Magic of leverage

I have seen many families fail because of liquor and leverage- Warren Buffet Badly managed leverages not only destroy individuals; but also they bankrupt companies including investment banks. They put many out of their jobs as a consequence. We see even nations struggle if they have too much debt. But what is the impact of well managed loan? It may make you fly. Leverage acts as financial amplifier. You can see lot of business papers write about virtues of prepaying home loans to save interest cost without giving a thought about underlying asset's expected returns or the amplifier effect of the loan. Leverage improves the profits, if the returns are in excess of interest rate you pay. It destroys your capital if the underlying asset returns cannot exceed the interest outgo. Assume a person who bought a land for Rs 10 lakh in 2015. After 2 years we will consider 4 scenarios and compare the returns below. In one he makes prepayment and another is EMI for 2 years with 10 percent interest. What will happen if the land is sold for 30% annualized gains? What will happen if the land just appreciated 2% annually?                Date 30% return 30% return 2%return 2% return full payment EMI @10 per Full payment EMI @ 10 percent 01-Jan-15 -1000000 0 -1000000 01-Feb-15 0 -46145 0 -46145 01-Mar-15 0 -46145 0 -46145 01-Apr-15 0 -46145 0 -46145 01-May-15 0 -46145 0 -46145 01-Jun-15 0 -46145 0 -46145 01-Jul-15 0 -46145 0 -46145 01-Aug-15 0 -46145 0 -46145 01-Sep-15 0 -46145 0 -46145 01-Oct-15 0 -46145 0 -46145 01-Nov-15 0 -46145 0 -46145 01-Dec-15 0 -46145 0 -46145 01-Jan-16 0 -46145 0 -46145 01-Feb-16 0 -46145 0 -46145 01-Mar-16 0 -46145 0 -46145 01-Apr-16 0 -46145 0 -46145 01-May-16 0 -46145 0 -46145 01-Jun-16 0 -46145 0 -46145 01-Jul-16 0 -46145 0 -46145 01-Aug-16 0 -46145 0 -46145 01-Sep-16 0 -46145 0 -46145 01-Oct-16 0 -46145 0 -46145 01-Nov-16 0 -46145 0 -46145 01-Dec-16 0 -46145 0 -46145 01-Jan-17 0 -46145 0 -46145 01-Jan-17 1690000 1690000 1040400 1040400           XIRR % 29.95335042 50.72 1.997236907 -6.358949691 @30% return , EMI route gives 50.72% annualized return on deployed capital. @2% return you will lose around 6% of your deployed capital. As you know there are only two ways of generating higher returns on your equity. a) Deploy cash on asset that is expected to generate higher return ( probably more risky) b) Deploy cash on an asset that is expected to generate moderate returns but amplify returns with leverage. Many companies take leverage to have higher Return on Equity than Return on Asset For a Rs 50 L investment if you go through EMI route, paying 20% at first and 80% of amount @ 8.5 % interest loan for 20 years , the expected home price to earn 15% return is 3.38 Cr Rs. This is far away from Rs 6+ Cr we saw in the last post for an outright purchase. You may run the below program for different rent growth, interest rates, expected returns for leveraged scenarios. package com.srini.home.returns; public class ReturnsWithEMI { public static void main(String s[]){ //first argument initial rent double rent = Double.valueOf(s[0]); //second expected rent growth rate ex. 0.05 double rentGrowthRate = Double.valueOf(s[1]); //third interest rate on EMI Double interest = Double.valueOf(s[2]); //fourth noOfMonths int noOfMonths = Integer.valueOf(s[3]); double payFromPocket = Double.valueOf(s[4]); double leverage = Double.valueOf(s[5]); //Expected Return on invested rental returns double expectedReturns = Double.valueOf(s[6]); double monthlyInterest = interest/12; calculateReturns ( rent, rentGrowthRate,monthlyInterest , noOfMonths,payFromPocket,leverage,expectedReturns); } private static void calculateReturns(double rent, double rentGrowthRate, Double interest, int noOfMonths, double payFromPocket, double leverage, double expectedReturns) { double emi = calculateEMI( leverage,interest,noOfMonths ); System.out.println("emi :"+ emi); double principal = payFromPocket; for ( int i =0 ; i < noOfMonths/12; i++){ System.out.println("Year:"+ i); principal = principal*(1+expectedReturns) ; System.out.println("principal :"+ principal); double emiSavings = (emi*12-rent); System.out.println( "emi savings :"+ emiSavings); double emiSavingsReturn = emiSavings * expectedReturns/2; principal = principal + emiSavings + emiSavingsReturn; System.out.println("rent obtained:"+rent); rent = rent * (1+rentGrowthRate); } System.out.println("expected sum:"+principal); } private static double calculateEMI(double leverage, Double interest, int noOfYears) { return leverage * interest * Math.pow((1+interest),noOfYears )/ (Math.pow((1+interest),noOfYears) -1); } }

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