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are there regulatory requirements for using the lehman formula | while there may not be specific regulations dictating the use of the lehman formula regulatory bodies may scrutinize compensation arrangements including those based on the formula to ensure they do not encourage excessive risk taking or unethical behavior the bottom linethe lehman formula is a method used in financial transactions particularly in investment banking to calculate compensation based on the transaction s value it employs various methods such as mda tva and pva to determine fees or commissions aligning compensation with the size and structure of the deal the formula can be customized per deal though firms must be mindful of misalignment of incentives | |
what is a lemon | the theory of lemons was put forward in a 1970 research paper in the quarterly journal of economics titled the market for lemons quality uncertainty and the market mechanism written by george a akerlof an economist and professor at the university of california berkeley 1 a lemon problem arises regarding the value of an investment or product due to asymmetric information possessed by the buyer and the seller asymmetry of informationnobel prize recipient george akerlof examined the used car market and illustrated how the asymmetry of information between the seller and buyer could cause the market to collapse getting rid of any opportunity for profitable exchange and leaving behind only lemons or poor products with low durability that the buyer purchased without sufficient information 1asymmetrical information means that buyers and sellers don t possess equal information required to make an informed decision regarding a transaction the seller or holder of a product or service usually knows its value or at least knows whether it is above or below average in quality potential buyers however typically lack this knowledge and can only rely on the seller s information used car exampleakerlof s example of the purchase of a used car noted that the potential buyer of a used car cannot ascertain the value of the vehicle therefore they may be willing to pay no more than an average price which they perceive as between a bargain price and a premium price 1adopting such a stance may offer the buyer financial protection from the risk of buying a lemon akerlof pointed out however that this stance favors the seller since receiving an average price for a lemon would still be more than the seller could get if the buyer knew that the car was a lemon ironically the lemons problem creates a disadvantage for the seller of a premium vehicle since the potential buyer s asymmetric information and the resulting fear of getting stuck with a lemon means they are unwilling to offer a premium price for a vehicle of superior value the u s lemon law that sets regulations for consumer products covered by written warranties is found in title 15 chapter 50 of the u s code in sections 2301 2312 also known as the magnuson moss warranty federal trade commission improvements act 2protection from lemonsthe lemons problem exists in the marketplace for consumer and business products and investing related to the disparity in the perceived value of investments between buyers and sellers the lemons problem is also prevalent in the financial sector such as the insurance and credit markets for corporate finance a lender has asymmetrical and less than ideal information regarding the actual creditworthiness of a borrower akerlof proposed strong warranties to thwart the lemons problem as they can protect a buyer from any consequences of buying a lemon another solution akerlof did not know when he wrote the paper in 1970 is the explosion of readily available information disseminated through the internet information services such as carfax help buyers feel more confident by providing a vehicle s history 3 | |
what is the lemons theory | the basic tenet of the lemons principle is that low value cars force high value cars out of the market because of the asymmetrical information available to the buyer and seller of a used car this is primarily because a seller does not know the value of a used car and therefore is unwilling to pay a premium on the chance that it might be a lemon premium car sellers are not willing to sell below the premium price so only lemons are sold | |
what percentage of new cars are lemons | it is estimated that each year approximately 150 000 cars 1 are considered lemons however it is believed that the number is probably higher due to people not reporting defective cars or not being aware of the extent of the defects 4 | |
what are lemon laws | lemon laws help provide a solution and protection for purchasers of cars and other goods they implement compensation programs for buyers when the products fail to meet quality and performance standards the bottom line lemon commonly refers to a vehicle with defects that negatively impact its worth the lemon theory was described by nobel prize recipient george a akerlof an economist who noted the asymmetric information available to the buyer and seller when purchases are made in the marketplace | |
what is a lender | a lender is an individual a group public or private or a financial institution that makes funds available to a person or business with the expectation that the funds will be repaid repayment will include the payment of any interest or fees 1 repayment may occur in increments as in a monthly mortgage payment or as a lump sum one of the largest loans consumers take out from lenders is a mortgage 2understanding lenderslenders provide funds for a variety of reasons such as a home mortgage an automobile loan or a small business loan the terms of the loan specify how it must be satisfied e g the repayment period and the consequences of missing payments and default a lender may go to a collection agency to recover any funds that are past due | |
how do lenders make loan decisions | qualifying for a loan depends largely on the borrower s credit history the lender examines the borrower s credit report which details the names of other lenders extending credit current and previous the types of credit extended the borrower s repayment history and more the report helps the lender determine whether based on current employment and income the borrower would be comfortable managing an additional loan payment as part of their decision about creditworthiness lenders may also use the fair isaac corporation fico score in the borrower s credit report 3the lender may also evaluate the borrower s debt to income dti ratio which compares current and new debt to before tax income to determine the borrower s ability to pay 4 | |
when applying for a secured loan such as an auto loan or a home equity line of credit heloc the borrower pledges collateral the lender will make an evaluation of the collateral s full value and subtract any existing debt secured by that collateral from its value the remaining value of the collateral will be the equity that affects the lending decision i e the amount of money that the lender could recoup if the asset were liquidated 3 | the lender also evaluates a borrower s available capital which includes savings investments and other assets that could be used to repay the loan if income is ever cut due to a job loss or other financial challenge the lender may ask what the borrower plans to do with the loan such as use it to purchase a vehicle or other property other factors may also be considered such as environmental or economic conditions 3different lenders have different rules and procedures for business borrowers banks savings and loans and credit unions that offer small business administration sba loans must adhere to the guidelines of that program private institutions angel investors and venture capitalists lend money based on their own criteria these lenders will also look at the purpose of the business the character of the business owner the location of business operations and the projected annual sales and growth for the business 5small business owners prove their ability for loan repayment by providing lenders both personal and business balance sheets the balance sheets detail assets liabilities and the net worth of the business and the individual although business owners may propose a repayment plan the lender has the final say on the terms | |
where can i get a small business loan | one good lender option for small business borrowers is the small business administration sba a u s government agency that promotes the economy by assisting small businesses with loans and advocacy the sba has a website and at least one office in every state | |
what are the different types of mortgage lenders | the three most common options for borrowers seeking a mortgage lender are mortgage brokers direct lenders e g banks and credit unions and secondary market lenders e g fannie mae and freddie mac | |
how can i get a mortgage with bad credit | getting a mortgage when you have bad credit is possible but a larger down payment mortgage insurance and a higher interest rate will likely be required the bottom line | |
what is lender of last resort | a lender of last resort lor is an institution usually a country s central bank that offers loans to banks or other eligible institutions that are experiencing financial difficulty or are considered highly risky or near collapse in the united states the federal reserve acts as the lender of last resort to institutions that do not have any other means of borrowing and whose failure to obtain credit would dramatically affect the economy understanding lender of last resortthe lender of last resort functions to protect individuals who have deposited funds and to prevent customers from withdrawing out of panic from banks with temporary limited liquidity commercial banks usually try not to borrow from the lender of last resort because such action indicates that the bank is experiencing a financial crisis critics of the lender of last resort methodology suspect that the safety it provides inadvertently tempts qualifying institutions to acquire more risk than necessary since they are more likely to perceive the potential consequences of risky actions as less severe lender of last resort and preventing bank runsa bank run is a situation that occurs during periods of the financial crisis when bank customers worried about an institution s solvency descend on the bank en masse and withdraw funds because banks only keep a small percentage of total deposits as cash a bank run can quickly drain a bank s liquidity and in a perfect example of a self fulfilling prophecy cause the bank to become insolvent bank runs and subsequent bank failures were prevalent following the 1929 stock market crash that led to the great depression the u s government responded with new legislation imposing reserve requirements on banks mandating they hold above a certain percentage of liabilities as cash reserves 1in a situation in which a bank s reserves fail to prevent a bank run a lender of last resort can inject it with funds in an emergency so that customers seeking withdrawals can receive their money without creating a bank run that pushes the institution into insolvency criticisms of lenders of last resortcritics of the practice of having a last resort lender allege that it encourages banks to take unnecessary risks with customers money knowing they can be bailed out in a pinch such claims were validated when large financial institutions such as bear stearns and american international group inc were bailed out in the midst of the 2008 financial crisis proponents state that the potential consequences of not having a lender of last resort are far more dangerous than excessive risk taking by banks | |
what is leptokurtic | leptokurtic distributions are statistical distributions with kurtosis greater than three it can be described as having a wider or flatter shape with fatter tails resulting in a greater chance of extreme positive or negative events it is one of three major categories found in kurtosis analysis its other two counterparts are mesokurtic which has no kurtosis and is associated with the normal distribution and platykurtic which has thinner tails and less kurtosis understanding leptokurticleptokurtic distributions are distributions with positive kurtosis larger than that of a normal distribution a normal distribution has a kurtosis of exactly three therefore a distribution with kurtosis greater than three would be labeled a leptokurtic distribution in general leptokurtic distributions have heavier tails or a higher probability of extreme outlier values when compared to mesokurtic or platykurtic distributions | |
when analyzing historical returns kurtosis can help an investor gauge an asset s level of risk a leptokurtic distribution means that the investor can experience broader fluctuations e g three or more standard deviations from the mean resulting in greater potential for extremely low or high returns | leptokurtosis and estimated value at riskleptokurtic distributions can be involved when analyzing value at risk var probabilities a normal distribution of var can provide stronger result expectations because it includes up to three kurtoses in general the fewer the kurtosis and the greater the confidence within each the more reliable and safer a value at risk distribution is leptokurtic distributions are known for going beyond three kurtoses this typically decreases the confidence levels within the excess kurtosis creating less reliability leptokurtic distributions can also show a higher value at risk in the left tail due to the larger amount of value under the curve in the worst case scenarios overall a greater probability for negative returns farther from the mean on the left side of the distribution leads to a higher value at risk leptokurtosis mesokurtosis and platykurtosiswhile leptokurtosis refers to greater outlier potential mesokurtosis and platykurtosis describe lesser outlier potential mesokurtic distributions have kurtosis near 3 0 meaning that their outlier character is similar to that of the normal distribution platykurtic distributions have kurtosis less than 3 0 thus exhibiting less kurtosis than a normal distribution investors will consider which statistical distributions are associated with different types of investments when deciding where to invest more risk averse investors might prefer assets and markets with platykurtic distributions because those assets are less likely to produce extreme results while risk seekers may seek leptokurtosis example of leptokurtosislet s use a hypothetical example of excess positive kurtosis if you track the closing value of stock abc every day for a year you will have a record of how often the stock closed at a given value if you build a graph with the closing values along the x axis and the number of instances of that closing value that occurred along the y axis of a graph you will create a bell shaped curve showing the distribution of the stock s closing values if there are a high number of occurrences for just a few closing prices the graph will have a very slender and steep bell shaped curve if the closing values vary widely the bell will have a wider shape with less steep sides the tails of this bell will show you how often heavily deviated closing prices occurred as graphs with lots of outliers will have thicker tails coming off each side of the bell | |
what are least developed countries ldc | least developed countries ldcs sometimes referred to as less developed countries are underdeveloped countries that face significant structural challenges to sustainable development the un s list of ldcs currently comprises 46 countries understanding least developed countriesleast developed countries are highly vulnerable to economic and environmental shocks and have fewer human assets than other nations in some cases least developed countries are referred to as emerging markets ldcs have access to specific international support measures for development assistance and trade that are not available to more developed nations 2the u n s committee for development policy cdp secretariat of the department of economic and social affairs department of economic and social affairs dpad desa created measures to help ldcs gain access to and benefit from international support the secretariat is responsible for reviewing the status of ldcs and monitoring their progress after they graduate from the ldc category 4the secretariat s criteria for placing nations on its list of least developed countries include the categories of income human assets and economic vulnerability list of least developed countriesforty seven countries comprised the united nations list of ldcs as of sept 2020 in march 2018 the cdp recommended that bhutan kiribati s o tom and pr ncipe and the solomon islands graduate from the ldc category by the year 2024 this endorsement was unprecedented at the time as never before had the committee recommended so many countries for graduation at a single review in the 47 years that the ldc category has existed only five countries have graduated botswana cabo verde equatorial guinea maldives and samoa 6 the committee has also scheduled angola for graduation in 2024 7 | |
what is a lessee | a lessee is a person who rents land or property from a lessor the lessee is also known as the tenant and must uphold specific obligations as defined in the lease agreement and by law the lease is a legally binding document and if the lessee violates its terms they could be evicted understanding lesseeslessees who rent a property may be required to follow certain restrictions and guidelines in the use of the property or real estate they are paying to access and use if the property is a vehicle under a lease the lessee may need to keep their usage within certain mileage limits the lessee could be subject to paying additional fees in the event that the mileage usage of the leased vehicle exceeds the agreed upon limits leased vehicles must also be maintained by the lessee with regular service and upkeep throughout the term of the agreement these conditions must be met because the vehicle will be returned to the auto dealer at the end of the lease the vehicle would then go on the market as a used car for sale it is possible that a lessee might want to seek full ownership of the vehicle at the end of the lease if such an option is made available a lessor must provide a lessee with reasonable notice if they want to enter the leased property 1rights of lesseesa lessee who is a tenant of a commercial or residential property may face different types of restrictions on their use of the space a commercial lessee could be granted certain rights to remodel the property to better suit the business that will use the space this can include repainting of walls adding signage associated with the company s brand or installing equipment that will be used during the course of business a commercial lease will also specify if the property must be returned to its original state when the tenancy ends residential lessees may be limited in the choices for or barred from repainting the space they occupy as tenants they might be allowed to add nonpermanent decorations to the property the lessee s rights include rights of lessorsthe lessor also has rights these include the lessor s responsibilities include complying with health and safety codes making necessary repairs returning a fair amount of the tenant s security deposit when the lease is terminated and providing advance notice to the tenant if it will be necessary to enter the unit 251 | |
