Why almost all businesses borrow even when they don't need to: A primer on Leverage

[HamdenRice]

I posted this as a response to a query to this forum, and thought it might be useful to everyone if it got more exposure. The basic idea is that businesses don't only borrow because they have to -- ie don't have the money to meet payroll or finance inventories.

They borrow for the simple mathematical reason that borrowing boosts profits. That's what all the financial press is talking about when they talk about "leverage."

It's the first thing you learn on the first day of "Corporate Finance 101" in Business School or Law School:

http://www.democraticunderground.com/discuss/duboard.php?az=show_mesg&forum=114&topic_id=50595&mesg_id=50610

It's called leverage.

Let's use a landlord's rental property as an example. Assume that he owns the building outright (paid off mortgage), and paid $100,000 for it. Let's assume that at the end of the year his profit is $10,000.

His equity in the house, therefore is $100,000.

That's a rate of return of 10,000/100,000 = 10%. So his rate of return is ten percent.

Now, let's suppose he can borrow money at 5% in an interest only loan. If he refinances 1/2 the value of the building for $50,000, then he will have to pay interest of 5% on $50,000, which is $2,500.

So now his investment or equity in the property is $50,000. The $2,500 interest has become an expense. The house now earns $10,000 - $2,500 for the landlord, or $7,500.

Notice that his rate of return is now 7,500/50,000 = 15%

He has increase his rate of return just by borrowing. That's because the amount he pays in interest is less than the amount he makes on the building; or in other words, interest is less than the rate of return on the whole business.

Borrowing money is like getting a partner (the bank) who doesn't want as much from the business as you do -- he just wants certainty that he gets paid.

If that same landlord refinanced $80,000, the landlords investment or equity in the building is only $20,000.

His interest cost is 5% of $80,000 or $4,000.

The total return on the business is now $10,000 - $4,000 = $6,000.

The landlord's rate of return on equity is now $6,000/20,000 = 33% !!!

That's the "magic of leverage".

But, you may ask, if the landlord only has $20,000 equity in the building, what happened to the other $80,000? He can keep it in safe cash. Or more likely, he can own 5 times as many buildings, all generating 33% returns instead of 10% returns.

Instead of earning $10,000 on a single $100,000 house, he is now earning $30,000 on five $100,000 houses -- $500,000 worth of houses -- in which his equity or investment is only $100,000.

$30,000/$100,000 = 33% rate of return. Most people would rather earn $30,000 than $10,000.

The problem is that this increases risk. If in any year, the amount earned on the house slips below his interest costs (eg if all the tenants move out or can't pay rent), then he goes bankrupt -- something that would not have happened if he had never refinanced.

This is what's happening across the economy right now.

So corporate finance is all about figuring out how much debt to take on compared to equity, to boost the rate of return without taking on too much risk.

Even mega profitable companies take out loans. Not because they need the money, but to boost profits. In that way banks are silent partners in most businesses. They usually quietly earn lower rates of return in exchange for the certainty of getting paid.

This is entirely separate from unexpected expenses, needing to make payroll, financing short term inventory expansion or so on.

This is a permanent structural, mathematical reason that businesses always stay in debt -- to boost profits.

[sandnsea]

1. No,

what is happening right now is that people took that $50,000 and put it in investment vehicles that were based on phony reset profits that anybody who understood how to add income and subtract a mortgage payment could see wouldn't work out.

The problem with economists is that they maneuver numbers on a page and forget that there are real people behind those numbers.

[akwapez]

2. Ok his rate of return increased from 10% to 15%, but

his profit dropped from $10,000 to $7,500. Lower profits, decreased equity, increased risk. That is bad business imho.

[ipfilter]

4. In this example the landlord has an additional

$50,000 in cash since he financed half the house. That's $50,000 more capital to invest somewhere else instead of locking it up in illiquid real estate.

[HamdenRice]

5. As nocaster pointed out

His profit per house dropped from $10,000 to $7,500, but because his equity dropped from $100,000 to $50,000, he can now have two houses for his $100,000 equity, and his total profits on $100,000 in equity went from $10,000 to $15,000 (ie $7,500 + $7,500).

[westerebus]

7. Please reverse the process.

To demonstrate how investing the equity on a mortgaged property will get you into trouble very fast if the real estate market goes south and you are over leveraged. Which is real easy to do when credit is cheap and the economy is good. Buy another house on equity leverage and your income grows even more. Leverage up some more and buy another, you look real good on paper. It's easy, the nice people at the bank are glade to help property investors. Just keep making the mortgage payments by collecting rents or flipping the houses. Use lease purchase agreements and keep the cash flowing. Until the renters don't pay because they lost their job. Or there's a nasty divorce and the house they leased gets trashed and they go their separate ways out of state. Or your sister-in-law's ex stops paying support and your wife is not about to put her up in a smaller rental. What's a little money when its' family? And now that houses in the neighborhood are loosing value, your last purchase is under water. The house you had up for sale isn't moving either. The only bid was from you sister-in- law who has no down payment and no income to cover a mortgage. No problem, you get to hold her mortgage. Looks good on paper. Leverage is a wonderful thing. Just ask the sister-in-law.

That is the story of my once rich brother. Looked good on paper.

[HamdenRice]

8. I did include that

I mentioned that the greater the leverage the greater the risk. The person with 100 percent equity can tolerate a fall in profit from $10,000 to zero and remain insolvent.

The person with 50% leverage can tolerate a fall in profit from $10,000 to $2,500 after which he would be insolvent.

And the person who is 80% leveraged can only tolerate a fall in profit from $10,000 to $4,000 after which he would be insolvent.

A lot of the study of finance is building in probabilities into this simple model and quantifying them.

While it's easy to say the entire theory is faulty now that we are in a liquidity crunch during most times, it works pretty well for most capitalists.

[akwapez]

10. Yeah, I understand the idea and advantages.

Its just not how I run my business and do not personally believe it is a good business model.

[ipfilter]

3. This is a very good explanation of leverage.

Unfortunately, the past decade has been an example of "Leverage gone mad".

[HamdenRice]

6. Yes, you can use the same example ...

to go to 90% leverage. But then your margin for lower rents compared to your interest cost become very, very small.

"Leverage gone mad," indeed.

[fasttense]

9. First off you are using simple interest not compounded interest.

There is a big difference. You end up, even in good times, paying back a lot more than you borrowed.

Second what corporations usually do is get the loans to buy another company then put the debt they used to buy the company onto the company they just bought. Either they have to slice and dice the company they just bought and sell off pieces of it to pay back the debt, or fire a whole bunch of people in order to get the company's expenses down, or they file bankruptcy and do away with a competing company all together.

This is how you get monopolies with fewer overall jobs and less competition. The bigger you are, the more you can borrow, the more companies you can destroy with "leverage". But if hard times hit or credit dries up while you are in the middle of these "leveraged" buy outs, then you are in trouble.

[HamdenRice]

11. A few points

Corporations generally don't pay compound interest. Corporate debt also doesn't generally amortize. A typical bond is a security that pays a fixed rate of interest (assuming no default) for a fixed time, and then the entire amount is payable. Bank loans to corporations often follow the same model.

Corporations sometimes borrow to buy back a portion of its stock. But that's really just an example of leverage -- replacing equity with debt to increase the rate of return to the stock that isn't bought back.

Credit can help a corporation expand, but doesn't necessarily lead to monopolies. In fact, credit tends to be a great leveler, enabling small companies like Dell, to borrow and be so profitable, that they topple bigger companies like IBM, in a particular market like the PC market.

Much of the two decade growth of the pc, server and software boom was financed by debt -- especially junk bonds.