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Honestly my best advice to a child about debt would be be to avoid getting into it.
Tell that little punk to leverage up and purchase undervalued assets FTW ballin bottles and models fuck yeah
I'll answer this later toady when this hang over I have goes away.
Heister 3's debt right?
In kid terms, just think of the lemonade stand. The child wants to set up a lemonade stand, but has no money. So his parents offer to loan him $20 and for the purpose of this example, let's say the parent tells the kid that he/she must pay them back $21. So, if the kid makes $50 at his lemonade stand, he gained $29 (not including COGS). So, he kid could make money and grow his "business without having the capital upfront.
Obviously you can have the capital and still take on debt, but I am not sure if a ten year old would understand that as easily.
Thanks for this.
How about if one is to buy a car or a house? Would it be better to take on debt even if you had the entire cash to pay for them? Why or why not?
Some have used the phrase "eat well vs. sleep well" to dumb down the debt vs. equity decision. Perfect debt financing would allow the highest return (eat well) but is highly risky because a slow sales year or a large unexpected expense can bankrupt you with the high interest payments from 100% debt financing (you won't sleep well)
For personal finance consumption smoothing over time is also a benefit.
I absolutely love debt, it is the single greatest invention in the history of man kind. Well maybe second or third to fire and spoken/written language. Debt essentially allows one to juice their returns while smoothing their outputs of cash over a longer period.
Example: Lets say I wanted to purchase an income producing real estate property. Lets say this property was 10MM and had a gross yearly rent of 1.8MM. This gives me a CAP rate of 18% regardless of if I use 100% cash, 100% debt of a combo of the two. So what does debt do for you then? Well for one if we exclude purchase expenses such as closing costs if we were to purchase this property on a 90/10 debt to cash ratio this would allow us to control the cash flows on a 10MM property for 1MM. This allows us to extend our 10MM cash pool to control 100MM worth or assets. Debt allows us to control more asset value with less cash.
Debt also allows us to juice our cash on cash returns. Back to our example property. With 1.8MM in cash flows in year one we have expenses that go along with this cash flow. Lets say that other expenses (taxes, maintenance, etc.) are 300k a year. This lowers our income to 1.5MM from 1.8MM. Lets say our loan for simplicity sake is a 10 year loan at 10% simple interest. This would mean that our debt obligations for year 0 (1st year) are 1.1MM. When we subtract our debt payments and expenses from our gross income we arrive at our BTCF of 400k. This is a 40% cash on cash return of the 1MM we invested into the deal.
Now lets look at what an all cash purchase would have yielded on this investment. Keeping the simple numbers from before we would have purchased the property for 10MM cash. The property makes 1.8MM a year and has 300k in expenses. This leaves us with a BTCF of 1.5MM or a 15% cash on cash return.
Equity gains are slightly dampened by the inclusion of debt due to the inclusion of interest payments. However these are also juiced when put in to a cash on equity return basis for the same reason that your cash on cash return is juiced by the debt. The less cash you have in a deal the higher your cash on cash returns will be.
40% > 15% Debt > Cash
Granted this analysis is if the purpose of the investment is to solely find the highest possible return on the cash invested. Not all investment goals are the same. Some are specifically designed to protect capital, others are designed to show "operating losses" others are geared exclusively at equity gains while enduring break even or slight operating losses.
If you were going to ask me I would say, if its not making me money from day one I wont even consider the deal. Does this mean I pass up on some great deals? Yes. Also this isn't as literal as it sounds. Yes I understand that getting to 95% occupancy takes time, however I am not going to invest in a place that when it's preforming its best I am going to be loosing money. However I will invest in a place that is loosing money today but when performing at 100% the numbers look completely different.
I like your example. With regard to a business, in my experience the consistency of cash flies should largely determine the amount of debt. If your cash flows are very cyclical and subject to large decreases you have to really watch much much leverage you use.
I like John Malone's comments that in a business like cable, with reasonably consistent recurring cash flow you can safely push 4-5x cash flow. In a business like manufacturing, you are best not pushing past 1x, at most 2x cash flow.
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