Chapter 12 - DEBT CAPACITY

Question 0

Elements of debt capacity and associated risks

Answer 0

Short run liquidity and solvency
Expected net assets and net cash flow.
Risk: will cash flow cover debt service charges.
Risk:variation in net cash flow - death disability, job loss
Risk:variation in net asset values from damage, depreciation, economic conditions, etc.

Question 1

What is debt capacity?

Answer 1

The amount of debt that can be repaid under the terms of the loan agreements.
Depends of current and future situation.
Assets
Liabilities
Income
Cash flow

Question 2

How much debt can you afford?

Answer 2

Gross debt service ratio - <40%

gds= annual mort payment + prop taxes/gross family income

Tds= mort payments+prop taxes+other debt/gross family income

Question 3

Problems in using debt service ratios

Answer 3

No risk adjustment
Based on gross income rather than net
Benchmarks apply to average income.
Better info regarding liquidity and solvency can be obtained from family budgets.

Question 4

Rule of thumb : matching principle

Answer 4

Match economic life of an asset to the term of maturity of the financing.
Home: 25 years
Auto: 4-6 years
Entertainment: cash

Question 5

Sources of credit - groups by risk exposure

Answer 5

Least risky: banks, trusts, credit unions
More risky: finance and loan companies tied to specific sellers (the bay, GM, Sears)
Even more risky: smaller companies, pawn shops.

Question 6

Qualifications for credit

Answer 6

Personal: age, marital status, character.
Assets: home, auto, investments
Debt: mortgage, loan, credit card, balances
Credit history: credit record, bankruptcy, etc.

Question 7

Credit cards features

Answer 7

Annual fee
Free loan period
Interest rate on unpaid
Additional features - rewards etc

Question 8

Types of credit

Answer 8

Open account 
Overdraft protection
Unsecured PLC
Secured PLC 
Home equity line of credit 
Payday loans(50-500$, <30 days, very high EAR)
Pawn

Question 9

Why borrow to invest?

Answer 9

Increase rate of return on investment
Increase after tax investment return
Create tax shelter by deferring tax

Question 10

Good debt management strategies

Answer 10

Pay cash for consumption, borrow for investment

If you have investment assets and consumer debt, convert consumer debt to investment debt.

Question 11

BORROWING TO REACH SPECIFIC GOALS

Answer 11

Slide 12-23

Question 12

How borrowing creates tax shelters

Answer 12

Interest on borrowing is tax deductible.
Capital gains are taxed at a lower rate
Save high current taxes and pay lower taxes on capital gains.