Now’s the Time to Find It. Buy It.

Debt capital remains shockingly cheap. Residential mortgage rates recently dipped to levels not seen since the 1940s. This means the cost to purchase leverable assets is at record lows – when debt is utilized.

Leverable assets are ones debt providers will loan against. Generally, these are assets that generate cash flow and can be liquidated (sold) for cash, such as real estate, stocks, bonds, mineral rights, and equipment.

All things being equal, investors will maximize their use of leverage – relative to equity – because debt capital is less expensive.

Why?

1. Contributors of debt (lenders) demand lower returns than equity providers because debt has a senior claim on the assets and cash flow and is therefore less risky
2. The cost of debt (interest expense) is tax deductible

For these reasons, the use of debt (leverage) will boost the return to equity holders – so long as the assets earn a rate of return, i.e. return-on-total-capital (ROC), that exceeds the cost of the debt. Here’s a simple example.

Let’s say the investor has $100,000 to invest. He can purchase a $100,000 asset using all his equity or he can purchase an asset (or assets) of greater value and borrow the difference. Here’s the calculation of pre-tax and after-tax return-on-equity (ROE) at varied capital structures.

In the table below, we assume the assets held are generating a ten percent operating profit (ROC, which is the same as return-on-assets (ROA)) and the interest rate on the debt is 7%. As you can see, both the pre-tax and after-tax ROE rise as leverage increases.

Notice as well the differing values of the assets controlled by the equity holder (the top line). Leverage allows higher-value assets to be owned. As such, one should consider the possibility of changes in the market value of the assets over time. If we assume the assets in the above example rise in value by ten percent, the no-leverage scenario adds $10,000 to equity, for an equity value increase of 10%. In the highest leverage scenario, the rise in equity is $40,000, for an increase of 40%.

Wealth (equity) can be generated rapidly when leverage is utilized. Of course, it works the other way as well. Leverage adds financial risk.

Let’s look at what happens when the spread between the cost of debt and the return on capital shrinks. This can occur by either an increase in the cost of debt, decline in operating profit, or both.

In the table below, we assume the cost of debt rises to 10% and the ROC stays the same (at 10%). The investor gains nothing from the use of leverage (unless he assumes or can achieve a rise in the value of the assets held).

Returns are also impacted by changes in the operating profit (ROC or ROA). To demonstrate, let’s assume the cost of debt remains at 7% but operating profit grows to 15%. That’s a 50% increase on operating profit. Here’s the calculation of ROE at the varied capital structures.

As one can see in the example, when profit rises in a leveraged company, ROE rises at accelerated rates. The higher the leverage, the greater the rate of ROE increase. Again, it also swings the other way when profit declines. Further, if operating cash flow falls below the required debt service, the assets can be lost entirely. In this way, the use of leverage is risky and should be used with great caution. Assets that generate consistent earnings (or more to the point, cash flow) can support higher amounts of debt. Assets that generate unpredictable earnings should not be purchased with debt.

Owners of established and profitable companies will, in most cases, be able to utilize debt to boost equity returns, and do so with a manageable level of financial risk. How much risk is a function of the characteristics of both the business and the owner.

Today, with asset values depressed and debt at historical lows, every business owner should consider ways to take advantage. The first option is to refinance existing personal or business debt. The second is to acquire real estate, whether it’s the space occupied by your business, an investment property, or a new home. So assess your needs and wants, and look around for a good deal. They’re out there. Odds are, the economy will recover; assets will once again appreciate; moderate inflation will return; interest rates will rise to more “normal” levels; and you’ll be sitting pretty.