The effect of gearing Week 11

What is gearing Capital structure = equity + debt Gearing is a general term used to describe borrowing within an investment context It refers to the use of borrowed funds to earn a return greater than the interest paid on the debt

Gearing measures Gearing is usually expressed as the ratio of debt to total assets Gearing ratio (debt ratio) = Debt / Total Assets Example: Total assets – $100m Debts – $25m Gearing ratio? Relatively low gearing ratios for LPTs ING (Argosy) – 0.39, AMP (Precinct) – 0.29, KIPT – 0.37

The effect of gearing on returns More debt means more fixed costs Thus, in good years, there will be enough to pay off the fixed costs and leftovers for the shareholders In bad years, we might not make enough to pay debt service, and we could be in trouble Effectively, variation of income and ROE will increase with increasing debt

The effect of gearing on investment risk The higher the ratio the more the business is exposed to interest rate fluctuations and to having to pay back interest and loans before being able to re-invest earnings Increases the investment payback period

Leverage example ABC Corporation currently has no debt but is considering restructuring. In the restructure, it would borrow and buy back some shares. The company has 400,000 shares issued and the market value is $8 million. In the restructure, the company will issue $4 million of debt with 10% annual interest. The share market price remains at $20/share. The company has an annual NOI of $1,000,000. Examine the impact of the proposed restructure on the investment return (ROE and EPS) and risk (Payback period)

Leverage example Current Proposed Assets $8,000,000 Debt $0 $4,000,000   Current Proposed Assets $8,000,000 Debt $0 $4,000,000 Equity Debt/Equity Ratio 1 Share Price $20 Shares Outstanding 400,000 200,000 Interest rate - 10%

Leverage example Current Capital Structure: No Debt Expected NOI   Expected NOI Interest Net Income (distributable) ROE EPS Proposed Capital Structure: Debt = $4 million

Leverage example Current Capital Structure: No Debt Expected NOI   Expected NOI $1,000,000 Interest Net Income (distributable) ROE 12.50% EPS $2.50 Proposed Capital Structure: Debt = $4 million 400,000 $600,000 15.00% $3.00

Leverage example Variability in ROE Variability in EPS Current: ROE – 12.5% Proposed: ROE – 15% Variability in EPS Current: EPS – $2.50 Proposed: EPS – $3.00 The variability in both ROE and EPS increases when financial leverage is increased

Leverage example Variability in payback period Current: 8 years Proposed: 13.33 years It increases the payback period and therefore decreases the certainty of being able to recover the original investment If the building becomes untenanted for a period the investor has to find the cashflow necessary to service the debt from other sources and the investment will make loss sooner.

The effect of taxes The preceding analysis was under the idealization that there are no corporate taxes. Interest are a tax deductible expense and thus the firm can get a tax shield This is an added benefit of debt financing On the negative side of debt financing is the absolute obligation to meet promises of debt service payments. Not meeting them could result in bankruptcy.

Interest tax shield example Unlevered Firm Levered Firm NOI 5000 Interest 500 Taxable Income 4500 Taxes (28%) 1400 1260 Net Income (ATCF) 3600 3240

Interest tax shield example Annual interest tax shield Tax rate times interest payment Annual tax shield = $140 PV of annual interest tax shield Discount rate = 10%, investment term = 10 years PV of annual $140 tax shield = $860.24 The value of the firm increases by the PV of the interest tax shield

Interest tax shield Firms with accumulated losses will get little benefit from the interest tax shield, especially since their benefits will come later, after the losses carry forward and are finally offset by gains (loss of PV of tax benefits). Also, firms with other large tax shield forms, e.g., depreciation will benefit less from debt.

The effect of gearing on risks If the level of debt increases, the riskiness of the firm increases Financial risk – ability to pay the interest Default risk – ability to pay back the principal This fact is largely neglected by equity holders Payback period of the investment significantly increases

Default on debt The risk that the firm cannot pay back the loans When a debtor defaults on payments, the lenders can take him to court and lay claim to assets Bankruptcy can result from default on debt obligations: it is a legal process A firm becomes bankrupt, in principle, when A <= L, so E <= 0, and transfer of control goes from owners to creditors

Default risk measurement – Solvency ratio Measures the portfolio’s ability to meet long-term obligations = After tax cash flow / long term liabilities Acceptable solvency ratios will vary from industry to industry, but as a general rule of thumb, a solvency ratio of greater than 20% is considered financially healthy. The lower the solvency ratio, the greater the probability that the portfolio will default on its debt obligations.

Bankruptcy Reasons for bankruptcy Business failure – business has terminated with a loss to creditors Technical insolvency – firm is unable to meet debt obligations Accounting insolvency – book value of equity is negative Voluntary bankruptcy – petition for bankruptcy Creditor bankruptcy – under the Insolvency Act 2006 creditors can file a creditor’s petition with the Insolvency and Trustee Service

Bankruptcy Process Liquidation Reorganization Covered under the the Insolvency Act 2006 Firm is terminated as a going concern Trustee takes over assets, sells them and distributes the proceeds Reorganization Keep firm as going concern Involves issuing new securities to replace old securities Depends on whether the company is worth more dead or alive

Liquidation process Petition filed voluntarily by company or involuntary petition by creditors Administrator is appointed to assume control of assets and oversee liquidation After liquidation and payment of administrative costs, proceeds are distributed to creditors Any leftovers go to the owners

Order of liquidation payments The Official Assignee’s costs of administering your bankruptcy estate Petitioning creditor’s costs and disbursements Any GST and any wages you owe to employees Secured creditors Unsecured creditors

Agreements to avoid bankruptcy Instead of letting things go too far once a default event has occurred, it is better for all parties to negotiate a way to avoid bankruptcy and liquidation Debt might be rescheduled, and the firm’s capital might be reorganized voluntarily with the help of creditors and company Remedies – extension, postponing payment, or recomposition, allowing for a reduced payment

Avoid bankruptcy Get budgeting advice Sell assets Get refinancing advice Reach an agreement with your creditors Deal with IRD first Create a Creditors’ Pool Pay back your debts in instalments

Minimizing gearing risks Don’t over-commit. Only borrow as much as you can comfortably afford to repay, remembering that there might be periods when your investments don’t generate income. Diversify your investments so that you aren’t relying on just one or two investments. Invest only in quality growth assets which have proven track records of reliable income streams and capital growth. Invest for the long term to give your investments sufficient time to generate enough capital growth. Fix your loan to protect your cash flow in case interest rates rise.

Conclusions on capital structure Need to make calculations as we did, but should also recognize inputs are “guesstimates” As a result of imprecise numbers, capital structure decisions have a large judgmental content We end up with capital structures varying widely among firms, even similar ones in same industry