week 8

Question 1

what is ‘capital stucture’

Answer 1

Determines how the investment will be financed e.g. debit or equity
The primary decision of capital structure decisions is to improve the profitability of investment by employing an optimal mix of debit and equity

Question 2

explain equity financing

Answer 2

Accounting terms refers to ‘owners equity’ – difference between the value of the assets and the value of the liabilities of something owned.

In relation to real estate equity in real estate the notion of ‘redemption’ arises. This equity is a property right valued at the difference between the market value of the property and the amount of any mortgage or other encumbrance
Equity = assets – debts (liabilities)
If the investor is a corporation (public / private)
Internal equity financing (retained profits)
External equity financing (major) – shares issues / ownership interests

Question 3

advantages of equity financing

Answer 3

o Additional capital resources on more favourable terms
o Financial flexibility in bad times
o Can usually be kept permanently
o No collateral required
o Increased liquidity
o An avenue for the existing share holders to realize market value for their shareholdings

Question 4

disadvantages of equity financing

Answer 4

o Direct costs; legal, auditing, management and brokerage fees
o Profit sharing
o Follow strict rule of public disclosure
o Reporting duties and loss of confidentiality
o Vital information may be disclosed to competitors in the reporting process
o Founding partners may face the risk of losing control of company (ownership structure)
o Dividend payments are not tax deductible

Question 5

explain debt financing

Answer 5

Debt is money owed by one party, the borrower or debtor, to a second party, the lender or creditor

o Debt is generally subject to contractual terms regarding the amount and timing of repayments of principal and interest. Loans, bonds, notes and mortgages are all types of debt

o Mortgage; a mortgage loan, is used either by purchasers of real property to raise funds to buy real estate; or alternatively by existing property owners to raise funds for any purpose, while putting a lien (security) on the property being mortgaged

Question 6

advantages of debt financing

Answer 6

o No direct claim on future profits of the business
o Interest payments are tax deductible
o Debt has little or no impact on control of the company
o Principal and interest obligations are known amounts which can be forecasted and planned for
o Raising debt capital is less complicated

Question 7

disadvantages of debt financing

Answer 7

o Collateral assets must usually be available
o Requires regular interest payments which must be repaid
o Excessive debt financing may impair your credit rating and the ability to raise more money in the future
o Debt instruments often constrain restrictions on the company’s activities, preventing management from pursuing alternative financing options and other business opportunities
o Can increase the risk of insolvency during difficult financial periods

Question 8

what is gearing

Answer 8

o Capital structure: proposition of equity and debt in the total asset
Also known as financing structure, gearing ration or leverage ratios
o Gearing is a general term used to describe borrowing within an investment context
o It refers to the use of borrowed funds to earn a return greater than the interest paid of the debt
o Statement of financial position; Value of assets = value of equity + value of debt
Gearing ratio: The ratio of debt to total assets (loan/value ratio, debt/asset ratio) = total debt / total assets

Debt to equity ratio: expressed as the ratio of debt to equity
= Total debts / Total equity

Example:
Gearing ratio
24,000 / 45,000 = 53.33%
35 – 80% is common for property investment

Debt - equity ratio
24,000 / 21,000 = 1.14

Value of the asset = Value of equity + Value of debt

Gearing ratio: The ratio of debt to total assets (loan/value ratio, Debt / Asset ratio)
= Total debt / Total assets

Debt to Equity ratio: Expressed as the ratio of debt to equity
=Total debts / Total equity

Question 9

why is gearing popular

Answer 9

o Generally is favourable as long as the rate of return on assets exceeds the cost of borrowing

o When debt service is less than the rate of return on asset value, additional financial leverage increases the net cash flow of the firm

look at table

Question 10

explain tax shielding

Answer 10

Greater leverage increases risk that cash from from investment will be insufficient to meet debt service obligation (financial risk) (dependant on getting income coming in)
Debt converge ratio

o Tax shield = reduction in taxable income for an individual or corporation achieved through calming allowable deductions such as mortgage interest, medical expenses, charitable donations, amortization and depreciation
o These deductions reduce taxable income for a given year or defer income taxed into future years
o Gearing can provide tax shield because the debt payment is not subject to cooperate tax
o Dividend imputation is a cooperate tax system in which some or all of the tax paid by a company may be attributed or imputed, to the shareholder by way of a tax credit to reduce the income tax payable on a distribution

Question 11

define gearing

Answer 11

Is a general term used to describe borrowing within an investment context, it refers to the use of borrowed funds to earn a return greater than the interest paid on the debt
o
In comparison to the classical system, it reduces or eliminates the tax disadvantages of distributing dividends to shareholders by only requiring them to pay the difference between the cooperate rate and their marginal rate

Question 12

o The benefit of tax shielding provided by the debt financing is reduced by imputation system?

