As Oxford’s poet-philosopher Ludovic Phalippou once put it, “we are all just levered monkeys!”
What did Phalippou mean by this comment?
Well, as I explained to my corporate finance students this week, the use of debt by companies is called “financial leverage”. That is, debt acts like a lever which can magnify the size of both gains and losses.
Imagine that you are the CEO of Apple Corporation and require a return on investment of 10%. There is a new venture you can undertake that will generate a return on assets of 2%, but you can currently borrow money at an interest rate of 0%, and so you can use debt to help you achieve your required return.
You decide to go ahead with the project, and the numbers look something like this:
Venture – Debt = Investment
$1 million – $800,000 = $200,000
EBIT – Interest = Income
$20,000 – $0 = $20,000
ROI = Income/Investment = 10%
Bravo!
In this very simple example (which ignores things like taxes and capital gains), you have successfully used debt to increase your return on investment from 2% to 10%.
As I mentioned in an earlier post, central banks in some of the world’s major economies are keeping interest rates at record low levels. And in a few places (like Japan, Europe, and Switzerland) interest rates are negative.
Since debt can be used to magnify investment gains, central banks are no doubt hoping that businesses will take advantage of lower interest rates to increase investment and thereby stimulate the economy.
However, record low interest rates can’t last forever.
When will central banks return interest rates to more normal levels?
This past week there was talk about whether the Fed would raise interest rates in September. Jamie Dimon, CEO of JPMorgan Chase, argued that the Fed should raise rates sooner rather than later. However, Goldman Sachs reduced the chance of an interest rate hike in September from 40 percent to 25 percent; while at the same time increasing the odds of an increase in December from 30 percent to 40 percent.
Nobody knows exactly when central banks will start to increase interest rates again, but it seems that it could happen in the not too distant future.
As the CEO of Apple Corporation, you had managed to achieve your required rate of return of 10%, and you were feeling pretty pleased with yourself. However, imagine now that the central bank decides over the course of a few short years to increase interest rates back to a more normal level of, say, 4%.
What happens to your return on investment?
Venture – Debt = Investment
$1 million – $800,000 = $200,000
EBIT – Interest = Income
$20,000 – $32,000 = -$12,000
ROI = Income/Investment = -6%
Bazinga!
As a result of rising interest rates, the return on investment for your venture has fallen to minus-6%. This is below the return on assets of 2%, and even further below your required return of 10%.
What can we learn from this simple example?
Well, one of the goals of central banks, in keeping interest rates at record low levels, is to stimulate the economy. This should work because lower interest rates reduce the required rate of return, as we saw in our example. However, by encouraging business leaders to undertake projects that offer low returns, it may be that central banks are sowing the seeds of the next downturn.
They have to raise interest rates at some point, and when they do, businesses who have taken advantage of financial leverage to pursue projects with low returns will have their losses magnified.
The more debt a business has used, the more pain it will feel.
Silly monkeys!
(Image Source: Flickr)
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