what is a lessor | a lessor is essentially someone who grants a lease to someone else as such a lessor is the owner of an asset that is leased under an agreement to a lessee the lessee makes a one time payment or a series of periodic payments to the lessor in return for the use of the asset understanding lessorsa lessor can be either an individual or a legal entity the lease agreement that they enter into with another party is binding on both the lessor and the lessee and spells out the rights and obligations of both parties in addition to the use of the property the lessor may grant special privileges to the lessee such as early termination of the lease or renewal on unchanged terms solely at their discretion for a lessor the main advantage of entering into a lease agreement is that they retain the ownership of the property while generating a return on their invested capital for the lessee periodic payments may be easier to finance than the total purchase price of the property types of leases and lessorsin the public s mind leases are usually associated with real estate a rented residence or office but actually almost any sort of asset can be leased it can be tangible property such as a home office car computer or intangible property like a trademark or brand name the lessor in each instance is the owner of the asset for example in the case of real estate or a car the lessor is the property owner or automobile dealer respectively in the case of a trademark or brand name the lessor is the company that owns it and has conferred the right to use the trademark or brand name to a franchisee when used in connection with the motor carrier industry a lessor refers to the owner of a commercial motor vehicle who contracts with the entity that holds operating authority for the use of the vehicle some lessors can also grant a rent to own lease whereby some or all of the payments made by the lessee will eventually be converted from lease payments to a down payment on the eventual purchase of the leased item this type of arrangement usually occurs in a commercial context when leasing large industrial equipment for example but it is also common in a consumer context with automobiles and even with residential real estate the lessor is also known as the landlord in lease agreements that deal with property or real estate special considerationsthe most common type of lease is for homes or apartments in which individuals and families live because housing is an important matter of public policy many jurisdictions have created governing bodies that regulate and oversee the legal relationships and acceptable terms of leases between lessors and lessees in this field for example in the state of new york the new york state division of housing and community renewal dhcr is responsible for administering rent regulation in the state including new york city 1 this responsibility includes both rent control and rent stabilization | |
is a lessor a landlord | a lessor may be called a landlord a lessor is a person or legal entity that owns a property and rents it out to a lessee who in term pays the lessor to live in their property who is the lessor in a lease agreement the lessor in a lease agreement is the person or legal entity who grants a lease to an individual or family often a lease on a property the lessor is the owner of the asset in the lease agreement who is the lessee in a lease agreement a lessee is the person or legal entity leasing the asset provided by the lessor a lessee in a lease agreement is responsible for making a payment or payment to the lessor for using the asset named in the lease agreement such as an apartment or a storefront | |
what is a letter of comfort | a letter of comfort also known as a letter of intent or a solvency opinion is a written document that provides a level of assurance that an obligation will ultimately be met in its traditional context a letter of comfort is given to organizations or persons of interest by external auditors regarding statutory audits statements and reports used in a prospectus the letter of comfort will be attached to the preliminary statements as assurance that it will not be materially different from the final version understanding a letter of comfortin practical uses letters of comfort are often issued by auditors to lenders as solvency opinions on whether a borrower can meet the payment obligations of a loan they are opinions not guarantees that the underlying company will remain solvent letters of comfort can also be issued to underwriters as an obligation to carry out reasonable investigation into offerings of securities these letters of comfort will ensure that the reports conform to generally accepted accounting principles gaap this helps the underwriter better understand aspects of the financial data that might not otherwise be reported such as changes to financial statements and unaudited financial reports yet another broad category of letter of comfort application is the parent company to a subsidiary entity whereby a parent company can issue a letter of comfort also known as a keepwell agreement on behalf of a subsidiary that needs to borrow from a bank in its locale or provide a letter to a supplier of a subsidiary that wishes to transact a large purchase order of raw materials benefits of a letter of comforttwo parties in a business deal can use a letter of comfort to put in writing the outline of the terms of their deal most major business transactions require a lot of time on management s part to perform due diligence before they can finalize a deal a letter of comfort can summarize the steps each party agrees to take to ensure the successful completion of the transaction a well written letter of comfort can assure each party that the time spent on completing these tasks will be well worth the effort although the letter of comfort is not binding between the two parties it may have binding provisions the letter of comfort provides an opportunity for the two parties to clearly spell out these binding provisions for example a binding provision might state that one party owes the other party a sum of money should it decide to pull out of the deal this sum of money might be equal to the costs incurred by the party who has not left the deal a letter of comfort might also include binding provisions regarding confidentiality stipulating what the parties may or may not divulge to outside parties regarding the transaction a letter of comfort can have a wide range of binding provisions including ones regarding non competition or the hiring of certain executive employees should the deal go through if a deal goes through the terms of the final contract will supersede the details outlined in the letter of comfort a letter of comfort can also enhance a company s ability to obtain much needed funding if a reliable third party attests to the company s capacity to repay a loan the company can present this statement to the lending institution as evidence of its creditworthiness while the lending institution will consider many factors in its decision a persuasive letter of comfort can be a critical factor on the company s behalf special considerationsa letter of comfort is typically couched in vague wording in order to prevent the issuer from being saddled with a legally enforceable obligation in many cases a letter of comfort creates a moral obligation for the issuer rather than a legal one companies generally do not furnish letters of comfort unless absolutely necessary this is because in the worst case scenario the company may be on the hook financially should an unexpected situation occur for example if a subsidiary is unable to repay a debt the parent company may either be liable for the full amount if the letter of comfort was poorly worded or may have to incur expensive legal fees to prove that its letter of comfort was not a tacit guarantee of its subsidiary s payment obligation | |
what is a letter of credit | a letter of credit or a credit letter is a letter from a bank guaranteeing that a buyer s payment to a seller will be received on time and for the correct amount if the buyer is unable to make a payment on the purchase the bank will be required to cover the full or remaining amount of the purchase it may be offered as a facility financial assistance that is essentially a loan due to the nature of international dealings including factors such as distance differing laws in each country and difficulty in knowing each party personally the use of letters of credit has become a very important aspect of international trade to protect buyers and sellers jessica olah investopedia | |
how a letter of credit works | buyers of major purchases may need a letter of credit to assure the seller that the payment will be made a bank issues a letter of credit to guarantee the payment to the seller essentially assuming the responsibility of ensuring the seller is paid a buyer must prove to the bank that they have enough assets or a sufficient line of credit to pay before the bank will guarantee the payment to the seller 1banks typically require a pledge of securities or cash as collateral for issuing a letter of credit because a letter of credit is typically a negotiable instrument the issuing bank pays the beneficiary or any bank nominated by the beneficiary if a letter of credit is transferable the beneficiary may assign another entity such as a corporate parent or a third party the right to draw the international chamber of commerce s uniform customs and practice for documentary credits oversees letters of credit used in international transactions 2banks usually charge a fee for a letter of credit which can be a percentage of the total credit they are backing the cost of a letter of credit will vary by bank and the size of the letter of credit for example the bank may charge 0 75 of the amount that it s guaranteeing fees can also depend on the type of letter in an import export situation an unconfirmed letter of credit is less costly a confirmed letter of credit may have higher fees attached based on the issuing bank s credit strength 3types of letters of creditthe types of letters of credit include a commercial letter of credit a revolving letter of credit a traveler s letter of credit a confirmed letter of credit and a standby letter of credit international trade will also sometimes use an unsecured also called a red clause letter of credit this is a direct payment method in which the issuing bank makes the payments to the beneficiary in contrast a standby letter of credit is a secondary payment method in which the bank pays the beneficiary only when the holder cannot 4this kind of letter allows a customer to make any number of draws within a certain limit during a specific period it can be useful if there are frequent merchandise shipments for example and you don t want to redraft or edit letters of credit each time 5for those going abroad this letter will guarantee that issuing banks will honor drafts made at certain foreign banks 6a confirmed letter of credit involves a bank other than the issuing bank guaranteeing the letter of credit the second bank is the confirming bank typically the seller s bank the confirming bank ensures payment under the letter of credit if the holder and the issuing bank default the issuing bank in international transactions typically requests this arrangement 3a standby letter of credit provides payment if something does not occur which is the opposite of how other types of letters of credit are structured 7 so instead of facilitating a transaction with funding a standby letter of credit is like an insurance contract it protects and compensates one party the beneficiary if the other party named in the agreement fails to perform the stated duty or meets certain service level agreements outlined in the letter of credit example of a letter of creditcitibank offers letters of credit for buyers in latin america africa eastern europe asia and the middle east who may have difficulty obtaining international credit on their own citibank s letters of credit help exporters minimize the importer s country risk and the issuing bank s commercial credit risk 8letters of credit are typically provided within two business days guaranteeing payment by the confirming citibank branch 9 this benefit is especially valuable when a client is located in a potentially unstable economic environment | |
how to apply for a letter of credit | letters of credit are best prepared by trained professionals as mistakes in the detailed documents required can lead to payment delays and fees due to industry variations and types of letters of credit each may be approached differently 10here s an import export example advantages and disadvantages of a letter of creditobtaining letters of credit may be necessary in certain situations however like anything else related to banking trade and business there are some pros and cons to acknowledge can create security and build mutual trust for buyers and sellers in trade transactions makes it easier to define the specifics of when and how transactions are to be completed between involved parties letters of credit can be personalized with terms that are tailored to the circumstances of each transaction can make the transfer of funds more efficient and streamlined buyers typically bear the costs of obtaining a letter of credit letters of credit may not cover every detail of the transaction potentially leaving room for error establishing a letter of credit may be tedious or time consuming for all parties involved the terms of a letter of credit may not account for unexpected changes in the political or economic landscape | |
how does a letter of credit work | often in international trade a letter of credit is used to signify that a payment will be made to the seller on time and in full as guaranteed by a bank or financial institution after sending a letter of credit the bank will charge a fee typically a percentage of the letter of credit in addition to requiring collateral from the buyer among the various types of letters of credit are a revolving letter of credit a commercial letter of credit and a confirmed letter of credit | |
what is an example of a letter of credit | consider an exporter in an unstable economic climate where credit may be more difficult to obtain a bank could offer a buyer a letter of credit available within two business days in which the purchase would be guaranteed by the bank s branch because the bank and the exporter have an existing relationship the bank is knowledgeable of the buyer s creditworthiness assets and financial status | |
what is the difference between a commercial letter of credit and a revolving letter of credit | as one of the most common forms of letters of credit commercial letters of credit are when the bank makes payment directly to the beneficiary or seller revolving letters of credit by contrast can be used for multiple payments within a specific time frame typically these are used for businesses that have an ongoing relationship with the time limit of the arrangement usually spanning one year | |
when does payment occur with a letter of credit | a letter of credit is like an escrow account in that payment to the beneficiary only happens when the other party performs a specific act or meets other performance criteria spelled out in the letter of credit agreement 11the bottom lineletters of credit can play an important part in trade transactions there are different types of letters of credit that may be used depending on the circumstances if you need a letter of credit for a business transaction your current bank may be the best place to begin your search however you may need to expand the net to include larger banks if you maintain accounts at a smaller financial institution | |
a bank typically issues a letter of guarantee on behalf of a client who has entered into a contract to buy goods from a supplier the letter contractually guarantees to pay the recipient even if the client should default to get a letter of guarantee the customer will need to apply for it like a loan if the bank is comfortable with the risk it will back the customer with the letter for an annual fee letters of guarantee are used in importing and exporting commercial contracts margin trades major purchases real estate investments mergers and acquisitions and other significant financial transactions | a letter of guarantee may also be issued by a bank on behalf of a call writer when assuring another party that the writer owns the underlying asset and that the bank will deliver the underlying securities should the call be exercised call writers will frequently use a letter of guarantee when the underlying asset of a call option is not held in their brokerage account understanding letters of guaranteeletters of guarantee are often used when one party in a transaction is uncertain that the other party can meet their financial obligation this is especially common when buying costly equipment or other property however a letter of guarantee may not cover the whole value of the property at issue for example a letter of guarantee in a bond issue may promise either interest or principal repayment but not both the bank will negotiate how much it will cover for their client banks charge an annual fee for this service typically a percentage of how much the bank would owe should the client default letters of guarantee are used in a wide variety of business situations these include contracting and construction financing from a financial institution or declarations during export and import processes letter of guarantee for a call writerbecause many institutional investors maintain investment accounts at custodian banks rather than at broker dealers brokers will accept a letter of guarantee for call writers with short options as a replacement for holding cash or securities the letter of guarantee must be in a form that the exchange and potentially the options clearing corporation accept the issuing bank agrees to give the broker the underlying securities if the call writer s account is assigned to obtain a letter of guarantee a customer must apply for it much like a loan example of a letter of guaranteeassume company xyz is buying a large piece of customized equipment for 1 million the equipment supplier will need to fabricate it and it won t be ready for several months the buyer doesn t want to pay right now but the supplier also doesn t want to spend time and resources building the equipment without guaranteeing that the buyer will pay for it and has the resources to do so the company can go to its bank and get a letter of guarantee this is all the supplier should need to go forward since the bank guarantees it will pay should the buyer not do so for another example suppose a call writer has 10 short contracts on the stock in company xyz which equals 1000 shares if the stock price rises the short positions will lose money the loss could theoretically be infinite since there is no cap on how far a stock can rise but if the call writer owns 1000 shares of a stock then the risk is mitigated this is a covered call to short the stock in the first place the writer may have had to produce a letter of guarantee that they own the stock in another account if the broker thought an uncovered short call was too risky | |
how much does a letter of guarantee cost | the fee for a letter of guarantee varies from issuer to issuer but is traditionally a percentage of the amount being guaranteed typical fees range from 0 5 to 1 5 of the amount | |
