How to analyze how much to borrow from your banker

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Post on 20-Jan-2017



Economy & Finance

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<ul><li><p> </p><p> Page 1 </p><p>How to Analyze How Much to Borrow from Your </p><p>Banker? </p><p>Money has no royalty to one master, it is always going to the highest bidder. </p><p>Introduction </p><p>When faced with two alternatives for borrowing, it is normal to see that the corporate analyst will </p><p>see direct to the annual interest rate being quoted for each loan facility alternative. If the loan </p><p>proposal for each alternative has the same terms and conditions other than the quoted annual </p><p>interest rate, this practice might sound reasonable, that is just looking at the stated borrowing </p><p>interest rate. Yet, how about if one alternative, lets say will make the company to borrow more </p><p>funds compared to the other alternative. </p><p>For example, a company has a plan to purchase a property project with a market value of IDR </p><p>100,000,000,000 (IDR 100 billion). The company might not have funds at companys vault </p><p>sufficiently to execute the purchase. The company then considers going to obtain the loan </p><p>facility from the bank under mortgage scheme, meaning that the property purchased will be </p><p>used as a main collateral to the loan facility. </p><p>Sukarnen </p><p>DILARANG MENG-COPY, MENYALIN, </p><p>ATAU MENDISTRIBUSIKAN </p><p>SEBAGIAN ATAU SELURUH TULISAN </p><p>INI TANPA PERSETUJUAN TERTULIS </p><p>DARI PENULIS </p><p>Untuk pertanyaan atau komentar bisa </p><p>diposting melalui website </p><p> </p></li><li><p> </p><p> Page 2 </p><p>Assuming that the loan facility will have (a) fixed interest rate and (b) constant monthly </p><p>installment payment during the term of the loan. </p><p>Lets say, the company only considers two banks for the financing sourcing: </p><p> Bank A agrees to finance 70% of the market value of the property project (this is usually </p><p>called loan-to-value ratio), meaning the loan facility will amount to IDR 70,000,000,000 </p><p>(IDR 70 bio). Bank A will charge a fixed annual interest rate of 11% for 10 years. We </p><p>name this Alternative 1. </p><p> Bank B comes up with a higher financing portion, which is 80% of the market value of </p><p>the property project, or IDR 80,000,000,000 (IDR 80 bio) with a fixed annual interest rate </p><p>of 12% for 10 years. We name this Alternative 2. </p><p>The summary of each Alternative 1 and 2 is as follows: </p><p>So we see that Bank A and Bank B offer the same lending terms and conditions, except for the </p><p>loan principal and the fixed annual interest rate, which in this example, Bank B has a higher loan </p><p>facility of IDR 10 bio (IDR 80 bio vs IDR 70 bio) offered compared to that of Bank A, and a </p><p>higher fixed annual interest rate of 1% (12% vs 11%). </p><p>Issue </p><p>Without much thinking, a corporate analyst could easily pick up Alternative 2 from Bank B by </p><p>saying that the interest rate is not much different from that offered by Bank B, yet at the same </p><p>time, the company could get an additional funding of IDR 10 bio from Bank B. </p><p>Is it that simple for the comparison analysis for making the right decision? </p><p>Alternative 1 Alternative 2</p><p>The market value of the property in IDR 100,000,000,000 100,000,000,000 </p><p>Financing portion by bank in percent (%) 70.00% 80.00%</p><p>Principal in IDR 70,000,000,000 80,000,000,000 </p><p>Term years 10 10</p><p>Interest rate per year (%) 11% 12%</p><p>Total installment months per year in months 12 12</p></li><li><p> </p><p> Page 3 </p><p>Analysis </p><p>Here we re-check the effective annual interest rate for Alternative 1 and Alternative 2 using </p><p>RATE formula (see cell G16 and I16 by using =Formulatext() in Excel 2013). </p><p>The answer to above question is NO. </p><p>We cannot use the fixed annual interest rate for Alternative A and Alternative B to decide which </p><p>loan facility that should be taken by the company. </p><p>If it is not the annual interest rate of both Alternative A and Alternative B, then how should we </p><p>compare these two Alternatives? </p><p>Here we are going to introduce the incremental or marginal cost of borrowing to be used in </p><p>such analysis. </p><p>Somehow we know that Alternative B will lend the company Rp 10 bio higher than that of </p><p>Alternative A, yet, for this higher loan facility of IDR 10 bio, the company should be willing to pay </p><p>a higher annual interest rate of 1%. Using the incremental or marginal cost of borrowing </p><p>concept, then we need to ask: </p><p>How much is the effective cost that the company should pay to get an additional or </p><p>incremental borrowing of IDR 10 bio from Bank B? </p></li><li><p> </p><p> Page 4 </p><p>We might think quickly that it might be possible that the incremental or marginal cost of </p><p>borrowing more IDR 10 bio from Bank B is 12% per year since in actual, the company has to </p><p>disbursed more money to pay this higher interest per monthly installment and this 12% is </p><p>applied to the whole loan facility from Bank B, that is IDR 80 bio. </p><p>The logic by linking the incremental or marginal cost of borrowing to the interest cost that have </p><p>to be paid over the whole loan facility from