Question

1. What is leverage? Please explain the leverage effect.

Answer 1

Leverage is an investment strategy of using borrowed money—specifically, the use of various financial instruments or borrowed capital—to increase the potential return of an investment. Leverage can also refer to the amount of debt a firm uses to finance assets.

Types of Leverage -

There are two main types of leverage: financial and operating. To increase financial leverage, a firm may borrow capital through issuing fixed-income securities. Operating leverage can also be used to magnify cash flows and returns, and can be attained through increasing revenues or profit margins.

Leverage Effect: is the difference between Return on Equity and Return on Capital employed. Leverage effect explains how it is possible for a company to deliver a Return on Equity exceeding the Rate of return on all the Capital invested in the business, i.e. its Return on Capital employed.