A few years ago, getting a loan for any project could be difficult and costly. Lately, however, there is a proliferation of lenders wanting to fund new business ventures.
Now when you need cash for a new project, instead of getting just one “take-it-or-leave-it” offer, you may be faced with multiple financing offers all with different pricing and conditions. When this happens, it becomes difficult to determine exactly which offer is best considering different interest rates, points and fees not to mention collateral, covenants and conditions.
We use the premise of the discounted cash flow method regularly with our clients. The basic premise of the discounted cash flow method is that $1 received today is more valuable than $1 received five years from now. On the other hand, $1 paid today is more costly than $1 paid five, ten or fifteen years from now. By recording the timing of the out-of-pocket cash for each loan and then applying a discount factor to cash paid out in future years, you can easily determine the best financing package for your project.
Let’s use a hypothetical project with a total cost of $1,000,000 to illustrate how to select a project lender using the discounted cash flow method.
Let’s say a supplier loan program offers the lowest interest rate, but this loan must be repaid in a shorter time than the other lenders — only 15 years. Furthermore, this lender is willing to finance only 80% of the project costs. The mortgage lender will finance 90% of the project, however, the interest rate is slightly higher and the points and fees are significantly higher than the supplier. Finally, the banker has offered their standard 75% financing with the lowest loan fee of any of the lenders.
To determine which offer is the most cost-effective, we first determine the effect on our company’s cash for a ten-year period with each loan. The down payment and any fees or other costs will be paid immediately. (They show up in today’s dollars.) Loan payments are listed annually and are “discounted” to account for the fact that a dollar paid in the future is not as valuable as a dollar paid today.
For each offer, we assume that the loan balance will be paid in entirety at the end of year ten. Given the parameters of each lender’s offer, our best choice is the mortgage company loan despite the fact the fees are more than the other lenders. The smaller down payment outweighs the higher fees.
If the mortgage lender falls through, our second choice should be the supplier loan program. Based purely upon cash flow, we would not select the bank offer. Finally, before accepting any offer, be sure the project can support the debt payments. In this example, the store should be able to support $7,800 per month loan payments and still provide an acceptable rate of return to the owners.
