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Distribution required to cover margin interest costs

Discussion in 'Managed Funds & Index Funds' started by Simon Hampel, 22nd Jun, 2006.

  1. Simon Hampel

    Simon Hampel Co-founder Staff Member

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    Following on from a comment in another thread about covering margin loan interest costs ... I thought I would share with you a simple formula for the distribution required from a fund to cover the margin loan costs. It's rather crude - but does give you a rule of thumb.

    The formula is simply this: Minimum distribution (as a percentage of value) = LVR * Interest rate

    In other words, if you hold a fund at 60% LVR and are paying 8% interest, then you need a minimum of 0.6 * 0.08 = 0.048 = 4.8% distribution to cover your interest costs.

    An example:

    Loan $20,000
    Investment value $40,000 (50% LVR)
    Interest rate 8%

    Annual interest = $20,000 * 8% = $1,600
    Minimum Distribution required = $1,600 or as a % = $1,600/$40,000 = 4%

    Another example:

    Loan $150,000
    Investment value $250,000 (60% LVR)
    Interest rate 7.8%

    Annual interest = $150,000 * 7.8% = $11,700
    Minimum distribution required = $11,700 / $250,000 = 4.68%

    Now if you choose a fund that can cover your annual interest costs in one quarterly distribution, then you have 3 quarters of pure profit each year :D
     
  2. MichaelWhyte

    MichaelWhyte Well-Known Member

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    Sim,

    You forgot to mention that sometimes the principal used to leverage off is often borrowed too. In my case it is. I've used an LOC on my PPOR for the principal at 6.77% pa then margined up with a margin loan at 8.1% pa.

    So for me the equation is:

    (0.6 * 0.0677) + (0.4 * 0.081) = 7.3% hurdle rate.

    i.e. the fund needs to beat 7.3% for me to make a profit.

    Cheers mate,
    Michael.
     
  3. Nigel Ward

    Nigel Ward Team InvestEd

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    So you basically figure out your weighted average cost of capital...
     
  4. MichaelWhyte

    MichaelWhyte Well-Known Member

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    Yep,

    In Sim's example he basically just omitted the portion of the equation that is at zero cost of capital since those funds aren't borrowed and are incurring no interest.

    To complete his equation it would be:

    (0.6 * 0.08) + (0.4 * 0.00) = 0.048 = 4.8%

    Personally I'd mount an argument that even your cash reserves have an opportunity cost of capital that should be considered when calculating hurdle rates for investments but won't go there. ;)

    Cheers,
    Michael.
     
  5. Nigel Ward

    Nigel Ward Team InvestEd

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    Why shouldn't we go there? :D Perhaps the figure should be the best deposit rate available for that money (probably 5.4-5.6%pa through an online account such as ING Direct - not sure if the BankWest 6% is still available...)

    N.
     
  6. Simon Hampel

    Simon Hampel Co-founder Staff Member

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    I didn't forget ... I just didn't assume, because I'd suggest the majority of investors are NOT in this situation.

    If this is your situation (it is for me too !!), then you should take that into acocunt in your calculations.

    It was just a simple raw calculation.
     
  7. MichaelWhyte

    MichaelWhyte Well-Known Member

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    Agreed.

    OK, so Sim's equation should read:

    (0.6 * 0.08) + (0.4 * 0.06) = 0.072 = 7.2%

    Or, in other words, even at a 60% LVR at 8% pa, the fund should be required to beat 7.2% for you to justify investing in it. Otherwise you would be better off parking that cash (the principal) in a risk-free bond earning 6% pa.

    Mind you, that's not what Sim was illustrating. He was illustrating how much distribution you would need to earn to cover your interest cost on your margin loan. In that regard his equation is spot on!

    I really should go do some work now... ;)

    Cheers,
    Michael.
     
  8. gad

    gad Well-Known Member

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    Shouldn't you also include the amount of tax you would have to pay on those distributions?
     
  9. Simon Hampel

    Simon Hampel Co-founder Staff Member

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    My original point was to come up with a simple rule-of-thumb for measuring or comparing returns with margin loans.

    If you want to add in cost of capital, tax and all those other aspects, then sure - you can do that ... but you'd then also better add in franking credits and all that other stuff too if you are actually trying to get an accurate figure. It all gets too complicated.

    ... and tax is practically impossible to predict before the end of financial year anyway - there are so many other factors that impact on your after tax returns.