Debt Part 1

Quick reference

• 00:04 Onwards and downwards, next stop, Debt and Interest Expense.
• 00:09 Let me explain how I got to that conclusion Are you fed up with this slide?
• 00:16 Good if you are because it shows the messages getting through,
• 00:20 you're understanding what the order is.
• 00:22 Yes, you have your arrow to get through A to B as efficiently
• 00:24 as possible using a communicative tool of your financial model.
• 00:28 Putting your checks.
• 00:29 We've completed the operation, the working capital adjustments and
• 00:33 asset sections of the model.
• 00:34 Next up therefore is financing.
• 00:37 After that, we'll have to do tax.
• 00:39 And then we're looking at the financial statements and other key outputs as well.
• 00:43 Well, that's really in part three of this course.
• 00:46 We're plowing through the PNL.
• 00:48 We've done Revenue, we've done COGS we've done Op Ex, we've done Depreciation.
• 00:52 Next up, Interest Expense.
• 00:55 We can't calculate Interest Expense unless we've
• 00:58 actually worked out what the debt is as well.
• 01:00 So you can see, we're clearly plowing through the model now.
• 01:04 We've got the top half of our graphic all nice and green,
• 01:07 and we have highlighted now Debt and
• 01:09 Interest in yellow because that's what we have to turn out attention to now.
• 01:13 But before we do,
• 01:14 I want to conceptionally go through all the general ideas about financing.
• 01:20 Yes, we're in the financing section.
• 01:22 Now businesses require cash for a variety of reasons.
• 01:27 And they're listed here.
• 01:28 I'm not gonna go through all of them.
• 01:29 You can see capital expenditure, paying tax,
• 01:32 providing returns on existing funding.
• 01:34 You're looking at external funding.
• 01:38 When referring to Capital in modeling, we're referring to all external
• 01:42 forms of funding by entity, ranging from Ordinary Equity to Senior Debt.
• 01:47 Not the profits generated to the retain, but actually the external funding.
• 01:51 So we're looking all of it in that spectrum from Debt to Equity.
• 01:56 Now, when people look at providing this Capital to you,
• 01:59 it's going to be a risk return proposition for them.
• 02:02 If the shareholders, there's a quick chance they'll get more money, but
• 02:07 there's a good risk they'll lose it all.
• 02:08 Whereas debt that wasn't secured against certain assets but,
• 02:11 they'll expect a lower return as a consequence.
• 02:14 Now let's talk about returns.
• 02:17 It doesn't matter how complicated a financier,
• 02:20 a bank, whoever makes the financial instrument.
• 02:24 There's only two types of return, period.
• 02:26 It's the Return on Capital and the Return of Capital and that's it.
• 02:33 So, Return on Capital is an income or gain earned on money invested in an entity.
• 02:38 And it's paid to capital providers in the form of some sort of distribution.
• 02:42 It can be dividends of interest, or an increase in share price.
• 02:45 Whereas a Return of Capital,
• 02:48 is a return from an investment that isn't considered income.
• 02:52 This can be where some or
• 02:53 all of the money an investor has made in the investment is paid back.
• 02:57 So it's repayment of debt, and it's buyback of shares, for instance.
• 03:01 And the next slide sort of highlights this.
• 03:04 So examples for Debt and Equity.
• 03:06 Return on Capital could be interest for debt or dividends or
• 03:09 capital gains on the share for equity.
• 03:12 The Return of Capital for debt will be the repayment.
• 03:15 Whereas, Equity, typically it's more likely than not to be equity repayment
• 03:20 though it could be a share or stock sale.
• 03:22 And if you're gonna have a contract, you'll have a debt sheet or
• 03:25 a term sheet that you'll have to actually read through an indenture.
• 03:29 And this could be quite complex to model in real life.
• 03:32 Now that's a course all on its own.
• 03:34 We're going to assume the Debt here is a number.
• 03:37 We're gonna just put it through.
• 03:38 Typically what will happen in a model, though, is you'll have to workout how your
• 03:42 financial health is in this period, and therefore how much you need to draw down.
• 03:46 This course is all about being the first rung on the ladder to
• 03:49 building a complex financial model.
• 03:51 There's more sophisticated things to come, and
• 03:54 we can talk about that in a later course.
• 03:57 Equity is explained in a prospectus.
• 04:00 The actual rewards can be higher, but there's not guaranteed return whatsoever.
• 04:04 And therefore the contract with the entity is just to say,
• 04:08 you will get your share if there is a share.
• 04:13 Risk and Return then,
• 04:14 means capital providers face the risk that returns may not be received.
• 04:18 So they want to make sure that it looks okay to them, and yields an investment.
• 04:23 And that can be quite complex to negotiate, and explain, and
• 04:26 they'll want a financial model to see how it goes, but as far as you're concerned,
• 04:29 when you're building the model, these are just numbers.
• 04:33 The risk is going to be a percentage return they require.
• 04:37 The return will be the calculation of that total repayments.
• 04:40 Simple as that.
• 04:41 What's more complicated for a modeler is ranking.
• 04:45 The different contractual arrangements between capital providers and
• 04:49 an entity result in a hierarchy of capital provider entitlements.
• 04:53 Read that rather robotically, what it means is,
• 04:56 that there is an order who gets who's when.
• 05:00 So we've got to decide.
• 05:02 Debt gets their money first, finance later, and shareholders right at the end.
• 05:08 If there's a break-up, it might change around, but we have to model this and
• 05:11 work out what's the order of pay.
• 05:15 We got two examples of Capital here.
• 05:16 First is Debt.
• 05:18 Money, goods, or services one party's obliged to pay another.
• 05:22 It can be loan or borrowings.
• 05:23 The risk is low because it's usually securitized.
• 05:26 The returns are low for the same reason, ranking high gets that first.
• 05:32 Whereas for equity, is the owners' interests in an entity's assets
• 05:37 after every one else has been paid off.
• 05:38 So it kind of with a nice high return.
• 05:42 The risk is high though.
• 05:43 And the ranking is, well, you write down at the bottom of the pyramid.
• 05:48 So let's go on.
• 05:49 We're gonna model equity later.
• 05:51 Let's look for now at debt.

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