10 ms·
> Leverage reduces equity value Not at all: Equity = Assets - Liabilities Borrowing money adds an equal amount to Assets and Liabilities. The difference re
by skookumchuck 8y ago
> Leverage reduces equity value
Not at all:
Equity = Assets - Liabilities
Borrowing money adds an equal amount to Assets and Liabilities. The difference remains the same.
- Bud 8y agoWait, was the concept of interest abolished while I wasn't looking?
- skookumchuck 8y agoAccrued interested is added to the Liability as time goes on, but it is not there on Day 0. Furthermore, businesses borrow money in order to use it to increase assets, not just sit in a pile.
- kbenson 8y ago> but it is not there on Day 0. I'm pretty sure there are loans where it is, or at least a portion of it is, or at a bare minimum there's an early repayment fee. It would not surprise me to learn that in the world of business finance, these happen. It also wouldn't surprise me to learn that these are used creatively to shift money between entities.
- skookumchuck 8y agoI've borrowed plenty of money in business without such fees, and I'm a pipsqueak nobody.
- kbenson 8y agoI didn't mean to imply these loans were the norm, just that I believe they exist, while your prior comment seemed to imply they did not.
- GlennS 8y agoThe interest can be treated as finance cost, and amortized over time. Rather than going straight on the balance sheet, it goes on the income statements (which are change in balance sheet) a little bit each statement period. This makes the company's performance look less spiky, making it easier to reason about (from a pure profit/loss perspective, not a cashflow one) and less scary to shareholders. It also matches with the way the rest of the balance sheet is reported (current value). For example: if you have some aspect of the business which you believe will appreciate in value over time, you probably shouldn't immediately book the increase at the as-yet unrealized future value.
- airstrike 8y agoIt didn't, but companies don't issue debt just to have it sit on their balance sheet. Presumably, the additional capital is put to use in projects with an expected return that is greater than the cost of capital (usually the weighted average between (i) the equity holder's required return on equity and (ii) the cost of debt that is usually expressed in the form of the interest rate, to keep it simple). Taking on debt is always done with the purpose of creating value. Sometimes it fails, but that doesn't mean failure was the objective. LBOs aren't evil.
- PakG1 8y agoI know what you're saying, but I think it's easier to conceptualize if you write the equation: Assets = Liabilities + Equity The other way lends credence to the thought that an increase in liabilities requires a decrease in equity. Without knowing how journaling works, I think such an error would actually be quite logical.
- skookumchuck 8y agoIt's still an error. What would you think of a person who confidently made erroneous assertions about the relationship between Volts and Amperes? As V=IR is the most basic equation in electricity, A=L+E is the most basic equation in business. It's necessary to understand them in order to pontificate about them, instead of just making things up.
- Spooky23 8y agoAll things remaining equal, yes that’s the accounting 101 definition. When you’re talking private equity LBO activity, all things are not equal.