Leverage is a strategy to increase returns by borrowing money and investing it in tangible or intangible assets.
Let’s assume that you have $1000 and invest it in the stock market by buying 100 shares at ten dollars each. After one year, the stock price value rises to $12 meaning the total value of the investment is $1200; the company pays zero dividends. The stock has appreciated 20%, or the rate of return on the investment was 20%. This is an example of all-equity investment.
Now, let’s assume that you have $2000 to invest, having borrowed $1000 from a broker, and invested it in the same stock. The interest rate for borrowing from the broker is 6%. After one year, the stock price is $12, the total investment value is $2400, and the company pays zero dividends. The stock still appreciated 20%, so let’s compute the rate of return on the investment.
The total investment value at the end of the year is $2400. You return the $1000 you borrowed from the broker which leaves a balance of $1400 in your investment account. The interest rate for borrowing was 6% which, for $1000, is $60. After paying the interest, the balance in your account is $1340. You invested $1000 dollars of your own money, and so your profits are $340. This is the difference between the total value of the investment at the end of the year minus the loan and the interest on the loan: $340 profit or a return of 34%. If you had only invested $1000 of your own money, that would be all equity, and you would have generated a return rate of 20%.
The following exhibit shows the returns of all-equity and leveraged investments in the stock market.
Exhibit 1
Borrowing $1000 from the broker and investing a total of $2000 in the same stock resulted in a rate of return of 34%. This strategy is referred to as leverage. The difference in return between the two approaches is 14%, and this increase is the result of leveraging. Again, leveraging is the strategy of borrowing and investing in tangible or intangible assets to generate profits. Leveraging brings risk into your investment, so you should always remember that you must take a risk to generate higher returns.
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There are four key points that mangers should remember when using leverage:
In business, investment managers also use leveraging strategies to increase returns for the shareholder. Publicly held corporations can raise funds by issuing common stock as equity, preferred stock as hybrid securities, and bonds as debt instruments. The point of leveraging is to raise money at a lower cost than an all-equity approach in order to minimize cost of capital and increase the firm’s value.
The value of a firm is the function of the present value of its future cash flows. Let’s assume that the forecasted cash flows for a company are $120k dollars. If it raises all of the money it needs to invest by equity, the cost of that capital is 15% meaning that its all-equity, or no leverage, value is $120k divided by 15%: $800k. The following exhibit shows the value of a leveraged firm.
Exhibit 2
Let’s assume that managers decide to use leverage to maximize returns for their shareholders, and opt to finance their investment needs 50% by equity and 50% by debt. The cost of the equity is 15% and of the debt is 5%, so that the average cost of capital becomes 10%. The company's value is calculated by dividing the forecasted cash flow of $120k by this 10%, resulting in a change in value from $800k to $1.2M from this leverage, an increase of $400k.
Managers should, however, take into consideration the risk involved in leveraging a firm before formulating and implementing it as a strategy. Leverage is good if the company generates enough cash flow to cover interest payments and pay off the borrowed money at the maturity date, but it is bad if the firm is unable to meet its future obligations and may lead to bankruptcy.
