Understanding Financial Leverage: Risk, Reward, and Optimization in Corporate Finance

Financial Leverage

• Definition: Financial leverage is the use of borrowed funds to acquire assets with the expectation that the income or capital gn from the new asset will exceed the cost of borrowing.

• Mechanism: When purchasing assets, a company has three options for financing them: equity, debt, and leases. Debt provides lower fixed costs than the expected income or capital gns from the asset.

• Example: Company X wants to acquire an asset worth $100,000. If it uses equity, it will own 100 of the asset with no interest payments. But if it finances using debt e.g., 50 common stock and 50 debt, profits or losses are affected by debt repayments.

• Measurement: The most common measure of financial leverage is the debt-to-equity ratio, which shows the proportion of debt to company equity. Other ratios include:

  • Debt-to-capital ratio

  • Debt-to-EBITDA ratio

  • Interest coverage ratio

• Risks: Increased financial leverage leads to enhanced earnings but also disproportionate losses if returns from assets are insufficient or costs exceed revenues.

• Consequences: Volatility in stock prices, increased interest payments on equity, and potential bankruptcy due to fluctuating revenues and rising debt obligations.

In summary, financial leverage is a strategy that amplifies profits through borrowed funds but poses risks like loss magnification, volatility, and increased default risk. Proper measurement and management of these ratios are crucial for companies to optimize their capital structure and minimize risks associated with excessive borrowing.

Sources:

• Corporate Finance Institute CFI: Financial Leverage Explnedhttps:www.corporatefinanceinstitute.comresourcesfinancial-managementfinancial-leverage

• Investopedia: Definition Examples of Financial Leveragehttps:investopedia.comtermsffinleverage.asp

• Wikipedia: Leverage in financehttps:en.wikipedia.orgwikiLeverage_finance
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