Risk and Ruin

Risk and Ruin 

You can be risk loving and yet completely averse to ruin.  And indeed, you should.

The idea is that you have to take risk to get ahead, but no risk that can wipe you out is ever worth taking.

Russian roulette

The odds are in your favour when playing Russian roulette.  But the downside is not worth the potential upside.   There is no margin of safety that can compensate for the risk.

Playing Russian roulette with your own money

Same with money.  The odds of many lucrative things are in your favour.   But if something has 95% odds of being right, the 5% odds of being wrong means you will almost certainly experience the downside at some point in your life.  And if the cost of the downside is ruin, the upside the other 95% of the time likely isn't worth the risk, no matter how appealing it looks.

Leverage is capable of producing ruin

Leverage is the devil here. Leverage - taking on debt to make your money go further - pushes routine risks into something capable of producing ruin.  The danger is that rational optimism most of the time masks the odds of ruin some of the time.   The result is we systematically underestimate risk.   

Housing prices fell 30% last decade.  A few companies defaulted on their debt.  That is capitalism.  It happens.  But those with high leverage has a double wipeout:  Not only were they left broke, but being wiped out erased every opportunity to get back in the game at the very moment opportunity was ripe.  A home owner wiped out in 2009 had no chance of taking advantage of cheap mortgage rates in 2010.  Lehman Brothers had no chance of investing in cheap debt in 2009.  They were done.

Survive to succeed

I take risk with one portion of my own money and am terrified with the other.  This is not inconsistent, but the psychology of money would lead you to believe that it is.  I just want to ensure I can remain standing long enough for my risks to pay off.   You have to survive to succeed.   The ability to do what you want, when you want, for as long as you want, has an infinite ROI.

You have to give yourself room for error.  You have to plan on your plan not going according to plan.

The best way to achieve felicity is to aim low.  (Charlie Munger)

Differences between Value Investors

The distinction between price and value is the sole requisite principle of value investing. It’s the only must. Beyond that, there are valid differences in  approach. I see eight.


1.  First is asset class. 
Listed equities return best over time, as addressed. But there are practitioners able to squeeze performance out of other sorts of holdings. Bonds work for some, real estate works for others. They’re tougher rows to hoe, but some hoe them well.

2.  A second valid difference is holding period. 
Some value investors plan to hold what they buy for just months. Others hope to hold indefinitely. Different timelines occasion different priorities. For example, short-term holders consider catalysts. A catalyst is a reason that a price could soar from the depressed level that helped to make a security attractive. Unexpectedly good quarterly results could be a catalyst, as could the dismissal of an unpopular executive.

Catalysts are less interesting to long-term investors. They’re too near-term a concern. Never intending to sell, I don’t give them a thought. 

3.  A third valid difference is activism. 
Activist investors agitate for change in the companies that they own. They might be viewed as their own catalysts. The alternative is staying uninvolved. It’s the choice of most investors, both good and bad. I call it inactivism, since passive implies index fund investing.

Activism requires an extraordinary level of gravitas and tenacity. People who are feared and skilled in this specialty are the ones that achieve the best results. Activism is not something in which one fruitfully dabbles.


4.  Fourth is diversification. 
Some value investors have diversified portfolios, with perhaps 50 or more names. Others prefer concentration, with fewer than 10.

These thresholds depend somewhat on the amount of money managed. A $50,000 portfolio spread out among a dozen different stocks might be considered diversified, while a $10 billion fund invested in a dozen names might seem concentrated.

Diversification tends to decrease volatility, should that be a goal. But, the more diversified a portfolio is, the harder it is to beat a relevant index.

One way to appreciate this is through the law of large numbers. It’s a principle from probability. It says that the more times an experiment is run, the closer the average result will be to the expected result. In investing, the expected result is the index’s return. So the more names in the portfolio—each name being an experiment, in the parlance of the law—the closer the portfolio’s return will
be to that of the index.

Some stripes of value investing force one into a diversified portfolio. Small cap investing can, since there aren’t that many shares traded of each company.  They’re small. So a small-cap investor that adds $100,000 to assets under management might have to find a new name because the ones already owned don’t have enough shares available to buy.


5.  A fifth valid difference is quality. 
Our approach has been to focus on how good a business is in an absolute sense, before considering price. We labor over historic performance metrics, strategic positioning, and shareholder-friendliness. We look for quality.

