Leverage

 

 

Leverage is the use of debt to supplement investment. Also known as gearing or levering, leveraging is used to maximize thepotential return on an investment. Leverage can help you achieve your financial goals even if you do not have ample funds initially.[br]

 

Leverage can be used in two different ways.

• You can increase the size of the new worth such that it outweighs the resting force of the business.

• Alternatively, you can expand the new worth of your business without increasing the equity. This increases the effectiveness of the business performance. 

Benefits of Leverage

With the help of leverage:

• Investors can increase their exposure to financial instruments such as foreign exchange or real estate. This set of people capitalizes on leverage through the use of options, futures, margin and other financial instruments. For example, instead of buying 10 shares worth $100 from their capital worth $1,000, they can buy five options worth $200 each to acquire 500 shares. Alternatively, investors can use leverage offered by brokers to buy foreign currencies or equities worth 10 times the capital available with them. This offers investors a chance to earn higher profits.

• Companies can use debt to finance its operations. This helps a company to invest in business operations without raising its equity. For example a company issues equity to raise $9 million in capital. If the company now uses debt financing to borrow $25 million, it will have $34 million to invest in the business. Thus, by using debt financing, the company has increased the number of opportunities which it can capitalize on, without further diluting the shareholder value.[br]

Disadvantages of Leverage

While leverage provides greater profit-making opportunities to both investors and firms, it also magnifies losses. However, an investor or a business, which makes an investment using leverage, faces a higher risk as compared to a person who is not exposed to leverage.

 

If an investor makes a wrong decision while using leverage, he will suffer greater losses than someone who had not used leverage. In the business world, a company that has failed to generate shareholder wealth through leverage may end up destroying shareholder value.