Three Basket Choice

When I was with a good friend who is also an astute businessman, I posed the following question. Which basket would you choose? In basket #1 is an asset worth $100,000 without any debt; in basket #2 is an asset worth $100,000 as a result of $200,000 of asset value and $100,000 of liability value; in basket #3 is an asset worth $100,000 as a result of $1,000,000 of asset value and $900,000 of liability value.

He told me that he would want the basket against which he could borrow the greatest amount of money. I found this answer fascinating, because it implies that he is most comfortable where the lender has the lowest perceived risk. Because debt is a four letter word in my world, I would have chosen the basket without any debt. I am most comfortable where the equity holder has the lowest perceived risk.

An implied advantage of his way of looking at the world is that the cost of capital is much lower. When studying an asset tied-up from a loss of lending perspective, the cost of capital is roughly 8%, whereas when studying an asset tied-up from a loss of investing perspective, the cost of capital is roughly 12-15%.