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McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved CHAPTER12CHAPTER12 CHAPTER12CHAPTER12 Financial Leverage and Financing Alternatives.

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Presentation on theme: "McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved CHAPTER12CHAPTER12 CHAPTER12CHAPTER12 Financial Leverage and Financing Alternatives."— Presentation transcript:

1 McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved CHAPTER12CHAPTER12 CHAPTER12CHAPTER12 Financial Leverage and Financing Alternatives

2 12-2 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Financial Leverage What is financial leverage? Benefit of borrowing at a lower interest rate than the rate of return on the property. Why use financial leverage? Diversification benefits of lower equity investment Can invest in other property Mortgage interest tax benefit Magnify returns if the return on the property exceeds the cost of debt

3 12-3 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Financial Leverage: Before-Tax Positive Financial Leverage Returns are higher with debt Unlevered BTIRR Return with no debt If unlevered BTIRR > interest rate on debt The BTIRR on equity increases with debt. There is positive financial leverage.

4 12-4 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Financial Leverage: Before-Tax Equation 1: BTIRR E =BTIRR P + (BTIRR P – BTIRR D )(D/E) BTIRR E = Before-Tax IRR on equity invested BTIRR P = Before-Tax IRR on total investment in the property BTIRR D = Before-Tax IRR on debt (effective cost including points) D/E =Debt/Equity ratio

5 12-5 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Financial Leverage: Before-Tax Equation 1 shows that as long as: BTIRR P > BTIRR D, then BTIRR E > BTIRR P This implies increasing D/E…… But the use of debt is limited Debt coverage ratio restrictions Higher loan to value ratios are riskier to lenders…leading to higher interest rates Higher debt levels increase risk to equity investor

6 12-6 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Financial Leverage: Before-Tax Negative Financial Leverage If BTIRR D > BTIRR P, then BTIRR E < BTIRR P The use of debt reduces the return on equity.

7 12-7 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Financial Leverage: After-Tax Equation 2: ATIRR E =ATIRR P + (ATIRR P – ATIRR D )(D/E) ATIRR E = After-Tax IRR on equity invested ATIRR P = After-Tax IRR on total investment in the property ATIRR D = BTIRR D (1-t) After-Tax IRR on debt (effective cost after taxes including points) D/E =Debt/Equity

8 12-8 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Financial Leverage Example Building Value=$85,000, Land Value=$15,000, Total Value=$100,000 Loan Assumptions: Loan Amount=$80,000 Interest Rate=10% Term: Interest Only 80% LTV Income Assumptions: NOI=$12,000 per year (level) Income tax rate=28% Depreciation=31.5 years (straight line) Resale price= $100,000 Holding period=5 years

9 12-9 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved

10 12-10 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Cash Flow Summary and IRR With Leverage

11 12-11 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved

12 12-12 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Cash Flow Summary and IRR Without Leverage

13 12-13 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Financial Leverage: After-Tax Break-even interest rate Maximum interest rate before negative financial leverage ATIRR D = ATIRR P ATIRR D = BTIRR D (1-t) BTIRR D = = Risk considerations

14 12-14 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Break-even Interest Rate

15 12-15 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Alternative Financing Structures Sale-Leaseback of Land and Ground Leases Own building and lease land from a different investor Motivations 100% financing possible Lease payments are tax deductible Building is depreciable; land is not Possible purchase option at end of lease


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