what is the difference between a letter of credit and letter of guarantee | a letter of credit is like a letter of guarantee assuring that a borrower can pay what they owe typically letters of credit are more commonly used in international trade while letters of guarantee are used for domestic purposes such as real estate contracts | |
how do i get a letter of guarantee | to get a letter of guarantee you need to apply for one from a financial institution such as a bank while you can get one from any bank the issuer will want to examine your finances closely before offering the letter for this reason you ll likely find it much easier to work with a bank with which you already have a relationship the bottom linea letter of guarantee acts as a form of insurance giving suppliers confidence that they ll get paid for the goods or services they provide if the customer fails to pay the bill the bank issuing the letter will step in to pay this makes letters of guarantee important for businesses that want to work with new suppliers or make especially large purchases and need proof that they can afford them | |
a letter of indemnity loi is a document that guarantees certain provisions will be met between two parties to a contract or compensation will be provided these letters promise to make one or more parties to a contract whole again if a contractual obligation doesn t end up being fulfilled for instance in finance lois can be used to protect against losses from lapses in security documentation or procedure banks or insurance companies issue lois to cover parties against financial losses from a breach of contract these offer contracting parties some protection and greater ease when entering a transaction knowing they will be covered should there be any losses from another party s failure to fulfill the contract | the chief role of an loi is to ensure that one or more parties to a contract won t take on losses if another party doesn t fulfill their part lois can be provided by a third party who insures the contract and assumes responsibility for any financial losses or damage the loi shields against liability ensuring that the parties will be held harmless even if there is a breach of contract indemnity refers to the full amount of compensation you would need to recover as a legal term indemnity also describes an exemption from liability a letter of indemnity provides immunity from liability for one or both parties in a contract with a third party often agreeing to indemnify against the potential losses understanding loislois state that any damage caused to a contracting party is the responsibility of the other party or a third party to the contractual agreement 1 for this reason lois also called indemnity bonds or bonds of indemnity are like insurance policies known as indemnity insurance lois are used in various types of business transactions in cases where items of value are transported by moving companies or delivery services lois ensure that the party that owns the valuables will be compensated if the possessions are lost damaged or stolen during transport lois are generally signed when the valuable items are presented to the shipping company and before a bill of lading which is a document issued by a carrier acknowledging receipt of the cargo they are also used when a second party borrows something of value from the first party such as a car or a power tool in this case the person borrowing the car or power tool can protect themselves with a letter of indemnity this would typically mean a third party such as an insurance firm takes financial responsibility for any losses or damage that might result from using the car or tool lois should always be signed by a witness when the assets involved are quite valuable it s preferable to have an insurance carrier representative a banker or another professional sign the document not just any available witness letters of indemnity should include the names and addresses of both parties involved plus the name and affiliation of the third party if any detailed descriptions of the items and intentions are also required as are the signatures of the parties and the date the contract is executed examples of loislet s say you hire professional painters for your house painters often carry insurance to protect themselves against injuries or damage from the job the painters can present an loi showing that an insurance company has accepted legal responsibility for their contractual obligations and has agreed to compensate you for any damage to your home in this situation lois protect painters and other contractors against any damage or inability to complete the job from your perspective as the homeowner the loi establishes that you won t pay for any problems that come about should the painters not be able to complete their part of the contract in finance an loi can be crucial in addressing unforeseen circumstances for example let s say you ve misplaced a physical stock certificate and can t find it you can approach the company that issued the stock and provide it with an loi that states that the stock certificate has been lost destroyed or stolen the letter would ask the company to issue a replacement certificate and state that should the original certificate resurface you would take full responsibility and indemnify the company against any loss or complications that might come about because it was found in this way the company guards against potential double claims on the same stock and you can get back your stock certificate more quickly | |
when are lois needed | lois are a useful protection they are often needed to make another party comfortable enough to take part in a contract in the first place the following are some common uses of lois | |
why is a letter of indemnity important | a loi can provide important protection for one party of a contract if the other party fails to fulfill its obligations in effect the loi assures that one or more parties in the contract will be held harmless that is they are not left on the hook for any negative financial consequences that the other party has caused who can issue an loi a third party generally writes a loi promising to compensate one party to a contract for any losses related to the other party frequently large institutions like insurance companies and banks take on this role | |
what are the risks of a letter of indemnity | a loi is designed to manage risks but some could come with using them any loi must be properly executed to be legally enforceable explicitly defining what is covered and specifying the obligations of all parties how effective and enforceable an loi is depends on its precise wording and the jurisdiction in which it s executed the bottom linea loi assures a party to a contract that they will be made whole for any losses that result from the other party many times a third party like an insurance company agrees to indemnify against loss or damage that stems from a contract | |
what is a letter of intent loi | a letter of intent loi is a document declaring the preliminary commitment of one party to do business with another the letter outlines the chief terms of a prospective deal commonly used in major business transactions lois are similar in content to term sheets one major difference between the two though is that lois are presented in letter formats while term sheets are listicle in nature 1investopedia madelyn goodnightunderstanding a letter of intent loi lois are useful when two parties are initially brought together to hammer out the broad strokes of a deal before the finer points of a transaction are resolved lois often include provisions stating that a deal may only go through if financing has been secured by one or both parties or that a deal may be squashed if papers are not signed by a certain date since lois typically discuss potential points of deals that have yet to be cemented they are almost universally intended to be non binding lois can be iterative in nature one party may present an loi to which the other party may either counter with a tweaked version of that loi or draft a new document altogether ideally by the time both parties come together to formalize a deal there will be no surprises on either side of the table many lois include non disclosure agreements ndas which contractually stipulate the components of a deal both parties agree to keep confidential and which details may be shared publicly many lois also feature no solicitation provisions which forbid one party from poaching the other party s employees a letter of intent is usually drafted and signed while negotiations between parties are ongoing so that the final terms of a deal might vary from what was agreed upon in the letter of intent due diligence is conducted by both parties before doing business it is a prudent business practice to complete due diligence before signing a letter of intent purpose of a letter of intent loi letters of intent may be used by different parties for many purposes parties can use an loi to outline some of the basic fundamental terms of an agreement before they negotiate and finalize all the fine points and details furthermore the loi may be used to signal that two parties are negotiating a deal such as a merger or joint venture jv overall lois aim to achieve the following applications of a letter of intent loi in the context of business deals lois are typically drafted by a company s legal team which outlines the details of the intended action for example in the merger and acquisitions m a process lois detail whether a firm plans to take over another company with cash or through a stock deal letters of intent also have applications beyond the business world for example parents may use them to express the expectations they have for their children in the event both parents die although they aren t legal documents like wills lois may be considered by family court judges responsible for legislating what happens to the children under such circumstances lois are also used by those seeking government grants and by highly sought after high school varsity athletes these individuals frequently draft lois to declare their commitments to attend particular colleges or universities | |
what is level 1 | level 1 is a type of trading screen used with stock trading that displays the best bid offer volume quotes in real time or the national best bid and offer nbbo level 1 quotes supply basic information that for the most part is more than sufficient for most investors though some extremely active traders prefer order book and market depth information that can be found in higher level quotes the u s stock market has three tiers of quotes level 1 level 2 and level 3 looking at these quotes allows an investor to see how a specific stock is performing over time as well as where the market action is consolidating understanding level 1level 1 quotes were relatively rare before the advent of the internet and online trading but are now widely offered and investors can access them for free these quotes can be found on brokers websites as well as across financial news and media portals such as morningstar or yahoo finance the information is often provided directly by an exchange or through a data broker intermediary reliable level 1 quotes aid investors in getting better prices for security purchases and sales especially in fast moving markets where investors may prefer limit orders rather than market orders for example an investor looking to purchase 1 000 worth of stock may check the level 1 quote to see if they will be able to purchase the entire amount at a given price or if their order will likely be executed at a higher price level 1 quotes are often enough for long term investors who don t care too much about the price changing slightly however active traders looking to capture much smaller gains often use level 2 quotes so they can gather more information quote levelsall three levels of quotes build on top of each other level 1 quotes provide investors with the highest bid and the lowest ask prices for an individual stock this will also represent the most recent data for the particular security based on the order book in an exchange these types of quotes are the most common and are what individual investors see when they request information from their financial services company level 1 quotes provide the best real time bid ask for a given security level 2 quotes go a step further by offering market depth to real time quotes for each symbol the added granularity helps active traders determine the magnitude of buy and sell orders at different prices depth and shows where most orders are concentrated among market makers order book this allows investors to identify the tightest lowest bid ask spread which is important for larger investors who conduct high volume and high frequency trades hft for example suppose that an active trader sees that acme co has a level 1 quote showing a 5 00 price with a 5 10x100 ask and a 4 90x500 bid the trader may assume there is strong support at 4 90 with an order for 500 shares and relatively weak resistance at 5 10 with just 100 shares on the market however level 2 quotes may show an order for 1 000 shares at 5 11 and no orders below 4 90 until 4 85 which makes the stock look a lot weaker than the level 1 quotes would imply there are also level 3 quotes which provide all the information and services of level 1 and level 2 quotes as well as granting an investor the ability to enter or change quotes execute orders and send out confirmations of trades these types of quotes are reserved for registered brokers and financial institutions market makers for example participate in level 3 quotes which allows them to execute customer orders | |
what is level 2 | first introduced in 1983 as the nasdaq quotation dissemination service nqds level 2 is a subscription based service that provides real time access to the nasdaq order book it is intended to display market depth and momentum to traders and investors 1 the service provides price quotes from market makers registered in every nasdaq listed and otc bulletin board securities the level 2 window shows the bid prices and sizes on the left side and ask prices and sizes on the right side basics of level 2level 2 provides users with depth of price information including all the available prices that market makers and electronic communication networks ecn post 1 level 1 offers enough information to satisfy the needs of most investors providing the inside or best bid and ask prices 2 however active traders often prefer level 2 because it displays the supply and demand of the price levels beyond or outside of the national best bid offer nbbo price this gives the user a visual display of the price range and associated liquidity at each price level with this information a trader can determine entry and or exit points that assure the liquidity needed to complete the trade price movement on level 2 is not necessarily an actual reflection of the recorded trades level 2 is just a display of the available price and liquidity this is an important distinction because high frequency trading programs frequently adjust level 2 bid and ask prices violently to shake the trees and panic onlookers despite the lack of actual executed trades this practice is common in momentum stocks level 2 and reserve and hidden ordersmany ecns which are the automated systems that match buy and sell orders for securities offer the ability for traders to post reserve orders and hidden orders ecns generally display the best available bid and ask quotes from multiple market participants and they also automatically match and execute orders ecns offer a reserve order option which is composed of a price and display size along with the actual size this order only shows the specific display size on level 2 as it hides the true size of the entire order hidden orders which are an option where investors can hide large orders from the market on the ecn function in a similar way but are invisible on level 2 this allows for more discretion in determining prices the best way for users to determine the status of reserve or hidden orders is to check the time and sales for trades at the indicated prices benefits of trading using level 2 quotesthe main benefit of using level 2 quotes is getting access to a wealth of information related to the market this information can be used in various ways for profit making for example you can ascertain liquidity volumes and order sizes for a stock traded on nasdaq you can also identify trends using information about bid and ask orders example level 2 quotethere are six important columns in a level 2 quote for a given stock the first one is mmid this column identifies the four letter identification for market makers the second column is bid or the price that the market maker is willing to pay for that stock the third column is size this column is the number of orders placed by the market maker at that size the remaining three columns on the right hand side are similar the sole exception is ask which is the price that the market maker is willing to sell that stock price traders can use the difference between the bid and ask prices to determine pricing pressure and implement trading strategies | |
what is a level iii quote | a level iii quote is pricing information about a security provided by a trading service it includes the real time bid price ask price quote size price of the last trade size of the last trade high price for the day and low price for the day level iii allows institutions to enter quotes execute orders and send information because the level iii service offers a high level of market depth it is restricted to registered nasdaq market makers level iii quotes are not available to individual investors or traders quote levelsall publicly traded equities have a bid price and ask price when bought and sold the bid is the highest price an investor is willing to purchase a stock the ask offer is the lowest price at which an investor is willing to sell a stock each time a bid price or ask price is disseminated it is considered a quote the u s stock market has three tiers of quotes level i level ii and level iii these quotes allow an investor to see how a specific stock performs over time and where the market action is consolidating a market maker is a nasdaq member firm that buys and sells securities at prices it displays in nasdaq for principal trades and customer accounts | |
