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McGraw-Hill/Irwin©2008 The McGraw-Hill Companies, All Rights Reserved
CHAPTER
12
CHAPTER
12
Financial Leverage and Financing Alternatives
12-2
Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved
Financial LeverageFinancial Leverage
• What is financial leverage? Benefit of borrowing at a lower interest rate
than the rate of return on the property.
• Why use financial leverage? Diversification benefits of lower equity
investment• Can invest in other property
Mortgage interest tax benefit Magnify returns if the return on the property
exceeds the cost of debt
12-3
Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved
Financial Leverage: Before-TaxFinancial Leverage: Before-Tax
• Positive Financial Leverage Returns are higher with debt
• Unlevered BTIRR Return with no debt
• If unlevered BTIRR > interest rate on debt The BTIRR on equity increases with debt. There is positive financial leverage.
12-4
Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved
Financial Leverage: Before-TaxFinancial Leverage: Before-Tax
• Equation 1:
• BTIRRE= BTIRRP + (BTIRRP – BTIRRD)(D/E)
BTIRRE = Before-Tax IRR on equity invested
BTIRRP = Before-Tax IRR on total investment in the property
BTIRRD = Before-Tax IRR on debt (effective cost including points)
D/E =Debt/Equity ratio
12-5
Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved
Financial Leverage: Before-TaxFinancial Leverage: Before-Tax
• Equation 1 shows that as long as: BTIRRP > BTIRRD, then BTIRRE > BTIRRP
This implies increasing D/E……
• But the use of debt is limited Debt coverage ratio restrictions Higher loan to value ratios are riskier to
lenders…leading to higher interest rates Higher debt levels increase risk to equity
investor
12-6
Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved
Financial Leverage: Before-TaxFinancial Leverage: Before-Tax
• Negative Financial Leverage If BTIRRD > BTIRRP, then BTIRRE < BTIRRP
The use of debt reduces the return on equity.
12-7
Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved
Financial Leverage: After-TaxFinancial Leverage: After-Tax
• Equation 2:
• ATIRRE= ATIRRP + (ATIRRP – ATIRRD)(D/E)
ATIRRE = After-Tax IRR on equity invested
ATIRRP = After-Tax IRR on total investment in the property
ATIRRD = BTIRRD (1-t)
• After-Tax IRR on debt (effective cost after taxes including points)
D/E =Debt/Equity
12-8
Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved
Financial Leverage ExampleFinancial Leverage Example
• Building Value=$85,000, Land Value=$15,000, Total Value=$100,000
• Loan Assumptions: Loan Amount=$80,000 Interest Rate=10% Term: Interest Only 80% LTV
• Income Assumptions: NOI=$12,000 per year (level) Income tax rate=28% Depreciation=31.5 years (straight line) Resale price= $100,000 Holding period=5 years
12-9
Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved
12-10
Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved
Cash Flow Summary and IRR With Cash Flow Summary and IRR With LeverageLeverage
12-11
Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved
12-12
Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved
Cash Flow Summary and IRR Cash Flow Summary and IRR Without LeverageWithout Leverage
12-13
Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved
Financial Leverage: After-TaxFinancial Leverage: After-Tax
• Break-even interest rate Maximum interest rate before negative
financial leverage
• ATIRRD= ATIRRP
• ATIRRD= BTIRRD(1-t)
• BTIRRD= =
• Risk considerations
t1
ATIRRD
t1
ATIRR P
12-14
Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved
Break-even Interest RateBreak-even Interest Rate
12-15
Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved
Alternative Financing StructuresAlternative Financing Structures
• Sale-Leaseback of Land and Ground Leases Own building and lease land from a different
investor
• Motivations 100% financing possible Lease payments are tax deductible Building is depreciable; land is not Possible purchase option at end of lease