But an equally convinced group focuses on buying companies that are inexpensive relative to how good they are. To them garbage is fine, as long as it’s cheap garbage. Some in this group get exceptional results.

My focus on company quality reflects three of my other preferences: inactivism, concentration, and a long holding period. What I buy has to be good because I’m not going to fix it, I’ve only got a few others like it, and it’s mine forever.

These preferences aren’t about great foresight or morality. They’re about taxes. Unrealized appreciation isn’t taxed in the United States, so everything else being equal, holding is advantageous. I draw a straight line from tax policy to investment policy.


6.  Sixth is leverage. 
Leverage is debt. What is true for operating companies is true for investors: debt amplifies results. When an investor buys on margin, results that would otherwise be good become exceptional, and results that would otherwise be bad become catastrophic. The potential of the latter keeps many value investors away from debt. But not all.



7.  Seventh is complexity. 
Some value investors prefer simple setups. They like common stock in straightforward companies. I do, as the model makes clear. But others like it complicated. They may seek convertible bonds that become equity only under hard-to-forecast circumstances. They may prefer stock in development-stage pharmaceutical companies undergoing clinical trials, or in technology companies whose fortunes are dependent on the outcome of pioneering research.

They adore these complications not because they’re falling prey to the cleverness bias. They adore them because it gives them less buy-side competition. Other investors will simply abstain from trying to sort out convoluted situations. This can keep prices lower than they would be otherwise.


8.  Eighth is shorting. 
Shorting is a way to bet on a stock price’s decline. It involves selling stock without actually owning it, by renting it from someone who does, with the goal of profiting when the price falls.

Shorting is theoretically attractive. It promises a way to benefit from a finding that a security is overpriced. But it’s thorny to implement. Shares to rent can be hard to find, fees can be high, and a short squeeze can cause a price meant to plunge to actually soar.

Despite these complications, some value investors do short. But many do so as agents, not as principals. That’s because it increases their compensation. Shorting is a hallmark of a complicated fund. It’s the kind of stunt that managers attempt in order to justify compensation schemes of 2 percent plus 20 percent. It’s a ticket out of the land of 1 percent.




Dicey Strategies:  Can work and Doesn't work sometimes

Of the eight dimensions on which value investors can differ, two invite suspicion. 

1.  Shorting is one. 
It just doesn’t work that well. I know of no principals that both rely on shorting and outperform over the long term.

2.  Leverage is the other. 
While debt can be milked for bonus returns much of the time, one big margin call can be enough to foul years of solid results.



I nonetheless include shorting and leverage on the list to allow for the possibility that they could be made to work under some circumstances. 

• But they’re dicey. 
• They’re back doors out of the kingdom of value investing and into a land of some other, less practical strategy. 
• Some would say that this invalidates them as intelligent tactics. 

To those with long-term perspectives, something that doesn’t work sometimes can ultimately be indistinguishable from something that doesn’t work at all.



Summary

Dimensions on which bona fide value investors can differ include:

1. Asset class

2. Holding period

3. Activism

4. Diversification

5. Quality

6. Leverage

7. Complexity

8. Shorting

Volatility and Leverage: A vicious circle?

Where leverage is involved, a small loss is magnified into a big one.

That bigger loss creates considerable indigestion for the losers.

They see what's happening and rush to deleverage; that is, to sell assets to reduce exposure to volatility.

That rush to the exits creates more volatility.

The cycle continues.

This deleveraging cycle goes a long way to explain the 2008 financial crisis:  the volatility that created it and that it created.

When we look at the causes and consequences of volatility, we can see how it frequently can become a self-fulfilling prophecy, particularly where leverage is involved.

A Horrifying Storm Is Brewing Inside the Stock Market

A Horrifying Storm Is Brewing Inside the Stock Market

The markets continue to hover around record highs. But there could be a storm brewing investors need to watch.

MoneyShow.com
Aug 8, 2018


Don't forget risk.

Leverage remains insanely high at $647 billion, 55% higher than at the 2007 double housing and stock bubble peak and 116% higher than the 2000 tech mania peak. Total margin debt has exceeded 3% of Gross Domestic Product only three times; in 1929 as the madness of the Roaring Twenties peaked, last year and this year.

