Leverage

Definition

Leverage refers to the use of borrowed funds to increase the potential return on investment. It allows a company to amplify its profits by utilizing debt to finance its operations and projects, but it also comes with increased risk since it must meet debt obligations regardless of business performance. Understanding leverage is essential when assessing the components of capital costs, the cost of capital for specific divisions or projects, and the marginal cost of acquiring additional capital.

5 Must Know Facts For Your Next Test

1. Leverage can magnify both gains and losses; while it can enhance returns on equity, it can also increase the risk of bankruptcy during downturns.
2. Companies must carefully evaluate their optimal level of leverage since excessive borrowing can lead to higher costs of capital and increased financial risk.
3. The cost of debt is typically lower than the cost of equity due to tax advantages, making leverage an attractive option for financing growth.
4. Operating leverage and financial leverage are two types of leverage that impact a company's earnings and risk profile differently.
5. Using leverage effectively requires balancing the potential benefits against the risks associated with repayment obligations and interest rates.

Review Questions

• How does leverage impact a company's cost of capital?
  • Leverage affects a company's cost of capital by altering the proportion of debt and equity in its capital structure. When a company uses more debt financing, it typically lowers its overall cost of capital because debt is usually cheaper than equity due to interest tax deductions. However, if leverage becomes too high, it can increase perceived risk among investors, raising the cost of equity as they demand higher returns to compensate for increased financial risk.
• Discuss how different levels of leverage can affect project-specific evaluations in a corporate setting.
  • In evaluating specific projects, different levels of leverage can significantly influence the project's feasibility and expected returns. A project financed with high leverage may show impressive returns during profitable periods but may also be vulnerable during downturns due to fixed repayment obligations. Therefore, companies must assess each project's unique risk profile against their overall capital structure and determine an appropriate cost of capital that accounts for the intended leverage.
• Evaluate the implications of leveraging when considering investments in new divisions or projects.
  • When considering investments in new divisions or projects, leveraging can provide the necessary capital for expansion without diluting ownership through equity financing. However, it also introduces substantial risks if the investment does not generate expected cash flows. Therefore, evaluating the potential returns alongside the associated financial risks is crucial. A comprehensive analysis should include sensitivity testing on how different levels of operational success impact debt servicing ability, thereby affecting long-term sustainability and strategic growth objectives.

Related terms

Debt-to-Equity Ratio: A financial ratio that compares a company's total debt to its shareholder equity, indicating the proportion of funding from debt versus equity.

Financial Risk: The risk associated with a company's ability to meet its financial obligations, often increased by high levels of leverage.

Capital Structure: The mix of a company's long-term sources of funds, including debt and equity, which influences its overall cost of capital.