what are level 1 assets | level 1 assets include listed stocks bonds funds or any assets that have a regular mark to market mechanism for setting a fair market value these assets are considered to have a readily observable transparent prices and therefore a reliable fair market value understanding level 1 assetspublicly traded companies must classify all of their assets based on the ease that they can be valued with level 1 assets being the easiest a big part of valuing assets comes from market depth and liquidity for developed markets robust market activity acts as a natural price discovery mechanism this in turn is a core element to market liquidity which is a related gauge measuring a market s ability to purchase or sell an asset without causing a significant change in the asset s price financial accounting standard 157 fas 157 established a single consistent framework for estimating fair value in the absence of quoted prices based on the notion of an exit price and a three level hierarchy to reflect the level of judgment involved in estimating fair values ranging from market based prices to illiquid level 3 assets where no observable market exists and valuations have to be based on proprietary internal information like the most recent funding round classifying level 1 assetsthe classification system including level 1 level 2 and level 3 under fasb statement 157 required public companies to allocate all assets based on the reliability of fair market values the statement went into effect for all fiscal years after 2007 and came about largely as a result of the credit market turbulence surrounding subprime mortgages and related securitized assets like asset backed securities abs many assets became illiquid and fair value pricing could only be done by internal estimates or other mark to model procedures during 2007 s credit crunch as such regulators needed a way to inform investors about securities where value could be open to interpretation advantages of level 1 assetslevel 1 assets are one way to measure the strength and reliability of an entity s balance sheet because the valuation of level 1 assets is dependable certain businesses can enjoy incremental benefits relative to another business with fewer level 1 assets for example banks investors and regulators look favorably on an entity with a majority of assets that have a market based valuation because they can rely on supplied financial statements if a business heavily uses derivatives and a majority of its assets fall into the level 2 or 3 category then interested parties are less comfortable with the valuation of these assets the issue with assets outside level 1 is best displayed during times of distress naturally during a volatile market liquidity and market depth erode and many assets will not enjoy a reasonable price discovery mechanism these assets then need to be valued by appraisals or according to a model both of these are less than perfect methods so investors and creditors often lose confidence in reported valuations during periods of peak uncertainty such as during the depths of the great recession level 3 assets are especially scrutinized with pundits calling mark to model methods more like mark to myth | |
what is a level 2 asset | level 2 assets are financial assets and liabilities that are difficult to value and can be determined based on other data values or market prices however these assets don t have regular market pricing level 2 asset values are sometimes called mark to model assets they can be closely approximated using simple models and extrapolation methods these methods use known observable prices as parameters level 2 assets stand in contrast to level 1 assets which are liquid and easy to value based on market prices understanding level 2 assetspublicly traded companies are obligated to establish fair values for the assets they carry on their books investors rely on these fair value estimates to analyze the firm s current condition and future prospects according to generally accepted accounting principles gaap certain assets must be recorded at their current value not historical cost publicly traded companies must also classify all their assets based on the ease with which they can be valued in compliance with the accounting standard financial accounting standards board fasb 157 three asset levels were introduced by the fasb to bring clarity to corporations balance sheets level 2 assets are the middle classification based on how reliably their fair market value can be calculated level 1 assets such as stocks and bonds are the easiest to value level 3 assets can only be valued based on internal models or guesstimates they have no observable market prices level 2 assets are commonly held by private equity firms insurance companies and other financial institutions that have investment arms level 2 assets must be valued using market data obtained from external independent sources the data used can include quoted prices for similar assets and liabilities in active markets prices for identical or similar assets and liabilities in inactive markets or models with observable inputs these include default rates interest rates and yield curves an interest rate swap is an example of a level 2 asset the asset value can be determined based on the observed values for underlying interest rates and market determined risk premiums example of a level 2 assetblackstone inc breaks down its level 2 assets in the firm s 10 k and 10 q filings for shareholders the asset manager disclosed the following information in the filings fair value is determined through the use of models or other valuation methodologies financial instruments that are generally included in this category include corporate bonds and loans including corporate bonds and loans held within clo vehicles government and agency securities less liquid and restricted equity securities and certain over the counter derivatives where the fair value is based on observable inputs senior and subordinated notes issued by clo vehicles are classified within level ii of the fair value hierarchy 1observable vs unobservable inputsinvestors and analysts sometimes struggle to identify the difference between level 2 and level 3 assets the difference is important however particularly because gaap requires additional disclosures for level 3 assets and liabilities whether an asset or liability is level 2 or level 3 is dependent on the valuation inputs and whether the market data that s used is available to the public this brings a few questions to the forefront the input may be considered unobservable if the answer to any of these questions is no level 3 is the fair value hierarchy as a result 2 | |
what is an interest rate swap | an interest rate swap occurs when two parties exchange interest payments to be made at a future point in time swaps are typically made over the counter not on exchanges they re based on the principal value of the underlying assets they commonly come into play between loans with floating and fixed rates | |
what is fair market value | the cornell law school legal information institute defines fair market value as the value of property as determined by the marketplace or objective purchasers rather than as determined by a subjective individual this is what an informed and unpressured buyer would pay to an informed unpressured seller in an arm s length transaction | |
what is gaap | gaap generally accepted accounting principles was jointly created and issued by the financial accounting standards board fasb and the governmental accounting standards board gasb it sets accounting rules and standards that can be used across industries so financial information can be more easily compared and exchanged the bottom linethe fair value of level 2 assets is based on related intrinsic but not readily apparent factors and prices these values fall in the middle between assets that are true to their market prices and those with values that are educated guesses these assets are primarily held by investment firms and institutions understanding them can be key to undertaking certain types of investments | |
what are level 3 assets | level 3 assets are financial assets and liabilities considered to be the most illiquid and hardest to value they are not traded frequently so it is difficult to give them a reliable and accurate market price a fair value for these assets cannot be determined by using readily observable inputs or measures such as market prices or models instead they are calculated using estimates or risk adjusted value ranges methods open to interpretation understanding level 3 assetspublicly traded companies are obligated to establish fair values for the assets they carry on their books according to generally accepted accounting principles gaap certain assets must be recorded at their current value not historical cost investors rely on these fair value estimates in order to analyze the firm s current condition and future prospects in 2006 the u s financial accounting standards board fasb verified how companies were required to mark their assets to market through the accounting standard known as fasb 157 no 157 fair value measurements now named topic 820 fasb 157 introduced a classification system that aims to bring clarity to the balance sheet assets of corporations types of assetsthe fasb 157 categories for asset valuation were given the codes level 1 level 2 and level 3 each level is distinguished by how easily assets can be accurately valued with level 1 assets being the easiest level 1 assets are those valued according to readily observable market prices these assets can be marked to market and include treasury bills marketable securities foreign currencies and gold bullion these assets and liabilities do not have regular market pricing but can be given a fair value based on quoted prices in inactive markets or models that have observable inputs such as interest rates default rates and yield curves an interest rate swap is an example of a level 2 asset level 3 is the least marked to market of the categories with asset values based on models and unobservable inputs assumptions from market participants are used when pricing the asset or liability given that there is no readily available market information on them level 3 assets are not actively traded and their values can only be estimated using a combination of complex market prices mathematical models and subjective assumptions examples of level 3 assets include mortgage backed securities mbs private equity shares complex derivatives foreign stocks and distressed debt the process of estimating the value of level 3 assets is known as mark to model these assets received heavy scrutiny during the credit crunch of 2007 when mortgage backed securities mbs suffered massive defaults and write downs in value the firms that owned them were often not adjusting asset values downward even though credit markets for asset backed securities abs had dried up and all signs pointed to a decrease in fair value recording level 3 assetspast misjudgments of level 3 asset values prompted tougher regulatory measures topic 820 introduced in 2009 ordered firms not just to state the value of their level 3 assets but also to outline how using multiple valuation techniques might have affected those values then in 2011 the fasb became more stringent demanding a reconciliation of the beginning and ending balances for level 3 assets with particular attention paid to changes in the value of existing assets as well as details on transfers of new assets into or out of level 3 status more clarity on what disclosures companies must make when dealing with level 3 assets was also provided including requirements for quantitative information about the unobservable inputs used for valuation analysis as part of a wider breakdown of valuation processes another addition was sensitivity analysis in order to help investors get a better handle on the risk that valuation work on level 3 assets ends up being incorrect in august 2018 the fasb issued an update to topic 820 titled accounting standards update 2018 13 in this guidance effective for financial statements with fiscal years beginning on or after dec 15 2019 some of its earlier rules were modified companies have been asked to disclose the range and weighted average of significant unobservable inputs and the way they are calculated the fasb also ordered narrative descriptions to focus on account measurement uncertainty at the reporting date not the sensitivity to future changes this new approach is designed to boost transparency and comparability even further although companies do still have considerable freedom when deciding which information is relevant and disclosable special considerationsbecause level 3 assets are notoriously difficult to value the stated worth they are given for accounting purposes should not always be taken at face value by investors valuations are subject to interpretation so a margin of safety needs to be factored in to account for any errors in using level 3 inputs to value an asset often level 3 assets make up just a small portion of a company s balance sheet however in some industries such as large investment shops and commercial banks they are more widespread | |
how many levels of company assets are there | companies classify assets as level 1 2 or 3 depending on how easily they can be valued level 3 is considered the most illiquid and hardest to value | |
what are level 1 and level 2 assets | level 1 assets are considered to have readily observable transparent prices and therefore a reliable fair market value level 2 assets are difficult to value but their value can be closely approximated using simple models and extrapolation methods using known observable prices as parameters | |
what are examples of level 3 assets | examples of level 3 assets include complex derivatives distressed debt foreign stocks mortgage backed securities mbs and private equity shares the bottom linelevel 3 assets are financial assets and liabilities that are considered to be the most illiquid and hardest to value since they are not traded frequently it is difficult to give them a reliable and accurate market price | |
what is a level death benefit | a level death benefit is a payout from a life insurance policy that remains the same regardless of whether the insured person dies shortly after purchasing the policy or many years later there are also policies that offer the option of an increasing death benefit which rises in value over time generally speaking life insurance policies with level death benefits will charge lower premiums than those with increasing death benefits however this does not necessarily mean that level death benefits offer superior value since inflation can reduce the level death benefit s real value over time | |
when you buy a life insurance policy you pick a death benefit for your coverage this is the amount your heirs receive if you pass away while insured a level death benefit policy provides the same payout the entire time you re insured if you sign up for 500 000 in coverage that s what the policy will pay out tomorrow a year from now or a decade in the future assuming you keep your life insurance coverage level death benefits are available with both term life insurance and permanent life insurance policies 1 | in comparison there are also life insurance policies that change the death benefit over time an increasing death benefit policy grows the payout over time these policies cost more than one with a level death benefit 2a decreasing term policy reduces your death benefit over time in exchange a decreasing term policy costs less than one with a level death benefit you might use a decreasing term policy for a need that goes down over time like your mortgage as you pay off your home you need less life insurance to cover the remaining debt 3level death benefits versus inflationfrom the perspective of the insurance company level death benefits are relatively low risk because they allow the insurer to know with certainty what their maximum potential liability will be when the insured dies this lower risk means policies with level death benefits are still generally less expensive than those with increasing death benefits that are more difficult to predict moreover because of inflation the real value of the level death benefit actually declines each year a dollar today is worth more than a dollar in the future because prices go up over time the level death benefit might be appropriate for your family today but could be too small a payout many years in the future 4if you are worried about inflation reducing the value of your death benefit you could buy an extra inflation rider benefit this feature increases your death benefit over time to match rising prices how this works depends on the insurance company in exchange for inflation protection you must pay a higher premium 5real world example of a level death benefitthe decision of whether to opt for a level death benefit or an increasing death benefit will depend on several factors including your personal budget and your expectations of alternative investment returns to illustrate consider the case of john a hypothetical insurance shopper at 30 years of age john is in perfect health and has an annual income of 70 000 after paying for his expenses john is able to save 700 per month he is eager to purchase life insurance to help provide for his young family in case he passes away if john opts for a level death benefit of 500 000 on a whole life policy in florida then his insurance premium will be around 300 per month according to a quote from quotacy this leaves him 400 to invest separately john plans to leave the proceeds from his investments to his family thus when he dies his family will receive both the 500 000 death benefit and the value of his investments at that time the effects of compound interest over time should not be underestimated even relatively modest investment returns can lead to very large sums when allowed to compound over the long term john calculates that if he lives for 50 more years and inflation averages 3 per year during that time frame the real value of the 500 000 benefit at that time after adjusting for inflation would only be about 114 000 in today s dollars this is why it s important to save extra for your heirs if you use a level death benefit policy your initial death benefit provides much less spending power in the future when you account for inflation given his long investment horizon john estimates he can obtain an average annual return of 6 on his monthly investments of 400 these would be worth more than 1 5 million in 50 years time with these observations in mind john decides to proceed with the level death benefit with the intention of investing an additional 400 per month on his family s behalf for the remainder of his life | |
what types of insurance offer level death benefits | level death benefits are commonly found on term life and whole life policies although each offers optional provisions that can increase the death benefit over time for universal life and variable life policies you can choose either a level or increasing death benefit option at issue with the ability to flip between the two options throughout the life of the policy you can also have the flexibility to increase or decrease the death benefit if your needs change in the future 6 | |
do level death benefit policies charge lower premiums than those with increasing death benefits | normally yes insurance companies can charge less for a level death benefit policy because the insurer can more accurately forecast their future financial liability the eventually payout for an increasing death benefit is less precise to anticipate | |
how can you protect your level death benefit policy against inflation | over time rising inflation rates will slowly reduce the real value of the death benefit for a level death benefit policy many carriers offer options available to counteract inflation including buying inflation protection riders and planned face amount increases 7the bottom linewhether a level death benefit life insurance policy offers the best protection for you and your family depends on your individual circumstances and needs level death benefits offer predictable payouts and premiums but will lose some of their value to inflation to make the best decision contact your insurance agent to discuss your long term financial plan | |