Leverage may seem like magic on the way up but the effects are horrifying when prices fall. The unwinding of margin debt between 1929-1932 resulted in a economic depression as the phenomenal wealth driving the nation's economy evaporated.

Stock prices fell as much as 90% after soaring 4.2-fold in only nine years and four months. The damage was so extensive that the Dow Industrials did not fully recover until 26 years later in 1955.

Thus, we look at today's stock market and worry about the similarities. In only nine years and four months from the previous bear market bottom in March 2009, the Dow Jones Industrial Average has now surged 4.1-fold, almost exactly the same as the run into the 1929 peak.

While we do not expect an exact repeat of the 1929-32 period when excessive leverage led to a crash and a collapse into an economic depression, the current environment is way too similar to past manias and in certain aspects — primarily leverage — is far worse than the prior two peaks in March 2000 and October 2007. Given our long term target of Dow 14,719, down 43% from today, we have zero comfort for the long side.

Meanwhile, total dollar trading volume (DTV) now stands at yet another new record high. Over the last 12 months, total DTV is now $81.24 trillion, up nearly 15% from last years record, roughly 75% higher than at the 2007 double bubble peak and 150% higher than at the tech mania peak.

The trend to trade more has kept average holding periods for U.S. stocks to just over four months. When stocks are held for the long term, valuation becomes a primary consideration. The shorter period one holds stocks, the less likely one is to rely on valuations, hence valuation methodologies are now routinely shunned and scorned in favor of chasing momentum.

Sentiment is perhaps the most significant driver of price, but it is not mere excessive optimism that makes the current environment so dangerous. Excessive valuations have been in place for so long that they are now accepted as entirely normal.

In the same way that buying stocks for 10% down in 1929 was regarded as normal, in the same way the "Nifty Fifty" one decision stocks in 1972 were considered normal, in the same way Nasdaq at a 250 P/E multiple in 2000 was considered normal, today's environment is accepted as normal and forecasts of higher prices abound.

In a CNBC survey of 19 top Wall Street firms, every strategist forecast higher prices and an average gain of another 10.6% through the remainder of the year. We are far more comfortable on the other side of the fence. Risks on the long side continue to be insanely high.

History has shown 30% downturns occur on average, roughly once every nine years. We are astonished how little attention is paid to risk parameters, even at this point when it is so ridiculously obvious how much leverage is built into stock prices and how overvalued stocks are.

We expect as bear market and our target remains Dow 14,719. Be careful. A storm is brewing.

By: Alan Newman, editor of CrossCurrents. Via MoneyShow.



https://finance.yahoo.com/m/79fb3e52-7b6f-3489-a678-e0731fb8b644/a-horrifying-storm-is-brewing.html

The Problems with Leverage and the tricks it can play on you

THE PROBLEM WITH LEVERAGE AND THE TRICKS IT CAN PLAY ON YOU

Leverage is the use of debt to increase the earnings of the company. The company borrows $100 million at 7% and puts that money to work, where it earns 12%. This means that it is earning 5% in excess of its capital costs. The result is that $5 million is brought to the bottom line, which increases earnings and return on equity.

The problem with leverage is that it can make the company appear to have some kind of competitive advantage, when it in fact is just using large amounts of debt. Wall Street investment banks are notorious for the use of very large amounts of leverage to generate earnings. In their case they borrow $100 billion at, let us say, 6% and then loan it out at 7%, which means that they are earning 1% on the $100 billion, which equates to $1 billion. If that $1 billion shows up year after year, it creates the appearance of some kind of durable competitive advantage, even if there isn't one.

The problem is that while it appears that the investment bank has consistency in its income stream, the actual source that is sending it the interest payments may not be able to maintain the payments. This happened in the recent subprime-lending crisis that cost the banks hundreds of billions of dollars. They borrowed billions at, say, 6% and loaned it out at 8% to subprime homebuyers, which made them a ton of money. But when the economy started to slip, the subprime home-buyers started to default on their mortgages, which meant they stopped making interest payments. These subprime borrowers did not have a durable source of income, which ultimately meant that the investment banks didn't either.

In assessing the quality and durability of a company's competitive advantage, Warren has learned to avoid businesses that use a lot of leverage to help them generate earnings. In the short run they appear to be the goose that lays the golden eggs, but at the end of the day, they are not.

Leverage and Arbitrage

When is it safe to use leverage in your arbitrage?

