How to Start Living a Debt Free Life
I repeat If you carry a balance on your credit card or have an outstanding auto loan, do not invest in mutual funds until these consumer debts are paid off. You won't be able to earn a consistently high enough rate of return in mutual funds to exceed the interest rate you're paying on consumer debt such as credit cards and auto loans. Although some financial gurus claim that they can make you 15 to 20 percent per year, they can't not year after year. Besides, in order to try and earn these high returns, you have to take great risk. If you have consumer debt and little savings, you're not in a position to take that much risk. I'll go a step further on this issue Not only should you delay any investing until your consumer debts are paid off, you should seriously consider tapping into any existing savings (presuming you would still have adequate emergency funds at your disposal) to pay off your debts.
The sixth performance measurement is known as the debt service coverage ratio (DSCR). The DSCR is a ratio that measures the relationship between available cash after operating expenses have been paid and the cash required to make the required debt payments. This ratio is especially important to lenders, as they want to ensure that the property being considered for investment purposes will generate enough cash to cover any and all debt obligations. In other words, they want and need to be assured that the real estate is throwing off enough cash to repay the loan. The debt service coverage ratio is calculated as follows Debt service coverage ratio - DSCR
The value of equity is obtained by discounting expected cashflows to equity, i.e., the residual cashflows after meeting all expenses, reinvestment needs, tax obligations and net debt payments (interest, principal payments and new debt issuance), at the cost of equity, i.e., the rate of return required by equity investors in the firm.
The bond ratings assigned by ratings agencies are primarily based upon publicly available information, though private information conveyed by the firm to the rating agency does play a role. The rating assigned to a company's bonds will depend in large part on financial ratios that measure the capacity of the company to meet debt payments and generate stable and predictable cash flows. While a multitude of financial ratios exist, table 2.1 summarizes some of the key ratios used to measure default risk. Not surprisingly, firms that generate income and cash flows significantly higher than debt payments, that are profitable and that have low debt ratios are more likely
I am willing to bet anyone an ice cold case of Beck's Beer that the numerous commercial real estate market meltdowns that have occurred during the past 30 years would not have been so severe if the high rollers had bought more real estate options instead of properties. In this way, if they did not want to exercise their real estate options, they could have simply let them expire, and that would have been the end of it. And they would not have incurred any of the transaction, maintenance, management, holding, and debt service costs that eventually forced them to go belly-up. In other words, they would not have been saddled with the financial responsibility and personal liability that go along with outright property ownership, and they automatically would have avoided having to
For example, a buyer purchases a 10-unit apartment complex for 500,000. There is an existing first mortgage of 250,000 with an annual debt service of 41,240 (principal The interest rates are not the only criteria to examine when you are looking into total debt payments. You may owe on several different loans at various repayment terms. The most specific item to note is the combined constant rate of payment of the loans. The term constant rate of payment is used within the lending industry, and you should become aware of what it means and how it is used. In Chapter 3, I provide you with details of how to use the constant rate of payment in analyzing mortgage situations. Consolidation of debt has many different benefits, as you will see when you combine its effects with some different financing tools illustrated in this book. The key to using any of the consolidation techniques is to make sure that you keep your ultimate goal in clear focus. For example, if you simply want to reduce...
Wallace wanted to sell his 25- unit apartment house for a price of 500,000. He had an opportunity to buy another property in another town and needed the cash for that purpose. The price he was asking was within the market range with a net operating income (NOI is gross rents less operating expenses, which does not include any debt service) of 53,000 out of a gross rent roll of 76,000.
Now, during these 30 years of ownership, the investor would have a constant annual debt service of 64,000 (8 percent X 800,000 64,000). Deducting this from the present NOI of 90,000 results in a cash flow of 26,000. Remember, the debt service in a mortgage with both principal and interest payments is calculated to include both the principal and interest portion of the mortgage. In this way, although each monthly payment will have a slightly different mix of interest and principal, the total for the year will be 64,000. The resulting 26,000 is the return that the investor would obtain on his or her investment of 200,000 ( 1,000,000 less the new debt of 800,000 200,000).
My research consists, primarily, of finding out who owns the property and where they live. It's generally the address where the tax bills are mailed. I want to know how many mortgages or trust deeds are secured by the property and what their original amounts were. Also, the tax bill will show me the value for tax purposes. I like to know if my estimate of value is somewhere in line with the county appraiser's view. I always like to get an idea of how much mortgage debt is still owed because I'm looking for properties with a lot of equity. Also, I'm looking for the opportunity to create a long-term seller carryback mortgage, should I be successful purchas-
The long-term hold investor's goals are simple They want deals with an upside, like the ability to increase the value by improving the cash flow of the property. For example, some of the wealthiest investors we know are our mentors, who are older gentlemen who bought their pieces of commercial real estate decades ago. One of them bought land and another bought apartments. Their philosophy was Good real estate will always have a higher value over many years if I wait long enough. It's a too-simple strategy that has worked incredibly well for many patient investors. Both of these gentlemen held onto their properties in three separate down market cycles over the years. Both have properties that are debt free, and they have made millions of dollars since.
Earlier in this chapter, we considered the relationship between equity betas and leverage and introduced the notion of an unlevered beta, i.e. the beta that a company would have it if it were all equity financed. The cost of equity that would result from using an unlevered beta is called the unlevered cost of equity Unlevered Cost of Equity Riskfree Rate + Unlevered Beta * Risk Premium There are some analysts who use the unlevered beta as the cost of capital for a firm. Their reasoning is based upon the argument made by Miller and Modigliani in their path breaking paper on capital structure that the value of a firm should be independent of its capital structure. If we accept this proposition, it follows that the cost of capital for a firm should not change as its debt ratio changes. The cost of equity (and capital) at 0 debt should be the cost of capital at every other debt ratio. While using the unlevered beta to arrive at the cost of equity has its conveniences, it does come with...
For some investors, the goal is to own properties free and clear, that is, with no mortgage debt. While this is a worthy goal, it does not necessarily make financial sense. See Figure 1.1. If the property were financed for 80 percent of its value ( 80,000) at 7.5 percent interest, the monthly payment would be approximately 560 per month, or 6,720 per year. Net rent of 10,000 per year minus 6,720 in debt payments equals 3,280 per year in net cash flow. Divide the 3,280 in annual cash flow by the 20,000 in equity and you have a 16.4 percent return on investment. Furthermore, with 80,000 more cash, you could buy four more properties. As you can see, financing, even when you don't necessarily need to do so, can be more profitable than investing all of your cash in one property.
