Module 5 : Gearing and Leverage

1
Module 5 Gearing and Leverage

• Objectives
• Define leverage
• Define negative gearing
• Describe reasons for borrowing
• Describe risk-reducing borrowing strategies
• Determine impact of borrowing on return to
  investment

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Leverage (gearing)

• Concept Use of borrowed money to increase
  returns to equity
• Definition ratio of borrowing to total capital
  ()
• Equity ratio equity/total assets
• Debt/equity ratio
• Text example
• 1. No loan 1500 from 10,000 15 return to
  equity
• 2. 50 loan 2,200 from 20,000 22 return to
  equity
• If inherent rate of return gt interest rate, then
  borrowing increases Return to Equity ( v.v.)

3

• As equity ratio declines, debt/equity increases
• Risk of failure increases
• Cost of loan money (interest rate) increases

4
Reasons for borrowing

• Business expansion
• Business diversification
• Increase efficiency
• Restructure business
• Overcome adversity

5
Risk-reducing strategies when borrowing

• Establish project viability (cash flow
  feasibility)
• Timing investment to best time in business cycle,
  agric cycle
• Structure loan according to project type (length,
  repayment schedule conforms to length and
  cashflow pattern of project
• Use conservative values in planning
• Scenario thinking (best, worst.) sensitivity
  analysis (range of outcomes for key variables) to
  increase confidence in decision making

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Negative gearing

• use of borrowed funds to purchase an investment
  that runs at a loss that is tax deductible
  against other income
• Loss due to high interest cost from high level of
  borrowing
• Benefit increases with marginal tax rate
• Only justified if capital gain exceeds operating
  losses

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Example

• purchase a property for 5 million
• borrow 80 at 15 p.a.
• first year cash surplus pre-interest 300,000
• 500,000 of other income in the same year
• Inflation 9
• tax rate 60
• property is expected to achieve 7 capital gain  
• Interest 0. 15 x 4 million 600000
•  
• Cash Surplus 300,000
• - Interest (600,000)
• Pre Tax Cash Loss (300,000)
•  
• This loss of (300000) can be written off other
  income.
•  
• Other Income 500000
• - Claim (300000)
• Taxable Income 200000
•  

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Example

• Interest 0. 15 x 4 million 600000
•   Cash Surplus 300000
• - Interest (600000)
• Pre Tax Cash Loss (300000)
•  This loss of (300000) can be written off other
  income.
•   Other Income 500000
• - Claim (300000)
• Taxable Income 200000
•   Tax Payable 200000 x 0.6 120000
• Tax saved 300,000 x 0.6 180,000

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To calculate the real return to equity

• Pre Tax Cash loss (300,000)
• Cash Saving 180,000
• Capital Gains 350,000 (0.07 x 5 million)
• Return 230,000
•  Nominal Return to(on) Equity (ROI)
  Return/Equity
• 230,000/1,000,000
• 0.23 or 23
•   Real Return to Equity
•   1 ir 1 in/l I
• ir (1.23/1.09) - 1
• 0.128 or 12.8

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Effect of tax rate

• Outcome at 30 tax rate
• Tax saving .3x300,000 90,000
• Pre Tax Cash loss (300,000)
• Cash Saving 90,000
• Capital Gains 350,000 (0.07 x 5 million)
• Return 140,000
•  Nominal Return to Equity Return/Equity
• 140,000/1,000,000
• 0.14 or 14
• Real return 4.59

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Conclusion

• Gearing allows investor access to larger
  investment than from equity alone
• If gains exceed costs, return to equity is
  increased
• BUT if gains are less than costs, or investment
  runs at a loss, then losses may be large
• Gearing magnifies gains AND losses
• Thus, Gearing increases business risk