what is level premium insurance | level premium insurance is a type of permanent or term life insurance where the premium remains the same over the policy s life with this type of coverage premiums are thus guaranteed to remain the same throughout the contract for a permanent insurance policy like whole life the amount of coverage provided increases over time as a result the coverage can be advantageous over a long period of time a policyholder keeps paying the same amount but has access to increased death benefit coverage as the policy matures term policies are also often level premium but the overage amount will remain the same and not grow the most common terms are 10 15 20 and 30 years based on the needs of the policyholder 1 | |
how level premium insurance works | level premium insurance premiums are fixed for the life of the policy for a term policy this means for the length of the term e g 20 or 30 years and for a permanent policy until the insured passes away level premium policies will typically cost more up front than annually renewing life insurance policies with terms of only one year at a time but over the long run level premium payments are often more cost effective this is because the higher premiums have typically been offset by an increase in coverage during a period when a policyholder typically has more medical issues the amount of level premium paid on a policy will depend on one s age and health the younger and healthier one is the lower the level premium will be for term life policies the length of the term will also matter longer dated policies will cost more per month than shorter policies the length of a term policy will often be selected to best suit one s specific needs for example if the primary purpose of the death benefit is to provide income to support very young children and fund college expenses a 20 year level premium might be appropriate however if these children are already in their early teens a 10 year level premium may be sufficient if the insured is the same age the 10 year term policy would cost less all else equal than the 20 year policy s premiums some forms of life insurance are vulnerable to premium increases or are sensitive to interest rate changes such as universal life or variable life policies with level premium insurance premiums and the death benefit are guaranteed as long as the policy is in force or unless the policyholder requests a change 1level premium term insurance vs decreasing term life insurancewith level premium term life insurance the policy pays a benefit if the policyholder passes away during a fixed period whatever the term of the insurance is if death occurs outside of this term timeframe there is no payout with decreasing term life insurance the amount of coverage declines over time similar to the way a repayment mortgage decreases over time decreasing term life insurance is usually purchased to pay off a specific debt like a repayment mortgage the policy ensures that upon death the repayment mortgage or other specified debt gets settled 1other specialty types of life insurance include over 50s life insurance which is a specialized kind of insurance geared toward people between the ages of 50 and 80 there is also joint life insurance in which two people in a relationship take out individual policies the policy will cover both lives usually on a first death basis death benefit for a fixed periodless expensive than whole lifecan be used for specific stages and ages of lifeno death benefit if policyholder dies outside of fixed periodmay not be long enough to cover the policy holder for their lifetimeexample of level premium insurancethe age and timeframe of the policyholder are both crucial factors in determining if a guaranteed level premium policy is optimal versus an annual renewable term art policy which increases as the policyholder ages 2for example suppose two female friends jen and beth both 30 years old and in good health opt to buy life insurance they each seek a 30 year term with 1 million in coverage in years two through five jen continues to pay 500 per month and beth has paid an average of just 357 per year for the same 1 million of coverage if beth no longer needs life insurance at year five she will have saved a lot of money relative to what jen paid but if beth still thinks she needs 25 more years of life insurance coverage she will start to be at a relative disadvantage each year as beth gets older she faces ever higher annual premiums meanwhile jen will continue to pay 500 per year | |
how do level premium insurance policies work | life insurers are able to provide level premium policies by essentially over charging for the earlier years of the policy collecting more than what is needed actuarially to cover the risk of the insured dying during that early period these extra premiums are then credited toward later years when the insured is a higher risk | |
what types of policies are traditionally level premium contracts | level premium insurance is usually associated with term life policies or with whole life policies which guarantee the premium will not change other forms of insurance like variations of universal life ul or annual term may be subject to changing premiums over time as circumstances change 1 | |
why are premiums higher for permanent as opposed to term insurance | premiums are higher for permanent insurance like whole life policies than term life for two primary reasons the first is that the policy covers the insured for their entire life and the second reason is that a portion of a permanent life premium is paid into the policy as cash and can be drawn upon while the policy owner is still alive 1 | |
what is financial leverage | financial leverage is the concept of using borrowed capital as a funding source leverage is often used when businesses invest in themselves for expansions acquisitions or other growth methods leverage is also an investment strategy that uses borrowed money specifically the use of various financial instruments or borrowed capital to increase the potential return of an investment investopedia lara antalunderstanding financial leverageleverage is using debt or borrowed capital to undertake an investment or project it is commonly used to boost an entity s equity base the concept of leverage is used by both investors and companies investors who are not comfortable using leverage directly have a variety of ways to access leverage indirectly they can invest in companies that use leverage in the ordinary course of their business to finance or expand operations without increasing their outlay the point and result of financial leverage is to multiply the potential returns from a project at the same time leverage will also multiply the potential downside risk in case the investment does not pan out when one refers to a company property or investment as highly leveraged it means that the item has more debt than equity | |
how to calculate financial leverage | there is an entire suite of leverage financial ratios used to calculate how much debt a company is leveraging in an attempt to maximize profits here are several common leverage ratios you can analyze a company s leverage by calculating its ratio of debt to assets this ratio indicates how much debt it uses to generate its assets if the debt ratio is high a company has relied on leverage to finance its assets a ratio of 1 0 means the company has 1 of debt for every 1 of assets if it is lower than 1 0 it has more assets than debt if it is higher than 1 0 it has more debt than assets debt ratio total debt total assets begin aligned textbf debt ratio mathbf textbf total debt mathbf div textbf total assets end aligned debt ratio total debt total assets keep in mind that when you calculate the ratio you re using all debt including short and long term debt vehicles instead of looking at what the company owns you can measure leverage by looking strictly at how assets have been financed the debt to equity d e ratio is used to compare what the company has borrowed to what it has raised from private investors or shareholders debt to equity d e ratio total debt total equity begin aligned textbf debt to equity d e ratio mathbf textbf total debt mathbf div textbf total equity end aligned debt to equity d e ratio total debt total equity a d e ratio greater than 1 0 means a company has more debt than equity however this doesn t necessarily mean a company is highly leveraged each company and industry typically operates in a specific way that may warrant a higher or lower ratio for example start up technology companies may struggle to secure financing and must often turn to private investors therefore a debt to equity ratio of 5 1 of debt for every 2 of equity may still be considered high for this industry you can also compare a company s debt to how much income it generates in a given period using its earnings before income tax depreciation and amortization ebitda the debt to ebitda ratio indicates how much income is available to pay down debt before these operating expenses are deducted from income a company with a high debt to ebitda carries a high degree of debt compared to what the company makes the higher the debt to ebitda the more leverage a company is carrying | |
what is a leverage ratio | a leverage ratio is any one of several financial measurements that look at how much capital comes in the form of debt loans or assesses the ability of a company to meet its financial obligations the leverage ratio category is important because companies rely on a mixture of equity and debt to finance their operations and knowing the amount of debt held by a company is useful in evaluating whether it can pay off its debts as they come due several common leverage ratios are discussed below laura porter investopedia | |
what does a leverage ratio tell you | in most cases leverage ratios assess the ability of a company to meet its financial obligations too much debt can be dangerous for a company and its investors however if a company s operations can generate a higher rate of return than the interest rate on its loans then the debt may help to fuel growth uncontrolled debt levels can lead to credit downgrades or worse on the other hand too few debts can also raise questions a reluctance or inability to borrow may indicate that operating margins are tight several different ratios may be categorized as leverage ratios the main factors considered are debt equity assets and interest expenses a leverage ratio may also be used to measure a company s mix of operating expenses to get an idea of how changes in output will affect operating income fixed and variable costs are the two types of operating costs depending on the company and the industry the mix will differ another leverage ratio is the consumer leverage ratio this ratio looks at the level of consumer debt compared to disposable income and is used in economic analysis and by policymakers understanding how debt amplifies returns is the key to understanding leverage debt is not necessarily a bad thing particularly if the debt is taken on to invest in projects that will generate positive returns leverage can thus multiply returns although it can also magnify losses if returns turn out to be negative banks and leverage ratiosbanks are among the most leveraged institutions in the united states the combination of fractional reserve banking and federal deposit insurance corp fdic protection has produced a banking environment with limited lending risks to compensate for this three separate regulatory bodies the fdic the federal reserve and the comptroller of the currency review and restrict the leverage ratios for american banks 1 these bodies restrict how much money a bank can lend relative to how much capital the bank devotes to its own assets the level of capital is important because banks can write down the capital portion of their assets if total asset values drop assets financed by debt cannot be written down because the bank s bondholders and depositors are owed those funds banking regulations for leverage ratios are complicated the federal reserve created guidelines for bank holding companies although these restrictions vary depending on the rating assigned to the bank in general banks that experience rapid growth or face operational or financial difficulties are required to maintain higher leverage ratios 2there are several forms of capital requirements and minimum reserve placed on american banks through the fdic and the comptroller of the currency that indirectly impact leverage ratios the level of scrutiny paid to leverage ratios has increased since the great recession of 2007 to 2009 when banks that were too big to fail were a calling card to make banks more solvent and these pressures haven t gone away restrictions keep getting tighter 3in 2023 following the collapse of several lenders regulators proposed that banks with 100 billion or more in assets dramatically add to their capital cushions these restrictions naturally limit the number of loans made because it is more difficult and more expensive for a bank to raise capital than it is to borrow funds higher capital requirements can reduce dividends or dilute share value if more shares are issued 4for banks the tier 1 leverage ratio is most commonly used by regulators 56types of leverage ratiosthere are many different leverage ratios below we look at some of the more common ones perhaps the most well known financial leverage ratio is the debt to equity d e ratio this is expressed as debt to equity ratio total liabilities total shareholders equity text debt to equity ratio frac text total liabilities text total shareholders equity debt to equity ratio total shareholders equitytotal liabilities for example in the quarter ending june 30 2023 united parcel service s long term debt was 19 35 billion and its total stockholders equity was 20 0 billion the company s d e for the quarter was 0 97 7a high debt equity ratio generally indicates that a company has been aggressive in financing its growth with debt this can result in volatile earnings as a result of the additional interest expense if the company s interest expense grows too high it may increase the company s chances of default or bankruptcy typically a d e ratio greater than 2 0 indicates a risky scenario for an investor however this yardstick can vary by industry businesses that require large capital expenditures capex such as utility and manufacturing companies may need to secure more loans than other companies it s a good idea to measure a firm s leverage ratios against past performance and with companies operating in the same industry in order to better understand the data the equity multiplier is similar but replaces debt with assets in the numerator equity multiplier total assets total equity text equity multiplier frac text total assets text total equity equity multiplier total equitytotal assets for example assume that macy s has assets valued at 19 85 billion and stockholder equity of 4 32 billion the equity multiplier would be 19 85 billion 4 32 billion 4 59 19 85 text billion div 4 32 text billion 4 59 19 85 billion 4 32 billion 4 59although debt is not specifically referenced in the formula it is an underlying factor given that total assets include debt remember that total assets total debt total shareholders equity the company s high ratio of 4 59 means that assets are mostly funded with debt rather than equity from the equity multiplier calculation macy s assets are financed with 15 53 billion in liabilities the equity multiplier is a component of the dupont analysis for calculating return on equity roe dupont analysis n p m a t e m where n p m net profit margin a t asset turnover e m equity multiplier begin aligned text dupont analysis npm times at times em textbf where npm text net profit margin at text asset turnover em text equity multiplier end aligned dupont analysis npm at emwhere npm net profit marginat asset turnoverem equity multiplier generally it is better to have a low equity multiplier as this means a company is not incurring excessive debt to finance its assets the debt to capitalization ratio measures the amount of debt in a company s capital structure it is calculated as total debt to capitalization s d l d s d l d s e where s d short term debt l d long term debt s e shareholders equity begin aligned text total debt to capitalization frac sd ld sd ld se textbf where sd text short term debt ld text long term debt se text shareholders equity end aligned total debt to capitalization sd ld se sd ld where sd short term debtld long term debtse shareholders equity in this ratio operating leases are capitalized and equity includes both common and preferred shares instead of using long term debt an analyst may decide to use total debt to measure the debt used in a firm s capital structure in this case the formula would include minority interest and preferred shares in the denominator degree of financial leverage dfl is a ratio that measures the sensitivity of a company s earnings per share eps to fluctuations in its operating income as a result of changes in its capital structure it measures the percentage change in eps for a unit change in earnings before interest and taxes ebit and is represented as d f l change in e p s change in e b i t where e p s earnings per share e b i t earnings before interest and taxes begin aligned dfl frac text change in eps text change in ebit textbf where eps text earnings per share ebit text earnings before interest and taxes end aligned dfl change in ebit change in eps where eps earnings per shareebit earnings before interest and taxes dfl can alternatively be represented by the equation below d f l e b i t e b i t interest dfl frac ebit ebit text interest dfl ebit interestebit this ratio indicates that the higher the degree of financial leverage the more volatile earnings will be since interest is usually a fixed expense leverage magnifies returns and eps this is good when operating income is rising but it can be a problem when operating income is under pressure the consumer leverage ratio is used to quantify the amount of debt that the average american consumer has relative to their disposable income some economists have stated that the rapid increase in consumer debt levels has been a contributing factor to corporate earnings growth over the past few decades others blamed the high level of consumer debt as a major cause of the great recession consumer leverage ratio total household debt disposable personal income text consumer leverage ratio frac text total household debt text disposable personal income consumer leverage ratio disposable personal incometotal household debt the debt to capital ratio is one of the more meaningful debt ratios because it focuses on the relationship of debt liabilities as a component of a company s total capital base it is calculated by dividing a company s total debt by its total capital which is total debt plus total shareholders equity debt includes all short term and long term obligations this ratio is used to evaluate a firm s financial structure and how it is financing operations generally the higher the debt to capital ratio the higher the risk of default if the ratio is very high earnings may not be enough to cover the cost of debts and liabilities again what constitutes a reasonable debt to capital ratio depends on the industry some sectors use more leverage than others the debt to ebitda leverage ratio measures the amount of income generated and available to pay down debt before a company accounts for interest taxes depreciation and amortization expenses this ratio which is commonly used by credit agencies and is calculated by dividing short and long term debt by ebitda determines the probability of defaulting on issued debt this ratio is useful in determining how many years of earnings before interest taxes depreciation and amortization ebitda would be required to pay back all the debt typically it can be alarming if the ratio is over 3 but this can vary depending on the industry the debt to ebitdax ratio is similar to the debt to ebitda ratio it just measures debt against ebitdax rather than ebitda ebitdax stands for earnings before interest taxes depreciation or depletion amortization and exploration expense it expands ebitda by excluding exploration costs a common expense for oil and gas companies this ratio is commonly used in the united states to normalize different accounting treatments for exploration expenses the full cost method vs the successful efforts method exploration costs are typically found in financial statements as exploration abandonment and dry hole costs other non cash expenses that should be added back in are impairments accretion of asset retirement obligations and deferred taxes another leverage ratio concerned with interest payments is the interest coverage ratio one problem with only reviewing the total debt liabilities for a company is that they do not tell you anything about the company s ability to service the debt this is exactly what the interest coverage ratio aims to fix this ratio which equals operating income divided by interest expenses showcases the company s ability to make interest payments generally a ratio of 3 0 or higher is desirable although this varies from industry to industry times interest earned tie also known as a fixed charge coverage ratio is a variation of the interest coverage ratio this leverage ratio attempts to highlight cash flow relative to interest owed on long term liabilities to calculate this ratio find the company s earnings before interest and taxes ebit then divide by the interest expense of long term debts use pretax earnings because interest is tax deductible the full amount of earnings can eventually be used to pay interest again higher numbers are more favorable | |