Sixty percent of transactions concluded at the seed, R&D, and start-up stages have fairly fixed financing structures. It is no accident that the transaction structure most commonly used by angels is the private placement. The formal definition of a private placement is the issuance of treasury securities of a company to a small number of private investors in the form of senior debt, subordinated debt, convertible debt, common stock, preferred stock, warrants, or various combinations of these securities. Although the vast majority of these investments by institutional investors involves debt securities, exempt offerings are common, involving direct, equity, and or debt investing by private investors.
The truth of the matter is that investors have no real control over how much a property-flipping transaction will ultimately cost them. The reason for this lack of cost control is that the actual amount of the holding cost is unknown when flipping a property. Holding costs include debt service, insurance, property taxes, maintenance, and security. And the single largest cost of holding on to a piece of property is its debt service or monthly loan payments. The problem with being the proud owner of a piece of investment property is that the mortgage meter is always running, whether the property is occupied or vacant. I learned this lesson the hard way when a property-flipping deal, which I thought was going to be a slam-dunk, turned out to be an air ball instead. When I was young and dumb, I bought a run-down single-family house in South Tampa with
If you're trying to improve your physical fitness by exercising, you may find that eating lots of junk food and smoking are barriers to your goal. Likewise, investing in real estate or other growth investments such as stocks while you're carrying high-cost consumer debt (credit cards, auto loans, and so on) and spending more than you earn impedes your financial goals. Before you set out to invest in real estate, pay off all your consumer debt. Not only will you be financially healthier for doing so, but you'll also enhance your future mortgage applications.
This chapter covers a range of financial securities and the markets in which they trade. Our goal is to introduce you to the features of various security types. This foundation will be necessary to understand the more analytic material that follows in later chapters. Financial markets are traditionally segmented into money markets and capital markets. Money market instruments include short-term, marketable, liquid, low-risk debt securities. Money market instruments sometimes are called cash equivalents, or just cash for short. Capital markets, in contrast, include longer-term and riskier securities. Securities in the capital market are much more diverse than those found within the money market. For this reason, we will subdivide the capital market into four segments longer-term bond markets, equity markets, and the derivative markets for options and futures. We first describe money market instruments and how to measure their yields. We then move on to debt and equity securities. We...
A bond issuer can arrange for a rating agency (such as Standard and Poor's or Moody's) to have a bond issue rated, based on an assessment of the issuer's ability to pay the bond cash flows as and when promised. The rating agency would carry out a detailed analysis of the issuing company's current and future cash flows and overall financial performance in relation to its industry sector it would focus on operating cash flow generation, existing debt service obligations, the quality and stability of the asset base, the ability to realise funds quickly (liquidity), capital expenditure requirements, and industry specific risk (using financial ratio analysis). The rating assigned would reflect the default risk and hence the required yield at issue (Standard & Poor's and Moody's rating categories can be found on their web sites www.standardandpoors.com and www.moodys.com).
Using Table 2-5 as a worksheet, list and calculate the money that's going out. What are you spending and on what The first column describes the source of the expense, the second column indicates the monthly amount, and the third column shows the amount projected for a full year. Include all the money you spend, including credit card and other debt payments household expenses, such as food, utility bills, and medical expenses and money spent for nonessential expenses such as video games and elephant-foot umbrella stands.
Currently use two 40,000 lines of unsecured credit, which have fixed-interest rates of between 3.4 percent and 4.5 percent. I am able to obtain these low-rate lines of unsecured credit because I have zero consumer debt and a credit score in the top 5 percent. The real beauty in using unsecured lines of credit, instead of secured credit lines such as a home equity line of credit (HELOC), is that you do not have to put your home on the line and pay those exorbitant closing costs that lenders generally charge borrowers for the privilege of doing business with them. In fact, the most that I have ever had to pay when using an unsecured line of credit was a 50 transfer fee.
Many of these owners had other financial challenges and little savings to fall back on, so they were unlikely to be able or willing to continue making their debt service payments on the upside down property. An owner in this situation is a prime candidate for a short sale.
One recent legislative change that has really helped owners of properties who want to work out a short sale is the Mortgage Forgiveness Act of 2007. Previously, mortgage debt that was forgiven or canceled by a lender had to be included on the borrower's tax return as taxable income. Under this new law, any loan that was used to buy, build, or substantially improve the borrower's principal residence (not second homes or investment properties) qualifies for the exemption from taxation as ordinary income. A refinance loan for the same purposes also qualifies. The lender is required to report the debt cancellation to the IRS on Form 1099-C, and the borrower must file Form 982. This law is scheduled to expire as of January 1, 2010, but may be extended. Be sure to seek the advice of your tax professional before agreeing to any short sale.
Table 7-1 breaks down the world debt securities market, which was worth 38 trillion at the end of 2001. This includes the bond markets, defined as fixed-income securities with remaining maturities beyond one year, and the shorter-term money markets, with maturities below one year. The table includes all publicly tradable debt securities sorted by country of issuer and issuer type as of December 2001. TABLE 7-1 Global Debt Securities Markets - 2001 (Billions of U.S. dollars) TABLE 7-1 Global Debt Securities Markets - 2001 (Billions of U.S. dollars)
Many investment banks see tremendous opportunities in China. Investment banking houses such as Goldman Sachs, Morgan Stanley, Citigroup, and UBS have all positioned themselves to take advantage of the market potentials. Access to China's market became a reality after China joined the WTO. Foreign securities houses now are able to establish joint-venture operations, become special members of all exchanges, and engage in underwriting A shares. In addition, they can engage in underwriting and trading B and H shares as well as government and corporate debt securities. At the same time, privatization of state-owned enterprises means many Chinese companies seek listing in foreign markets. For example, China Life, China Telecom, Suntech, China Construction Bank, Bank of China, and ICBC have listed their shares overseas.
Conventional wisdom suggests that companies should avoid combining high operating leverage (which leads to high business risk) and high financial leverage (which leads to high financial risk). Earnings are boosted in good times because of the presence of fixed costs and debt, but (earnings) get depressed in bad times for the same reason viz. presence of interest payments on debt and other fixed costs. Massey Ferguson, a multinational producer of farm machinery, industrial machinery, and diesel engines sought to increase its market share by turning to the Third world for growth. Massey manufactured its products in UK and Canada and sold the output to LDCs (less-developed countries) in the late 1970s. This strategy worked quite well in the initial years. Compared with competitors Massey had an aggressive debt policy and an aggressive product-market strategy. It coupled a risky strategy in a cyclical industry with high (short-term) debt.3 When short-term interest rates shot up and the...
