Use 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 Structure

$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???!!

• We applied a principle called leverage– analogy is to the use of a lever that magnifies

your strength

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

Use of Leverage

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

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

increases your return

– What makes more money than 400 shares doubling their price

– 4000 shares of stock doubling their price

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

How Can You Do That?

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

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

many chances and have a lower risk premium on investment

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

Risk deals with Likelihood and Magnitude of 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 Rotten

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 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 Leverage

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

• Leverage magnifies often improves project rate of return

• But it can also increase down-side risk

Use Leverage with Caution

And a Generous Helping of Understanding