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Chapter 11: Financial Leverage

Chapter 11: Financial Leverage. Leverage = Adding Debt Leverage and ATIRR Condition for Positive Leverage: Un-levered ATIRR > (1 – tax rate) * Cost of Debt Leverage will raise returns if the project earns more than the after-tax cost of debt.

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Chapter 11: Financial Leverage

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  1. Chapter 11: Financial Leverage Leverage = Adding Debt Leverage and ATIRR • Condition for Positive Leverage: Un-levered ATIRR > (1 – tax rate) * Cost of Debt • Leverage will raise returns if the project earns more than the after-tax cost of debt

  2. Breakeven Interest Rate: Rate = Un-levered ATIRR/(1 – tax rate) Leverage is wide-spread in Real Estate Leverage raises risk. The risk is possibility that the project will default on the debt and result in foreclosure. Investors may choose to default if the value of the property is though to be less than the value of the debt.

  3. Examples of common financial arrangements: • Equity participation loans • Sale and lease-back of land. Here the developer may be able to borrow back the cost of the land. • Interest Only and Balloon Payment Loans. • Accrual Loans (like GPMs) • Convertible Mortgages, here the lender has a call option on some portion of the equity of the project.

  4. Homework Problems: 11-1, 11-2 (page 390)

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