Triple net properties are often promoted as another real estate option for investors looking to avoid the headaches of day-to-day management. These investments may seem like real estate investments, but they're primarily an investment in the net cash flow (after debt service) from a lease to a credit tenant, and they're promoted based on the cash-on-cash rate of return or cap rate (see Chapter 12 for information on these measures of investment return).
The bond ratings assigned by ratings agencies are primarily based upon publicly available information, though private information conveyed by the firm to the rating agency does play a role. The rating assigned to a company's bonds will depend in large part on financial ratios that measure the capacity of the company to meet debt payments and generate stable and predictable cash flows. While a multitude of financial ratios exist, table 4.6 summarizes some of the key ratios used to measure default risk. Not surprisingly, firms that generate income and cash flows significantly higher than debt payments, that are profitable and that have low debt ratios are more likely to be
In early June 1997 the management of Flagstar Companies, Inc. sent a detailed prospectus to holders of 1.5 billion of its debt securities, as well as holders of all of its preferred and common stock, in a solicitation of votes on a prepackaged plan of reorganization. Flagstar was one of the largest restaurant companies in the United States, operating either directly or through franchisees over 3,200 low- to moderately priced restaurants. It had lost money, however, almost every year since its leveraged buyout in 1989 by Coniston Partners, one of the most aggressive takeover firms in the United States. (Exhibit 4.1 shows selected financial data for Flagstar from 1988 through 1996.) Flagstar management was now hoping to be able to restructure the company quickly. It was apparent, however, that there might be problems in doing so The company's various claimants particularly the senior subordinated debt holders, the junior subordinated debt holders, and the common stockholders had...
Think about how you grow and prosper as an individual or as a family, and you see the same issues with companies and how they grow and prosper. Low earnings and high debt are examples of financial difficulties that can affect both people and companies. You'll understand companies' finances when you take the time to pick up some information in two basic disciplines accounting and economics. These two disciplines play a significant role in understanding the performance of a company's stock.
In this example, you have the same NOI as before, of course, and your disbursements are the payments you make on three mortgages. Using the techniques you learned in the previous chapter, you can calculate the monthly payment for each of the two regularly amortized mortgages. Once you have the monthly payment for each, you simply multiply it by 12 to find the total debt service for each year. The third mortgage is interest only, so the annual debt service is exactly the same as the annual interest. You subtract these mortgage payments from the NOI to leave you a positive CFBT in 2006 of 72,391. In subsequent years, the debt service - Debt Service, 1st Mortgage 72,268 72,268 72,268 72,268 72,268 - Debt Service, 2nd Mortgage 15,201 15,201 15,201 15,201 15,201
As we have explained, the private placement is the issuance of treasury securities of a company to a small number of private investors. This investment is an offering of debt, stock, warrants, or various combinations of these securities. Although the greater number of private placement investments to institutional investors involve debt securities, exempt offerings of direct, equity, and or debt investing by private investors are common. These private investors often become involved in a venture in order to limit the downside risk associated with illiquid investments. These participatory investors also begin with transactions requiring less money. Moreover, these transactions move quickly compared with a public offering, are more flexible due to the lack of SEC requirements, and are much less expensive.
To some extent, the change in consumer installment credit could reflect consumer spending, consumer confidence, and consumer debt burdens, but how does a person distinguish among these factors Not easily. In the early 1980s, the Fed reported the extension of new credit, and the liquidation of old credit to reflect a net change in total consumer installment credit. In that case, an increase in extensions would surely indicate increases in consumer spending and probably a degree of consumer confidence. Individuals would extend their credit obligations only if they anticipated being able to repay their debts. A slowdown or decline in repayments would suggest that consumer incomes were being stretched to their limit and a drop in spending might soon follow. Unfortunately, the Federal Reserve Board was unable to continue to publish this detail and has reported only the net change in consumer installment credit for over 20 years. That leaves market participants with the problem of having to...
Dillon Read's March 13, 1997, report on Flagstar provided a sensitivity analysis of the value of Flagstar's public debt securities. Using a conservative valuation, it concluded that the secured debt and the senior unsecured notes would most likely be completely covered in the restructuring. It also did an analysis of possible returns from purchase of the senior
I want you to know that whether you are a beginner or an advanced trader, it is important to know what to look for and how certain reports may affect the price behavior of the markets. Figure 1.10 shows what I see as the major focuses of economic reports here in the United Statees and what is in my opinion the order of importance. My selection holds true in all business cycles. The number-one focus should always be to read and to listen to what the voting members of central banks are looking at and on what they are basing their decisions to adjust interest rates. That makes sense, right So the releases of their FOMC meeting announcements are important, as well as the minutes of their last meeting. The minutes are released within two weeks of the last FOMC meeting. In Figure 1.10, I have two small branches from the FOMC meetings One is the Beige book heighten your awareness of this, as it is released two weeks prior to a Fed meeting. The other is the Federal Reserve districts business...
It can enable the buyer to structure the total financing so that he or she can afford the required equity down payment. Because the terms of the secondary financing may vary, the overall debt service may require lower monthly payments due to the combined financing, when compared to other alternatives. Of course, there are times when the new first mortgage money market will not permit the loan-to-value ratio needed, and the secondary financing may be the only way to achieve that ratio.
The seller who doesn't have money and needs money from the transaction is generally the one who is most motivated to take the secondary financing. Why Look back at the motivation. If he or she needs money, the sale of the property becomes the important aspect. It could be that the person is being transferred, or just cannot afford to keep the home or property being sold. The desire to get money (that seller's goal) may really be the need to get off the current debt. The transaction can provide some of both benefits. By selling there are no more debt payments to make, and a small down payment with secondary financing provides sufficient cash to meet that part of the deal. In this situation, the need to make the sale will motivate the seller to hold some reasonable paper. Many sales are lost because the broker assumes the seller will not hold secondary paper. The fact may be that the seller cannot afford not to be flexible.
The second question most commercial investment brokers ask about a property is What is the cap rate '' This rule of thumb improves on the GRM because the income used for its calculation is the net income after vacancy and expenses. In the market for large properties where tax exempt institutions purchase property for all cash, this measure is quite useful. Imagining the property as a parking place for cash, the capitalization rate constitutes the interest rate the property earns debt free as if the property were a bank account. Naturally, the bank account analogy is limited. Investment property capitalization rates are typically much higher than interest rates paid by banks for reasons that should be apparent.