Answer 12

Yes for the domestic investor but no for the foreign investor

Question 13

explain concept of negative gearing

Answer 13

o Negative gearing means that the loan interest and other expenses in maintaining the asset exceeds the income that it generates. Thus the asset is running at a loss and as such is called ‘Negative’.
o The losses are tax deductible, the person can offset the losses against their taxable income thus generating a short term gain by reducing the amount lost by the tax credit on the loss.
o For a person on a high rate of marginal tax, negative gearing is highly attractive as the losses they sustain are only marginally higher than if they had paid the tax on that income

Annual income $150,000

1) Taxable income without negative gearing (NG) $250,000 èTax: $90,732
2) Taxable income with NG : $150,000- $26,000= $124,000 è Tax: $35,992

Question 14

negative gearing suitable for those with

Answer 14

Suitable for investors with
o	 High risk tolerance
o	 High tax rates
o	 Have a degree of security in terms of income
o	 Have sufficient disposable assets

Question 15

negative gearing not suitable for

Answer 15

Low risk tolerance
o	 Have little or no taxable income
o	 Unsure of their future prospects
o	 Depend upon the income that the asset generates to continue to be able to afford the asset
o	 Unpredictable market prospects

Question 16

define refining

Answer 16

may refer to the replacement of an existing debt obligation with another debt obligation under different terms. If the replacement of debt occurs under financial distress, refinancing might be referred to as debt restructuring.
e.g. fixed rate of $100,000 @ 6% = $6,000
0r $100,000 @3% = $3,000 (peruse the more competitive loan)

Question 17

why would someone re-finance

Answer 17

o To take advantage of a better interest rate
o To consolidate other debt(s) into one loan
o To reduce the monthly repayment amount
o To reduce or alter risk
o To cash out

Question 18

disadvantages of negative gearing

Answer 18

o More debt means more fixed costs (debt service) each year and lower equity.
o Thus, in good years, there will be enough to pay off the fixed costs and leftovers for the shareholders’ equity (higher return)
o In bad years, we might not make enough to pay debt service, and we could be in trouble (lower return)
o Effectively, variation (risk) of income and return on equity (ROE) will increase with increasing debt

o Greater leverage increases risk that cash flow from investment will be insufficient to meet debt service obligation (financial risk)
o Debt service coverage ratio
o = NOI / debt service (PMT)
o Shows the number of times a company could make its debt payment
o The higher the ratio, the ease in making debt payment
o Above 1.25 considered good
o Interest coverage ratio
o = NOI / interest expenses
o Shows the number of times a company could pay its interest expenses
o The higher the ratio, the ease in making interest payments
o Above 1.5 considered good

Question 19

financial risk when defaulting on debt

Answer 19

o When a debtor defaults on payments, the lenders can take the debtor to court and lay claim to assets
o Bankruptcy can result from default on debt obligations: it is a legal process
o Reasons for bankruptcy
o Business failure – business has terminated with a loss to creditors
o Technical insolvency – firm is unable to meet debt obligations
o Accounting insolvency – book value of equity is negative

Question 20

how to avoid bankruptcy

Answer 20

o	Get budgeting advice
o	Sell assets
o	Get refinancing advice
o	Reach an agreement with your creditors
o	Create a Creditors’ Pool or Debt Management Plan
o	Pay back your debts in instalments

Question 21

how to control gearing risks

Answer 21

o Don’t over-commit, borrow less than you can afford
o Invest only in quality growth assets with proven records
o Invest for the long term
o Diversify your investments
o Repay your interests regularly
o Reinvest the income you earn from investments
o Fix your loan to protect your cash flow in case interest rates rise
o Review your situation regularly with your Financial Planners

Question 22

explain gearing for investment mortgage loans

Answer 22

o A mortgage loan, also referred to as a mortgage, is used either by purchasers of real property to raise funds to buy real estate; or alternatively by existing property owners to raise funds for any purpose, while putting a lien on the property being mortgaged.
o The loan is “secured” on the borrower’s property. This means that a legal mechanism is put in place which allows the lender to take possession and sell the secured property (“foreclosure” or “repossession”) to pay off the loan in the event that the borrower defaults on the loan or otherwise fails to abide by its terms.
o Two basic types of amortized loans are the fixed rate mortgage (FRM) and adjustable-rate mortgage (ARM) (also known as a floating rate or variable rate mortgage).

