ReallyVeryFoolish wrote:Alaric wrote:dealtn wrote:It doesn't matter if the debt is yours, or the company's, the effects are the same!
What about limited liability?
If you put 50 into a Company, the most you lose is 50. If you borrow 50, put the extra 50 into the Company, you could not only lose 100 on the Company, but still owe 50. It's like whether a Company should be financed by equity or debt. In the case of equity, the Company can cancel dividends and let the equity become next to worthless. If it borrows, it has to service the debt and if it cannot not afford to do so, can be driven out of business when it defaults.
Exactly, but some people seemingly either don't understand or ignore the risk. Thanks. (My bold).
RVF
Ok, I am not ignoring the risk, I am aware of the risk, and further more am aware of the risks in both scenarios, are you?
I assume you saw the "maths" with the example of the prices doubling. Now let's consider if the assets halve in value.
So if you invest £50 in a company with £100 assets and £50 corporate debt you have 50 shares at £1 each.
Alternatively you borrow £100, using £50 debt and buy a company having £100 assets, but no debt. You own 100 shares at £1 each, but have £50 debt. Both routes you start with £50 and have net £50 of investments.
Now this time instead of doubling to £200 the assets fall from £100 to £50.
In the "safe" example where you have no personal debt, but the company has the leverage. The company now has £50 assets, and £50 debt and is worthless. You own 50 shares worth £0.
If you had borrowed the £50 you would have 100 shares in a company whose assets were £50 and had no debt. You own an investment of 100 shares worth 50p each, so worth £50 still. You would still have the loan, so the net worth is also £0.
It is only if you "allow" your personal situation to worsen such that you get negative wealth, that you get into a situation such as is described where your loans exceed your assets.
In the first example corporate bankruptcy "protects" you. In the second your own personal balance sheet "observation" protects you. Again the "location" of the gearing is irrelevant.
This is simply finance theory. Now I grant it is "theory" not "practice", and in the real world there will be both plenty of people that don't understand it, and also plenty of people who I am sure in the second scenario would be tempted to "run" the position, and risk "negative wealth" outcomes, believing "it will be all right/it will turn around" etc.
I am not suggesting you, or anyone, should do it, particularly if you don't understand it, or can't be disciplined to monitor/manage in the down scenarios, but that doesn't mean the point about the locality of the debt, and who has the gearing, the company or the investor, is invalid.
Crucial to the understanding of this is the fact you are not comparing a £50 investment in a company with £50 assets and no debt, and an alternative of investing £100 of your money, £50 of which is borrowed, in the same company with £50 assets and no debt. That is an entirely different proposition and clearly the personal gearing makes a big difference, to both the upside and downside scenarios in such a scenario.