ShmoopTube

00:00

Principles of finance ah la shmoop present value of buying

00:05

versus leasing a bottling factory to buy or not to

00:10

buy That is the question and you've probably tasted the

00:13

salty and sweet mash up already in real life It's

00:17

a big in the car industry where simply put the

00:20

large automakers have better access to credit than joe six

00:24

pack So for gm and the others are in a

00:27

sense banks leasing cars to some and loaning money for

00:31

purchase toe others if purchase and lise were identical while

00:34

the only story would be about ferreting out the math

00:37

and going with whatever option was cheaper for you the

00:40

buyer but owning carries different risk than does leasing both

00:44

in cars and bottling factories So as we go through

00:47

this video you have tto add the suffolk ce ish

00:51

to a lot of numbers here and listen to that

00:52

little lise whisperer on your shoulder mumbling oh if we've

00:56

only leased this thing we'd be calling the owner to

00:59

fix it And then with the buy whisper on the

01:02

other shoulder whispering we need to spend the money to

01:05

upgrade this guy who's a more it'll produce twice as

01:09

many flux capacitors Thank goodness we own it All right

01:12

Remember the sauce company people Yeah Bubby artie bernie and

01:15

the gang Well they went public and our big baby

01:18

big And now with one hundred million dollars in cash

01:21

in the bank they think that they might want to

01:23

own their own processing facility like this thing Why Well

01:27

if they owned it they could reduce their current cost

01:30

per bottle by thirty cents at least assuming that they

01:33

keep growing at the break neck speed that they're growing

01:36

at now But more importantly they could meet her measure

01:38

and optimize the way they produce sauce bottles to meet

01:41

demand Custom bottles and the flexibility of owning the plant

01:45

would make their end product feel and look better to

01:48

the customer It would add brand equity to their value

01:52

Well in their current setting i released Set up They

01:54

have to go out to bid and then try to

01:56

lisa facility from dozens of bottling plants that put onion

01:59

brown sugar salt water in the bottles And then they

02:02

have to spend a small fortune policing those least facilities

02:06

to be sure that they uphold you know cleanliness standards

02:09

And that no one steals their secret formula when they

02:12

get a huge order from a latin american dictator flush

02:15

with cash for whatever reason and we don't ask why

02:18

the sauce company often can't fulfill that order and not

02:22

only leaves money on the table that opens the door

02:24

for a competitor to come in and make that fire

02:27

happy and they you know potentially anger customers they really

02:31

don't want to anger How do they even begin to

02:33

think about this problem Well like all things dictator they

02:37

divide and conquer the brand improvement value in better customer

02:40

service that would come from owning instead of leasing is

02:43

hard to calculate for now so they ignore it But

02:46

the thirty cents a bottle savings is easy to calculate

02:48

They produce a million bottles a month today and they

02:51

think they'll produce five million a month in three years

02:54

right So it's expected big growth so a million bottles

02:57

a month at thirty cents is three hundred grand a

02:59

month in savings and all of that savings drops to

03:01

the bottom line as incremental cash profits the math well

03:04

twelve months times three hundred thousand bucks in savings orc

03:07

incremental pre tax profits of three point six million dollars

03:11

a year if they owned their own plant and in

03:13

three years at five million bottles a month while that's

03:16

one point five million dollars a month or a savings

03:18

of twelve times one point five million there for eighteen

03:21

million dollars a year like three point six million this

03:24

year maybe eight or nine million in savings next year

03:27

And so on like big numbers So yes of course

03:30

they should own their own plant But there's one minor

03:33

problem ah bottling plant of this scale cost three hundred

03:37

million dollars up front payable in cash plus cost to

03:41

service and maintain it and insurance plus the risk that

03:44

the glass production has proven teo kill puppies and then

03:47

they'll have to switch to plastic cost more money But

03:50

since the cost savings are so massive on operational base

03:54

as well assuming that they cannon will grow to five

03:56

million bottles a month and they feel certain or at

03:59

least fairly sure that they'll grow toe ten or twenty

04:02

million bottles a month after that well they get all

04:05

their money back in a small number of years Owning

04:07

the plant is probably a good idea considering their current

04:10

growth expectations assuming they're accurate so today they only have

04:14

a hundred million dollars in cash in the bank They

04:16

can't just write a check for that huge three hundred

04:18

million dollar amount but a bunch of other net present

04:21

value questions are now clear in their heads Do they

04:24

go into debt to buy the plant like what's The

04:27

cost of that debt Well if it's five percent then

04:31

wait a minute five percent on a cost of three

04:33

hundred million in cash today That's fifteen million dollars a

04:37

year just in interest payments on the loan All the

04:40

