Real World Examples of Financial Leverage: How it can Boost Returns and Risks Involved

In this blog post, we will dive deeper into the topic of financial leverage by providing examples to illustrate how it works in practice. We will examine the potential benefits and risks of using leverage and how it can be used effectively to maximize returns on investment.

Leverage in Action – An Example of a Leveraged Investment

Let‘s say an investor wants to invest in a rental property that costs $100,000. Instead of using all of their money, they decide to put down a 20% down payment of $20,000 and borrow the remaining $80,000 from a bank. The investor expects to earn $1,000 per month in rent, giving them a 12% return on their initial investment.

Let’s compare this to an unleveraged investment where the investor would have to use all their money to purchase the rental property. In this case, the return on investment would only be 8%, which is 4% less than the leveraged investment. In this example, leverage has allowed investor to increase their return on investment by 4%.

Leverage in Action – An Example of Leverage in Business

A company wants to expand its operations by purchasing new equipment to increase its production capacity. The cost of the equipment is $500,000. The company has $200,000 in cash but borrows the remaining $300,000 from a bank. The company expects the new equipment to increase its revenues by $50,000 annually.

In this case, the return on investment for the company would be 20%, which is calculated as the increase in revenues ($50,000) divided by the total cost of the investment ($500,000 + $300,000). This example illustrates how leverage can help a company grow and expand more quickly than it would have been without it.

The Risks of Leverage

While leverage can be a powerful tool for maximizing returns, it also comes with risks. For example, in the rental property example, if the property value decreases or the investor cannot find tenants, they may not be able to make their loan payments and may default on the loan.

In the case of the company, if the new equipment does not increase revenues as expected, the company may not be able to make its loan payments and may experience financial distress. It’s important to keep in mind that leverage amplifies potential gains as well as losses. It’s crucial to have a solid understanding of the underlying investment and the ability to service the debt in case of unexpected downturns.

Conclusion:

Financial leverage can be a helpful tool for maximising returns on investment, whether in rental properties, equipment, or other investments. However, it’s essential to understand the risks and to use leverage carefully. Always have a clear plan for using the leverage and a realistic projection of the returns. Leverage is a powerful tool, but you should use it cautiously only when the potential return justifies the risk.