Tuesday, December 31, 2019

Debt versus Equity Funding

A bank these days can lend up to 80% of the total cost of the project (land + permits + construction + sales). This means in order to make a project possible a developer only needs to come up with 20% of the money required themselves, with the rest being borrowed.

A good project needs to deliver at least a 20% profit on the total money invested in the project. However, out of the total money invested only 20% is equity and the rest is being borrowed. Let's say we have a 12-month project which cost $100 and generated a profit of $20. Out of the $100 investment, only $20 was equity by the developer and the rest $80 was lent by the bank at 5%. 

So out of the $20 profit, $4 goes to the bank as interest on its $80 at 5%. And the remaining $16 goes to the developer for his $20 investment. This is an 80% return on equity in one year. Not bad at all! If the project was two years long then the yearly equity return would be 40%. For a 4 year project, this would be 20%. The annual return on equity is also called Internal Rate of Return or IRR.


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