Leverage

Definition

Leverage refers to the use of borrowed capital to increase the potential return on investment. It allows a business to use debt to finance its operations or growth while aiming for higher profits than would be possible by using only equity. Understanding leverage is critical because it affects both the risk and return profiles of a company, especially in relation to its weighted average cost of capital (WACC).

5 Must Know Facts For Your Next Test

1. Higher leverage typically means higher potential returns but also higher financial risk, as fixed interest payments must be met regardless of business performance.
2. Leverage can magnify both gains and losses, making it crucial for businesses to manage their debt levels carefully.
3. The weighted average cost of capital (WACC) reflects how much a company needs to earn on its investments to satisfy all its stakeholders, including both equity and debt holders.
4. Using leverage can lead to a lower WACC, as debt is often cheaper than equity due to tax advantages, which can enhance a company's valuation.
5. Companies with high leverage may face increased scrutiny from investors and creditors, especially during economic downturns when cash flow is uncertain.

Review Questions

• How does leverage influence a company's weighted average cost of capital?
  • Leverage impacts a company's weighted average cost of capital (WACC) by introducing debt into the capital structure, which typically has a lower cost compared to equity. When a company uses debt financing, it can reduce its overall WACC because interest on debt is tax-deductible, making it cheaper than equity. As a result, leveraging can potentially increase the company's valuation by optimizing its capital structure.
• Discuss the risks associated with high levels of leverage in a company's capital structure.
  • High levels of leverage expose a company to increased financial risk due to the obligation to make fixed interest payments regardless of its financial performance. In periods of economic downturn or reduced cash flow, highly leveraged companies may struggle to meet these obligations, leading to defaults or bankruptcies. This financial strain can also result in reduced investor confidence and higher costs of borrowing in the future.
• Evaluate the trade-offs between using leverage for growth versus maintaining financial stability in a business context.
  • Using leverage can propel growth by allowing companies to invest in new projects or expand operations without needing to raise equity capital. However, this comes with trade-offs; while leverage can amplify returns when investments perform well, it also increases financial obligations and risk. If the investments fail to generate expected returns, the burden of debt may compromise financial stability and lead to severe consequences like insolvency. Thus, businesses must carefully balance the desire for growth with prudent financial management.

Related terms

Debt-to-Equity Ratio: A financial ratio that indicates the relative proportion of shareholders' equity and debt used to finance a company's assets.

Cost of Debt: The effective rate that a company pays on its borrowed funds, which influences its overall cost of capital.

Financial Risk: The possibility of losing money on an investment due to the use of debt financing, which increases the company's obligations.