FINANCE BANKING

Finance Banking

Finance Banking

Q1. Which company has the greater leverage (risk)? Which company would you prefer to buy shares in and why?

A company is said to be highly leveraged if a company with a high level of debt, because with own resources of 100 may have assets worth 1,000, with 900 of debt. And since in this case, the assets are 10 times greater than the resources themselves, talk about leverage 10x, 1x being the company has no debt, and 0.5 x a company where the assets are half of its own resources (the other half of its equity would be in cash).

But the point, consider the problem: A company with no debt worth 100, if their assets fall by 5%, going to be worth 95. But a company worth 100 10x leveraged, has assets worth 1000 but has debt worth 900. If assets fall by 5%, to 950, its total value falls by 50% to 50. And yes, as you're thinking, if your assets fall by 10%, its total value is zero.

The first implication of this is fairly obvious: the risk of highly leveraged companies is very high, because a small drop in the value of its assets will result in a sharp drop in its total valuation.

But a second implication much less evident, and the risk assessment: As they said in Bestinver , valuing a business is not anything scientific at all, which is why it requires a safety margin at the time of valuation. What happens as a highly leveraged company? That if we value the assets in 1000, will think that the company is worth 100 (since we know that debt is exactly 900), but here is not worth applying the safety margin at the price of the company, and say that at 60 you can buy quiet (Weygandt, Kieso, & Kell, 1996), the margin of safety must be applied to asset prices, which are the total valuation uncertainty we face, and if the 1000 will apply a margin of safety, any assessment below 900 leaves the firm is 0, so it's impossible to buy with a margin of safety in the valuation of a company with strong leverage.

For levels of leverage, we would like to make some considerations:

Risk-Adjusted leverage

One should consider the risk-adjusted leverage, that is not the same to be leveraged 5x very low risk assets (highways, airports and power plants that generate recurring revenues very predictable) to be 5x leveraged real estate or shares in a an oil, as Sacyr, whose prices can vary greatly depending on the evolution of the housing market or the price of oil.

Leverage is always a risk

Nevertheless, even in "safe" assets, leverage is always a risk right now, prices have fallen to a very low level, simply because it has money to offer many investment options more profitable than before: from high interest accounts to corporate bonds. And that makes most profitability requiring any investment asset, so prices fall so that the profitability is ...