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The story of a margin call - example margin gearing

Margin gearing is a method u can use to gain more wealth rapidly if u use it wisely .

I wanted to write a example for margin gearing in simple terms but i just found one on the net .Below is a example in its most simplest form which is refrenced from Ashleighs blog

Time for a worked example: suppose I have no cash but I do have a some assets, and a margin loan with low gearing. Then I see Kick-ass Consolidated shares going for a good price, and giving (say) a dividend yield of about 5%.

If I have to use cash - tough - I lose because I don’t have any.

Bull!But if I buy using debt, I’ll pay about 8% interest on the borrowings. If I get a 5% dividend yield, fully franked, that is an equivalent interest rate of 7%. So the dividends are paying the debt for me, and the cost to me (to prevent the debt from rising) is the difference in interest rates: 1%.

This is a pretty neat deal: If I can buy an asset, and use the cash flow from the asset to pay the debt used to buy it, then I only have to make up the difference. If I can find that 1% of the purchase price, then paying the interest on the loan means you get the capital growth of the asset for 1% down. Potentially this is a very big return. I need to pay that 1% forever, though!

$10,000 purchase of Kick-ass Consolidated - all bought on debt.

Return is $500 per year + franking credits, effectively $700 per year.

Interest on the loan is $800 per year.

So to control $10,000 worth of Kick-ass, I only need to find $100 per year.

Now suppose that I can find (say) 20% of the cost price… lets use some numbers:

I buy $10,000 worth of kick-ass, using debt.

Results as before…

Now I get $2000 from Uncle Freddies inheritence, and pay that straight off the debt.

Return is still $700 per year.

Interest cost is now $8000 * 0.08 = $640 per year.

I can now do nothing and the asset will eventually pay off the debt entirely. Compound interest works in my favour, and the reduction in the loan gets faster each year.

Once the debt is reduced a little, I can go buy something else. The debt goes up, as does the income, and the first asset is helping pay for the second.

And so on, and so on…

Trouble with the above approach is that it is using a very high level of gearing (80%), so I’m at risk of a margin call if the price falls.

If instead you were to reverse the figures, ($2K debt, $8K cash) then the interest charges are well and truly covered, the likelihood of a margin call is dramatically reduced, and when you get the opportunity you have plenty of equity cover already in place to take advantage of opportunities that crop up.

Low to moderate gearing thus forms a low risk, cash-flow positive virtuous circle, where the more you own, the more cash you generate, so the more you can buy.

The kicker is that if you are very patient, and buy quality assets on bad news, you stand a better chance of getting some very nice capital growth thrown in as well.

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