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Let’s Talk About Leverage

September 12, 2013

Happy Thursday everyone! Last night I finishedh my first full week of school and will be 32 classroom meetings away from my MBA! One of the courses I am taking is Corporate Risk Management. For those that don’t know – I love numbers and finance and have taken a few finance-based classes over the past two years just for fun (e.g. Derivatives, Investment Banking). One concept from all of these classes that I think is particularly applicable to all people is that of leverage.

For the non-financial types out there, leverage is a fancy word for debt.  In school, we’ve talked about how companies can use debt to increase their risk (lever up), and thus, potential return; the cost of using debt vs. the cost of using equity or cash to finance expenses, and the advantages of using debt to finance expenses as compared to using equity or cash. In finance you’ll also be presented with this idea of “optimal debt” that suggests that, for a company, it is better to have some debt than none at all.  I thought it would be interesting to take the concept of leverage and apply it to individuals. What does being leveraged mean for a person, what are the advantages of using debt to finance expenses, and is there an optimal level of debt for individuals?

To really address these questions, we need to understand some basic assumptions about companies and how these assumptions differ from those about individuals:

Assumptions about Companies

  1. We assume that companies are in existence basically forever, and, if they choose to exit the market, they can liquidate their assets.
  2. We assume that companies have three ways to finance their expenses: cash, equity (issuing/selling stock), and debt (issuing bonds and/or acquiring loans, credit, etc.)

Assumptions about Individuals

  1. We assume that individuals are not in existence forever, and that their working life has an end point.  When they choose to exit, they don’t have tangible assets they can liquidate (i.e. you still need a place to live after you stop working and probably a car or some mode of transportation, etc.)
  2. We assume that individuals have two ways to finance their: cash and debt

When an individual or company is trying to determine how to pay for its expenses they have to figure out the “cost” of using the financial instruments available to them.

CASH: The cost of cash really isn’t $0 as many would assume. It’s the lost returns you could have gotten if you’d invested instead. Taking a conservative approach, we could say the cost of cash is the risk free rate. This is the interest rate on a treasury bond for the same maturity as your debt or equity. So, if you’re going to take out a 30 year mortgage, the cost of using cash would be the interest rate on 30 year treasury bill.

DEBT: The cost of debt is the interest rate. The more risky the company or individual, the higher the cost of debt. For individuals, this riskiness is usually measured by a FICO score and for a company, it’s usually measured by their credit rating. There are all kinds of debt at all kinds of costs (securitized, senior debt, junior, debt, etc.) but we’re not going to worry about those differences too much right now.

EQUITY: This is the return required by investors. It is a premium over the risk free rate and adjusted for the directional volatility of a company relative to the market. A company that is more volatile than the market and positively correlated (moves in the same direction as the market), has bigger gains than average when the market is up and bigger losses than average when the market is down. To compensate for this risk, investors require a higher rate of return than they would for a company that moves exactly with the market. As a result, the cost of equity is higher.

What does being leveraged mean and what are the advantages of using debt financing?

For an individual, being leveraged really describes how much debt you have relative to your income.  The more leveraged you are, the more risk you are taking on. However, this also generates the greatest opportunity for returns, assuming that you are using the cash that you would have spent is generating more returns for you elsewhere. For a company, this means that when you finance the purchase of equipment instead of paying cash for it, you are assuming that over the useful life of that equipment, it will generate enough income to at least cover its cost, including interest. That frees up the cash you would have spent on the machine for other investments that can then generate additional revenue. However, if the machine covers its costs, including interest, you’re better of financing it then spending your cash on the machine. However, if the machine breaks early and doesn’t generate enough income to cover its costs, including interest, you’re in a crappy position and you might have been better off just paying cash instead of financing.

To complicate things a bit, Uncle Sam subsidizes the cost of debt. For companies, this takes the form of a tax deduction for interest expenses paid in a given year. For individuals, it takes the form of a tax deduction for things like mortgage interest paid in a year and interest on student loans. This means that there is a tax advantage  to using debt to finance expenses.  So, in the example above, the financed equipment could be a better choice than spending cash as long as it generated enough income to cover its cost and the tax adjusted interest.

