Question in SS13 Alternative Investment - Reading 39

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MissSongJ

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Hi guys
I have a question in EOC problem in ss13, reading 39 in Schweser notes (Alternative Investment - Private Real Estate Investments):
[question removed by admin]
I know a and b are wrong, and leveraged IRR is greater than unleveraged IRR, but not sure why c (For a property funded with debt, a change in NOI will result in a more than proportionate change in cash flow) is corret. The solution says Financial leverage magnifies the effect of changing NOI on cash flow because the interest expense owed to lenders is a fixed cost. I’m not sure that answers the question. Can any one please help?
Thanks in advance.
Song
 
You have to go back and understand the concept of leverage/gearing.
When you take out a loan (a debt) you are bound to pay interest, which is normally a fixed rate. No matter how your income changes, your interest expense remains the same. If you make abnormal profit before expense, the interest expense is relatively small and your profit is big. If you make a loss before interest, the fixed interest still adds to the loss and you end up with a bigger loss.
Google “financial gearing” to understand how leverage works and then it will make all sense.
 
Thanks krokodilizm. I understand the concept of leveraging / gearing as you’ve explained, but I’m not too sure how to link it to NOI and cashflow here. If I have debt obligation, why would a change in NOI will result in bigger proportionate change in cashflow? Assuming I’ll have to pay interest in cash with or without the NOI change…
 
If you recall degree of operating leverage (DOL), degree of financial leverage (DFL), and degree of total leverage (DTL) from Level I Corporate Finance, you’ll see that they’re talking about DFL here: fixed costs increase leverage.
I wrote a series of articles on these that may be of some help here:
 
Thanks for the links, I think it starts to make sense but I still have a few doubts. NOI doesn’t include interest expenses and tax, hence it’s more like EBIT in the DFL equation, which is the denominator. With leverage, DFL >1.0, hence numerator changes more than denominator, hence cash flow should change more than NOI does?
I’m probably making the question more complicated than necessary but I really want to understand it better.
 
I think what is confusing in the question is the use of cash flow whereas in a broader sense they mean net profit. So if DFL=1, 1% change in NOI equals 1% change in net profit (let’s call it cash). If DFL=2, then 1% change in NOI will change net profit by 2%.
If you want to speak strictly in terms of cash flows then perhaps we can incorporate FCFF using net income approach
Unleveraged FCFF = NI + NCC - FCinv - WCinv + 0(1-t)
Leveraged FCFF = NI + NCC - FCinv - WCinv + int(1-t)
 
After re-reading option C, I realised I had mis-read it earlier on. So yes I agree, 1% unit change in NOI (denominator) will result in a more than 1% change in cash (numerator). C is right. My bad. It is very confusing to use cash and net profit interchangeably under this context…I hope during the exam the questions won’t be so ambiguous.
Thank you guys for your help!
 
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