Give me a lever long enough and a fulcrum on which to place it, and I shall move the world. Archimedes (attributed)

Transcription

1 ENGM 401 & 620 X1 Fundamentals of Engineering Finance Fall 2010 Lecture 12: Give me a lever long enough and a fulcrum on which to place it, and I shall move the world. rchimedes (attributed) M.G. Lipsett University of lberta Effect Balance Example: Income Balance of Slow Statements Sheets Sheets Goodco Working Payment Review Review & Inventory: Which statement is NOT true about the Short Term Credit Line? a) It can be thought of as negative cash. b) The STCL is debt that is unsecured. c) The STCL is debt that is not tied to any specific assets. d) The lender can ask that it be paid back at any time. e) The lender does not typically put any conditions on the STCL. True or False: s far as the lender is concerned, debt has higher risk than equity. True or False: s far as the lender is concerned, debt has a higher return than equity. MG Lipsett,

2 Effect The Example: Income The Concept Concept of Slow Statements Goodco Working Payment of of & Inventory: In a western agricultural or industrial society, wealth is not held by society at large. There are exceptions (e.g., resources), but the profits from development generally flow to individuals. Wealth and entrepreneurial spirit often do not align. The borrower believes inherently that he/she can create more wealth than the cost of the borrowed funds Lenders trade lower return (growth in wealth) for lower risk (the risk-reward relationship ) MG Lipsett, Effect The Example: Income The Concept Concept of Slow Statements Goodco Working Payment of of & Inventory: The benefit to the borrower is that debt does not convey ownership The lender may restrict the business through covenants, but the equity owners own the business - and its blue sky potential MG Lipsett,

3 Effect The Example: Income The Concept Concept of Slow Statements Goodco Working Payment of of (3) (3) & Inventory: Interest is the cost of debt Interest is highly variable from loan to loan is often secured Interest on debt is always lower than the projected rate of return on equity in the project or business MG Lipsett, Effect The Example: Income The Concept Concept of Slow Statements Goodco Working Payment of of & Inventory: Return (i.e., growth in wealth) is more volatile (more levered ) as debt goes up and equity goes down. This arises because the risk in the project or business is being concentrated onto a smaller base of equity. The debt gets a fixed (and hopefully lower!) return than equity, but it ranks ahead of equity; it must be serviced first. MG Lipsett,

4 Effect The Example: Income The Concept Concept of Slow Statements Goodco Working Payment of of & Inventory: is usually measured by Ratio: lternatively, leverage is also sometimes measured as a ratio of bank debts only: or sometimes as a ratio of asset value relative to equity: MG Lipsett, Effect Illustrating The Example: Income Illustrating Concept of Slow Statements Goodco Working the the Payment of Effects Effects & of of Inventory: 50% in Good Times return on equity (12%) % Return 50 % 50 % earning power of investment (10%) cost of debt (8%) MG Lipsett,

5 Effect Illustrating The Example: Income Illustrating Concept of Slow Statements Goodco Working the the Payment of Effects Effects & of of Inventory: 80% in Good Times return on equity (18%) % Return 80 % 20 % earning power of investment (10%) cost of debt (8%) MG Lipsett, Effect Illustrating The Example: Income Illustrating Concept of Slow Statements Goodco Working the the Payment of Effects Effects & of of Inventory: (3) (3) 50% in Bad Times % Return cost of debt (8%) earning power of investment (6%) 50 % 50 % return on equity (4%) MG Lipsett,

6 Effect Illustrating The Example: Income Illustrating Concept of Slow Statements Goodco Working the the Payment of Effects Effects & of of Inventory: (4) (4) 80% in Bad Times % Return 80 % 20 % cost of debt (8%) earning power of investment (6%) return on equity (-2%) MG Lipsett, Effect, Illustrating The Example: Income, Concept of Slow Statements Goodco Working Net Net the Payment of Income, Income, Effects & of and and Inventory: Return Return on on Base Case Here, we use course notes definition of leverage For very simple cases (and before tax), we can assume that net income is affected only by interest on the long-term debt: Finally we calculate the return on equity: MG Lipsett,

7 Effect Illustrating The Example: Income Concept of Slow Statements Example Example Goodco Working the Payment of Effects & of Inventory: Calculate (a) leverage, (b) net income, and (c) return on equity of three nearly identical companies in good times: Income Statement Lodebtco Medebtco Hidebtco Sales $10,000 $10,000 $10,000 COGS $5,000 $5,000 $5,000 Margin $5,000 $5,000 $5,000 SG& $3,000 $3,000 $3,000 Operating Income $2,000 $2,000 $2,000 Balance Sheet (partial) Total ssets $9,700 $9,700 $9,700 (assume 10 % rate) Long-term $970 $3,880 $6,790 Capital Shares $6,930 $4,020 $1,110 Retained Earnings $1,000 $1,000 $1,000 Net Income Return on MG Lipsett, Effect Illustrating The Example: Income Concept of Slow Statements Example Example Goodco Working the Payment of Effects versus Capital Review & of Inventory: Calculate (a) leverage, (b) net income, and (c) return on equity of three nearly identical companies in bad times: Income Statement Lodebtco Medebtco Hidebtco Sales $7,000 $7,000 $7,000 COGS $3,500 $3,500 $3,500 Margin $3,500 $3,500 $3,500 SG& $3,000 $3,000 $3,000 Operating Income $500 $500 $500 Balance Sheet (partial) Total ssets $9,700 $9,700 $9,700 (assume 10 % rate) Long-term $970 $3,880 $6,790 Capital Shares $6,930 $4,020 $1,110 Retained Earnings $1,000 $1,000 $1,000 Net Income Return on MG Lipsett,

8 Effect Summary Illustrating The Example: Income Summary Concept of Slow Statements Example Goodco Working the Payment of Effects versus Capital Review & of Inventory: has lower risk than equity (a lender gets paid back, and loans may be secured; owners may lose their money) has a lower return than equity: Interest is the cost of debt. If this cost to a company for debt were more than the return on equity, then the owners would not get an adequate return on their investment (& an owner needs to be compensated for their risk by getting a higher return) is the ratio of debt to assets (there are other definitions as well), which tells us how much the growth of wealth would be affected by changes in debt and equity highly leveraged company (which holds a lot of debt) does well when debt interest is low highly leveraged company does poorly when debt gets more expensive MG Lipsett,