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: Leverage 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 MG Lipsett, 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. Wealth is held primarily by individuals. There are exceptions (e.g., resources), but the profits from development generally flow to individuals. Most with wealth wish to preserve or grow wealth Wealth and entrepreneurial spirit often do not align. There are vast differences in the tolerance for risk 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 ) is the primary mechanism to reduce risk, because it ranks ahead of equity 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 To the lender (who provides the money), debt has a lower risk than equity. If a business fails, debts (liabilities) are paid before shareholders get to collect their investment (equity). In many real cases, shareholders will get nothing after debts are paid off s can also be secured against specific assets (consider a car loan or a home mortgage). MG Lipsett,

3 Effect The Example: Income The Concept Concept of Slow Statements Goodco Working Payment of of (3) (3) & Inventory: Interest is the Interest is highly variable from loan to loan depends on the risk associated with the loan, and over time reflects the balance between savers and borrowers, and inflation rates is often secured i.e., if it is not repaid, then the lender can attach (seize) certain assets in order to recover the principal Interest on debt is always lower than the projected rate of return on equity in the project or business Otherwise, the business would not be able to repay the equity investors at an acceptable return MG Lipsett, Effect The Example: Income The Concept Concept of Slow Statements Goodco Working Payment of of Leverage Leverage & Inventory: (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 Leverage Leverage & Inventory: Leverage is usually measured by Ratio: Total Liabilities Total ssets lternatively, leverage is also sometimes measured as a ratio of bank debts (long-term liabilities) only: Bank s Total ssets or sometimes as a ratio of asset value relative to equity: Total ssets Total MG Lipsett, Leverage & of of Inventory: Leverage Leverage (a) MG Lipsett,

5 50 Leverage in Good Times & of of Inventory: Leverage Leverage (b) The company is making 10 on its investment, but it only costs 8 to service the interest on its debt (10) (8) MG Lipsett, Leverage in Good Times & of of Inventory: Leverage Leverage (c) The of the debt portion in excess of the is transferred to equity and increases the return on equity return on equity (12) (10) (8) MG Lipsett,

6 80 Leverage in Good Times & of of Inventory: Leverage Leverage More of the debt portion in excess of the cost of debt is transferred to less equity and increases the return on equity return on equity (18) (10) (8) MG Lipsett, & of of Inventory: Leverage Leverage (3) (3) 50 Leverage in Bad Times The of the debt portion is higher than the of the investment; the equity return is reduced to cover the debt. (8) (6) return on equity (4) MG Lipsett,

7 80 Leverage in Bad Times & of of Inventory: Leverage Leverage (4) (4) gain, the of the debt portion is higher than the of the investment; the equity return is reduced to cover the debt. But now, so much cash must be transferred to service the debt that the return on equity is below zero; interest and principal can t be covered (8) (6) MG Lipsett, return on equity (-2) Effect Leverage, Illustrating The Example: Income Leverage, Concept of Slow Statements Goodco Working Net Net the Payment of Income, Income, Effects Leverage & of and and Inventory: Leverage on on Base Case Here, we use one of the definitions of leverage Leverage = bank debt / total assets For very simple cases (and before tax), we can assume that net income is affected only by interest on the long-term debt: Net income = operating income - interest on the long term debt Finally we calculate the return on equity: on equity = net income / total equity MG Lipsett,

8 Effect Leverage Illustrating The Example: Income Leverage Concept of Slow Statements Example Example Goodco Working the Payment of Effects Leverage & of Inventory: Leverage Calculate (a) bank debt leverage, (b) net income, and (c) return on equity of 3 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 Bank debt Long-term $970 $3,880 $6,790 (assume 10 rate) Capital Shares $6,930 $4,020 $1,110 Retained Earnings $1,000 $1,000 $1,000 Bank debt/total assets Leverage Net Income on $1,903 $1,612 $1, MG Lipsett, Effect Leverage Illustrating The Example: Income Leverage Concept of Slow Statements Example Example Goodco Working the Payment of Effects Leverage versus Capital Review & of Inventory: Leverage Calculate (a) bank debt leverage, (b) net income, and (c) return on equity of 3 nearly identical companies in bad times: Income Statement Lodebtco Medebtco Hidebtco Sales $7,000 $7,000 $7, drop in sales 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 Bank debt Long-term $970 $3,880 $6,790 (assume 10 rate) Capital Shares $6,930 $4,020 $1,110 Retained Earnings $1,000 $1,000 $1,000 Bank debt/total assets Leverage Net Income on $403 $112 ($179) (8.5) MG Lipsett,

9 Effect Summary Leverage Illustrating The Example: Income Summary Concept of Slow Statements Example Goodco Working the Payment of Effects Leverage versus Capital Review & of Inventory: Leverage 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) Leverage is the ratio of debt to assets (there are several 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,