Profitability Analysis of Leveraged Transactions

Because the decision function is usually separated from the financing function, most venture analyses do not explicity encompass the source, the cost, or the repayment of the necessary capital. This must change as industry moves toward more venture financing, for in leveraged - or "project financed" - ventures, those factors cannot be ignored. Introduction If we may differentiate between "simple" ventures and "leveraged" ventures, we can state that the great majority of the ventures that a petroleum engineer and profitability analyst will be asked to evaluate will be of the simple variety. By "simple" we mean here that the specifications for the venture include a capital cost and call for calculating a return on that cost either through income or through savings. The venture specifications make no mention of where the capital is to come from, how much it will cost, and if or how it is to be repaid. This practice makes good sense because in most businesses there is a definite segregation of duties and responsibilities between the engineers who screen, rank, and implement ventures and the financial people who must come up with the needed funds on the most favorable terms obtainable. Occasionally, however - and we predict it will be with increasing frequency - the engineers will be handed venture specifications for profitability analysis that specifically include financing changes. Such ventures are not directly comparable with the so-called simple ventures: for screening or ranking purposes the two types of ventures must first be made comparable, and the procedures to achieve this and the reasoning behind them are the subject of this paper. Our presentation will consist of three parts. First, we shall treat leverage where there are no particular constraints: then we shall examine the situation where "equity"' capital (that is, one's own capital) is insufficient and money must be raised from outside sources if the venture is to be undertaken at all; and finally we shall compare leasing with acquiring and subsequently depreciating plants and equipment - leasing being a rather specialized and sometimes unrecognized form of leveraging. The term "leverage" stems from the analogy of the lever and is used to describe the attempt to gain a greater return from one's own (equity) capital by utilizing outside capital (debt). More often than not, the venture for which one's capital is to be "leveraged" is larger than could be undertaken with one's own equity capital alone. Then, if things turn out as expected - or by good fortune even better than expected - return on equity will be very high, But the tong arm of a lever swings widely both up and down, and if venture results are poorer than expected, any return on equity can quickly be wiped out. In a leveraged venture, equity capital represents only a portion of the total needed funds, and the profile of the cash return on equity capital is very different from that in an unleveraged venture. In a leveraged venture, interest and repayment of loan principal come first. Table 1 is a simple illustration of what we mean. Case 1 shows an investment of 1,000 units, which gives rise to a cash flow of 220 units/year for 6 years. We shall use as our profitability criterion the profit of the venture discounted at 8 percent/year. For Case 1 this works out to 57 units. (An internal rate of return for this venture of a little more than 9 percent/year may be calculated.) JPT P. 319