In this tutorial, we're going to discuss financial leverage, which is the practice of borrowing money to finance the purchase of an asset.
Definition of Financial Leverage
Financial leverage is the practice of borrowing money to finance the purchase of an asset. Leverage increases returns, but it also increases the risk.
How it Works
Let's look at an example. Let's say I purchase an asset for $10 million. Whether that asset is a real estate asset or a company doesn't matter if I expect the annual profit to be one million dollars. My unlevered return, meaning assuming no leverage or no debt, would be one million divided by 10 million or 10 percent. One million over 10 million. That would be my unlevered return, assuming I don't finance the purchase.
Let's assume I finance the purchase with 50 percent debt, which means I'm putting in 50 percent of my own money or equity. So the debt is equal to 50 percent of the acquisition price. What is my interest expense? I take the debt times the interest rate (5%) and I get two hundred fifty thousand dollars of interest expense. My profit is now the one million I had previously minus my new expensive interest. That takes my total profit down to 750000.
What is my equity invested? That's the money that I put in. That's the acquisition price minus the debt. My levered return is the profit after interest divided by not the original acquisition price because I didn't have to put in $10 million. I only put in five million. So I divide by five million. My levered return is fifteen percent. I take the same asset, and by financing it, I increase my return from 10 to 15 percent.
And if I increase that leverage, my return would only go higher and higher. Let's go back to 50 percent. As you can see, increasing leverage increases your return.
There's one condition for that. As long as your interest rate is lower than your unlevered return financing, the purchase is going to increase your percentage return. You might say, well, wait, my profit is lower.
How is my return higher? Well, the answer is because your denominator, the equity invested is lower, so it increases the ratio. Now, what is the downside of leverage? You might say, OK, well, this is amazing. Why doesn't everyone do this? Well, first of all, people in finance do this a lot. You finance home purchases, companies, finance expansions, and acquisitions of other companies. They do.
So what is the risk here? I'm going to illustrate it with an example. Let's say we take that asset and sell it for 11 million dollars. What is my return? My return would be the 11 million over the 10 million minus 1. That's a 10 percent return, 11 million over the 10 million minus 1 to get a percent change. That's 10 percent.
And if I sell it for less, my return would be 9 million divided by the 10 million I paid minus one and my return would be minus 10 percent. Those are my unlevered returns when I go to sell the asset.
Let's look at my levered returns if I go to sell that same asset for the same prices. My initial outlay is only $5 million now because I finance is purchased with 5 million dollars of debt. Let's say I go to sell it for 11 million. If I go to sell it for 11 million, I have to repay the five million dollars in debt.
So my sales price is 11 million, minus the 5 million in debt and I'm left with six million. That's how much cash is left after I repay the debt. If I take the six million that I'm left with and divided by what I put into the purchase, minus one to get a percent change, I get a 20 percent return.
Let's look at what happens if I sell it for a lower price. If my sales price is nine million, what am I left with? After I repay the debt, I'm left with four million. My net cash on the sale is four million and I put in five million and again minus one to make it a percent change. And my return is minus 20 percent. As you can see, the debt magnified.
The return on the positive side as well as on the negative side. So leverage increases your returns if things go well, but it decreases your returns even more when things don't go well. That's why leverage is a factor causing bankruptcy and risk and financial crisis.
The more leverage there is in the system, the more risk there is. If things take a downturn and that's the concept of financial leverage in a separate tutorial, we discuss the concept of operating leverage.