1. The effect of gearing
Week 11

2. 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

3. 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

4. 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

7. 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

8. 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)

9. 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%

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

11. 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

12. 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

13. Leverage example Variability in payback period
Current: 8 years
Proposed: 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.

14. 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.

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

16. 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

17. 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.

18. 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

19. 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

20. 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.

21. 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 creditors can file a creditor’s petition with the Insolvency and Trustee Service

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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.

30. 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