The certainty of the deal presents an opportunity to safely use leverage - borrowed money - to increase the rate of return.

With arbitrage situations that is certain to reach fruition, be willing to leverage.

This is the exception to the usual advice against the evils of borrowing money to buy stocks.



What is the risk of using leverage?

The danger with any stock investment is that it will not perform, that the share price won't increase, that it will drop like a rock, taking our capital with it.

Borrowing money to invest in a risky investment is a sure way to eventually go broke.


How can you benefit from using leverage?

A high probability of the arbitrage deal being completed equates to a large amount of the risk being removed.

If you are certain that you are going to make your projected profit, it is safe to use borrowed money to increase your rate of return.

The use of leverage gives you the advantage of being able to pull additional earning power out of capital tied up in other investments.



When should you not use leverage?

There are two reasons:

(1)  If the deal or event that drives the profit is not certain, then borrowing capital to invest in it can be an invitation to folly, and,
(2)  If the time element is not certain, then determining the difference between the cost of borrowed capital and the rate of return becomes an impossible calculation.


The Time Danger of Using Leverage

In the game of using leverage, time is never on your side - quicker is always better

You can comfortably borrow $1 million at 5% to invest if we are 'certain" that the deal will be completed in the time period we projected.

If the investment, instead of its taking one year for our stock to move up, it takes four years; then the borrowed money is costing us $50,000 a year and if we hold it for four years, our interest costs will balloon to $200,000.

It is the certainty of both the time and the return that allows you to leverage up and use borrowed money to safely invest in arbitrage and other special situations.

Leverage, if used carefully, and only with deals where there is a high probability of performance, this strategy makes it possible to greatly enhance the performance of your arbitrage investments.

Arbitrage is Warren's secret for producing great results

Professors Gerald Martin and John Puthenpurackal's studied the stock portfolio's performance from 1980 to 2003 of Berkshire Hathaway.

Their findings:

• Portfolio's 261 investments had an average annualised rate of return of 39.3%.
• 59 of those 261 investments were identified as arbitrage deals.
• Those 59 arbitrage deals produced an average annualised rate of return of 81.28%!

Their study brought to light the powerful influence that Warren's arbitrage operations had on Berkshire's stock portfolio's entire performance.

If those Warren's 59 arbitrage investments for that period were cut out from the portfolio, the average annualised return for Berkshire's stock portfolio drops from 39.38% to 26.96%.

In 1987, the S&P 500 delivered a 5% return, while Warren's arbitrage activities earned an amazing 90% that year.

Arbitrage is Warren's secret for producing great results when the rest of the stock market is having a down year.

Certainty of the deal being completed is everything.  The high probability of the event happening creates the rare situation in which Warren is willing to use leverage to help boost his performance in these investments to unheard-of numbers.

Terms: Arbitrage,  Leverage, Compounding

Understanding the importance and implications of Leverage

Importance of Leverage

Leverage increases the volatility of a company's earnings and cash flows, thereby increasing the risk borne by investors in the company.

The more significant the use of leverage by the company, the more risk it is and therefore, the higher the discount rate that must be used to value the company.

A company that is highly leveraged, risks significant losses during economic downturns.



Leveraged is affected by a company's cost structure.

Generally companies incur two types of costs:

• Variable costs: vary with the level of production and sales (e.g., raw materials costs and sales commissions).
• Fixed costs:  remain the same irrespective of the level of production and sales (e.g., depreciation and interest expense).

Conclusion:

The higher the proportion of fixed costs (both operating and financial) in a company's cost structure (higher leverage) the greater the company's earnings volatility.

The greater the degree of leverage for a company, the steeper the slope of the line representing net income.

Leverage

Leverage refers to a company's use of fixed costs in conducting business.

Fixed costs include:

• Operating costs (e.g., rent and depreciation)
• Financial costs (e.g., interest expense)

A 5% return may end up being a better deal than a 20% return.

If one is able to get a 5% return in a month, we could argue that it is a better investment than one that earns us a 20% return over a two-year period.

The reason for this is that a 5% rate of return in a month is arguably the equivalent of getting a yearly rate of return of 60% (5% x 12 = 60%). 

Likewise, a 20% return at the end of two years is arguably the same as only getting a 10% yearly rate of return.  (20% / 2 years = 10%).

