To: MichaelW who wrote (51635 ) 7/16/1998 12:52:00 PM From: Chuzzlewit Respond to
Michael, there's nothing wrong with that strategy. That's the pristine way to increase your leverage. You increase debt and decrease your capital. That way you increase return on capital. Here's an example: You have a company with assets of $1BB, liabilities of 250MM and capital of 750MM. Let's say earnings are $150MM, so return on equity is 20% (150/750). Now lets say that the company decides to borrow $250MM and retire 250MM in equity. Now let's say that the debt is at 6% per annum, and that earnings grow at 15% (before interest). That means that next year earnings before interest will rise to 172.5MM. The interest on the debt will be 15MM, but since interest is a tax-deductible item, and assuming a 30% statutory rate (for ease of calculation) the after-tax effective interest will be 70% of 15MM, or 10.5MM. Thus the earnings after taxes will be $162MM. But look at the effect on return on capital. We will now have an ROI of 24.9% ($162/650).
