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Financial Leverage: Corporate Borrowing & Homemade Leverage

Financial Leverage: Corporate Borrowing & Homemade Leverage
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  • 0:03 Leverage
  • 2:01 Corporate Borrowing
  • 3:32 Lesson Summary
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Lesson Transcript
Instructor: Ian Lord

Ian is a real estate investor, MBA, former health professions educator, and Air Force veteran.

In this lesson, we'll explain the basic principle of financial leverage and demonstrate how it appears in corporate borrowing. We'll also explore how homemade leverage can replicate the effects of corporate borrowing in a personal portfolio.

Leverage

As an investor willing to take on the risk of borrowing money to invest, Drew needs to understand how the concept of financial leverage works. Let's help him learn the basic principles of financial leverage and how he can apply it as an investor as well as understand how leverage works in corporate financing.

In finance, the concept of leverage describes how borrowing money can magnify the effects of returns. Drew pictures a lever or see-saw balancing on a point. If both ends were the same distance from the balance point, the ends would move the same distance equally. But if one end were about twice as long as the other end and the short end moves, the other end moves much farther up or down. Likewise, by borrowing money, Drew can magnify his returns.

Imagine Drew only has $100 to invest. If he bought one share of stock at $100 and sold it a year later at $110, he would have made $10 profit. But what if instead he borrowed the $100 at two percent annual interest for one year, and did the same transaction? He could have bought the stock without using any money of his own, and after selling the stock for $110 he would have made a profit of $8. How is this a good deal you might ask? To earn a $10 profit, Drew had to risk his own $100. But to earn an $8 profit Drew only had to risk the $10 interest.

The downside of leverage is that losses can also be multiplied. If Drew paid his own $100 for the share and then sold it at $90, he would have only lost $10 and still have $90 left over. If he borrowed the money, he still would have to pay the $100 loan back plus $10 interest, and so he would have lost $110 instead of the $90 if he hadn't borrowed the money.

Corporate Borrowing

Now that Drew understands the fundamentals of leverage, the same principle can be applied to corporate borrowing. Corporations can raise money through borrowing by selling bonds. When Drew buys a corporate bond, that business pays him periodic interest payments for the use of that money until it's time to repay the investment. These interest payments are an expense which reduce the earnings per share (EPS) of the company stock. This amount is simply the company earnings divided by the number of existing shares. The reduced earnings per share represents an increased risk, which can lead to magnified gain or loss on the company's profitability.

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