GEARING - Definition

Gearing and leverage mean essentially the same thing. Gearing is British terminology while leverage is an American terminology

Gearing

Is intended to lift your wealth creation to a higher plan. If it does not help the borrower to move it forward, then there is one less reason to lend

What is Gearing then?

Beal: Use small amount of capital to access to a larger amount of assets. i.e. it magnifies any gains made on an investment

Gearing
With Gearing Own fund Borrowing 12% incr less debt Gain ROI 20,000 20,000 40,000 44,800 (20,000) 24,800 Without gearing 20,000 Nil 20,000 22,400 Nil 22,400

Types of Financing

Margin Loan Mortgage Loan Hire Purchase

Gearing Ratio
Measure the amount of debt in relation to current market value of investment asset purchased with the debt Gearing Ratio = Borrowed Funds Investors Contribution
Investor Contribution= Mkt value borrowed funds

What is the Gearing Ratio?

Year 1

Deposit $ 40,000 Loan $ 60,000 MV $100,000 Market Value reduced $80,000

Year 2

(I) Margin Loan

If LRV increase above the maximum limit, the investor will have a margin call. Investor can either: - top up with cash - sell the asset (force selling) - add more asset to the portfolio

How much to top up? GR

This is set up at the time the loan begins under the terms and conditions of the loan agreement. For instance, if the condition set is to maintain the gearing ratio of 1.5 , then the amount to be top up is by using the formula : Gearing = Borrowed Fund (D) Investor Contribution (I)

Loan to Valuation Ratio (LVR)

LVR =

Loan_____ MV of asset

If the loan is $60,000 Market Value of the asset is $100,000 Compute the LVR.

Loan to Valuation Ratio (LVR)

Subsequently the market value of the asset drops to $80,000
(i) (ii) (iii)

what is the margin call amount? Compute the new LVR In order to maintain 60% LVR, what should be the margin call amount?

Benefits of Margin Lending

1) Greater access to wealth creating assets 2) Diversification 3) Liquidity 4) Personal Income Tax Benefits 5) Direct Investing and Management

Risks of Margin Lending

1) Capital Loss (Amount Invested + Amount Borrowed + interest + charges) 2) Funding interest payment (esp if increase in interest (esp rate) 3) Cash flow risk -Unrealised capital gains do not generate CF -- Possibility of fall in income. 4) Government policies ( esp income tax rate reduction will make the structure less profitable) 5) Funding margin call

How to protect from Margin Call?

Buy Out-of-money put option Leveraged share investment Hold cash reserve

Options

A call option gives the holder the right, but not the obligation, to purchase the underlying index at a stipulated exercise price at a specified time during the life of the option

A put option gives the older the right, but not the obligation, to sell the underlying index at the stipulated exercise price and at a specified time before expiry i.e. during the life of the option

Pg 184 Students Guide out-of-money put option

First, the investors position can be protected by buying an out-of-themoney put option (that is, one with a low strike price)

A problem with this approach is that, if share prices fall below the value that will trigger a margin call, the option will need to be sold to meet the call. It will not than be available to meet further falls in share prices

This problem can be overcome by choosing an option with a strike price that means it starts to generate profits as soon as the LVR moves into the buffer. When the margin call is made, the option can be sold and the buffer re-established which allows for further falls before another margin call has to be met

Warrant
Warrant gives the holder the right , but not the obligation, buy the underlying share on or before its expiry.

Warrants vs Options (further details, pg 344 of Beal)

Differentiator Trading System Warrants ASXs share trading system A warrant issuer Variable Between 3 mths 15years No Options ASXs options trading system

Who issues them What are the terms What is their lifetime

ASX decides Standardised and set by ASX Spot to 5 years

Can short?

Yes

Types of Mortgages
Level payment fix rate mortgage - fixed term - fixed interest rate - fixed monthly repayment Graduated Payment mortgage (first home buyer) - fixed term - fixed interest rate - monthly payment increase over time and may level off

Types of Mortgages

Adjusted Rate Mortgage (Floating Rate) interest rate adjusted periodically Other Variation Interest Only Loan Bullet Payments

(II) Home Equity Loan

Categories Residential Office Retail Industrial Property Undeveloped Land

Amortisation

Is the process of gradually reduce a debt through scheduled periodic payment Monthly Payment =
T x 12

Loan x Mthly Int rate x (1+mthly int rate)

T x 12

(1 + Mthly Int Rate)

-1

Amortisation

Compute the monthly payment with the following information. Term 25 years Loan amount - $50,000 Interest Rate 7%

Problems facing Mortgage Loans

1) Property is indivisible 2) Illiquid 3) Cost of managing property is high - management fee - rates - land tax - repair and maintenance 4) High Transaction cost (solicitor, stamp duty, bank fees and search costs)

(III) Hire Purchase

Hire purchase is a system of acquiring goods on credit whereby the seller of the good is regarded as the dealer, the purchaser is regarded as the hirer and the financier as the owner.

Features and Benefits

(a) The consumer can obtain a maximum of 90% financing (b) The hirer becomes the owner of the goods on settlement of the hire purchase facility The hirer can opt for early settlement

Formula for computing the monthly hire purchase instalment

R= P + (P x I x N) N x 12 where R = monthly payment P = loan amount I = rate of interest charged N = Hiring period (in years)

Computation Aspects of Hire Purchase Loan

Westpac has agreed to provide Sandra with hire purchase facility of $75,000. The details are: Cost of vehicle Deposit paid Amount of Loan Hiring Period Add on rate $100,000 $25,000 $75,000 4 years 6.5%

Compute the monthly repayment amount.

Add On Rate
In an OD, the interest charge is expressed as a % based on the outstanding balance at any particular point in time. Thus when we say that the rate of 10% , we mean that the interest will be calculated at the rate of 10% on the outstanding balance However, in hire purchase, it is customary to state the financing charges as a % of the original cash price of the asset That % is called add-on rate asset. addof interest

APR (Annual Percentage Rate)

Is the % cost of credit on yearly basis. APR = 2 x n x I P (N + 1) where n = number of periods I = Total amount of interest P = principal loan amount

Compute APR

In a hire-purchase loan of $75,000, interest rate charged is 6.5% flat, the term charges is $19,500 and the number of instalments is 48, then the APR is _______

Cost Component

Cost of Purchase Down Payment Monthly Loan Payment Total Cost

xxxxx xxxxx xxxxx _____

Negative Gearing

Occurs when interest cost exceed the cash flow produced by the asset. Many Australians viewed negative gearing unfavourably as they see it as simply a tax avoidance scheme which has been abused.

Risk of Gearing

(a) capital value risk (b) interest rate risk cash flow risk d) margin call risk e) government policies and attitudes