Financial Leverage

Financial Leverage There are many ways that one can finance a project. Either a company can use its investors own funds, that is equity, or borrowed money, meaning debt can be used. Generally, the two are used in a combination depending on the risk preference of the investor. Financial leverage is financial leverage "The degree to which an investor or business is utilizing borrowed money" (InvestorWords.com). There are many views on using debt to finance a company.

Some would say that it is a bad thing, and that it feeds on itself, but then again, it could be used to boost up return on equity very easily. This is because it can be used to increase the asset base of the company, and hence increasing the earning power of the company, without actually increasing the amount of equity.

The reason is that an equity investor is entitled to a share of the profits of the venture in proportion to his ratio of the total equity involved in the venture. A debt investor on the other hand is only entitled to a certain fixed return, and anything over that can be kept by the other equity investors in the venture. Another advantage of debt financing is the tax advantage, as the interest payments are usually allowed as a tax expense.

The main difference is that the debt investor has a certain fixed amount of income, but his income is limited to that, regardless of what the outcome of the venture is, whereas the equity investor has no fixed return on his investment. Also, the debt is generally secured against the assets of the venture whereas equity is not. So in other words, the equity investor takes the debts investors share of the risk involved, but for a share of the debt investor's profit. There are many risks involved with leverage.

Having debt in the capital structure of a company creates a fixed operating cost for the company, which must be met at all times. If the company defaults on the fixed interest payments, then the debtor has the legal right to take over the assets of the enterprise. This could lead to the winding up of the company. The debtor then has rights over the assets before the equity holders do, so they may not get anything in return if the company goes down.

Debt basically increases the risk that the company gets hurt during a cyclical downturn. Also, if the company has too much debt already, it may not be able to get further loans if needed on an urgent basis. If a firm were to issue long-term debt at 10% per annum, and invest it in a venture earning a return on investment of 12% per annum, its return on equity will go up.

This is because the 2% spread between the cost of the funds and the return on the investment will add to the total profit of the company, without adding to the equity amount invested in the company. In a way, the owner gets a 2% return for free. The higher the proportion of debt to the total equity, the more of this extra revenue the firm gets. Having more debt in the total capital structure of the company will reduce the overall.