This one some argument someone put up recently on the reason why he’d rather use a bank loan than his cash to finance a short term investment. On the face of it it might look rather crazy but when you dig deep it might just make some sense.
Let’s run 2 parallel investors to help illustrate our point. Mr Wise and Mr Wisest
The both have a N40m building project that they wish to finance. Mr Wise prefers to use his cash to finance the business whilst Mr Wisest prefers to borrow 50% from a Bank and use N25m of his cash. They both have N40m cash in the bank by the way. Mr Wisest decides to invest his N20m in another project that will earn him N10m as well. He gives them a property worth N10m that he owns as well as the property being developed as collateral. The bank charges Mr Wisest 20% interest per annum.
After building, they both sell the property for N80m each. Mr Wise makes a cool N40m as profit. Mr Wisest on the other hand makes N32m as profit. Who do you think got the most value for money? Mr Wisest off course.
Mr Wisest only invested N20m of his money and made N32m (after paying the bank N8m in interest cost), so technically his return on investment is N32/N20m a whopping 160%. Mr Wise on the other hand makes a return of 100%, that is N40m profit divided by N40m invested. Based on this you would agree Mr Wisest got a better value for his investment even though his profit was N8m less that of Mr Wise. But if you include the N10m extra that Mr Wisest earns then you will agree he also gets a better cash on cash returns for his investments.
Mr Wisest off course gets taxed on N32m as well, whilst Mr Wise is taxed on N40m. With a capital gains tax of 10% wisest pays N3.2m tax whilst Wise pays N4m.
There are offcourse several other factors to consider but it’s not hard to see why the rich are always the heaviest debtors.
There is this story once of a rich guy who says he likes to borrow big. When asked why he says “when I owe a bank N1b the bank MD books an appointment to see me. But when I borrow N1m his banking officer gives me a call. When I’m in the default the Bank MD kindly invites me for a cup of coffee and a chat. But when I default on N1m my account is closed and collateral quickly confiscated”.
What do you think? Would you rather borrow and hedge your risk?
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