it all to buy one company, his total profit is $1.2 million per year. If he takes that same capital and also borrows additional money to buy 4 or 5 companies with similar cashflows, his total profits could be $3.6 million per year.

Borrowing money to go gambling is a fool’s errand, but borrowing money for sound investments which will yield higher returns than the interest on the loan is fine work. Next time you’re considering paying off a loan, take an extra second to think about what else you could do with the capital.