Of course, this argument is premised on being able to reallocate the capital that we had out at 5% for a month, at attractive rates in the preceding months. 

But in theory, if you could reallocate your capital 5 times over a two-year period and each time earn 5% a month, it would still produce better results than getting a 20% return at the end of a two-year period.  

The certainty of the deal is important.  This allows for a quick and certain return

Leverage and Risk

The most obvious risk of leverage is that it multiplies losses. 

• A corporation that borrows too much money might face bankruptcy during a business downturn, while a less-levered corporation might survive. 
• An investor who buys a stock on 50% margin will lose 40% of his money if the stock declines 20%.

There is an important implicit assumption in that account, however, which is that the underlying levered asset is the same as the unlevered one.

• If a company borrows money to modernize, or add to its product line, or expand internationally, the additional diversification might more than offset the additional risk from leverage.  
• Or if an investor uses a fraction of his or her portfolio to margin stock index futures and puts the rest in a money market fund, he or she might have the same volatility and expected return as an investor in an unlevered equity index fund, with a limited downside.

So while adding leverage to a given asset always adds risk, it is not the case that a levered company or investment is always riskier than an unlevered one. In fact, many highly-levered hedge funds have less return volatility than unlevered bond funds, and public utilities with lots of debt are usually less risky stocks than unlevered technology companies.

Popular risks

There is a popular prejudice against leverage rooted in the observation that people who borrow a lot of money often end up badly. But the issue here is those people are not leveraging anything, they're borrowing money for consumption.

In finance, the general practice is to borrow money to buy an asset with a higher return than the interest on the debt. That at least might work out. People who consistently spend more than they make have a problem, but it's overspending (or underearning), not leverage. The same point is more controversial for governments.

People sometimes borrow money out of desperation rather than calculation. That also is not leverage. But it is true that leverage sometimes increases involuntarily. When Long-Term Capital Management collapsed with over 100 to 1 leverage, it wasn't that the principals tried to run the firm at 100 to 1 leverage, it was that as equity eroded and they were unable to liquidate positions, the leverage level was beyond their control. One hundred to one leverage was a symptom of their problems, not the cause (although, of course, part of the cause was the 27 to 1 leverage the firm was running before it got into trouble, and the 55 to 1 leverage it had been forced up to by mid-August 1998 before the real troubles started).  But the point is the fact that collapsing entities often have a lot of leverage does not mean that leverage causes collapses.

Involuntary leverage is a risk.  It means that as things get bad, leverage goes up, multiplying losses as things continue to go down. This can lead to rapid ruin, even if the underlying asset value decline is mild or temporary.  The risk can be mitigated by negotiating the terms of leverage, and by leveraging only liquid assets.




Forced position reductions

A common misconception is that levered entities are forced to reduce positions as they lose money. This is only true if the entity is run at maximum leverage.

The point is that it is using maximum leverage that can force position reductions, not simply using leverage. It often surprises people to learn that hedge funds running at 10 to 1 or higher notional leverage ratios hold 80 percent or 90 percent cash.


Model risk

Another risk of leverage is model risk. Economic leverage depends on model assumptions.  If that assumption is incorrect, the fund may have much more economic leverage than it thinks. For example, if refinery capacity is shut down by a hurricane, the price of oil may fall (less demand from refineries) while the price of gasoline might rise (less supply from refineries). A 5% fall in the price of oil and a 5% rise in the price of gasoline could wipe out the fund.

Counterparty risk

Leverage may involve a counterparty, either a creditor or a derivative counterparty. It doesn't always do that, for example a company levering by acquiring a fixed asset has no further reliance on a counterparty.

In the case of a creditor, most of the risk is usually on the creditor's side, but there can be risks to the borrower, such as demand repayment clauses or rights to seize collateral.  If a derivative counterparty fails, unrealized gains on the contract may be jeopardized. These risks can be mitigated by negotiating terms, including mark-to-market collateral.

http://en.wikipedia.org/wiki/Leverage_(finance)

Leverage

Using OPM (other people's money) to make money is smart business as long as the company doesn't go over its head in debt.

From the perspective of a shareholder, the more revenue-producing assets a company can put into play without requiring more money from the shareholders, the better.

The downside, of course, is the vulnerability issue and what creditors might do if the income dries up enough to make servicing the debt difficult or impossible.

