90 90

Financial Leverage and

Financial Leverage and
Investment Analysis
Investment Analysis
LDM GROUP
LDM GROUP
Franklin Templeton Asset Group
Franklin Templeton Asset Group
91 91
Why Leverage is So
Why Leverage is So
Popular
Popular

Financial leverage
Financial leverage

using
using
borrowed funds to amplify the
borrowed funds to amplify the
outcome of equity investment
outcome of equity investment

Greater ratio of borrowed funds

Greater ratio of borrowed funds
to equity, greater degree of
to equity, greater degree of
financial leverage
financial leverage

Leverage is favorable so long

Leverage is favorable so long
as the rate of return on assets
as the rate of return on assets
exceeds the cost of borrowing
exceeds the cost of borrowing
92 92
Why Leverage is So
Why Leverage is So
Popular
Popular

Spread
Spread

difference between
difference between
rate of return on assets and
rate of return on assets and
cost of borrowing
cost of borrowing

Favorable spread magnifies

Favorable spread magnifies
return on equity of highly
return on equity of highly
leveraged investment
leveraged investment

When
When
debt service constant
debt service constant
is
is
less than the rate of return on
less than the rate of return on
total assets, additional financial
total assets, additional financial
leverage increases cash flow
leverage increases cash flow
to the equity position
to the equity position
93 93
Table 7.1
Table 7.1
94 94
Why Leverage is So
Why Leverage is So
Popular
Popular

Federal income tax law creates

Federal income tax law creates
major incentive to use financial
major incentive to use financial
leverage
leverage

Interest payments generally tax

Interest payments generally tax
deductible
deductible

Depreciation allowance to
Depreciation allowance to
recover costs
recover costs

Gains on disposal treated as

Gains on disposal treated as
capital gains
capital gains
95 95
Measuring Financial
Measuring Financial
Leverage
Leverage

Debt/equity ratio
Debt/equity ratio

ratio
ratio
between borrowed funds and
between borrowed funds and
equity funds
equity funds

Loan/value ratio
Loan/value ratio

ratio
ratio
between borrowed funds and
between borrowed funds and
market value of asset being
market value of asset being
financed
financed
96 96
Measuring Financial
Measuring Financial
Leverage
Leverage

Greater leverage increases risk that

Greater leverage increases risk that
cash flow from investment will be
cash flow from investment will be
insufficient to meet debt service
insufficient to meet debt service
obligation (
obligation (
financial risk
financial risk
)
)

Debt coverage ratio

Debt coverage ratio

degree to
degree to
which actual net operating income
which actual net operating income
can fall below expectations and still
can fall below expectations and still
be sufficient to meet debt service
be sufficient to meet debt service
obligation
obligation
97 97
How Much is Enough
How Much is Enough
Financial Leverage?
Financial Leverage?

Lenders frequently express

Lenders frequently express
maximum amount of loan in terms
maximum amount of loan in terms
of minimum permissible debt
of minimum permissible debt
coverage ratio
coverage ratio

Lenders specify maximum

Lenders specify maximum
permissible loan
permissible loan
-
-
to
to
-
-
value ratio
value ratio

As more money is borrowed to

As more money is borrowed to
finance an investment, the venture
finance an investment, the venture
becomes increasingly risky
becomes increasingly risky

Increasing amount of borrowed

Increasing amount of borrowed
funds relative to equity funds drive
funds relative to equity funds drive
up cost of borrowing
up cost of borrowing
98 98
Table 7.3
Table 7.3
99 99
Who Are the Lenders?
Who Are the Lenders?

Commercial banks
Commercial banks

Life insurance companies

Life insurance companies

Pension funds
Pension funds

Commercial mortgage
Commercial mortgage
-
-
backed
backed
securities (CMBs)
securities (CMBs)