Financial Leverage Simplified:
It is hugely utilized in corporate finance. However today, we are simplifying it by giving illustration of a sole trade. We know that in sole trade each and every capital is of one person and his purpose is to maximize it. With financial leverage he can perform it.
Financial leverage is a tool to employ own capital with debt for doing business. Following is the illustration which will make simpler this finance term.
Mr. X has own capital of $ 5,00,000 and he bought a machine with his $ 5,00,000. Mr. X is not employing financial leverage since he is utilizing his own money for trading.
Mr. Y has own capital of $ 5,00,000 and he took the loan of $ 10,00,000 @ 5% fixed interest. Now, he has $ 1500000 and he bought top quality machine with this $ 15,00,000.
When the machines owned by Mr. X and Mr. Y increase in value by 10% and are then sold, Mr. X will have a $ 50,000 gain on his own capital $ 500,000, a 10% return. Mr. X’s land will sell for $ 16,50,000 and will consequence in a gain of $ 150,000.
Now when we compute the Mr. Y's return on his own capital, it will be much high.
Mr. Y's Return on his own capital = $ 150000/ $ 500000 X 100 = 30%
Assume that when Y has to pay interest of 5% on debt, then he will gain net = $ 150000 - 50,000 = 1,00,000 That will be the 20% of his own capital? Mr. X who is not employing financial leverage, is gaining merely 10% return.
Assume that when machine's value will raise by 20% and sell, then Mr. Y's Return on his own capital after subtracting 5% fixed interest, will be = $ 300,000 gain from sale of machine - $ 50000 interest = Rs. 250000
Or = 250000/500000 X 100 = 50% that is 30% more than Mr. X's gain.
This means whenever assets inflate in value financial leverage works fine. However when assets refuse in value the employ of leverage works not in favor of you.
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