Leverage

Definition

Leverage refers to the use of debt or other financial instruments to increase the potential return on an investment. It involves using borrowed funds or financial derivatives to magnify the impact of market movements, allowing investors to potentially generate higher returns but also exposing them to greater risk.

5 Must Know Facts For Your Next Test

1. Leverage can be used to increase the potential returns on an investment, but it also amplifies the risk of losses.
2. The debt-to-equity ratio is a key metric used to assess a company's capital structure and the level of financial leverage employed.
3. Financial leverage involves using debt to acquire additional assets, with the goal of generating a higher return on equity.
4. Operating leverage refers to the sensitivity of a company's earnings before interest and taxes (EBIT) to changes in sales, based on the proportion of fixed and variable costs.
5. Optimal capital structure is the balance between debt and equity that maximizes a company's value and minimizes its weighted average cost of capital (WACC).

Review Questions

• Explain how leverage is reflected in a company's balance sheet.
  • Leverage is reflected in a company's balance sheet through the debt-to-equity ratio, which measures the extent to which the company is financed by debt versus equity. A higher debt-to-equity ratio indicates a greater reliance on leverage, as the company is using more borrowed funds to finance its assets. This can potentially increase returns, but also exposes the company to higher financial risk and the possibility of greater losses if the investment does not perform as expected.
• Describe the relationship between leverage and the costs of debt and equity capital.
  • The level of leverage employed by a company directly affects the costs of its debt and equity capital. As a company takes on more debt, the risk to lenders increases, leading to higher interest rates and a higher cost of debt. Conversely, as a company becomes more leveraged, the risk to equity investors also increases, resulting in a higher required rate of return on equity. The optimal capital structure balances the trade-off between the benefits of debt (tax shields) and the costs of debt (financial distress) to minimize the company's weighted average cost of capital (WACC).
• Analyze how a company's capital structure choices can impact its optimal level of leverage.
  • A company's capital structure choices, including the mix of debt and equity, can significantly impact its optimal level of leverage. Factors such as the company's industry, growth prospects, asset structure, and management's risk preferences all play a role in determining the optimal capital structure. Companies must carefully consider the trade-offs between the tax benefits of debt, the potential for financial distress, and the impact on their cost of capital to identify the leverage level that maximizes the firm's value. Striking the right balance between debt and equity is crucial for achieving an optimal capital structure and ensuring the long-term financial sustainability of the business.

Related terms

Debt-to-Equity Ratio:

A financial ratio that measures the extent to which a company is financed by debt versus equity. It provides insight into a company's capital structure and the level of leverage employed.

Financial Leverage:

The use of debt to acquire additional assets in the hope of generating a higher return on equity. It can magnify both gains and losses.

Operating Leverage:

The degree to which a company's costs are fixed, rather than variable. It measures the sensitivity of a company's earnings before interest and taxes (EBIT) to changes in sales.