Bank B, is correct, since: </p><p> If the company will only be willing to take the loan facility of IDR 70% from Bank A, the </p><p>annual interest to be paid is 11%, yet </p><p> By obtaining additional Rp 10 IDR with a higher loan facility of IDR 80 bio from Bank B, </p><p>the company will pay a 1% higher, not only on the additional IDR 10 bio, but also on the </p><p>IDR 70 bio that previously could be obtained by paying 11% annual interest rate. </p><p>Intuitively from the above paragraph, we could sense that the incremental or marginal cost of </p><p>borrowing more of IDR 10 bio cannot be 12% per year, but even higher. </p><p>The question, then, how much higher is it? </p><p>The term incremental or marginal cost of borrowing will require us to compare the additional </p><p>against the additional, in this case, the higher monthly payments versus the higher loan </p><p>principal from Alternative B. </p><p>The snapshot of the spreadsheet below indicated that the company will pay a higher monthly </p><p>installment payment of IDR 183.5 mio for a higher loan facility of IDR 10 bio, to Bank B. </p></li><li><p> </p><p> Page 5 </p><p>Once we have a monthly installment payment of IDR 183.5 mio for 10 years and the additional </p><p>loan facility of IDR 10 bio, then we could use RATE function from Excel to obtain the annual </p><p>interest rate, in this case, the result is 18.52% (see cell Q10). </p><p>You might be surprised that the incremental or marginal cost of borrowing more of IDR 10 bio is </p><p>much higher than the stated or quoted annual interest rate from Bank B, 18.52% compared to </p><p>12%. </p><p>Then you might want to ask, then how about 12% annual interest rate quoted by Bank B? </p><p>Are they misleading you by giving you intentionally a lower quoted interest rate so that you </p><p>might be induced to take up that loan offering from Bank B, by thinking that it is not really </p><p>expensive by obtaining IDR 10 bio more yet the additional annual interest rate is 1% higher? </p><p>Not really, Bank Bs 12% annual interest rate is not wrong. </p><p>Bank financial calculator should always be rightas usual, money attracts brain, and there are </p><p>surely many smart persons inside Bank B. </p><p>Then you are asking further, how to link this considerably higher marginal rate of 18.52% with </p><p>the quoted 12% from Bank B? </p><p>Though Bank B financial calculator is correct, but Bank B doesnt really tell you the whole </p><p>storysilence is golden. </p><p>This is the secret </p><p>What Bank B doesnt tell you is that the quoted or stated annual interest rate of 12% is in fact </p><p>calculated from the approximated weighted average of the loan interest rate of 11% (for </p><p>loan facility of IDR 70 bio, the same that is offered by Bank A) and 18.52% of lending an </p><p>additional IDR 10 bio more compared to that offered by Bank A to the company. </p><p>Here is the calculation. </p></li><li><p> </p><p> Page 6 </p><p>From the above analysis, we obtain 11.94% or rounded to 12%, the annual interest rate that </p><p>Bank B is offering to the company with a loan-to-value ratio of 80%, 10% higher than that </p><p>offered by Bank A. By taking the loan facility from Bank B, implicitly, the company is willing to </p><p>pay 11% annual interest rate for the IDR 70 bio (the same as offered by Bank A) plus 18.52% </p><p>annual interest rate for the additional IDR 10 bio. </p><p>Now you are not really happy to know the fact that the instead of just paying 1% annual interest </p><p>rate more (12% vs 11%), you need to pay 18.52% annual interest rate for that additional IDR 10 </p><p>bio, or </p><p> the spread is 18.52% - 11% or 7.52%, or approximately 7.52% / 11% = 68% considerably </p><p>higher. </p><p>I will say to you to cool down first instead of confronting this fact direct to your Bank B banker. </p><p>At the end of the day, Bank B doesnt force you to accept its loan facility offering. </p><p>Then the next question is how to deal with this 18.52%? </p></li><li><p> </p><p> Page 7 </p><p>I will say, well it depends: </p><p>i. whether you have money of IDR 10 bio in the companys bank account and </p><p>ii. whether the company could get the additional IDR 10 bio from other financier with a </p><p>lower annual interest rate. </p><p>Let discuss the i) point first. </p><p>Lets say, the company has IDR 10 bio in its bank account, that is not reserved for other fund </p><p>request within another 10 years (for example, to support capital expenditures which are needed </p><p>to drive EBITDA and growth, or financing working capital requirements), then the company </p><p>could use this IDR 10 bio to fund the property purchase. This will implicate that the company will </p><p>only accept a loan-to-value ratio of 70% from Bank A, paying IDR 30 bio as the down payment </p><p>and the rest to be covered by the loan facility. The reason driving this choice is that the </p><p>company is not willing to accept a relatively higher annual interest rate of 18.52% for that </p><p>additional loan amount of IDR 10 bio, to reach a loan-to-value ratio of 80%. </p><p>Is this reasoning correct? </p><p>Well, my answer, this again depends. </p><p>We do know from the above analysis that to obtain additional IDR 10 bio, Bank B will charge the </p><p>company with a rate of 18.52%. We could use this 18.52% as the minimum rate of return that </p><p>the company could utilize that IDR 10 bio that is now sitting idly in the companys bank </p><p>account. </p><p>Suppose the company could have a new business project in its pipeline with an initial </p><p>investment of IDR 10 bio and with a comparably equal risk that could guarantee the annual </p><p>rate of return of more than 18.52%, then the company might be better off to consider to accept </p><p>Bank B loan facility, paying only IDR 20 bio (IDR 100 bio for property market price minus IDR 80 </p><p>bio of funds from Bank B) as a down payment (instead of IDR 30 bio as a down payment if the </p><p>company chooses the loan facility from Bank A). This choice will leave the company with IDR 10 </p><p>bio intact in its bank account, and could use this IDR 10 bio to fund the initial investment of that </p><p>new business prospect. </p><p>We could interpret this 18.52% as the [minimum] opportunity cost of capital. If the company </p><p>could invest this IDR 10 bio elsewhere that could earn the annual rate of return of more than </p><p>18.52%, then the company might be better off taking a higher loan facility that is from Bank B. If </p><p>not, then the company is better off with a smaller loan facility from Bank A. </p></li><li><p> </p><p> Page 8 </p><p>Now we go to the ii) point above. </p><p>How about if the company doesnt have an excess cash of IDR 10 bio that could be channeled </p><p>to fund the property purchase. So it might seem that the only road to go is by taking a higher </p><p>loan facility from Bank B, paying IDR 20 bio for the down payment using its own money and </p><p>leaving IDR 80 bio to be covered by Bank B loan facility. </p><p>Will the analysis be different even if the company doesnt have IDR 10 bio? </p><p>Well, I would like to say again, it depends. </p><p>If the company doesnt have money, it doesnt mean that the company has no other option or </p><p>alternative to consider to make it better off. </p><p>How about if the company could go to other bank, lets say, Bank C, which could extend a loan </p><p>facility of IDR 10 bio with the same terms and conditions of loan, including the loan term of 10 </p><p>years. </p><p>So instead of borrowing IDR 80 bio from Bank B with its weighted average of 11% rate on the </p><p>IDR 70 bio and 18.52% rate on the additional IDR 10 bio, then the company could take a </p><p>smaller loan facility of IDR 70 bio from Bank A, and then cover the shortage of IDR 10 bio for a </p><p>down payment (assuming the company has an IDR 20 mio in its bank account ready for the </p><p>down payment) from Bank C. </p><p>The above option will be financially feasible if the company could negotiate with Bank C to have </p><p>the loan annual interest rate for that IDR 10 bio, lower than 18.52%. </p><p>So if under (i) we could interpret 18.52% rate as the minimum rate of return that we should </p><p>earn from other alternative or option, yet under (ii), we could interpret 18.52% rate as the </p><p>maximum cost of borrowing that we could pay to get the additional loan facility from other </p><p>bank. </p><p>Conclusion </p><p>In analyzing how much to borrow from the bank in financing a property project, then in the </p><p>financial modelling, the corporate analyst should use the incremental cost of borrowing on an </p><p>annual basis in comparing one alternative with another option(s). </p><p>Before I am closing this article, there are some caveats in my analysis, which is under this </p><p>analysis: </p></li><li><p> </p><p> Page 9 </p><p> I do not factor the corporate income tax into the analysis. Corporate income tax could </p><p>reduce the interest rate effectively since by taking a higher loan facility, the interest </p><p>expense charged to the profit and loss statement will be higher, resulting in a lower </p><p>corporate income tax liability. If the companys EBIT is higher than the interest expense, </p><p>we could say that the company could realize this interest tax shield, making the effective </p><p>after-income-tax interest cost lower than that paid to the bank. </p><p>In addition, the company in a higher corporate income tax bracket might enjoy higher </p><p>income tax reduction by taking a higher loan facility. Yet for Indonesia context, this is not </p><p>really applicable, as Indonesia tax regime applies one single rate of 25%, unless if the </p><p>company has a significant tax loss that could be carried forward to reduce the corporate </p><p>income tax liability. </p><p> I assume that the loan facility will not be repaid early. The loan repaid early than </p><p>scheduled in the analysis will affect the incremental cost of borrowing, which in general, </p><p>we could say, it will increase the incremental cost of borrowing. </p><p> I dont consider all costs that could be charged by bank, such as loan provision, </p><p>insurance, administration/notary charge, that in most cases, could be collected by bank </p><p>at the beginning of the loan term, which could add several points to the effective </p><p>borrowing cost. Here, I assume that other than the loan principal amount and interest </p><p>rate, the terms and conditions of the loan facility from different banks are the same. </p><p>~~~~~~ ####### ~~~~~~ </p></li><li><p> </p><p> Page 10 </p><p>Disclaimer </p><p>This material was produced by and the opinions expressed are those of FUTUR...</p></li></ul>