Bankruptcy because the securities are undervalued even in light of the risk of default. Typically, hedge funds buy debt securities at deep discounts from face value. Upon entering bankruptcy, these debt holders frequently become the de facto shareholders, and the return on the hedge fund investment is determined by the liquidation value of the assets and the skill of the debt holders at renegotiating other obligations.
Some bonds linked to stocks are of particular interest for reducing the downside risk. The American Stock Exchange reports information about linked bonds under the structured-products tab at www.amex.com. These structured products are offered by various brokerage firms and have strange names given by the brokerage houses. Morgan Stanley calls them SPARQS, or Stock Participation Accreting Redemption Securities. Merrill Lynch calls them STRIDES, or Stock Return Income Debt Securities.
Average of the interest rates was about 8 percent although they tended to increase throughout the decade. The cash that borrowers received from new loans was substantially larger than the interest payments on their outstanding loans, so in effect they incurred no burden or hardship in making their debt service payments on a timely basis.
Ments of 240 per month (all that's left over) however, at 10 interest, the note could only be for 28,800 (10 times 28,800 equals 2,880, divided by 12 equals 240). If I agree to that and if the owner insists on a selling price of seven times gross ( 176,400), I would need to come up with a 47,600 cash down payment ( 100,000 existing mortgage debt, plus 28,800 new seller carryback note, plus 47,600 cash down equals 176,400).
3The exchange initially provided a listing facility for offshore mutual funds and specialist debt securities. In March 1998, rules for the listing of derivative warrants had been introduced, and after that followed an expansion into depository receipts and recently into Eurobonds.
The advantage of using the firm valuation approach is that cashflows relating to debt do not have to be considered explicitly, since the FCFF is a pre-debt cashflow, while they have to be taken into account in estimating FCFE. In cases where the leverage is expected to change significantly over time, this is a significant saving, since estimating new debt issues and debt repayments when leverage is changing can become increasingly messy the further into the future you go. The firm valuation approach does, however, require information about debt ratios and interest rates to estimate the weighted average cost of capital. If there is expected growth, the potential for inconsistency multiplies. We have to ensure that we borrow enough money to fund new investments to keep our debt ratio at a level consistent with what we are assuming when we compute the cost of capital.
In Japan, several issues surround the callability risk inherent in many convertible bonds. Although there has historically been an assumed immunity from callability, issuers facing financial troubles might be required to call in expensive debt that they have traditionally allowed to survive beyond
Safety is sacrificed when you select a stock with high leverage in preference to one with small leverage. A company with a very large debt burden is in greater danger of going bankrupt, as in the case of the Penn Central. For that reason financially conservative companies are preferred by many investment advisers. However, financial strength did not prevent the value of General Motors stock from declining in 1974 to less than one-third of its 1965 price. Financial strength did not prevent IBM from declining in less than two years from 3651 4 to 1501 2. Nor did financial strength prevent debt-free Polaroid from falling from 1431 2 to 145 s. But leverage and the financial strength of companies should be thoroughly studied and evaluated before stocks are selected for purchase. When money is tight and expensive, companies with large cash positions are at an advantage, particulary if they know how to use their financial resources effectively.
This question one has to look at the source of risk and return for the two companies in question. Companies may be matched on the basis of several characteristics like size, leverage, etc. It is important to understand the criterion of comparability differs from one multiple to another. For example, when one is using the P E multiple, leverage is crucial because two firms may be similar in all respect except the debt ratio. A firm with high debt ratio would have fewer shares, higher earnings per share (EPS) and lower P E multiple, other things remaining constant.
This section focuses on the sourcing of key deal-related and financial information for M&A transactions involving both public and private targets. Locating information on comparable acquisitions is invariably easier for transactions involving public targets (including private companies with publicly registered debt securities) due to SEC disclosure requirements.
The Cost of Debt and Non-Equity is the marginal return currently expected by the providers of that capital (i.e. based on current risk factors). The Cost of Debt, therefore, is the market required rate of return1 the yield for equivalent maturity government bonds (the risk free rate) plus a premium for the borrower's risk of default and other risks. If quoted debt securities are priced at par, the yield and Cost of Debt would equal the coupon rate. For bank loans and overdrafts, the effective cost will be the current required floating or fixed rate, unless the redemption amount is at a premium or discount to the nominal value of the debt (the IRR would need to be used). For private companies, the marginal medium to long term Cost of Debt could be estimated by assuming a given credit rating for the company and determining the implied Cost of Debt from quoted bond yields on similar rated debt.
Lack of knowledge about the local rental market, which results in rental units being rented at below-market rental rates This produces a breakeven cash flow, which is barely enough to pay for maintenance and debt service when the property is at 100 percent occupancy. Any vacancy causes cash flow problems that must be covered by the property owner. 3. Failure to respond to tenants' routine maintenance requests in a timely manner This causes tenant turnover and vacancies, which increases the negative cash flow that the owner must subsidize in order to maintain the property and pay the debt service.
If you understand and improve your qualifying ratios, you will raise the odds for loan approval and increase the amount the lender will loan you. Strong ratios may also help you slice your interest rate and your mortgage insurance premiums (if any). Both the housing cost ratio and the total debt ratio give lenders a way to measure whether your income looks like it's large and dependable enough to safely cover your mortgage payments, monthly debts, and other living expenses. Because the lender your talking with has set a housing cost guideline ratio of 28 percent, your numbers look like they might work. So we next turn to the total debt ratio. Total Debt Ratio The total debt ratio begins with your housing costs and then adds in monthly payments for all of your monthly payments (other mortgages, credit cards, student loans, auto loans, etc.). At present, say your BMW hits you for a payment of 650 a month, the Taurus another 280. Your credit card and department store...
Compound interest also works against you. When you owe money, compounding more frequently translates into greater interest. For example, home mortgage debt is usually subject to monthly compounding. Your monthly interest consists of one-twelfth of the annual rate, multiplied by the loan's balance forward. This explains
The blanket mortgage may cause an overextension of the debt against the properties. This can lead to the inability to meet the debt service. This is a potential problem whenever debt reaches high loan-to-value ratios. The mortgagee (seller or someone else) can take all the precautions possible to ensure that this does not happen. However, if the investor has little capital invested, the security may disappear relatively quickly. For example, Curtis purchased a 15- unit apartment house that had a fair market value of 800,000. Already in existence was a first mortgage of 550,000 held by a former owner. To close the deal, Curtis offered a second mortgage in the amount of 250,000 that would be secured by his remaining equity in the 15- unit complex he was purchasing and a second position on a vacant tract, which Curtis valued at 150,000. That property already had an existing first mortgage of 75,000.