Question 23

The “Four Rules” of Loan Payment & Balance Computation

Answer 23

Rule 1: The interest payment in each payment equals the applicable interest rate times the outstanding loan balance ( “OLB” for short) at the end of the previous period: INTt = (OLBt-1)rt.

Rule 2: The loan amortized (paid down) in each payment equals the total payment (debt service payment) minus the interest payment: AMORTt = PMTt - INTt

Rule 3: The outstanding loan balance after debt service payment equals the previous outstanding loan balance minus the principal paid down (Amortization) in the debt service payment:
OLBt = OLBt-1 - AMORTt.

Rule 4: The initial outstanding loan balance equals the initial contract principal (loan) specified in the loan agreement: OLB0 = L.
Where:
Loan amount (L) = Initial contract principal (loan) amount;
Interest rate (r )= Contract interest rate applicable for interest payment
Interest payment (INTt )= Interest payment in Period “t”;
Amortization (AMORTt )= Principal paid down in the Period “t”;
Debt service payment (PMTt )= Amount of the loan payment in Period “t“, including Amortization and Interest payment;
Outstanding Loan Balance (OLBt )= Outstanding Loan Balance after the debt service in Period “t” has been made

Question 24

explain interest only loan repayment

Answer 24

Only interest payment is made in each period (amortization in each period is zero), the Loan amount is paid off in the end of the last period.
Interest-only Mortgage Payments & Interest Component: $1,000,000, 12%, 30-yr, monthly pmts

Question 25

advantages of interest only loans

Answer 25

Advantages:
o	Low payments.
o	If interest rate is fixed, payments always the same (easy budgeting).
o	Payments invariant with maturity.
o	Very simple, easy to understand loan.

Question 26

disadvantages of interest only

Answer 26

o Big “balloon” payment due at end (maximizes refinancing stress).
o Maximizes total interest payments.
o Lack of pay down of principle may increase default risk if property value may decline in nominal terms.

Question 27

explain Constant Amortization Mortgage (CAM)

Answer 27

The Outstanding Loan Balance is reduced by constant amount in each period (Constant Amortisation)

see graphs
and google
mia somerville (0)(0)

Question 28

advantages of CAM

Answer 28

o No balloon (no refinancing stress).
o Declining payments may be appropriate to match a declining asset, or a deflationary environment.
o Lower total interest payments than Interest-only payment method
o Popular for consumer debt (installment loans) on short-lived assets, but not common in real estate.

Question 29

disadvantages of CAM

Answer 29

o High initial payments.
o Declining payment pattern doesn’t usually match property income available to service debt.
o Rapidly declining interest component of payments reduces PV of interest tax shield for high tax-bracket investors.
o Rapid pay down of principal reduces leverage faster than many borrowers would like.
o Constantly changing payment obligations are difficult to administer and budget for.

Question 30

explain Constant Payment mortgage (P&I)

Answer 30

The debt service payment (PMT), which contains both Interest payment(INT) and Amortization (AMORT), is constant in all period. Determined by DCF model, the proportions of INT and AMORT change over time

see diagrams

Question 31

advantages of P&I

Answer 31

o No balloon (no refinancing stress) if fully amortizing.
o Low payments possible with long amortization (e.g., $10286 in 30-yr CPM vs $10000 in interest-only).
o Constant flat payments easy to budget and administer.
o Large initial interest portion in pmts improves PV of interest tax shields (compared to CAM) for high tax borrowers.
o Flexibly allows trade-off between pmts, amortization term, maturity, and balloon size.

Question 32

disadvantages of p+I

Answer 32

o Flat payment pattern may not conform to income pattern in some properties or for some borrowers (e.g., in high growth or inflationary situations):
o 1st-time homebuyers (especially in high inflation time).
o Income property in general in high inflation time.