Common ratios to evaluate leverage are:

1.  Debt to Assets (Total Debt / Total Assets)
2.  Assets to Equity (Total Assets / Shareholder Equity)
3.  Debt to Equity (Total Debt / Shareholder Equity)
4.  Debt to Capital (Long-term Debt / Total Capitalization)


Don't base an investment solely on any of the ratios above.  Their most useful purpose could be to call your attention to possible upcoming changes in your quality criteria and might lead you to be more vigilant about them as you manage your portfolio.



Debt Service

For those companies with high leverage, you should also look at their ability to service their debts.  For this, look at these ratios:

1.  Interest Coverage (EBIT / Interest)
2.  Interest and Principal Coverage  [EBIT / (Interest + Adjusted Principal Repayments)]

Definition of 'Leverage Ratio'

Any ratio used to calculate the financial leverage of a company to get an idea of the company's methods of financing or to measure its ability to meet financial obligations. There are several different ratios, but the main factors looked at include debt, equity, assets and interest expenses.

Investopedia explains 'Leverage Ratio'

The most well known financial leverage ratio is the debt-to-equity ratio. For example, if a company has $10M in debt and $20M in equity, it has a debt-to-equity ratio of 0.5 ($10M/$20M).

Read more: http://www.investopedia.com/terms/l/leverageratio.asp#ixzz2ALwlASAr

Warren Buffett on Bubbles and Excess Leverage

http://www.youtube.com/watch?v=X37cv_Q0jnY&list=UUeC5fFyQB62lnEPlDMWCoXw&index=4&feature=plcp

Telltale signs of good cash generation are dividends, share buybacks, and an accumulation of cash on the balance sheet.

Economies of scale:  refers to a company's ability to leverage its fixed cost infrastructure across more and more clients.

Operating leverage:  The result of economies of scale should be operating leverage, whereby profits are able to grow faster than sales.

Low ongoing capital investment to maintain their systems:

The combination of operating leverage and low ongoing capital requirements suggests that the firms should have plenty of free cash to throw around.

Telltale signs of good cash generation are dividends, share buybacks, and an accumulation of cash on the balance sheet.


E.g.  Technology-based businesses:  A desirable characteristic of technology-based businesses is the low ongoing capital investment to maintain their systems.  For firms already in the industry, the huge upfront technology investments have already taken place.  And the cost of technology tends to drop over time, so upkeep expenditures are minimal.  The combination of operating leverage and low ongoing capital requirements suggests that the technology-based firms should have plenty of free cash to throw around. 

Understanding Free Cash Flow (Video)

Read more: http://www.investopedia.com/video/definitions#ixzz1yiD0k3ZQ

1. 
   

   Understanding Free Cash Flow

Differing amounts of debt financing cause changes in EPS and thus a company's stock price.

Effect of Changes in Sales or Earnings on EBIT 

Differing amounts of debt financing cause changes in EPS and thus a company's stock price. The calculations for EBIT and EPS are as follows:

Formula 11.16

EBIT = sales - variable costs - fixed costs EPS = [(EBIT - interest)*(1-tax rate)] / shares outstanding

This LOS is best explained by the use of an example. 

Example:The following is Newco's cost of debt at various capital structures. Newco has $1 million in total assets and a tax rate of 40%. Assume that, at a debt level of zero, Newco has 20,000 shares outstanding.

Figure 11.10: Newco's cost of debt at various capital structures

In addition, Newco has annual sales of $5 million, variable costs are 40% of sales and fixed costs are equal to $2.4 million. At each level of debt, determine Newco's EPS.

Answer:At debt level 0%:
Shares outstanding are 20,000 and interest costs are 0.
EPS = [($5,000,000 - 2,000,000 - 2,400,000-0)*(1-0.4)]/20,000
EPS = $18 per share

At debt level 20%:
Shares outstanding are 16,000 [20,000*(1-20%)] and interest costs are 8,000 (200,000*0.04).
EPS = [($5,000,000 - 2,000,000 - 2,400,000-8,000)*(1-0.4)]/16,000
EPS = $22.20 per share

At debt level 40%:
Shares outstanding are 12,000 [20,000*(1-40%)] and interest costs are 24,000 (400,000*0.06).
EPS = [($5,000,000 - 2,000,000 - 2,400,000-24,000)*(1-0.4)]/12,000
EPS = $28.80 per share