To calculate total debt ratio, lenders usually divide your monthly payments into two types (1) installment debt, which includes loans you're paying off such as autos, boats, medical bills, and student loans, and (2) revolving (or open) accounts which include Visa, Mastercard, Amex Optima, Home Depot, Texaco, and any other credit line that remains open until you or your friendly creditor closes it.
Look to the wraparound as a solution. In essence, there are only a few ways to increase cash flow. Assuming a status quo in all other factors, the increase of income will accomplish this. If this fails, a reduction of expenses will also increase the cash flow. A combined effect of increased income (via more rents, and so on) and lowered expenses often will solve the problem and make the wraparound unnecessary. Normally, however, the seller has already maximized income and minimized expenses. The resulting NOI can only show an increased cash flow based on lowered debt service. The yield resulting from the cash flow, based on the invested capital, must meet the investor's demand rate (at the price the seller is willing to sell at). In the general marketing of an income property, the cash down is often based on the seller holding some paper, or with new financing necessary. The cash flow yield may be too low with new financing at high market rates, to warrant the investment. The...
Your lender will use a debt coverage ratio (DCR) to help figure out whether a multiunit investment property will yield enough net operating income (NOI) to cover the debt service and still leave some margin of safety.4 Lenders want to satisfy themselves that even if rent collections fall or property expenses increase, you will still be able to make your mortgage payments without dipping into your personal funds. Net operating income (NOI) Annual debt service 4. To investors, the term debt service means the same thing as mortgage payments.
A lender's first checkpoint when determining a property's income is the debt coverage ratio, which is the ratio of net operating income to debt payments. This ratio basically answers these questions Does the property bring in enough money to cover its mortgage or its debt After paying all typical operating expenses, can the monthly income of the property adequately service the monthly debt payment on the property Here's how the debt coverage ratio is calculated Debt coverage ratio net operating income * annual debt service Net operating income is the yearly gross income minus operating expenses. However, don't include any mortgage expenses in this number. Annual debt service is the annual mortgage payments or monthly mortgage payments multiplied by 12. So, for example, if you have a monthly payment of 6,000, the annual debt service is 6,000 x 12, which is 72,000. Commercial lenders figure the debt coverage ratio because they require a minimum ratio to approve a property for a loan....
The second performance measurement is referred to as the cash return on investment, also known as the cash-on-cash return. It is the ratio between the remaining cash after debt service and invested capital, also known as owner's equity. This ratio differs from the net income ROI in that it excludes all noncash items, such as depreciation expense, and includes the nonincome portion of loan payments that are made to principal loan balances. As a general rule, investors tend to focus more on this performance measurement than they do on the net income ROI measurement since it represents the cash return on their investment. remaining cash after debt service The cash ROI, then, is the ratio between the remaining cash after debt service and invested capital, or owner's equity. This performance ratio is important to investors because it measures the monthly and annual cash returns on the cash they have invested.
Yet, the developer may not fare too badly either, and can cash out ahead of the project and still have control over the improvements. The cost of carrying the land and paying the portion of debt service that applies to the land lease will never retire any principal, and the ratio of constant to remaining balance of any comparison mortgage will increase faster than in a mortgage without a land lease. However, the developer may not have any of its own capital invested in the land portion of the project, and as long as the rent comes out of rents, well then, it is the tenants that are paying the lease payments.
Certain financial techniques or changes in capitalization are measures costly to the raiders. A poison pill is a right distributed to shareholders that allows them to buy additional shares triggered by certain events. Similarly, poison securities take on deterring character when the company is under siege. Poison shares are preferred stock with super-voting right, triggered by unwanted takeover attack. Poison puts are attachments to debt securities, triggered by a change of control, making it less attractive for a takeover. Capitalization changes include multiple classes of common stocks, with one class superior to the other in voting rights. Also, financial engineering techniques may produce temporary changes in capital structure. The techniques include leveraged recapitalization, self-tenders (large-scale repurchase), employee stock ownership plans (ESOPs), pension parachutes, and severance parachutes (golden parachutes).10
After a strong seven months, sterling's fundamentals began to deteriorate due to prolonged declines in housing prices, a struggling banking sector suffering from dried-up liquidity, and a near collapse of the nation's biggest mortgage lender, as well as eroding confidence among households and businesses. Personal debt had been stretched to the extent that the savings ratio headed below zero, a level not seen since the late 1980s, while household debt service soared to 14 percent of incomes, the highest since 1991. House price indexes began showing three consecutive monthly declines, a pattern not seen in over 12 years. With over a million fixed-rate mortgages due for reset in 2008, the risks to UK personal debt were considerable and also for consumer demand. Estimates placed the number of homes to be repossessed in 2007 at 30,000 to 45,000 in 2008, the highest since the property crisis of the 1990s. In other sectors of the economy, the services sector dropped to its lowest level in...
One of the most profitable opportunities you miss when seller financing is not a part of your investment strategy is the chance to buy back your own mortgage debt later on from the seller. During the course of 20 years or so, many things will change. For example, a seller who is only too happy at the time of the sale to receive monthly payments for the next 20 years may suddenly find himself in a cash bind several years down the road. Money shortages are quite commonplace for all of us. Things like death, divorce, college funds, lifestyle changes, and loss of employment or income can quickly create a serious need for immediate cash.
Several financial risk variables for Walgreens, its industry, and the aggregate market are shown in Exhibit 15.15. Notably, these do not consider fairly large leases of stores. The firm's financial leverage ratio (notably, total assetsIequity) has recently been less than 2.00, which is comparable to the industry and definitely lower than the aggregate market. Walgreens has a very large interest coverage ratio, a cash flowIlong-term debt ratio of over 300 percent, and a cash flow total debt ratio of about 30 percent. These financial risk ratios indicate that Walgreens has comparable financial risk to its industry and substantially lower financial risk than the aggregate stock market. In contrast, as shown in Chapter 10, when the leases are considered as they should be, the firm's financial risk is equal to, or somewhat higher than the market.
If more than 25,385,000 of debt is issued in substitution for stock there is a significant likelihood that the firm would not be able to pay the contractual debt payments. This conclusion is based on the market's valuation of the unleveraged firm, thus includes the market's risk perceptions.
There's no magic system that you can use to buy a property from owners facing foreclosure. These owners are plagued with financial troubles, personal anguish, and indecisiveness. In addition, they probably have been attacked by innumerable foreclosure sharks, speculators, bank lawyers, and recent attendees of get-rich-quick foreclosure seminars. These owners are living with public shame. For all of these reasons and more, they are not easy people to deal with.
