Leverage (finance)
From Wikipedia, the free encyclopedia
Leverage (or gearing) is using given resources in such a way that the potential positive or negative outcome is magnified. In finance, this generally refers to borrowing. If the firm's return on assets (ROA) is higher than the interest on the loan, then its return on equity (ROE) will be higher than if it did not borrow. On the other hand, if the firm's ROA is lower than the interest rate, then its ROE will be lower than if it did not borrow.
Financial leverage takes the form of a loan reinvested with the hope to earn a greater rate of return than the cost of interest. Leverage allows greater potential return to the investor than otherwise would have been available. The potential for loss is greater because if the investment becomes worthless, not only is that money lost, but the loan still needs to be repaid. Margin buying is a common way of utilizing the concept of leverage in investing. An unlevered firm can be seen as an all equity firm, whereas a levered firm is made up of ownership equity and debt. A firm's debt to equity ratio is therefore an indication of its leverage. This debt to equity ratio's influence on the value of a firm is described in the Modigliani-Miller theorem.
Derivatives allow leverage without borrowing explicitly. But the 'effect' of borrowing is implicit in the cost of the derivative.
- Buying a futures contract magnifies your exposure with little money down.
- Options do the same. The purchase of a call option on a security gives the buyer the right to purchase the underlying security at a given price in the future. If the price of the underlying security rises, the value of the call option will rise at a rate much greater than the value of the underlying security. However if the rate of the call option falls or does not rise, the call option may be worthless, involving a much greater loss than if the same money had been invested in the underlying instrument.
- Structured product that exist as either closed-ended funds, or public companies, or Income Trusts are responding to the public's demand for yield by leveraging. This is frequently not disclosed anywhere other than far down in the Prospectus.
Risk. Utilizing leverage amplifies the potential gain from an investment or project, but also increases the potential loss. Never forget the possibility that the interest costs may be higher than the investment returns. This increased risk may be perfectly acceptable or even necessary to reach the goals of the entity or person making the investment. In fact, precisely managing risk utilizing strategies including leverage and securities purchases, is the subject of a discipline known as financial engineering.
Math.[1]
EXAMPLE
5% Projected Return on Investment 4% Cost of Debt 8:1 Leverage Debt:Equity
LONG-FORM MATH
Investment 8+1 * 5% =45 less Interest (8) * 4% (=32) equals Equity 1 *13% =13
SHORT-FORM GENERIC CALCULATION
Interest Rate Differential 5-4 =1%
Debt to Equity Multiple 8/1 =8
Multiply Line1 * Line2
=8%
Add Investment Return
5%
Equals Total Return
=13%