At debt level 60%:
Shares outstanding are 8,000 [20,000*(1-60%)] and interest costs are 48,000 (600,000*0.08).
EPS = [($5,000,000 - 2,000,000 - 2,400,000-48,000)* (1-0.4)]/8,000
EPS= $41.40 per share

At debt level 80%:
Shares outstanding are 4,000 [20,000*(1-80%)] and interest costs are 80,000 (800,000*0.10).
EPS = [($5,000,000 - 2,000,000 - 2,400,000-80,000)* (1-0.4)]/4,000
EPS = $78.00 per share

With each increase in debt level (accompanied with the decrease in shares outstanding), Newco's earnings per share increases.

Read more: http://www.investopedia.com/exam-guide/cfa-level-1/corporate-finance/business-financial-risk.asp#ixzz1yey1qp1O

Corporate Finance - Business and Financial Risk

To further examine risk in the capital structure, two additional measures of risk found in capital budgeting:

1.Business risk
2.Financial risk

1.Business RiskA company's business risk is the risk of the firm's assets when no debt is used. Business risk is the risk inherent in the company's operations. As a result, there are many factors that can affect business risk: the more volatile these factors, the riskier the company. Some of those factors are as follows:

• Sales risk - Sales risk is affected by demand for the company's product as well as the price per unit of the product.
• Input-cost risk - Input-cost risk is the volatility of the inputs into a company's product as well as the company's ability to change pricing if input costs change.

As an example, let's compare a utility company with a retail apparel company. A utility company generally has more stability in earnings. The company has les risk in its business given its stable revenue stream. However, a retail apparel company has the potential for a bit more variability in its earnings. Since the sales of a retail apparel company are driven primarily by trends in the fashion industry, the business risk of a retail apparel company is much higher. Thus, a retail apparel company would have a lower optimal debt ratio so that investors feel comfortable with the company's ability to meet its responsibilities with the capital structure in both good times and bad.

2.Financial RiskA company's financial risk, however, takes into account a company's leverage. If a company has a high amount of leverage, the financial risk to stockholders is high - meaning if a company cannot cover its debt and enters bankruptcy, the risk to stockholders not getting satisfied monetarily is high.

Let's use the troubled airline industry as an example. The average leverage for the industry is quite high (for some airlines, over 100%) given the issues the industry has faced over the past few years. Given the high leverage of the industry, there is extreme financial risk that one or more of the airlines will face an imminent bankruptcy.

Read more: http://www.investopedia.com/exam-guide/cfa-level-1/corporate-finance/business-financial-risk.asp#ixzz1yewzbr6X

Investor concerns about the use of leverage in the Bakrie Group

Deadline looms for Bakries covenant breach

Mon Apr 23, 2012 7:11pm EDT

By Prakash Chakravarti and Janeman Latul

(Reuters) - Indonesian group Bakrie has until Friday to resolve a covenant breach on a $437 million loan following a drop in the price of its London-listed coal miner Bumi Plc last week, sources familiar with the loan said on Monday.

The breach was the latest in a series of debt problems for Bakrie Group, one of Indonesia's largest conglomerates and which avoided a debt crisis last year by selling a stake in Bumi Plc to an Indonesian investor for $1 billion.

Credit Suisse sent a notice on behalf of lenders to the borrower following the covenant breach, after Bumi Plc shares - pledged as collateral against the borrowing - slid 3.8 percent over the course of last week, according to the sources, who declined to be identified because the matter was not public.

Bumi Plc declined to comment. A director at the Bakrie Group's Jakarta-listed coal miner Bumi Resources said he was not aware of any default notice.

Bumi Resources shares dropped 7.4 percent on Monday, while Bumi Plc shares were down a further 7.6 percent on the day by 1150 GMT.

The sources said the notice required Bakrie Group to bring back the collateral coverage on the loan to a level that would require depositing cash of around $100 million with lenders.

Failure to do so by the deadline of April 27 would constitute a default that could lead to lenders demanding prepayment of the full $437 million loan.

The Financial Times first reported on Saturday that creditors issued a default notice on the $437 million loan.

One of the sources told Reuters that Bakrie family arm Long Haul, which took a $247 million portion of the loan, could either top up the loan or pay it and then refinance it.