what does leverage mean in finance | leverage is the use of debt to make investments the goal is to generate a higher return than the cost of borrowing if a company fails to do that it is neither doing a good job nor creating value for shareholders | |
how is leverage ratio calculated | there are various leverage ratios and each of them is calculated differently in many cases it involves dividing a company s debt by something else such as shareholders equity total capital or ebitda | |
what is a good leverage ratio | that depends on the particular leverage ratio being used as well as the type of company for example capital intensive industries rely more on debt than service based firms so they would expect to have more leverage to gauge what is an acceptable level look at leverage ratios across a certain industry it s also worth remembering that little debt is not necessarily a good thing companies can use debt to deliver shareholders greater returns the bottom lineleverage ratios are useful tools they provide a simple way to see the extent to which a company relies on debt to fund its operations and expand debt is important when used effectively it can generate a higher rate of return than it costs however too much is dangerous and can lead to default and financial ruin leverage varies by industry certain types of companies rely on debt more than others and banks are even told how much leverage they can hold leverage ratios work best when compared to the past or a peer group | |
what is a leveraged buyback | a leveraged buyback is a corporate finance transaction that enables a company to repurchase some of its shares using debt reducing the number of shares outstanding increases the remaining owners respective shares also known as a leveraged share repurchase a leveraged buyback has similar impacts as leveraged recapitalizations and dividend recapitalizations in which companies employ leverage to pay a one time dividend the difference is that dividend recapitalizations do not change the ownership structure | |
how a leveraged buyback works | theoretically leveraged buybacks should have no immediate impact on a company s share price net of any tax benefits from the new capital structure and higher interest payments but the extra debt provides an incentive for management to be more disciplined and improve operational efficiency through cost cutting and downsizing in order to meet larger interest and principal payments a justification for the extreme levels of debt in leveraged buyouts leveraged buybacks are sometimes used by companies with excess cash to decapitalize their balance sheets to avoid overcapitalization increasing the debt on the balance sheet can provide shark repellant protection from hostile takeovers but more often than not leveraged buybacks like other share repurchases are simply used to increase earnings per share eps return on equity roe and price to book p e ratio | |
don t confuse a leveraged buyback with a leveraged buyout while the former involves the repurchase of corporate shares the latter involves the use of debt to acquire another company | leveraged buybacks and epsboosting eps through leveraged buybacks can be an effective tool for companies to use but it does not signify an improvement in underlying performance or value it can even do damage to the business if financial engineering comes at the expense of not investing capital productively for the long term executives say there are not enough investment opportunities but there is clearly a big conflict of interest given that executive compensation is linked to eps in most american companies financial markets have rewarded companies using buybacks as a substitute for improving operational performance so it is no wonder that buybacks became one of wall street s favorite tools since the global financial crisis between 2008 and 2018 companies in the united states spent over 5 trillion buying back their own stock or over half their profits and for large companies like procter gamble mondelez and eli lilly approximately 40 of eps growth has been a result of buybacks buybacks are a mixed bag they can increase eps and improve other financial metrics but also put a firm s credit ratings at risk leveraged buyback returnsin 2017 leveraged buybacks were reported to have made a big comeback in the u s where share repurchases have exceeded free cash flow since 2014 they were also used to avoid having to repatriate cash and pay u s taxes the buyback boom increased the risk for both bondholders and shareholders even investment grade companies were willing to sacrifice their credit ratings in order to reduce the number of shares for example mcdonald s whose executives depend on eps metrics as a component of their performance incentive payout had borrowed so heavily to fund buybacks that its credit rating fell from a to bbb between 2016 and 2018 rising interest rates can impact leveraged buybacks but so could politicians the inflation reduction act of 2022 which was signed into law by president joe biden on aug 16 2022 includes an excise tax of 1 on share buybacks that exceed 1 million after dec 31 2022 senate democrats strongly criticized the buyback boom arguing that trump s tax reform didn t trickle down to workers they wanted to regulate buybacks which were seen as a form of market manipulation before the securities and exchange commission sec gave them the green light in 1982 when it adopted rule 10b 18 that protected corporations from charges of stock market manipulation if buybacks on any given day are no more than 25 of the previous four weeks average daily trading volume biden 2023 state of the union addressin his state of the union address in february 2023 president biden said he would propose quadrupling the tax on corporate stock buybacks it was not clear from his statements whether such a proposal would also impact leveraged buybacks further analysts like evercoreisi strategist tobin marcus suggested that the likelihood of the passage of a buyback tax was low still investors may keep future buyback related legislation in mind when developing strategies biden s announcement follows a dec 2021 push from sec commissioner allison herren lee in support of corporate share repurchase policies enhancing transparency by requiring more detailed timely and structured disclosures of buybacks | |
what are leveraged buybacks | leveraged buybacks are a form of stock repurchase in which a corporation repurchases a quantity of its shares by leveraging its own debt | |
what is the impact of a leveraged buyback | there are many potential effects of a leveraged buyback the earnings per share for the company may increase as a result of the overall reduction of the total number of outstanding shares companies can also use leveraged buybacks to fend of hostile takeovers by increasing their debt | |
what is on the horizon for leveraged buyback regulation | in the inflation reduction act of 2022 there is a 1 excise tax on buybacks exceeding 1 million as of jan 1 2023 president biden also announced in his feb 2023 state of the union address that he would propose quadrupling the tax on corporate stock repurchases although this is yet to be officially announced and it is unclear whether it would apply to leveraged buybacks specifically the bottom lineleveraged buybacks are corporate finance transactions through which a company repurchases a quantity of its shares using debt with added debt many companies that complete a leveraged buyback also institutes cost cutting or downsizing measures leveraged repurchases are often used to increase a corporation s earnings per share buy reducing the overall number of shares outstanding this does not fundamentally impact the company s underlying performance or value this technique can also help to decapitalize a balance sheet buybacks in general have been a target of the biden administration first through a 1 excise tax in the inflation reduction act of 2022 and more recently via comments the president made in the 2023 state of the union address | |
what is a leveraged buyout | a leveraged buyout lbo is the acquisition of one company by another using a significant amount of borrowed money to meet the cost of acquisition the borrowed money can be in the form of bonds or loans the assets of the company being acquired are often used as collateral for the loans along with the assets of the acquiring company investopedia matthew collinsunderstanding leveraged buyouts lbos in an lbo the ratio of debt to equity used for the takeover will be as high as possible the exact amount of debt that will be used depends on the market lending conditions investor appetite and the amount of cash flow that the company is expected to generate after takeover 1 the bonds issued in the buyout usually aren t investment grade and are referred to as junk bonds because of this high debt equity ratio the purpose of leveraged buyouts is to allow companies to make large acquisitions without having to commit a lot of capital returns are generated in an lbo in three ways private equity investment groups that carry out lbos have garnered a reputation for being ruthless and predatory because of their need to rapidly increase margins to do this many investors embark on strict cost cutting measures that can include making staff redundant to make their returns the private equity investors have to sell or realize their investment over a relatively short timeframe typically lbo investments are held for between 5 years and 7 years although there can be shorter or longer holding periods there are several ways the investment can be realized usually lbos are undertaken because a private equity investment group have identified the company as a good target a good target is one that is able to generate annualized returns in excess of 20 and so the company must generate cash to pay down debt deleverage and should have opportunities for margin and multiple improvements examples of leveraged buyoutsone of the largest lbos on record was the acquisition of hospital corp of america hca by kohlberg kravis roberts co kkr bain co and merrill lynch in 2006 the three companies valued hca at around 33 billion 2the number of such large acquisitions declined following the 2008 financial crisis but large scale lbos began to rise again as the covid 19 pandemic waned a group of financiers led by blackstone group announced a leveraged buyout of medline that valued the medical equipment manufacturer at 34 billion in 2021 34vista equity partners and elliott investment management entered into the first significant leveraged buyout of 2022 when they acquired citrix systems inc a software manufacturer for 13 billion in january 5yahoo finance reported in december 2023 that leveraged loans are on track for another boom year in 2024 6 | |
how does a leveraged buyout lbo work | a leveraged buyout lbo occurs when one company attempts to buy another by borrowing a large amount of money to finance the acquisition the acquiring company issues bonds against the combined assets of the two companies so the assets of the acquired company can be used as collateral against it large scale lbos experienced a resurgence in the early 2020s although they re often viewed as a predatory or hostile action 7 | |
why do lbos happen | leveraged buyouts lbos are commonly used to make a public company private or to spin off a portion of an existing business by selling it they can also be used to transfer private property such as a change in small business ownership the main advantage of a leveraged buyout is that the acquiring company can purchase a much larger company leveraging a relatively small portion of its own assets | |
what types of companies are attractive for lbos | equity firms typically target mature companies in established industries for leveraged buyouts rather than fledgling or more speculative industries 8 the best candidates for lbos have historically had strong dependable operating cash flows well established product lines strong management teams and viable exit strategies so that the acquirer can realize gains the bottom linea leveraged buyout lbo refers to the process of one company acquiring another using mostly borrowed funds to carry out the transaction firms often carry out lbos to take a company private or to spin off part of an existing business leveraged buyouts are often seen as a predatory business tactic because the target company has little control over approving the deal and its own assets can be used as leverage against it lbos declined following the 2008 financial crisis but have seen increased activity since then | |
what is a leveraged employee stock ownership plan lesop | a leveraged employee stock ownership plan lesop is an employee compensation program in which the sponsoring company leverages its own credit and borrows the money used to fund the plan and purchase shares from the company s treasury these shares are then used for the stock ownership plan esop with the company subsequently paying back the original loan with annual contributions understanding leveraged employee stock ownership plans lesops typically companies choose to use esops or other equity compensation programs to tie a portion of their employees interests to the bottom line share price performance of the company s stock in this way participating employees are given an incentive to ensure the company s operations run as smoothly and profitably as possible companies often use esops as a corporate finance strategy to align the interests of their employees with those of their shareholders by leveraging company assets the business can provide for its stock ownership plan and give workers ownership interest in the company without immediately putting up all the capital required to do so lesops use the proceeds of bank loans to purchase company stock from the company or its existing shareholders at a sale price established by independent appraisers the lending bank holds the purchased shares as collateral and typically requires payment guarantees from either the company the remaining shareholders or the selling shareholders tax considerationslesops serve as a tax advantaged method of financing corporate growth because shares allocated to an employee s account are not taxed until distributions are received which generally occurs after an employee ends their tenure with a company due to deduction limitations dictated under tax laws employer contributions made to make annual loan payments may not exceed 25 of a participating employee s annual compensation additionally a company may limit lesop participation to employees who are over age 21 and who have completed at least one year of service potential downsides to a leveraged employee stock ownership plan lesop despite the tax deferred benefit participating lesop employees enjoy this plan isn t without potential downsides chief among them an inherent investment risk since a lesop functions as a substitution for other types of qualified retirement plans they may lack the diversification of a typical retirement portfolio such as a 401 k plan and be too concentrated in company stock employees who reach the age of 55 and have completed at least ten years of participation in a lesop are permitted to diversify 50 of their accounts over five years in investments other than their own company s stock additionally since a lesop involves borrowing it can mar a young company s debt to income dti or debt to equity d e ratio making it appear as a less attractive investment than it may otherwise be moreover if a company cannot repay its lesop debts the lender can seize the assets put up as collateral | |
