How much debt is too much?

 Finding the correct balance between debt and equity is a problem commonly faced by many companies. Choosing to finance mainly through debt is often seen as the safer option as a large amount can be borrowed, for relatively low returns. In comparison, equity is more expensive and viewed as being more risky. Due to the increased risk, investors want higher returns and as a result reduce the owner’s control of the company. Additionally, debt is tax deductible, whereas dividends are not. By taking on more debt, the gearing of the company will increase, which will in turn reduce the Weighted Average Cost of Capital, increasing the overall value of the company.

So, everything is pointing towards using debt rather than equity, right? Unfortunately, it is not always that simple. American Apparel took on so much debt, that it had to file for bankruptcy in October 2015. A plan has been agreed with creditors to swap $200 million of debt for equity, and extension of $90 million in debtor-in-possession financing and $70 million in new capital. It is believed that this plan will help reduced the level of debt by 70% to $135 million and cut interest payment by $20 million. I think these figures truly highlight how wrong American Apparel had going with their financing and level of debt, and also show how damaging high levels of debt can be for a company. Quite how long it will take American Apparel to sort this out, if they can, I really don’t know. 

So, why would management at American Apparel allow such a highly geared capital structure? Modigliani and Miller argued in 1958 that the capital structure of a company has no impact on the WACC. Therefore the total market value of the company is not affected by the capital structure, whether this is financed through debt or equity. However, this theory was highly criticised, based on a number of assumption the M&M made. Notably, that there was no taxation and no costs of financial distress and liquidation. Following this, M&M revised their initial theory in 1963 and took a more real world approach, taking tax into account. Debt is a tax deductible expense, which is another added bonus to financing through debt, as opposed to equity. M&M (1963) suggested that if you increase the level of gearing within a company, WACC will be reduced, and as a result the total market value of the company will increase.

Taking this into account, I can understand the reasoning behind American Apparel’s financing. The after-tax cost of debt is cheaper than equity and ideally they just wanted to lower WACC and increase their market value. However, what was not taken into account was the cost of financial distress and potential for liquidation. American Apparel should have also looked into the market conditions and possibly how competitors were financing their companies, before taking on too much debt. 

Personally, I do not believe that financing a company solely using debt is a good idea. Yes, it may help reduce WACC and increase the market value in the long run, but how do you expect to attract potential investors when all you have backing you up is a whole lot of debt? Obviously, this is something that can vary drastically between industries and markets, but maybe in this case it should be more about fitting in with what others are doing, rather than trying to stand out.

Madoff Hustle: How do you make $64 billion just, disappear?

  "He was an equal opportunity thief..."

People often hear about money scams in the news and think "I would never be stupid enough to fall for that", however when a scam is so cleverly thought out and manipulated, and it appears to be a solid safe investment, do you really have 'stupid' to fall for it?

Bernie Madoff is regarded as the greatest conmen of all time and was the mastermind behind one of Wall Street's biggest Ponzi schemes. What is surprising, yet could have also contributed to his success, is that he was one of the people working on Wall Street that you would least expect to conduct a scam such as this. He was seen as the "gold standard" of Wall Street and was highly regarded, seen as a reputable family man. Due to this reputation, he was able to draw potential investors in, gain their trust and make them believe that their money would be safe with him. Little did they know, exactly the opposite was true!

This brings me on to the "3 key rules of the long con" highlighted throughout the programme:

1.  If something looks too good to be true, it probably is
2. Everyone wants something for nothing, you just give that nothing for something
3. You can't cheat an honest man (said to be the most important)

 

 

Firstly, the scam was shown to give steady returns of 1% each month, year after year. These were consistent, whether the market was going up or down. This is a modest return on an investment and would likely to be far lower than others around the same time, however what drew people in was the guarantee of consistent returns. It does not appear that this is a case of people being greedy and wanting to gain high returns for very little, just that naïve people put their trust in someone who appeared to be an expert in the area and what to gain a safe, steady return on their money. Indeed, the scheme almost seemed too good to be true and, unfortunately, in this case it was!

Secondly, Madoff convinced his clients that they would be getting steady returns for very little risk, when in reality they were not getting any returns at all. What was actually happening was Madoff was slowing giving them their own money back, rather than gaining the interest they had been guaranteed. Madoff grew this Ponzi scheme as more and more money came in, through new generations hearing about this desirable high returns. As with every Ponzi scheme, it would collapse when the inflow of cash stopped. This occurred for Madoff during the 2008 credit crunch, when all the marks, or victims as they may be referred, wanted their money back all at once, the scam almost became too big to keep going. As noted above, I don't think that those drawn into the scam were being particularly greedy, and therefore may deserve what they got, but rather they just wanted a safe and steady investment. However, Madoff was taking their money and giving them nothing in return. He was indeed giving them nothing for something.