Jayco, Inc. currently has a debt asset (D A) ratio of 33.33 percent but feels its optimal D A ratio should be 16.67 percent. Sales are currently 750,000, and the total assets turnover (sales assets) is 7.5. If Jayco needs to raise 100,000 to expand, how should the expansion be financed so as to produce the desired debt ratio Finance Debt Ratio Expected Dividends Cost of Equity After the expansion, the value of the assets will be 200,000 100,000 + 100,000. The amount of debt required to have the desired debt ratio of 16.67 percent is determined as This means that the current level of debt, 33,333.00, will be all that is necessary to have a debt ratio of 16.67 percent after the expansion. So, the expansion should be financed entirely with equity.
In order to continue, you must calculate the annual debt service. Your first mortgage has a monthly payment of 3,400 and you are making these payments for the entire year. Your new second mortgage calls for a Annual Debt Service (3,400 x 12) + (700 x 6) Annual Debt Service (40,800) + (4,200) 45,000 less Debt Service 45,000
Fascination, one product of which is one of the more surreal museums I have visited, one devoted to external debt. Housed in the basement of a building used by the economics department of the University of Buenos Aires, the debt museum takes as its mission to explain how Argentina's indebtedness to foreign debtors ebbed and flowed through the 1980s and 90s. This museum, a joint venture between the University of Buenos Aires and the local government, depicts the economic changes of the last quarter century in Argentina to explain how it became so indebted, from the debt crisis of the 80s, to the increasing multilateral loans which supported the dollar-peso currency peg. One of its most powerful sections is a black hole out of which one can pull examples of all the public goods such as health, education and infrastructure on which spending was cut to maintain debt payments. The museum fulfils a role to encourage debate on the economic condition when I visited, it was the site of a...
Various types of corporate debt securities are available to allow corporations to match their financing requirements with investor needs. This section reviews the major types of corporate debt instruments commercial paper, medium-term notes, and various types of corporate bonds.
Conversely, trouble in the auto industry is a red flag for trouble in the general economy. If auto repossessions and car loan delinquencies are rising, that's a warning about general economic weakness. In early 2005, some weakness definitely showed up in the auto industry as GM and Ford continued to have financial troubles.
They also look at a number of financial ratios like interest coverage, cash flow as a percentage of total debt, and long-term debt as a percentage of capitalization to rate an issue. The amount of debt a project can support depends on the amount of cash flow the project can generate to service debt - interest and principal, credit support available to the project, and the lender's coverage requirements. Two ratios are widely used to measure a project's ability to service debt interest coverage ratio and debt service coverage ratio.
Llli Investors can do very well buying a depressed REIT in hopes of a turnaroundbut they should be aware of the risk
Many apparently cheap REITs have potentially serious pitfalls that include unsustainably high dividends, high debt leverage, and suspect managements some even present substantial conflicts of interest issues. REITs like this can be compared to junk bonds high risk sometimes brings high rewards, but sometimes just brings further woes. Proceed with caution.
The value of an asset comes from its capacity to generate cash flows. When valuing a firm, these cash flows should be after taxes, prior to debt payments and after reinvestment needs. When valuing equity, the cash flows should be after debt payments. There are thus three basic steps to estimating these cash flows. The first is to estimate the earnings generated by a firm on its existing assets and investments, a process we examined in the last chapter. The second step is to estimate the portion of this income that would go towards taxes. The third is to develop a measure of how much a firm is reinvesting back for future growth.
Managing exchange rate and commodity price risk Dual currency bonds are bonds offered in one currency while the interest payments and redemption are made in another currency. The issuer offers to make interest and principal payments in some specified list of currencies. The investor has the option to choose the currency DCBs thus reallocate currency risk. Likewise, commodity indexed bonds, bear coupon, and principal payments tied to the price of a commodity to which the issuer has an exposure. The issuer's revenue declines when the price of the commodity falls. So does debt service. In other words, such bonds increase the debt capacity of the company. Floating rate instruments These are debt securities whose coupon rates vary over time according to a predetermined formula. The coupon rate is pegged to a reference rate such as the Prime Rate or London Inter bank Offered rate (LIBOR) or T-Bill rate. The coupon rate equals the reference rate plus a mark up to reflect the credit risk of...
Several examples shown thus far have included land leases as a part of the financing package. In the previous example, Brad owned several different properties, all of which were producing more income than was needed to support the expenses and current debt service that was on the property. This gave Brad a positive cash flow that increased the value of the property substantially over his original cost. He wanted to remove some of this equity, but wanted to keep the cost of the new debt at a minimum.
Example 13 Brad Creates a Land Lease. Brad had a 12-unit apartment building. It was throwing off a net operating income of 46,000. From this, he had existing debt service of 31,000 (which represented annual payments on 305,000 of mortgages). The office building he was trying to buy was offered at 275,000 and was free and clear. The seller demanded a minimum of 150,000 cash down and said he would hold a first mortgage for the balance. That would not work for Brad, so he created a land lease on his apartment building. He sat down with his lawyer and had a simple, but effective lease drawn up. It had provisions that I will show you later on in this chapter, and an annual rent of 11,250 per year. In addition, it had an option to buy the underlying land for 125,000 any time within the first 12 years of the lease, which was a 40-year lease.
Too much debt means that someone will get hurt. As the unprecedented explosion in debt gave a huge boost to the economy in the late 1990s, it now poses great dangers for the rest of this decade. This massive debt problem is obviously tied to the previous topic of real estate. However, it goes much further. Individuals, companies, and government agencies are carrying too much debt for comfort. It's not just mortgage debt it's also consumer, business, government, and margin debt. With total debt now in the vicinity of 40-43 trillion dollars, saying that a lot of this debt won't be repaid is probably a safe bet. Individual and institutional defaults will rock the economy and the financial markets. Bankruptcy will be a huge issue (in spite of bankruptcy reforms that became law on October 17, 2005). Debt will (does) weigh heavily on stocks either directly or indirectly. Because every type of debt is now at record levels, no one is truly immune. Say the stock you have is in a retailer that...
To see how the Acquisition Worksheets can be used in your investment decision making, let's look at two real-life examples. We will be dealing with the same property, but from two different investment points of view. In the first case we will be using the Buy & Sell Worksheet, and in the second case the Buy & Hold Worksheet. Our target property is a 125,000 single-family home. Whether we use Buy & Sell or Buy & Hold, this example will involve Costs of Purchase and Costs of Repairs. In the Buy & Sell analysis (case 1), we will be focusing on our Fast After-Repair Value, Carrying Costs, and Costs of Sale. In the Buy & Hold analysis (case 2), we will be focusing on our Net Operating Income and our Principal & Income (debt service). In both cases we will be looking for and factoring in a Discount Profit Margin of 30 percent for the Buy & Sell and 20 percent for the Buy & Hold. Finally, we are going to assume that we have about 28,000 to put toward either investment.