what is a leveraged etf | a leveraged exchange traded fund letf is a security that uses financial derivatives and debt to amplify the returns of an underlying index or other assets it tracks some leveraged or geared etfs track specific stocks which were introduced in 2022 and crypto which can make an already volatile trading strategy far more combustible 12 while a traditional etf typically tracks the securities in its underlying index on a one to one basis an letf will aim for a 2 1 or 3 1 ratio these products are available for most indexes such as the nasdaq 100 index and the dow jones industrial average 3investopedia michela buttignolbut first a word of caution is in order the securities and exchange commission sec first allowed letfs in 2006 4 ever since market analysts have been concerned about their effect on overall market volatility since they can magnify major swings in the market 1 but they also as we do here never fail to warn investors to avoid them as long term investments 3 they are meant for day to day trading and their results over longer periods are unpredictable and can significantly compound losses 5 for these reasons they come under perennial regulatory scrutiny before investing in one read the prospectus and understand the mechanics of these complicated trading instruments leveraged etfs explainedetfs sell like other securities on the stock market and contain a basket of securities these securities could be from an index they track a hand picked theme of stocks or individual stocks derivatives fixed income securities and currency for example etfs that track the s p 500 index contain the 500 stocks in the s p 500 typically if the s p moves 1 the etf will also move by 1 6an letf that tracks the s p 500 would use financial products and debt that magnify each 1 gain in the s p to a 2 or 3 gain the extent of the gain depends on the amount of leverage used leveraging is an investing strategy that uses borrowed funds to buy futures and other derivatives to increase the impact of changes in price letfs primarily use futures contracts index futures and swap agreements to magnify the daily returns of the underlying index stock or other tracked assets 7 these derivatives are needed for the daily rebalancing these letfs require more on this crucial aspect below this leverage can work in the opposite direction and lead to losses for magnified losses if the underlying index falls by 1 the loss is exaggerated by the leverage investors should be aware of the risks of letfs since the risk of losses is far higher than those from traditional investments as d j abner notes in his etf handbook while investors notoriously fail to read prospectuses and investor warnings before putting money into securities this is decidedly not the time to do so 3lastly the management fees and transaction costs associated with letfs can diminish the fund s return 8 for the 170 letfs it tracks in the u s markets etf com puts the average expense ratio at 1 02 9the leverage in leveraged etfsan letf applies derivatives to magnify the exposure to a particular index or other targeted asset stocks cryptocurrency commodities etc 10 it does not aim to amplify the monthly or annual returns of the target assets but instead tracks daily changes resetting each day 8the leverage in letfs comes from several sources first it can come from borrowing for instance the fund that aims to have twice the return of the targeted assets might take your invested funds and then borrow the same amount to effectively double how much is invested 11 letfs also employ derivatives like forward contracts futures contracts total return swaps and less frequently options 7futures contracts agreements to buy or sell an asset at a predetermined price at a specific time they are traded on exchanges and the parties have to fulfill the contract at its maturity date forward contracts like futures forwards are contracts to trade an asset at a set price in the future however unlike futures they are not standardized but are customizable private agreements total return swaps where one party agrees to pay the total return including dividends interest and capital gains of a tracked asset or set of assets to another party that pays a fixed or floating rate it s a way to gain exposure to an asset s return without owning it options options contracts grant an investor the ability to buy a call option or sell a put option an underlying asset without the obligation to buy or sell the security options contracts have an expiration date for when any action must be completed they are fundamentally different from futures and forwards which put obligations on both parties and from swaps which involve exchanging cash flows or returns employing derivatives for generating returns is a method known as synthetic replication the flip side of physical replication directly borrowing which is generally more efficient than borrowing to buy the securities of the benchmark 3 regarding options they have upfront fees called premiums that allow investors to buy many shares of a security 12 as a result options layered with investments such as stocks can add to the gains for letfs over 1 1 traditional etfs a leveraged inverse etf uses its leverage to make money when the underlying index is declining in value 13 in other words an inverse etf rises while the underlying index is falling allowing investors to profit from a bearish market or market declines 8the costs of leveragealong with management and transaction fee expenses there are other costs associated with letfs 5 these funds have higher fees than non leveraged etfs because premiums fees and interest need to be paid on the derivatives and for margin costs 8 many letfs have expense ratios of 1 or more 9despite the higher expense ratios associated with letfs they are often less expensive than other forms of margin trading on margin involves a broker lending money to a customer so that the borrower can buy securities with the securities held as collateral for the loan the broker also charges an interest rate for the margin loan for example short selling which involves borrowing shares from a broker to bet on a downward move can carry fees of 3 or more on the amount borrowed the use of margin to buy stock can become similarly expensive and can result in margin calls should the position begin losing money a margin call happens when a broker asks for more money to shore up the account if the collateral securities are losing value an fall below a certain minimum 14leveraged etfs are short term instrumentsletfs are typically used by day traders speculating on an index or other targeted sets of assets it is difficult to hold long term investments in letfs because the derivatives used for the leverage are not long term investments as a result traders often hold positions in letfs for day trading 8these etfs should not be used for long term strategies since they re anchored in techniques for returns within a trading day not a longer time and the daily reset means the fund can t build on itself 10 if you want etfs for long term investing there are myriad financial products for that 1letfs offer the potential for significant gains that exceed the tracked index or assets investors have a wide variety of securities to trade using letfs investors can make money when the market is declining using inverse letfs letfs can lead to significant losses that exceed the tracked index or assets letfs have higher fees and expense ratios compared with traditional etfs letfs are not long term investments real world example of a leveraged etfthe direxion daily financial bull 3x shares fas etf holds equities in large u s financial companies by tracking the financial select sector index it has an expense ratio of 0 96 and it tracks securities that include berkshire hathaway brk b visa v jpmorgan chase co jpm and other financial companies in the s p 500 this letf aims to provide investors three times 3x the return on the moves in the financial stocks it tracks 15 to do this the fund invests in swap agreements index securities and etfs that track the index now suppose an investor bought 10 000 of fas and the underlying financial stocks rose by 1 in a single day fas would seek to provide 3 returns on that day this means the 10 000 investment would increase to 10 300 at the end of the day before fees however because letfs reset each day the gains are not compounded over days tomorrow is another day entirely conversely if the tracked financial stocks declined 2 in a day fas would aim for a 6 decline for that same day so the original 10 000 investment would decrease to 9 400 before accounting for fees as this example shows the multiplier works both ways you can get three times the gains during a positive performance and three times the losses when the index declines the impact of daily resetsthe daily reset mechanism causes letfs to rebalance their entire portfolios daily to maintain their leverage thus they won t work necessarily for a buy and hold strategy since they don t allow gains and losses to compound over longer periods this resetting effect allows the etf to seek 3x leverage daily but can cause longer term returns to diverge significantly from simply multiplying the underlying index s total returns by 3x to demonstrate this here is an example covering several days let s assume the underlying financial index fas tracks has the following daily returns we need to triple each of these for the expected return of fas 3 0 6 0 and 1 5 respectively for the three days above on day 1 since the index rose 1 fas would seek to provide 3x that return or 3 0 so the 10 000 investment would rise to 10 300 but on day 2 the index fell 2 0 so fas would target returns of 3 x 2 6 the 10 300 balance would decline by 6 to 9 682 on day 3 the index rose 0 5 so fas would attempt to return 3 x 0 5 1 5 so the balance moves from 9 682 to 9 827 a net loss of 1 73 as you can see the daily reset prevents the gains and losses from compounding over several days the leveraged position is reset completely rather than just adding 3x each day s additional gain or loss while the index declined 0 5 over the three days the 3x letf declined more than 1 7 over the same period because of the effects of daily rebalancing which is more than 1 5 loss expected by multiplying the index return by three thus letf returns can significantly diverge from a simple multiplier of the underlying index s returns in volatile conditions over those same periods the sequence of daily gains and losses matters because of the daily reset mechanism so while useful for short term trading strategies letfs like fas generally should not be expected to achieve a consistent 3x return compared with the tracked index or assets for longer periods | |
what are the tax implications of owning leveraged etfs | letfs have unique tax implications because of their frequent trading and rebalancing they can generate higher short term capital gains inside the fund which are taxed at a higher rate than long term capital gains 16 also the use of derivatives and other financial instruments in these etfs can lead to complex tax situations in certain cases 17 it s advisable to consult a tax professional for guidance specific to your circumstances | |
do interest rate changes impact leveraged etf performance | for fixed income letfs yes since bond prices react to changes or expectations of changes in interest rates 13 for other letfs interest rates can significantly affect certain letfs that use borrowed money or rate sensitives derivatives instruments so rising interest rates can increase borrowing costs thus reducing returns 18 in addition changes in interest rates can affect the sectors or assets they track influencing their performance for example higher interest rates might negatively influence debt heavy sectors which in turn would affect letfs tracking those sectors | |
what s the difference between buying a leveraged etf and margin trading | letfs have built in leverage and aim to deliver a multiple of a tracked index s or assets daily returns margin trading meanwhile involves borrowing money from a broker to invest in securities while both involve leverage margin trading gives investors more control over the amount of leverage and the specific investments however margin trading also carries the risk of a margin call if the investments decline in value which is not a risk with letfs the bottom lineletfs are specialized financial instruments designed to deliver multiples of the daily performance of a specific index or asset they achieve this by using derivatives as leverage amplifying both gains and losses ideal for experienced traders and suited for short term i e intraday investment strategies letfs are used in scenarios when quick significant market moves are expected however their complex nature and the impact of daily rebalancing make them unsuitable for longer term investments investors should use caution as these etfs entail a higher degree of risk and volatility compared with traditional etfs because of their sensitivity to market fluctuations and the costs associated with their operation letfs should be used with a clear understanding of their mechanisms and potential impacts on investment portfolios | |
what is a leveraged lease | a leveraged lease is a lease agreement that is financed through the lessor with help from a third party financial institution in a leveraged lease an asset is rented with borrowed funds understanding leveraged leasesleveraged leases are most often used in the renting of assets planned for short term use assets like cars trucks construction vehicles and business equipment are typically all available through the option of leveraged leasing leasing in general means a company or individual will be renting an asset leasing any type of asset gives an entity the right to use the asset for a short term in general the entity is only renting the asset although many leveraged leases offer a buyout option at the end of the lease term the leveraged aspect of a leveraged lease involves borrowing funds to pay for the high cost of the asset s value a leveraged lease is usually used when an entity does not have the funds to buy the asset outright nor do they necessarily want to keep the asset for a long term a leveraged lease allows a lessee to obtain a loan for the leased asset s value during the lease term and repay the loan over the life of the lease the amount needed for the loan can be lower than buying the asset outright because the lessee is only paying for a specified value associated with the length of time on the lease accounting standards require a business to differentiate and account for leased assets differently depending on whether the lease is an operating lease or leveraged capital lease leverage leases can be more complex than a basic operating lease because leverage is involved the structure of the leveraged lease terms will depend on the lessor and their financing relationships the lessor may also be the financing institution who provides the loan in which case they approve the loan for the borrower the lessor may also work with a third party lender in this case the third party lender provides the borrowed funds to the lessor on your behalf allowing you to take possession of the asset as soon as a loan is approved in some cases a lessor may put up some funds combined with borrowed funds from a third party which can help to improve the overall terms of the lease once a leveraged lease is approved and agreed on the borrower takes possession of the asset and is responsible for making regularly scheduled payments toward the loan balance the asset s title is usually held by either the lessor or the lender depending on the structure regardless a leveraged lease doesn t involve the transfer of the title to the lessee during the lease period keep in mind that a leveraged lease is usually backed by a secured loan this means that if a lessee stops making payments the lessor can repossess the asset leasing vs financingleveraged leasing and leveraged financing are typically the two main options for any person or company buying a car or other high value asset a leveraged lease provides a loan that covers an estimated value of a car over the leasing timeframe leveraged lease payments can potentially be lower because the loan does not cover the full value of the car an entity can also have the option to finance a car in this scenario the car loan is similar to a home loan the buyer of the car obtains a loan for the full value of the car and payments are created over a longer timeframe for repaying the car loan special considerations accounting for leveraged leasesindividuals usually do not need to worry about the accounting standards for leasing an asset with leverage but this would be a factor for a business in business accounting leveraged leases are referred to as capital leases to determine the difference four criteria are used if any one of these criteria is met then the lease is considered a capital lease and if not then the lease is considered an operating lease capital leases generally involve accounting for the leased asset similarly to an asset purchase operating lease accounting will generally require entries for the lease payments as operating expenses operating lease vs leveraged capital leaseindividuals or business entities may encounter the differences in an operating lease vs a leveraged capital lease in general an operating lease does not include any options for buying the asset being rented common types of operating lease agreements include apartment leases and building leases leveraged capital leases are important to differentiate from operating leases in business accounting since accounting principles have different standards for the two | |
what is a leveraged loan | a leveraged loan is one that is extended to companies or individuals that already have considerable amounts of debt or a poor credit history lenders consider leveraged loans to carry a higher risk of default and as a result a leveraged loan is more costly to the borrower leveraged loans for companies or individuals with debt tend to have higher interest rates than typical loans these rates reflect the higher level of risk involved in issuing the loans understanding leveraged loansa leveraged loan is structured arranged and administered by at least one commercial or investment bank these institutions are called arrangers and subsequently may sell the loan in a process known as syndication to other banks or investors to lower the risk to lending institutions 1there are no set rules or criteria for defining a leveraged loan some market participants base it on a spread for instance many of the loans pay a floating rate often based on the secured overnight financing rate sofr which replaced the london interbank offered rate libor in june 2023 or another benchmark plus a stated basis or arm margin in general the adjustment of the credit spread adds basis points to the interest rate on a loan to make up for the fact that sofr has traded below libor 2if the arm margin is above a certain level it is considered a leveraged loan others base the classification on the borrower s credit rating with loans rated below investment grade which is categorized as ba3 bb or lower by the rating agencies moody s and s p typically banks are allowed to change the terms when syndicating the loan which is called price flex the arm margin can be raised if demand for the loan is insufficient at the original interest level in what is referred to as upward flex conversely the spread over sofr can be lowered which is called reverse flex if demand for the loan is high | |
how do businesses use leveraged loans | companies typically use a leveraged loan to finance mergers and acquisitions m a recapitalize the balance sheet refinance debt or for general corporate purposes m a could take the form of a leveraged buyout lbo an lbo occurs when a company or private equity company purchases a public entity and takes it private typically debt is used to finance a portion of the purchase price a recapitalization of the balance sheet occurs when a company uses the capital markets to change the composition of its capital structure a common transaction in this process issues debt to buy back stock or pay a dividend which are cash rewards paid to shareholders leveraged loans allow companies or individuals that have high debt or poor credit history to borrow cash though at higher interest rates than usual example of a leveraged loans p s leveraged commentary data lcd which is a provider of leveraged loan news and analytics places a loan in its leveraged loan universe if the loan is rated bb or lower alternatively a loan that is nonrated or bbb or higher is often classified as a leveraged loan if it is secured by a first or second lien | |
what is a leveraged loan | a leveraged loan is a type of loan made to borrowers with high levels of debt or a low credit rating lenders consider leveraged loans to carry a higher than average risk that the borrower will be unable to pay back the loan also known as the risk of default these loans generally earn higher interest rates for lenders because of the higher level of risk 1 | |
what is the difference between a bank loan and a leveraged loan | leveraged loans also known as floating rate loans or bank loans are loans made by banks or other financial institutions that are then sold to investors companies may use the money they get to refinance their debt fund mergers and acquisitions or finance projects the companies that receive these loans typically have credit ratings that are below investment grade they are secured by collateral such as the borrower s real estate and equipment or by intellectual property including brands trademarks and customer lists 3 | |
