This document discusses using debt (leverage or "gearing") to invest. It provides an example showing how borrowing $400,000 to invest $500,000 in shares can magnify returns but also losses, depending on whether share prices and dividends increase or decrease. It defines gearing as borrowing to invest in growth assets. It notes that gearing is for long-term investors who can withstand short-term market fluctuations and have a high tax rate to reduce interest costs. It also defines positive and negative gearing in terms of whether investment income exceeds or is less than costs.

1. GENC3003Personal Financial PlanningAndrew Hingstonandrew.hingston@unsw.edu.auUnit 15: Debt – foe and friend

2. 2DiscussionYour starting cash is $100,000You invest the money into ANZ sharesHow much money would you have at the end of the year if:ANZ share price goes up by 10% and pays a 5% dividend?(assume dividend is paid at end of year)ANZ share price goes down by 10% and pays no dividend?

3. 3AnswerPrice increase by 10% plus 5% dividend$100,000 x ( 1 + 0.10 + 0.05 ) = $115,000Price decrease by 10%$100,000 x ( 1 – 0.10 ) = $90,000

4. 4DiscussionYour starting cash is $100,000You borrow an extra $400,000.You invest $500,000 into ANZ sharesYou pay back the loan plus interest of $20,000 at end of yearHow much money would you have at the end of the year if:ANZ share price goes up by 10% and pays dividend of 5%? (assume dividend is paid at end of year)ANZ share price goes down 10% and pays no dividend?

5. 5AnswerPrice increases by 10% + 5% dividend$500,000 x ( 1 + 0.10 + 0.05) = $575,000Amount leftover after paying back loan + interest$575,000 – $420,000 = $155,000This is a 55% return on your original $100,000Price decreases by 10%$500,000 x ( 1 – 0.10 ) = $450,000$450,000 – $420,000 = $30,000This is a -70% return on your original $100,000

6. 6What is “gearing”?Borrowing money to invest in a growth assetEg. Family home, investment property, shares, managed fundMagnifies your potential returns and losses (risk)If after-tax returns are higher than after-tax borrowing rate then you can make a lot of moneyIf after-tax returns are lower than after-tax borrowing rate then you can lose a lot of moneyFor higher expected average returns over 10+ years

7. 7Who is gearing for?Anyone who borrows money to buy a home or investment property … ie most Australians do it but don’t realise!For geared investments in shares / managed funds …Long term investment time horizon (pref 20+ years)Invest in good quality, diversified portfolios and hold for long-termDon’t gamble by trying to pick stocks and time the marketSelf-controlled people who will not “freak out” when markets fallHigh marginal tax rate to significantly reduce after-tax interest costs and cover any “margin calls” (more later)

8. 8Positive vs negativePositive gearingInterest or dividends and other income related to investment is more than the cost of the investment (interest on loan, maintenance etc)Investment is cash flow positive and helps to cover your living expenses but increases tax billNegative gearingInvestment income is less than costsDifference can be claimed as a tax deductionDrain on cash flow taking money away from other savings and from living expenses but reduces tax bill