Introduction The Financial Fragility Hypothesis the offspring of Induced Investment and Business Cycles
As investment decisions are a function of financial conditions reflected in balance sheet structure and projections of cash flows, a firm's survival constraint becomes a serious matter. 'If we begin at any date we have that at each and every future date, in order to survive, the firm must satisfy the condition that the initial cash plus receipts minus the costs payable to that date are greater than zero' (p. 158). To avoid bankruptcy, the firm's cash flows from the sale of output must be greater than production costs and debt service commitments. 'The debts of a firm reflect the conditions that existed in the relevant financial markets at the date the debts were assumed. The survival conditions therefore are measures of the effects that financial and money market conditions have upon the behavior of firms' (p. 202). In this respect, the constraints of survival can be viewed as those of liquidity and solvency. Liquidity is the ability to meet cash commitments (it is hindered when...
That would include adjustments for off-balance sheet liabilities like pension obligations employee stock option debt the current and long-term liability for lease commitments and a reserve-calculated expense and approximation of the value of contingent liabilities. On its Stock Reports, further breakdowns of key ratios (like the debt ratio, current ratio, EPS, and P E) could also be provided on two levels GAAP and core.
The pyramid can be a very safe and profitable way to finance new acquisitions if used conservatively. This means the amount of real equity transferred via a mortgage should be kept at a low to moderate amount. In most cases, the total debt service on the property should not exceed 80 percent of the net operating income of that property. In very stable income properties this percentage may be extended to 90 percent. There should be a 10 percent or greater buffer between income and expenses. In taking over a new property, the buyer should consider out- ofSpocket expenses to bring the income up, and this out-of-pocket must be taken into account before the transaction is completed. It should be figured into the total price or at least accounted for in later expenditures. If the buyer is able to generate this needed out- of-pocket cash from additional financing on the acquired property, then the total debt should be reasonable and not excessively leveraged.
The advantage of the discount sale-buyback or leaseback is the seller can generate capital while retaining interest in the property. If the property sold is vacant land, the seller has the added advantage of getting capital out of the property without having the obligation of meeting debt service.
A futures contract on Treasury Bonds on expiration requires that the Treasury Bond indicated in the contract be delivered to the futures holder. Generally, in a Treasury Bond futures contract the counterparty who has to deliver the securities can choose the treasuries to be delivered from within a basket of predetermined debt securities, so as to avoid short squeezes and preserve market liquidity. On expiration of a Treasury Bond futures, the cheapest to deliver (defined below) securities will be delivered. So upon expiration of the futures contract, the price of the cheapest to deliver bond and the price of the futures contract will converge. Since it is uncertain which bond will be the cheapest to deliver on expiration, this can open up profit opportunities for arbitrageurs.
If you have equity in your current home, you can try to tap into that and take out a home equity loan to purchase a foreclosure as an investment, but we don't recommend that in the current market for two reasons. First, getting a home equity line of credit at the time of this writing is difficult. Second, we believe in being as debt free as possible or at least having a strong debt-to-equity balance. We feel that people should tap into the equity on their own property only for emergencies and not to buy investment property or any other investments.
What if I lend you 500,000 at 10 percent interest and you want to spread your debt service payments out over five years At equal principal repaid each year, the first payment would be 150,000 the first year ( 100,000 is the principal repaid each year, and as the loan is for 500,000 at 10 percent there will be 50,000 in interest added to the principal for the first payment but only 40,000 the second year). The third year would be 100,000 plus 30,000 or 130,000 for that year. I still have a 10 percent return on what I lent you, but if you had purchased an income property you may have a hard time having any positive cash flow for a few years (if ever) with that kind of a repayment schedule. now that the conventional type of mortgage that is used in the United States is amortized over long terms with fixed payments of variable interest and principal. This is a magical form of mathematics that allows a borrower to repay the loan over a long period of time with the same monthly payment....
Redding, an investor, offered to buy a strip store from Shelly. Redding has up to 250,000 in cash and a 150,000 first mortgage he was holding on a vacant piece of land he had sold the year before. This gives Redding a total of 400,000 in equity (cash plus mortgage) to be used to acquire the strip store. Shelly was asking 1,650,000 for the property that had a first mortgage of 1,200,000 and an annual debt service of 120,000. The NOI of the store was 145,500, and a cash flow of 25,500 ( 145,500 less 120,000 25,500). Her equity (at the price offered) was 450,000, and if Redding paid 450,000 (in cash or combination of cash and other benefits), his cash flow would be 5.67 percent return. (What return is 25,500 on 450,000 invested Divide 25,500 by 450,000 to get 0.0567, which is 5.67 percent.) Redding made the following offer to test the water
The Financial Times of July 25, 2000, reports a legal loophole in the Russian capital market that can leave stockholders with nothing if the company has a cash flow problem. In the United States, if a company is not able to make debt payments, the company can first try to work out the payments privately. If that does not work, then the company enters bankruptcy proceedings, where the legal system decides the allocation of the companies remaining assets. The US legal system, with its large army of expensive lawyers, is often not seen as the most efficient method of resolving conflict, but one can see some benefits when compared to the risky Russian system, which fails to protect investors (who can afford lawyers). The Russian system reported on in the Financial Times article, Russian Oligarchs Take the Bankruptcy Route to Expansion, is a simpler bankruptcy proceeding. When a Russian company cannot make debt payments, the debt-holders take the company to court and receive ownership of...
It is difficult to measure the entire market of distressed securities, mainly due to the lack of transparency. Whereas information on the amount of public debt or defaulted shares is readily available, similar data are not available on privately placed debt securities or bank loans.
I n the table of constant annual percentages, you would look in the 10 percent interest column for the 15 years. The answer would be 12.895, representing the constant amount of annual payments (which consist of 12 monthly installments) to pay off any mortgage in full within 15 years. As the example we will use has a face amount of 150,000, that amount times the constant of 12.895 will require a total annual debt service of 19,345 from 12 monthly installments of 1,611.87.
