How can you borrow indirectly by holding shares...
Discussion
I'll have a go.
I don't think "borrow indirectly" means what you might think.
No one is lending you any money.
However, your investment in shares can give you exposure to the value of debt - which is what happens when you DO borrow money.
So indirectly you are exposed to borrowing and more particularly the cost of borrowing.
First you need to get comfortable with the concept of enterprise value, debt and equity.
The value of an enterprise is given by the sum of its debt and its equity.
Holding shares is the equity part and if the enterprise has debt - you are indirectly exposed to the value of the debt. i.e. the value of your equity depends on how much it costs to service the debt.
So if borrowing costs go up - the value of your equity will go down and vice versa.
Let's say the enterprise is simply a skyscraper in the docklands.
It cost $100m to buy and the enterprise buying it raised that money by selling $50m of bonds and $50m of equity.
(You bought some of the equity.)
The operating income is say $6m on renting out and running the skyscraper.
The bonds cost 6% in interest every year so that is $3m and the remaining $3m goes some to tax and the remainder to the shareholders (you).
However, if the cost of debt rises (it's a floating rate note) to 8%, then the cost to service the debt rises to $4m and you only have $2m left for the shareholders so, all else equal, the equity value will drop.
Hence - indirect exposure to borrowing.
If you had directly borrowed $50m from the bank then you would be out of pocket if the interest rates rise.
I don't think "borrow indirectly" means what you might think.
No one is lending you any money.
However, your investment in shares can give you exposure to the value of debt - which is what happens when you DO borrow money.
So indirectly you are exposed to borrowing and more particularly the cost of borrowing.
First you need to get comfortable with the concept of enterprise value, debt and equity.
The value of an enterprise is given by the sum of its debt and its equity.
Holding shares is the equity part and if the enterprise has debt - you are indirectly exposed to the value of the debt. i.e. the value of your equity depends on how much it costs to service the debt.
So if borrowing costs go up - the value of your equity will go down and vice versa.
Let's say the enterprise is simply a skyscraper in the docklands.
It cost $100m to buy and the enterprise buying it raised that money by selling $50m of bonds and $50m of equity.
(You bought some of the equity.)
The operating income is say $6m on renting out and running the skyscraper.
The bonds cost 6% in interest every year so that is $3m and the remaining $3m goes some to tax and the remainder to the shareholders (you).
However, if the cost of debt rises (it's a floating rate note) to 8%, then the cost to service the debt rises to $4m and you only have $2m left for the shareholders so, all else equal, the equity value will drop.
Hence - indirect exposure to borrowing.
If you had directly borrowed $50m from the bank then you would be out of pocket if the interest rates rise.
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