Now let’s apply this to an individual. In the example above we described a company financing the purchase of equipment that it expected would generate returns equal to or greater than the cost of debt. For an individual, this is like borrowing money to invest in the stock market. The most common scenario would be during a merger. Say Disney is going to merge with Pixar and people that own Pixar are going to get 1.5 shares of Disney for every share of Pixar they own. Further, let’s say that a share of Disney is worth $0.50 and a share of Pixar is worth $0.70. If you own one share of Pixar worth $0.70, you’ll own 1.5 shares of Disney worth $0.75 if the merger is consummated.  If the merger goes through you start out with 100 shares worth $70 an end up with 150 shares worth $75. A $5 profit represent approximately 7% of the value of your $70 loan. If you can borrow $70 at an interest rate less than 7%, you’ll end up making money on the deal. At the same time, your cash can stay in your other investments and continue generating returns, all while you get some free money. On the flip side, if the merger doesn’t go through, you end up losing money if your cash in other investments isn’t earning you more than 7%.  As you can see, there’s a risk to financing the purchase with debt, but there’s also a pretty big potential gain.

Most individuals, however, are not financing investments or equipment. Most individuals take on debt to buy things that will never generate enough income to cover the cost plus interest. Take for example, a car. Financing a car is probably one of the most ridiculous things to do ever (we have car loans, and  I still believe this is true!!).  The purpose of a car is to get you from point A to point B. A 2006 Honda Accord does this just as efficiently as a 2013 BMW 7 series, it just does it for a lot less money. And when it comes to generating a return on investment, your car is not going to earn you 3% or 4% more income. It doesn’t generate a return on investment, which is why it doesn’t make sense to finance it.

Is there an optimal level of debt for individuals?

My personal belief is that the optimal level of debt for individuals is as close to 0% as possible. This goes back to the previous point that none of the things an individual finances generates a return in excessive of the cost of debt (i.e. interest rate on the loan). What about mortgages and student loans? What about the tax benefits related to these? In general, the tax benefits for individuals are pretty minor. Take student loans.  Let’s say I expect to pay $7,900 of interest on my student loan over 3 years. Over time, the tax benefit associated with this is equal to the tax rate * the interest. Assuming a 28% tax rate, I end up paying $7900 – ($7900 * .28) = $5688 in interest over the life of the loan. Instead of paying my student loan back in 3 years, let’s say I pay it back in 1 year. In this case, I only pay 1/3 of the interest ($2607) and I also get the tax deduction for one year, which means I’ll pay a total of  $1887 in interest. Clearly, $1887 is less than $5688, so why on earth would I procrastinate on paying back this loan if I don’t have to?? Additionally, by paying off my loan, I am guaranteeing myself a return on investment equal to the interest rate of my loan. In the example above, by paying my loan off early, I save $3800!  Even if your money can earn more money invested in the market, your returns are not guaranteed. You might be up 20% today and down – 10% tomorrow.  You can figure out your expected return by looking at historical data, but the key point is that you are calculating an expected return, not a guaranteed one.

Bottom Line

We mentioned earlier that a key difference between individuals and companies is that individuals generally want to retire. In order to retire, people need to do something that companies don’t – they need to SAVE. People need to spend less than they earn. This parallel’s a company’s desire to increase profit and the best way that a company can increase profit is by reducing as many fixed costs as possible.  What are fixed costs, you ask? Those are any costs that are fixed and do not vary based output. For example, rent or mortgage is a fixed costs. Whether 5 people live in your house or 1 person lives in your house, the monthly rent or mortgage is fixed. For people, fixed costs generally align with debt – mortgage, student loans, car loans, credit cards with balances – those are all “fixed” costs in a sense if you have them, and one of the best ways to increase your savings is to reduce these fixed costs as much as possible. Think about how much money you’d have if you got rid of all of your fixed costs – without changing a single thing in your life, you instantly have a ton more money that you can dedicate to building your savings. Bottom line – people are not companies and we can’t run our finances the same way companies do.

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2 Comments
  1. b.c. permalink

    You probably should check the facts with some of your advice. Problem with your student loan example is that the tax deduction is capped at $2500 per year (individual or joint filing) and begins phasing out completely at a certain income levels ($60K and $125K, respectively). When you are in the 28% tax bracket, you hit this threshold pretty quickly, and may not even be eligible to take the deduction at all.

    • Thanks for the comment. You are absolutely right about the capping of the tax deduction. I didn’t mention it because I wanted to keep things as simple possible and show that even if tax deductions have no caps it is still better to pay off the loan early that it is to keep it around for “tax benefits.” The fact that there is a cap underscores this even more. Thanks for point this out to other readers!

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