UTS16657 Chap.2 Debt, Equity and the Effect of Leverage
Debt, Equity and the Effect of Leverage
Every asset in this subject is funded by some mix of two claims. Debt is capital provided as a loan, with or without security, carrying interest payments and an agreed date for the return of the capital. Equity buys a stake in the business itself, and its holder is entitled to profits only once every debt holder has been satisfied.
That single ordering generates almost every other difference between the two: debt has a definite term and equity does not, debt's return is contracted and equity's is discretionary, debt carries no ordinary control rights and equity votes, debt ranks ahead in insolvency and equity ranks last.
Because the lender is paid first and can enforce the contract, the lender bears less risk, and a provider bearing less risk accepts a lower return.
Debt is therefore, in almost every circumstance, the cheaper of the two funding sources, and in Australia a second and structural reason reinforces it: interest payments are tax-deductible to the borrower while dividends are paid out of profit already taxed. Notice that four natural questions reverse depending on which side of the contract you stand on.
Debt is riskier to the user and safer to the provider; equity is more expensive to the user and higher-returning to the provider.
If borrowed money is cheaper than owner's money, funding part of an asset with debt lifts the return on the equity that remains.
The mechanism is arithmetic: the asset produces a return that does not care how it was funded, the lender takes a fixed slice as interest, and what is left is divided by a smaller contribution. The effect is called positive gearing, and it depends entirely on the sign of the spread between what the asset earns and what the borrowing costs. Reverse the sign and gearing drags the equity return below the unlevered one.
Because it magnifies both directions, gearing raises return volatility, which is why a levered return series and an ungeared one for the same building are not comparable quantities.
What this chapter covers
- 01
What each provider is promised, and who is paid first
- 02
Ten dimensions on which the two claims differ
- 03
The two reasons debt is the cheaper source of capital
- 04
The four questions that reverse depending on which side you stand on
- 05
Positive gearing and the arithmetic behind it
- 06
Why gearing raises volatility rather than return
- 07
Where capital structure reappears in later weeks
One industrial asset, funded two ways, through a good year and a bad one
- +1The capital movement is the same whichever way the purchase is funded: 8,240,000 − 8,000,000 = $240,000. The building does not know how it was paid for.
- +1Unlevered return: total gain is 420,000 + 240,000 = $660,000 on a contribution of $8,000,000, so 660,000 ÷ 8,000,000 = 8.25%.
- +1Levered return: the interest bill is 4,000,000 × 0.065 = $260,000, so the gain after interest is $400,000 on an owner's contribution of $4,000,000, giving 10.00%.
- +1Read the mechanism rather than the number. The asset earned 8.25% and the debt cost 6.5%, a positive spread of 1.75 points applied to half the purchase price, which is exactly the 1.75 points of extra equity return.
- +1Now the bad year. With a $200,000 valuation loss instead, the unlevered return falls to (420,000 − 200,000) ÷ 8,000,000 = 2.75%, while the levered return falls to (420,000 − 200,000 − 260,000) ÷ 4,000,000 = −1.00%. A 5.5 point swing unlevered becomes an 11 point swing levered, at 50% gearing.
Key terms
- Positive gearing
- Funding part of an asset with debt that costs less than the asset earns, so the surplus accrues to a smaller equity base and lifts the return on equity.
- Unlevered return
- The return measured on the whole asset price, ignoring how the purchase was funded. It is a return on assets rather than on the owner's contribution.
- Levered return
- The return measured on the owner's equity contribution after the interest bill has been deducted. It is a return on equity and is not comparable with an unlevered series.
- Loan-to-value ratio
- The proportion of an asset's value funded by borrowing. The subject notes it can reach as high as ninety per cent on industrial assets, which is a statement of capacity rather than of prudence.
- Hybrid instrument
- A funding instrument carrying features of both claims, such as a convertible or participating loan, sitting between contracted debt and residual equity on the payment queue.
Debt, Equity and the Effect of Leverage FAQ
Is debt safer than equity?
The question is incomplete until you say safer for whom. For the provider of capital, debt is safer: it ranks ahead of equity in the payment queue and its return is contractual and enforceable. For the user of capital, debt is the riskier obligation, because it must be serviced whether or not the building is leased, and failure to service it can put the asset in the lender's hands.
Writing the beneficiary into the sentence is what turns half an answer into a whole one.
Does gearing always improve the return on equity?
Only while the asset out-earns the loan. Gearing multiplies the spread between the asset's return and the interest rate, so when that spread is positive the equity return rises and when it is negative the equity return falls below the unlevered one and can turn negative. In the worked example a 6.0% asset funded at 7.5% produces an equity return of 5.0%, below what the asset itself earned.
Gearing is a magnifier, not an improver.
Why does this chapter matter for a subject about portfolios?
Because gearing changes both terms this subject measures. It changes the return, by applying the spread to a smaller equity base, and it changes the risk, because magnifying the return in both directions raises the standard deviation of the series.
It is also named in Week 7 as the first reason some investments carry inherently high betas, and it drives the Week 8 question about how a rate rise reaches two trusts with different capital structures.
Do I need to know about hybrid instruments in detail?
Not in detail, but you should be able to place one. Convertible loans, participating loans and preference units carry a contracted return like debt plus a right to convert into or participate alongside equity, and listed trusts and property companies use them to raise funds on terms between the two extremes.
Ask the same two questions you would ask of anything else: where does it sit in the payment queue, and is its return contracted or residual.
Exam move
This chapter is short on formulas and long on direction words, so drill the directions. Build a two-column table of debt against equity and cover one column at a time until you can reproduce it. Then take the worked example and rerun it at different gearing ratios and different interest rates until you can predict, before calculating, whether the levered return will sit above or below the unlevered one.
That single instinct answers the Week 8 capital-structure question almost on its own.
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