interest is to do deductible so maybe tax dollars pay

04:44

five of that fifteen Is there depreciation that can mitigate

04:48

taxes further and make it easier to buy Maybe probably

04:52

somewhat The company has today no debt and an existing

04:55

one hundred million dollars on its balance sheet But in

04:57

doing the by versus least math that fact should not

05:00

be a factor here because it exists outside of the

05:02

box of the plant decision Like in theory the sauce

05:06

company could lend out that hundred million dollars at five

05:09

Percent interest it to somebody and make another five million

05:12

dollars a year on it Well what about the bigger

05:14

risks here Well the plant itself will be guaranteed by

05:16

the builder of it so they believe it'll work But

05:18

what if the man slips And instead of hitting five

05:21

million a month they hit only two million bottles While

05:24

then was it's still worth buying the plant No they'll

05:27

have tons of unused or wasted capacity But if they

05:30

did could they then bottle for other people Could they

05:33

make the money back by you know bottling for their

05:35

competitors Do they really want to be in the bottle

05:37

business anyway Well they really are in the manufacturing of

05:40

sauce business which has very different core skills needed and

05:44

well frankly it's just not their corporate culture Having three

05:46

hundred million bucks in dead also brings into question real

05:49

potential of bankruptcy if things go wrong won't that high

05:52

risk hurt the equity value of the company They have

05:55

a lot of nervous nellie investor slash owners who hate

05:58

debt hate financial leverage half their credit card every month

06:01

Well that fifteen million dollars in interest cost has to

06:03

be figured out It means that they'd have total potential

06:05

savings on five million bottles of eighteen million dollars Yeah

06:09

that's with the five hundred percent growth three years from

06:13

now So even at that very prodigious growth number well

06:16

this by the plant option really makes no sense So

06:20

for this example it's an easy punt and clearly at

06:23

this stage in their growth they'll just keep spot leasing

06:25

factory bottling space But what if they could get a

06:28

tease or loan rate for just two percent a year

06:31

For the first two years i e six million bucks

06:33

a year to rent that three hundred million But then

06:35

the rate goes toe three percent for two years or

06:38

nine million a year than to rent it And then

06:40

the rate goes toe six percent from there on or

06:43

eighteen million a year to rent whatever's left of that

06:46

three hundred million they haven't paid down well If the

06:48

company really does grow at the rate it projects maybe

06:51

all this then makes sense Maybe alright some quick math

06:54

and taking out all that debt you've introduced a whole

06:56

lot more risk into your company But what if in

06:59

the years beyond that five million a month they grew

07:01

toe ten million bottles a month what's a savings of

07:04

ten million times thirty cents or three mil a month

07:07

or thirty six million dollars a year of savings Well

07:09

then buying the plant is a total no brainer if

07:12

they were then heading toward twenty million bottles a month

07:15

the following year while the by decision would be a

07:17

really easy yes but at this point tough decision Even

07:21

with the teaser rate the problem is that the company

07:23

is early Its size or scale or scope just doesn't

07:27

match the scale of owning its own bottling plant So

07:30

while things being equal the three hundred million dollar price

07:33

tag on its own with the enormous amount of interest

07:35

to be paid back and risk and all the other

07:37

stuff makes the bottling plant pass as it stands so

07:40

everyone is bummed bottling plant that wanted to sell itself

07:44

Yeah well the bankers who wanted to take a fat

07:47

happy commission on the debt Reyes yeah they're bumped and

07:49

the managers of the sauce company They're bumped too But

07:52

then a clever junior banker who actually took this course

07:54

Whispers in artie's here you could do a convertible bond

07:58

offering and then you'd pay just three percent interest at

08:01

the most on the bond interesting idea There be no

08:04

escalating three going to six percent arm or in some

08:07

vague era in the future but in order to get

08:09

a cheaper price when they rent that money while the

08:12

debt would be convertible into stock at some dollar amount

08:16

later on say thirty percent or so above the price

08:19

where their stocks currently trading like if it's trading it

08:21

s a ninetieth share Now these shares converted one hundred

08:24

twenty bucks Now that means that the company would suffer

08:27

dilution from that conversion But with the stock at ninety

08:30

dollars today if they were able to sell equity at

08:32

one hundred twenty dollars a share to raise that three

08:34

hundred million well you'd almost certainly would and at three

08:38

percent cost of renting that money While the cost to

08:40

the company is nine million dollars a year in cash

08:43

interest which if you feel is only moderate risk and

08:46

well life can go on by having a combination of

08:49

debt and equity on the table Here you've optimized your

08:52

cost of capital for this project Nice job For now

08:55

the sauce company feels good about doing the deal And 00:08:58.41 --> [endTime] well they pray a lot

Full Transcript