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EC223 chapter11 - 1 Chapter 11 Learning Objectives The...

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Chapter 11: Learning Objectives The Leverage Concept The Production-Investment decision: no leverage, leverage, with spread The Irrelevance Proposition Does how you borrow matter? Tobin’s q : An Investment Rule 2
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Leverage Making investments or buying assets with borrowed funds with the objective  of profiting from the difference between the yield or return on the  investments (or assets) and the cost of borrowed funds.  One way in which a bank borrows by taking deposits from clients.  If a bank borrows at a rate of  R DEP   while lending at a rate of  R L  then     . The  spread  between borrowing and lending rates must be positive for the  financial institution to make a profit.  Leverage ratio is defined as  Debt/Equity  where equity corresponds to  ownership.  Leverage ratio increases as interest rates increase.  The greater proportion of assets financed through debt, the higher the  Leverage ratio.  A rise in the Leverage ratio signals a greater reliance on debt to finance  asset purchases.  The greater the leverage ratio the more leveraged the firm.  R L > R DEP 3
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Leverage Some analysts prefer to look at capital ratio as an  indicator of leverage.  Capital ratio= equity/assets Capital ratio falls as interest rates increase due to  the larger decrease in equity compared to decrease  in assets.  The lower the capital ratio the more leveraged the  firm. As a result, a fall in capital ratio gives the same  signal as a rise in the leverage ratio: a bank that is  less sound following the rise in interest rates.  4
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The Bank for international settlements BIS capital convergence requirements BIS is an international central bank for central banks.  Unfortunately some banks in their pursuit of profit and market share create  great risk for share holders.  Central banks and the agencies responsible for supervising the banks  agreed that there was a need for the methods used by authorities to assess  risks of all kinds to converge with those used in the private sector.  The original BIS capital standards, called the capital convergence  requirements, were phased in 1990s  and were developed to prevent one  country from taking advantage of lower capital-asset requirements of  another.  BIS’s capital adequacy standards consist of 3 pillars: 1. Minimum capital requirements 2.
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