Either way, a majority of creditors were backing the Bakrie Group so a default requiring full prepayment was seen as unlikely, meaning this was unlikely to become a new crisis, the source said.

A director at Bakrie Group holding firm Bakrie & Bros , which took the other $190 million of the loan that does not require a top-up, said: "We are not in any default situation with our loan at the moment."

Shares in Bakrie & Bros were unchanged on Monday.

Even so, the new debt issue is likely to add to investor concerns about the use of leverage in the Bakrie Group and its subsidiary companies and corporate governance, both issues that have weighed on its stocks in the past year.

Bumi Plc's stock has fallen 43 percent so far this year.

Bumi Plc sought to draw a line under discord between its main stakeholders last month, announcing a board shake-up that saw new major shareholder Samin Tan installed as chairman and that left a role for co-founder Nat Rothschild.

Warren Buffett: Choose sleep over extra profit

" I have pledged – to you, the rating agencies and myself – to always run Berkshire with more than ample cash. We never want to count on the kindness of strangers in order to meet tomorrow’s obligations. When forced to choose, I will not trade even a night’s sleep for the chance of extra profits."


Source: Letter to shareholders, 2008

Read more: http://www.businessinsider.com/warren-buffett-quotes-on-investing-2010-8#choose-sleep-over-extra-profit-15#ixzz1oXCaRr4n

Warren Buffett: Leverage is also a way to get very poor.

Unquestionably, some people have become very rich through the use of borrowed money. However, that’s also been a way to get very poor. When leverage works, it magnifies your gains. Your spouse thinks you’re clever, and your neighbors get envious. But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices. 

• And as we all learned in third grade – and some relearned in 2008 – any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero. 
• History tells us that leverage all too often produces zeroes, even when it is employed by very smart people.

Leverage, of course, can be lethal to businesses as well. Companies with large debts often assume that these obligations can be refinanced as they mature. That assumption is usually valid. Occasionally, though, either because of company-specific problems or a worldwide shortage of credit, maturities must actually be met by payment. For that, only cash will do the job.

Borrowers then learn that credit is like oxygen. When either is abundant, its presence goes unnoticed. When either is missing, that’s all that is noticed.

• Even a short absence of credit can bring a company to its knees. 
• In September 2008, in fact, its overnight disappearance in many sectors of the economy came dangerously close to bringing our entire country to its knees.

By being so cautious in respect to leverage, we penalize our returns by a minor amount. Having loads of liquidity, though, lets us sleep well. 

• Moreover, during the episodes of financial chaos that occasionally erupt in our economy, we will be equipped both financially and emotionally to play offense while others scramble for survival. 
• That’s what allowed us to invest $15.6 billion in 25 days of panic following the Lehman bankruptcy in 2008.

http://www.berkshirehathaway.com/letters/2010ltr.pdf

The Risks of Debt-Driven Returns on Equity

The three levers of ROE are:
- net profit margin  (achieve through operational efficiency)
- asset turnover (achieve through operational efficiency)
- financial leverage (achieve through employing high debt)

But does it matter if a company's high ROE comes from high debt and not operating efficiency?

If a company has a steady or steadily growing business, it might not matter that much.

For example, companies in the consumer-staples sector, where demand is stable, can handle fairly large debt loads with little problem.  And the judicious use of debt by such companies can be a boon to shareholders, boosting profitability without unduly increasing risk.

If a company's business is cyclical or volatile in some other way, though, watch out.

The problem is that debt comes with fixed costs in the form of interest payments.  The company has to make those interest payments every year, whether business is good or bad.

When a company increases debt, it increases its fixed costs as a percentage of total costs.

In years when business is good, a company with high fixed costs as a percentage of total costs can make for a great profitability because once those costs are covered, any additional sales the company makes fall straight to the bottom line.

When business is bad, however, the fixed costs of debt push earnings even lower.  

That is why debt is sometimes referred to as leverage:  It levers earnings, making strong earnings stronger and weak earnings weaker.

When companies in cyclical or volatile businesses have a lot of leverage, their earnings therefore become even more volatile.  

So the next time you're thinking about profitability, make the distinction between the kind that is internally generated (through operational efficiencies) and the kind that is inflated by debt (through leverage).

You can make a lot of money of stocks of companies structured like the latter, but your return is more assured with stocks of companies like the former.