Thirdly, I feel that the final rule may have been proven wrong in Madoff's case. Yes, there is arguably always an exception to the rule; however in this case there appears to be thousands of exceptions. Perfectly honest victims were cheated out of their money, through no direct fault of their own. However, what can also be said is that a common problem with Ponzi schemes, both back when they first became popular and also in modern day, is that people don't look beyond the promised rate of return. Could it then be said that the victims were maybe not as honest as first thought? Had they looked further than the initial face value of return, would they have spotted flaws within the system?

What stood out for me personally throughout the programme was how ruthless Madoff was with his scam, stopping at nothing to get what he wanted. Nobody was off limits when it came to him conning them out of hard earned money. The most shocking for me, and also notably for those interviewed, was the Elie Wiesel Foundation for Humanity, which was cleaned out of $15million worth of assets. It's one thing to scam the super-rich out of money, and the thousands of 'ordinary' people including friends and family, but to target charities and take money from those is just a whole new level of psychopathy. Did Bernie Madoff really have no morals? At least one thing can be said about him, he was an equal opportunities thief. He didn't care whose money he was taking.

Bernie Madoff has been sentenced to jail time and will spend the rest of his life behind bars. Unfortunately, he is still having the last laugh. In pleading guilty, he did not have to face trial and questioning as to how or why he did it and where in fact all the money has gone. I guess we never will find out his secrets and what possessed him to do what he did.

 

 

Leave a comment below letting me know what you think.

 

A Royal take on Portfolio Theory

"Diversifying risk means holding foreign assets too"

She became our Queen in 1952 and in this time has built a sizeable portfolio of assets and investments. Unfortunately, a number of these assets come with the job and cannot be bought and sold to obtain the best value of portfolio. Not that the Queen really needs to be watching the pennies! Her portfolio mainly includes diamonds, artwork, property, and of course the Crown Jewels. However, seeing at there's not much room for comparison on the jewels themselves, we may need to focus on the gold instead!


Markowitz developed the idea of Portfolio Theory in 1952 (anyone noticing a pattern in these dates?!), suggesting that investors should aim to reduce risk through diversification and holding a range of different investments. Investors should consider the potential returns, risks and standard deviation, and the correlation of a prospective portfolio. Markowitz says that a strong portfolio should contain investments that are not correlated with each other, therefore if one industry faces a fall, the other investments would not be affected by this and still bring in high returns. However, if you believe that an industry is going to continue doing well, why would you invest your money elsewhere?


The sterling price of gold has more than doubled in real terms, therefore excluding the effects of inflation, since the Queen came to the throne. Whilst this shows the benefits of a long term investment, the price of gold has been decreasing in the past five years, therefore suggesting this is not advisable for short term investors. At least not to invest in currently. In contrast, the diamonds have not fared as well and, if anything have suffered the effects of inflation over the same period of time. Personally, I find this surprising. Surely gold and diamonds would follow similar patterns to each other and would be highly correlated?


The key investment within the Royal Portfolio is the collection of artwork which has been gathered over the years. Over the past century this has been one of the best performing assets, bringing in 3% a year above inflation. I'm sure with the extensive collection held within the Royal family, and the extra 3% each year, this will amount to a pretty sizeable return! According to Christophe Spaejers, finance professor at HEC Paris, the price of artwork in London has risen more than 500 fold in nominal terms since 1952, or 20 fold after the affects of inflation.This could be due in part to various artists gaining higher profiles and interest, therefore increasing the value of their pieces of art. Alternatively, it could be argued that those with a keen interest in art are highly educated and subsequently have a high amount to spend on the desired artworks, thus pushing the prices up. The Telegraph also states that has a very low correlation to equity markets, therefore investing in art is an ideal way diversify and give a good overall investment porfolio.


Another crucial investment held is that of the various properties the Queen holds throughout Britain, which have also proven to be good investments over the years. Many of the properties and estates are older buildings and are likely to be graded, adding to their ever growing value. Needless to say, the added detail of them being owned at one point by Royalty will add the their pretty sizeable price tag! Over the years, the older properties, bought or inherited at the beginning of her reign, are estimated to have increased in value 127 fold. Quite whether this is solely due to the general trend of increased house prices, or whether the link to the Royals has something to do with this, I'm not convinced. However, the Queen doesn't show any signs of moving out of Buckingham Palace anytime soon, so her vast collection of properties are likely to bring in even higher returns.

One thing that does need to be noted about the Queen's investment portfolio, in particular the properties, is that it is far too concentrated in the UK. Therefore, should the Queen wish to strengthen her investment portfolio, my advice would be to look into foreign assets and holding more international investments.

Is Markowitz right with Portfolio Theory, is it better to diversify risk and hold a range of investments, or is it better to focus on one industry that is performing well?