Favorable risk return ratioIn Warren Buffet's 1984 shareholder's letter he shared: "From October 1983 through Jun 1984, Berkshire's subsidaries continuously purchased large quantities of bonds of Projects 1,2,and 3 of Washington Public Power Supply System (WPPSS). This is the same entity that on July 1983 defauled on $2.2billion of bonds issued to finance partial construction of now-abandoned Projects 4 and 5. While there are material differences in the obligators, promises, and propertoes underlying the two categories of bonds, the problems of 4 and 5 have cast a major coulb over Projects 1, 2, and 3 and might possibly cause serious problems for the latter issues. In addition, there have been a multitude of problems related directly to Projects 1, 2 and 3 that could weaken of destroy an otherwise strong credit position arising from guarantees by Bonneville Power Administration."
Despite the negatives, Charlie and I judged the risks at the time we purchased the bonds and at the prices Berkshire paid to be considerably more than compensated for by prospect of profit.
Coupon Rate was more attractive on a comparative basis to operating businessWe extend this business valuation approach even to bond purchases such as WPPSS. We compare the $139 million cost of the investment in WPPSS to a similar $139 million investment in an operating business. In the case of WPPSS, the "business" contractually earns $22.7 million after tax (via the interest paid on the bond) and those earnings are available to us currently in cash. We are unable to buy operating businesses with economics close to these. Only a relatively few businesses earn the 16.3% after tax on unleveraged capital that our WPPSS investment does and those businesses, when available for purchase, sell at large premiums to that cpaital.
In the average negotiated business transaction, unleveraged corporate earnings of $22.7 million after-tax (equivalent to about $45 million pre-tax) migh command a price of $250 - $300 million (or something more) [note: 5-6x EBIT]. For a business that we udnerstand well and strongly like, we will gladly pay that much, But it is double the price we paid to realize the same earnings from WPPSS bonds.
Estimated RiskHowever, in the case of WPPSS, there is what we view to be a very slight risk that the "business" could be worth nothing within a year or two. There also is the risk that interest payments might be interrupted for a considerable period of time. Furthermore, the most that the "business" could be worth is about the $205 million face value of the bonds that we own, an amount only 48% higher than the price we paid.
Thrilling ResultsBerkshire held the bonds into the early 1990's and received a 16% tax-free return. In addition, the bonds were eventually redeemed at par for a capital gain of 100%, which would have brought the total return to something just short of 30% per year
Despite the negatives, Charlie and I judged the risks at the time we purchased the bonds and at the prices Berkshire paid to be considerably more than compensated for by prospect of profit.
Coupon Rate was more attractive on a comparative basis to operating businessWe extend this business valuation approach even to bond purchases such as WPPSS. We compare the $139 million cost of the investment in WPPSS to a similar $139 million investment in an operating business. In the case of WPPSS, the "business" contractually earns $22.7 million after tax (via the interest paid on the bond) and those earnings are available to us currently in cash. We are unable to buy operating businesses with economics close to these. Only a relatively few businesses earn the 16.3% after tax on unleveraged capital that our WPPSS investment does and those businesses, when available for purchase, sell at large premiums to that cpaital.
In the average negotiated business transaction, unleveraged corporate earnings of $22.7 million after-tax (equivalent to about $45 million pre-tax) migh command a price of $250 - $300 million (or something more) [note: 5-6x EBIT]. For a business that we udnerstand well and strongly like, we will gladly pay that much, But it is double the price we paid to realize the same earnings from WPPSS bonds.
Estimated RiskHowever, in the case of WPPSS, there is what we view to be a very slight risk that the "business" could be worth nothing within a year or two. There also is the risk that interest payments might be interrupted for a considerable period of time. Furthermore, the most that the "business" could be worth is about the $205 million face value of the bonds that we own, an amount only 48% higher than the price we paid.
Thrilling ResultsBerkshire held the bonds into the early 1990's and received a 16% tax-free return. In addition, the bonds were eventually redeemed at par for a capital gain of 100%, which would have brought the total return to something just short of 30% per year
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