To counter this problem, we consider a broader definition of cash flow to which we call free cash flow to equity, defined as the cash left over after operating expenses, interest expenses, net debt payments and reinvestment needs. By net debt payments, we are referring to the difference between new debt issued and repayments of old debt. If the new debt issued exceeds debt repayments, the free cash flow to equity will be higher. Free Cash Flow to Equity (FCFE) Net Income - Reinvestment Needs - (Debt Repaid -New Debt Issued) FCFEBoeing Net Income - Reinvestment Needs - (Debt Repaid - New Debt Issued) 1,614 million - 1,876 million - (8 - 246 million) - 24 million Clearly, the Home Depot did not generate positive cash flows after reinvesment needs and net debt payments. Surprisingly, the firm did pay a dividend, albeit a small one. Any dividends paid by the Home Depot during 1998 had to be financed with existing cash balances, since the free cash flow to equity is negative. A firm is...
The first is the probability of default, N(-d2). The second is the loss when there is default. This is obtained as the face value of the bond K minus the recovery value of the loan when in default, VerTN(-d1) N(-d2), which is also the expected value of the firm in the state of default. Note that the recovery rate is endogenous here, as it depends on the value of the firm, time, and debt ratio.
Another important area to test on the balance sheet is trends in capitalization. A corporation funds its operations through equity (capital stock) and debt (notes and long-term bonds). The higher the debt, the greater the future burden on operations. Not only do these debts have to be repaid, but interest has to be paid to debtors as well. The greater the percentage of debt as part of total capitalization, the more profits have to be paid out in interest. This means that as debt rises, less profit remains for future growth or to pay dividends. An exceptionally high debt ratio is a sign of trouble. And if the debt ratio is rising each year, that means the problems are getting worse. The trend in all these instances is the key. GM reports a steadily rising debt level and 91 of total capitalization in the form of debt. Ford's debt is declining but remains at 83 as of 2005. Lucent's case is problematical for any analyst. How (and why) did the debt level go from 20 to 258 of total...
HELOCs are being advertised on television as a way to consolidate debt, but they can be used much more effectively by investors. When you need cash in a hurry for a short period of time, a HELOC can be very useful. For example, if a seller tells you to give him 75,000 cash on Friday and I'll sell you my house for a song, you need to act in a hurry. Another example of cash in a hurry is a foreclosure auction, which, in many states, requires payment at the end of the day of the auction. When you need cash in a hurry, there's no time to go to the bank.
Such as under Chapter 7 or 11 of the US Bankruptcy Code. A broader definition may also include debt securities that are publicly held and traded at a big discount to their issuing price, and that, if the issuer does not default, offer a significant yield (yield-to-maturity), typically 10 over comparable maturity US Treasury Bonds. But distressed securities can also include those bank loans and other privately placed debt of the same or similar entities with rather acute operating and or financial problems.
Assume you are looking at an office building that is offered for sale at 6,000,000. The property has a 10 percent vacancy factor, and yet is throwing off an NOI of 540,000. You know you can borrow 4,800,000 at a constant annual debt service of 8.29 percent, which will cost you 397,920 per year (this relates to an interest charge of 6.75 percent over a 25-year amortization). If you could purchase the building for 5,500,000 by investing the difference of 700,000, your cash flow is 142,080. This is an excess of 20 percent yield on your invested capital. You make that offer, but the seller tells you they are absolutely firm on the price of 6,000,000. However, by now you have learned that You have reduced your requirement for the first mortgage because you can now borrow at a constant of 7.92 percent, which relates to 6.25 percent interest over 25 years. You offer the seller an interest only payment schedule of the same 6.25 percent on the mortgage. That would mean that your overall debt...
The after-tax cost of debt securities represents the cost to the firm of borrowing funds at current yields in the debt markets after taking into account the tax deductibility of interest-to-finance investments for the operation of the company. Because a company's debt securities are risky investments (although not as risky as its common stock), the after-tax cost of debt primarily is a function of three variables the current yields associated with comparable-maturity risk-free debt, the default risk associated with the specific company's debt, and the company's income tax rate.
The debt service on the existing 3,050,000 mortgage is 320,000 per year. Charles reports that the operating expenses and taxes and the like total another 380,000 per year. Gross revenue at the moment is 850,000. First mortgage payment of principal and interest Second mortgage interest only payment Total annual debt service
With gold's impressive performance in 2003, and continuing in 2004 with copper and oil up around 45 percent, deflation is dead and inflationary pressures are bound to build along with further moves in commodities. While Fed officials have indicated their willingness to hold rates steady, negative real rates cannot last forever in the face of widening fiscal and trade deficits. The balance of risks clearly points to upside in U.S. yields across the entire maturity spectrum and to a classical flattening of the U.S. yield curve. Not all is great in the U.S. economy, however. Consumer debt, both secured and unsecured, now represents 82 percent of GDP. This level is considered excessive by many economists, and there are fears that rate hikes will increase the burden of already leveraged consumers, causing consumer spending to decline. Because of debt fears, the absence of material inflationary pressures, the U.S. industry operating at only 75.7 percent of capacity as of November 2003, and...
The best way to determine default risk is to see how a particular company's debt trades in the market and compare it on a spread basis to comparable-maturity Treasury yields. A small number of debt issues are traded on the New York Stock Exchange. Quotes for listed, publicly traded debt are often available on free Web sites, like Yahoo, in their finance sector. In a pinch, you could always resort to a good financial newspaper, like the Wall Street Journal or Investor's Business Daily for debt quotes. Many companies will not have outstanding debt that is listed or traded on an exchange. Their debt securities will trade in the dealer-to-dealer market, and trade data and market quotes may not be available to the general public.
There are two ways in which we can estimate the probability that a firm will not survive. One is to draw on the past, look at firms that have failed, compare them to firms that survived and look for variables that seem to set them apart. For instance, firms with high debt ratios and negative cash flows from operations may be more likely to fail than firms without these characteristics. In fact, you can use statistical techniques such as probits to estimate the probability that a firm will fail. To run a probit, you would begin, for instance, with all listed firms in 1990 and their financial characteristics. Identify the firms that failed during the 1991-99 time period and then estimate the probability of failure as a function of variables that were observable in 1990. The output, which resembles regression output, will then let you estimate the probability of default for any firm today.
Suppose we take a random sample of 30 companies in an industry with 200 companies. We calculate the sample mean of the ratio of cash flow to total debt for the prior year. We find that this ratio is 23 percent. Subsequently, we learn that the population cash flow to total debt ratio (taking account of all 200 companies) is 26 percent. What is the explanation for the discrepancy between the sample mean of 23 percent and the population mean of 26 percent
The CAD II allows national regulators to exempt banks from calculating counterparty risk in respect of cleared OTC trades if they meet the margin requirements of the clearing house with debt securities issued by Organisation for Economic Cooperation Developments (OECD) governments.
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