UCLA ECON 103 - Chap012 (2) (21 pages)

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Chap012 (2)



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Chap012 (2)

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Pages:
21
School:
University of California, Los Angeles
Course:
Econ 103 - Introduction to Econometrics
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Chapter 12 Financial Leverage and Financing Alternatives Solutions to Questions Chapter 12 Financial Leverage and Financing Alternatives Question 12 1 What is financial leverage Why is a one year measure of return on investment inadequate in determining whether positive or negative financial leverage exists Financial leverage is defined as benefits that may result to an investor by borrowing money at a rate of interest that is lower than the expected rate of return on total funds invested in a property To determine whether leverage is positive favorable or negative unfavorable the investor needs to determine whether the IRR calculated over the entire holding period is greater than the cost of borrowed funds A first year measure of return such as the overall capitalization rate can not be used because it does not explicitly consider the benefits that accrue to the investor over time from changes in income and value that do not affect the cost of debt Question 12 2 What is the break even mortgage interest rate BEIR in the context of financial leverage Would you ever expect an investor to pay a break even interest rate when financing a property Why or why not The BEIR is the maximum interest rate that could be paid on the debt before the leverage becomes unfavorable It represents the interest rate where the leverage is neutral neither favorable or unfavorable The BEIR remains constant regardless of the amount borrowed that is 60 70 or 80 percent of the property value An equity investor probably would not pay a break even interest rate when financing a property because the investor just earns the same after tax rate of return as a lender on the same project Borrowing at the BEIR provides no risk premium to the investor Normally a risk premium is required because the equity investor bears the risk of variations in the performance of the property Question 12 3 What is positive and negative financial leverage How are returns or losses magnified as the degree of leverage increases How does leverage on a before tax basis differ from leverage on an after tax basis When the before tax or after tax IRR are higher with debt than without debt we say that the investment has positive or favorable financial leverage When returns are lower with debt than without debt we say that the investment has negative or unfavorable financial leverage Positive leverage occurs when the unlevered IRR is greater than the interest rate paid on the debt Negative leverage occurs when the unlevered IRR is less than the interest rate paid on the debt Returns and losses are magnified by the greater the amount of debt the greater the return or loss to the equity investor Leverage on a before tax basis differs from leverage on an after tax basis because interest is tax deductible Therefore we must consider the after tax cost of debt which is different than the before tax cost of debt Question 12 4 In what way does leverage increase the riskiness of a loan Leverage increases the standard deviation of return regardless of whether it is positive or negative This means the investment is clearly riskier when leverage is used Because the NOI does not change when more debt is used increasing the amount of debt increases the debt service relative to NOI Therefore the debt coverage ratio DCR may exceed the lender s limits With higher loan tovalue ratios and declining debt coverage ratios risk to the lender increases As a result the interest rate on additional debt will also increase Question 12 5 What is meant by a participation loan What does the lender participate in Why would a lender want to make a participation loan Why would an investor want to obtain a participation loan A participation loan is where in return for a lower stated interest rate on the loan the lender participates in some way in the income or cash flow from the property The lender s rate of return depends in part on the performance of the property Participations are highly negotiable and there is no standard way of structuring them A lender s motivation for making a participation loan includes how risky the loan is perceived relative to a fixed interest rate loan The lender does not participate in any losses and still receives some minimum interest rate unless the borrower defaults Additionally the participation provides the lender with somewhat of a hedge 12 1 Chapter 12 Financial Leverage and Financing Alternatives against unanticipated inflation because the NOI and resale prices for an income property often increase as a result of inflation To some extent this protects the lender s real rate of return An investors motivation is that the participation may be very little or zero for one or more years This is because the loan is often structured so that the participation is based on income or cash flow above some specified breakeven point During this time period the borrower will be paying less than would have been paid with a straight loan This may be quite desirable for the investor since NOI may be lower during the first couple of years of ownership especially on a new project that is not fully rented Question 12 6 What is meant by a sale leaseback Why would a building investor want to do a sale leaseback of the land What is the benefit to the party that purchases the land under a sale leaseback When land is already owned and is then sold to an investor with a simultaneous agreement to lease the land from the party it is sold to this is called a sale leaseback of the land One motivation for the sale leaseback of the land is that it is a way of obtaining 100 percent financing on the land A second benefit is that lease payments are 100 percent tax deductible With a mortgage only the interest is tax deductible The investor may deduct the same depreciation charges whether or not the land is owned since land cannot be depreciated This results in the same depreciation for a smaller equity investment The investor may have the option of purchasing the land back at the end of the lease if it is desirable to do so Question 12 7 Why might an investor prefer a loan with a lower interest rate and a participation An investor s motivation is that the participation may be very little or zero for one or more years This is because the loan is often structured so that the participation is based on income or cash flow above some specified breakeven point During this time period the borrower will be paying less than would have been paid with a straight loan This may be


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