how do funds invest in leveraged loans | investment funds such as mutual funds and exchange traded funds or etfs may hold leveraged loans in their portfolios depending on their investment strategy some funds may make a small investment in leveraged loans as part of a diverse portfolio while other funds may invest heavily in these loans fund portfolio managers may be interested in purchasing these loans because their higher interest rates could mean a higher return for investors in the fund 1the bottom linea leveraged loan is extended to companies or individuals that have considerable amounts of debt or poor credit history lenders consider leveraged loans to carry a higher risk of default and as a result make them more costly to the borrowers with higher interest rates than typical loans reflecting the increased risk involved in issuing the loans there are no set rules for defining a leveraged loan some market participants base it on a spread calculating a floating rate based on a benchmark called sofr in addition to a basis or arm margin | |
what is a leveraged loan index lli | a leveraged loan index lli is a market weighted index that tracks the performance of institutional leveraged loans several indexes for the market exist but the most widely followed one is the s p lsta u s leveraged loan 100 index 1a leveraged loan is a senior secured debt obligation that is rated below investment grade i e part of the high yield or junk bond market leveraged loans are issued to finance leveraged buyouts lbos and most of the loans are traded in the secondary market the leveraged loan index tracks the prices of the loans | |
how a leveraged loan index works | a leveraged loan is structured arranged through a process known as syndication loan syndication is the process of bringing together a group of lenders in funding various portions of a loan for a single borrower often to diversify the credit risk exposure of any single lender this version of a leveraged loan index is a common benchmark and represents the 100 largest and most liquid issues of the institutional loan universe the most popular leveraged loan index lli was developed by standard poor s s p and the loan syndications and trading association lsta a sub index assembled by s p and lsta is the u s leveraged loan 100 b bb rating index while s p has a global leveraged loan 100 index on its own to include major issuers in europe the indexes are rebalanced twice per year ihs markit ltd and credit suisse also maintain proprietary leveraged loan indexes leveraged loan indices in practicean lli serves as a benchmark for performance measurement of fund managers dedicated to leveraged loan investment strategies and as a basis for passive investment vehicles such as exchange traded funds etf for example the invesco senior loan portfolio ticker bkln is based on the s p lsta u s leveraged loan 100 index according to invesco the asset management company that offers bkln the fund invests at least 80 of its total assets in the constituent securities that make up the leveraged loan index which tracks the market weighted performance of the component loans based on market weightings spreads and interest payments 2 if less than 100 of the assets are invested in the component securities of the index there will be variability in the performance of the etf versus the index llis and cdsssome llis are tailored to derivatives products that utilize leveraged loans for instance the itraxx levx are a pair of two tradable indexes that hold credit default swaps cdss representing a diversified basket of the 40 formerly 35 most liquid european companies that have tradable debt offerings in the secondary market 3the levx indices track what are known as leveraged loan credit default swaps lcds the itraxx levx senior index represents only senior loans while the itraxx levx subordinated index represents subordinated debt including second and third lien loans 4 | |
what is leveraged recapitalization | a leveraged recapitalization is a corporate finance transaction in which a company changes its capitalization structure by replacing the majority of its equity with a package of debt securities consisting of both senior bank debt and subordinated debt a leveraged recapitalization is also referred to as leveraged recap in other words the company will borrow money in order to buy back shares that were previously issued and reduce the amount of equity in its capital structure senior managers employees may receive additional equity in order to align their interests with the bondholders and shareholders usually a leveraged recapitalization is used to prepare the company for a period of growth since a capitalization structure that leverages debt is more beneficial to a company during growth periods leveraged recapitalizations are also popular during periods when interest rates are low since low interest rates can make borrowing money to pay off debt or equity more affordable for companies leveraged recapitalizations differ from leveraged dividend recapitalizations in dividend recapitalizations the capital structure remains unchanged because only a special dividend is paid understanding leveraged recapitalizationleveraged recapitalizations have a similar structure to that employed in leveraged buyouts lbo to the extent that they significantly increase financial leverage but unlike lbos they may remain publicly traded shareholders are less likely to be impacted by leveraged recapitalizations as compared to new stock issuances because issuing new stocks can dilute the value of existing shares while borrowing money does not for this reason leveraged recapitalizations are looked upon more favorably by shareholders they are sometimes used by private equity firms to exit some of their investment early or as a source of refinancing and they have similar impacts to leveraged buybacks unless they are dividend recapitalizations using debt can provide a tax shield which might outweigh the extra interest expense this is known as the modigliani miller theorem which shows that debt provides tax benefits not accessible via equity and leveraged recaps can increase earnings per share eps return on equity and the price to book ratio borrowing money to pay off older debts or buy back stock also helps companies avoid the opportunity cost of doing so with earned profits like lbos leveraged recapitalizations provide incentives for management to be more disciplined and improve operational efficiency in order to meet larger interest and principal payments they are often are accompanied by a restructuring in which the company sells off assets that are redundant or no longer a strategic fit in order to reduce debt however the danger is that extremely high leverage can lead a company to lose its strategic focus and become much more vulnerable to unexpected shocks or a recession if the current debt environment changes increased interest expenses could threaten corporate viability history of leveraged recapitalizationleveraged recapitalizations were especially popular in the late 1980s when the vast majority of them were used as a takeover defense in mature industries that do not require substantial ongoing capital expenditures to remain competitive increasing the debt on the balance sheet and thus a company s leverage acts as a shark repellant protection from hostile takeovers by corporate raiders | |
what is levered free cash flow lfcf | levered free cash flow lfcf is the amount of money that a company has left remaining after paying all of its financial obligations lfcf is the amount of cash that a company has after paying debts while unlevered free cash flow ufcf is cash before debt payments are made levered free cash flow is important because it is the amount of cash that a company can use to pay dividends and make investments in the business formula and calculation of levered free cash flow lfcf l f c f e b i t d a n w c c a p e x d where ebitda earnings before interest taxes depreciation and amortization nwc change in net working capital capex capital expenditures d mandatory debt payments begin aligned lfcf ebitda delta nwc capex d textbf where text ebitda text earnings before interest taxes qquad qquad quad text depreciation and amortization delta text nwc text change in net working capital text capex text capital expenditures text d text mandatory debt payments end aligned lfcf ebitda nwc capex dwhere ebitda earnings before interest taxes depreciation and amortization nwc change in net working capitalcapex capital expendituresd mandatory debt payments | |
what lfcf can tell you | levered free cash flow is a measure of a company s ability to expand its business and to pay returns to shareholders dividends or buybacks via the money generated through operations it may also be used as an indicator of a company s ability to obtain additional capital through financing if a company already has a significant amount of debt and has little in the way of a cash cushion after meeting its obligations it may be difficult for the company to obtain additional financing from a lender if however a company has a healthy amount of levered free cash flow it then becomes a more attractive investment and a low risk borrower even if a company s levered free cash flow is negative it does not necessarily indicate that the company is failing it may be the case that the company has made substantial capital investments that have yet to start paying off as long as the company is able to secure the necessary cash to survive until its cash flow increases a temporary period of negative levered free cash flow is both survivable and acceptable | |
what a company chooses to do with its levered free cash flow is also important to investors a company may choose to devote a substantial amount of its levered free cash flow to dividend payments or for investment in the company if on the other hand the company s management perceives an important opportunity for growth and market expansion it may choose to devote nearly all of its levered free cash flow to funding potential growth | levered free cash flow lfcf vs unlevered free cash flow ufcf levered free cash flow is the amount of cash a business has after paying debts and other obligations unlevered free cash flow ufcf is the amount of cash a company has prior to making its debt payments ufcf is calculated as ebitda minus capex minus working capital minus taxes lfcf is the cash flow available to pay shareholders while ufcf is the money available to pay shareholders and debtholders levered free cash flow is considered the more important figure for investors to watch as it s a better indicator of a company s profitability | |
how is levered free cash flow lfcf important to a business | levered free cash flow lfcf is the amount of cash that a company can use to pay dividends and make investments in the business | |
how does levered free cash flow work | levered free cash flow measures the ability of a company to expand its business and to pay returns to shareholders dividends or buybacks via the money generated through operations it may also indicate the ability of a company to obtain additional capital through financing | |
which is more important to investors levered or unlevered free cash flow | levered free cash flow is considered more important for investors to watch than unlevered free cash flow lfcf is a better indicator of a company s profitability the bottom linelevered free cash flow lfcf is the amount of money that a company has left remaining after paying all of its financial obligations since it s the amount of cash that a company has after paying debts it s important because lfcf is what a company can use to pay dividends and invest in itself | |
what is a levy | a levy is the legal seizure of property to satisfy an outstanding debt individuals who fail to pay taxes may be penalized by levies on tax refunds or property by the internal revenue service irs tax authorities can also levy other assets such as bank accounts rental income or retirement accounts types of levieslevies can be exercised by a tax authority such as a state treasury the internal revenue service irs or a bank 12in the u s the irs can levy an individual s property to satisfy a tax debt property that can be levied includes real property like cash in a bank account a house a car or a boat the internal revenue code irc authorizes levies for delinquent tax payments to the federal government the irs must assess the tax and send a notice and demand for payment to an individual owing federal taxes 34if the individual neglects or refuses to pay the tax the irs will send a final notice notice of intent to levy and your right to a hearing this is typically sent at least 30 days before the levy and can be given in person dropped at the tax debtor s home or place of business or mailed to the individual s last known address 3intangible property held by someone other than the defaulting taxpayer can be levied this includes wages retirement accounts dividends bank accounts licenses rental income accounts receivables commissions or the cash loan value of a life insurance policy 3a state tax levy applies to unpaid state taxes the irs can levy a debtor s state tax refund and receive a notice of levy on your state tax refund and a notice of your right to hearing after the levy 3a creditor must obtain a court judgment against a debtor to issue a bank levy the bank levy freezes the debtor s accounts until outstanding debt is repaid in full if the levy is not lifted the creditor can take the money from the bank account and apply it to the total debt owed 5banks may charge a fee to their customers for processing a levy on their accounts 6a bank levy can occur due to unpaid taxes or unpaid personal debt some accounts such as social security income supplemental security income veteran s benefits and child support payments cannot be levied unlike private debt from credit cards debt owed to the federal government such as student loan debt or delinquent taxes does not require a court order to levy an individual s bank account agencies like the irs generally provide notice of delinquency and allow the taxpayer to resolve the issue before securing a levy 72in the united kingdom the term bank levy also refers to taxes assessed on financial institutions due to the higher risk they pose to the economy at large a green levy is a tax on greenhouse gases or other sources of pollution these levies are intended to incentivize environmentally friendly behaviors by raising the costs of polluting businesses carbon taxes are among the most common green levies taxes on greenhouse gases are commonly assessed as an emissions tax or a tax on goods or services that are greenhouse gas intensive such as gasoline 8a mill levy or mill tax is a property tax based on the assessed value of real estate and used by local governments to allocate funding for school districts or parks every year each property in the district is valued by a tax assessor and taxation is based on a percentage 9garnishments and liensthe irs and private creditors may use garnishment a levy allows creditors to withdraw money from a bank account but a garnishment redirects a portion of an individual s wages or income to repay a debt 10both garnishments and levies are available to private creditors and the government federal agencies like the irs do not need a court order to levy or garnish assets garnishments are frequently used to pursue defaulted loans or delinquent child support debtors may be entitled to some relief if the garnishment would cause them financial hardship 1112a levy differs from a lien because a levy takes the property to satisfy the tax debt whereas a lien is a claim used as security for the tax debt a lien secures the government s interest or claim to an individual s or business s property while the tax debt remains unpaid and a levy permits the government to seize and sell the property to pay the tax debt 13the irs may impose a federal tax lien to inform other creditors of the taxing authority s legal right to a taxpayer s assets and property if the taxes remain unpaid the tax authority can use a tax levy to legally seize the taxpayer s assets to collect the money owed 14a tax lien once remained on a credit report for up to 15 years but tax liens are no longer listed on credit reports as of april 2018 1516avoiding leviestaxpayers should file returns on time and pay taxes when they are due individuals can request an extension or contact the irs and arrange to pay the balance in installments 17 debtors may be able to set up a payment plan or settle tax debt for less than the amount owed those who receive an irs bill titled final notice notice of intent to levy and your right to a hearing should contact the irs 18irs errorsthe irs may reimburse a taxpayer for bank charges caused by erroneous levies by submitting form 8546 claim for reimbursement of bank charges to the irs address on the taxpayer s copy of the levy to be eligible to recover bank charges from the irs all of the following conditions must be satisfied 7 | |
which constitutional amendment gave congress the power to levy an income tax | the sixteenth amendment allows congress to collect direct income taxes without regard to state census counts before the amendment s passage in 1909 income taxes could only be allocated among the states based on their population until the 16th amendment was ratified federal revenues largely came from customs duties and excise taxes 19 | |
how can you stop a levy on your bank account | the simplest way to avoid a bank account levy is to repay the debt that prompted the levy in the first place if an individual can prove that the levy was due to an error on the creditor s part or that they were the victim of identity theft account access is restored | |
how often can the irs levy my bank account | there is no limit to the number of levies the irs can place to collect unpaid taxes however the irs can only levy up to 15 of social security benefits and it cannot levy veterans benefits 220 in addition the irs may release a levy if the lost funds would create an undue economic hardship 11 | |
what is an ad valorem tax levy | an ad valorem tax is levied on the assessed value of a piece of property usually real estate or a vehicle the phrase ad valorem means according to value so these tax burdens are distributed among the community according to the value of each taxpayer s property these taxes are a source of revenue for local governments and school districts 21the bottom linelevies are used by a taxing authority or a bank to seize property for an outstanding unpaid debt property can include cash cars houses and wages a levy differs from a lien because a lien only represents the claim used as security for the debt a garnishment directs an employer to move part of an individual s salary to a creditor | |
what is a liability | a liability is something that a person or company owes usually a sum of money liabilities are settled over time through the transfer of economic benefits including money goods or services they re recorded on the right side of the balance sheet and include loans accounts payable mortgages deferred revenues bonds warranties and accrued expenses liabilities are the opposite of assets they refer to things that you owe or have borrowed assets are things that you own or are owed investopedia nono flores |
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