Leverage is a strategy to increase returns by borrowing money and investing it in tangible or intangible assets.
Let’s assume that you have $1000 and invest it in the stock market by buying 100 shares at ten dollars each. After one year, the stock price value rises to $12 meaning the total value of the investment is $1200; the company pays zero dividends. The stock has appreciated 20%, or the rate of return on the investment was 20%. This is an example of all-equity investment.
Now, let’s assume that you have $2000 to invest, having borrowed $1000 from a broker, and invested it in the same stock. The interest rate for borrowing from the broker is 6%. After one year, the stock price is $12, the total investment value is $2400, and the company pays zero dividends. The stock still appreciated 20%, so let’s compute the rate of return on the investment.
The total investment value at the end of the year is $2400. You return the $1000 you borrowed from the broker which leaves a balance of $1400 in your investment account. The interest rate for borrowing was 6% which, for $1000, is $60. After paying the interest, the balance in your account is $1340. You invested $1000 dollars of your own money, and so your profits are $340. This is the difference between the total value of the investment at the end of the year minus the loan and the interest on the loan: $340 profit or a return of 34%. If you had only invested $1000 of your own money, that would be all equity, and you would have generated a return rate of 20%.
The following exhibit shows the returns of all-equity and leveraged investments in the stock market.
Exhibit 1
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Borrowing $1000 from the broker and investing a total of $2000 in the same stock resulted in a rate of return of 34%. This strategy is referred to as leverage. The difference in return between the two approaches is 14%, and this increase is the result of leveraging. Again, leveraging is the strategy of borrowing and investing in tangible or intangible assets to generate profits. Leveraging brings risk into your investment, so you should always remember that you must take a risk to generate higher returns.
There are four key points that mangers should remember when using leverage:
- It increases the returns on investment;
- It also increases the risk in the investment or business;
- Leverage allows firms to explore new growth opportunities;
- It minimizes the cost of capital at a certain level of debt.
In business, investment managers also use leveraging strategies to increase returns for the shareholder. Publicly held corporations can raise funds by issuing common stock as equity, preferred stock as hybrid securities, and bonds as debt instruments. The point of leveraging is to raise money at a lower cost than an all-equity approach in order to minimize cost of capital and increase the firm’s value.
The value of a firm is the function of the present value of its future cash flows. Let’s assume that the forecasted cash flows for a company are $120k dollars. If it raises all of the money it needs to invest by equity, the cost of that capital is 15% meaning that its all-equity, or no leverage, value is $120k divided by 15%: $800k. The following exhibit shows the value of a leveraged firm.
Exhibit 2
Let’s assume that managers decide to use leverage to maximize returns for their shareholders, and opt to finance their investment needs 50% by equity and 50% by debt. The cost of the equity is 15% and of the debt is 5%, so that the average cost of capital becomes 10%. The company's value is calculated by dividing the forecasted cash flow of $120k by this 10%, resulting in a change in value from $800k to $1.2M from this leverage, an increase of $400k.
Managers should, however, take into consideration the risk involved in leveraging a firm before formulating and implementing it as a strategy. Leverage is good if the company generates enough cash flow to cover interest payments and pay off the borrowed money at the maturity date, but it is bad if the firm is unable to meet its future obligations and may lead to bankruptcy.
FAQs
A financial leverage ratio of less than 1 is usually considered good by industry standards. A leverage ratio higher than 1 can cause a company to be considered a risky investment by lenders and potential investors, while a financial leverage ratio higher than 2 is cause for concern.
Is being leveraged good or bad? ›
Leverage can be both good and bad, depending on how it is used and the context in which it is applied. Leverage refers to the use of borrowed funds or financial instruments to increase the potential return on an investment or business venture.
Is leverage good or bad in trading? ›
A trader should only use leverage when the advantage is clearly on their side. Once the amount of risk in terms of the number of pips is known, it is possible to determine the potential loss of capital. As a general rule, this loss should never be more than 3% of trading capital.
What are the negatives of leverage? ›
Using leverage can result in much higher downside risk, sometimes resulting in losses greater than your initial capital investment. On top of that, brokers and contract traders often charge fees, premiums, and margin rates and require you to maintain a margin account with a specific balance.
Why is leverage so risky? ›
Leverage can multiply your losses every bit as much as it can multiply your profits – which makes it a risky tool. But that doesn't necessarily mean you should avoid it altogether.
Can leverage make you rich? ›
Leverage is using borrowed money to increase your return on investment. Leverage can allow you to achieve returns that you thought were impossible but at a greater risk of losing your capital. Here are five ways that debt through the use of leverage can make you richer.
Why is leverage a good thing? ›
Leverage increases the return on equity, improving investors' return on capital invested; investors have fewer funds at risk and their ownership percentages do not get diluted (debt financing does not reduce their control of the entity or profit allocation).
What leverage is good for $10? ›
Here's a general guideline for determining optimal leverage based on account size: Account Size: $10 - $50 Recommended Leverage: 1:100 or lower. Account Size: $100 - $200 Recommended Leverage: 1:200 or lower. Account Size: $200+ Recommended Leverage: 1:300 - 1:500 (for experienced traders)
What is the best leverage for a beginner? ›
Leverage is solely a trader's choice. Most professional traders use the 1:100 ratio as a balance between trading risk and buying power. What is the best leverage level for a beginner? If you are a novice trader and are just starting to trade on the exchange, try using a low leverage first (1:10 or 1:20).
Is leverage good for beginners? ›
As a beginner trader, it is crucial to start with low leverage. This will help you to limit your losses and learn how to manage your risk effectively. A good rule of thumb is to start with leverage of 1:10 or lower. This means that for every $1,000 in your trading account, you can control a position worth $10,000.
The flipside of leverage is that the risk is also increased - in case the investment doesn't turn out as planned, you could incur losses higher than the amount you invested, i.e. your debt increases.
What happens if you lose leverage? ›
In leverage trading, you're required to maintain a certain amount of equity (initial margin) in your account to cover potential losses. If the market moves against you and your account falls below the required margin, you will face what is referred to as margin call.
What are the pros and cons of leverage? ›
While leverage can enhance gains when the market moves in favour, it also escalates losses if the market moves against the position. It's important to note that leveraging magnifies risk and isn't suitable for all investors. Sudden market fluctuations can lead to significant losses.
What is the safest leverage? ›
While 1:1 leverage offers limited profit potential compared to leveraged positions, it is a safer and more conservative approach that prioritizes capital preservation. On the other hand, higher leverage ratios may provide better margin efficiency but come with higher levels of risk.
Can you lose more than invested with leverage? ›
No. The most an investor can lose in a Leverage Shares ETP is the entire value of their initial investment plus any reinvested dividends.
What is leverage in simple words? ›
to use something that you already have in order to achieve something new or better: We can gain a market advantage by leveraging our network of partners. SMART Vocabulary: related words and phrases.
What does it mean to be leveraged? ›
1. : having a high proportion of debt relative to equity. 2. of the purchase of a company : made with borrowed money that is secured by the assets of the company bought. a leveraged buyout.
Is it better to be more or less leveraged? ›
A less leveraged company can be better positioned to sustain drops in revenue because they do not have the same expensive debt-related burden on their cash flow.
What is being leveraged? ›
Leverage is the amount of debt a company has in its mix of debt and equity (its capital structure). A company with more debt than average for its industry is said to be highly leveraged. Leverage is not necessarily bad.
