Calculate leverage effect
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The leverage effect tells us the effect of debt capital on the profitability of equity capital. With the use of debt capital, instead of equity capital, the return on equity of the owners can be increased.
A positive leverage effect requires that the return on investment,i.e., a company's return on assets, must be higher than the interest rate on borrowed capital. This means that the company achieves a return of 10 percent with its operating activities, as an example in automotive construction, which is higher than, for example, the interest on borrowed capital at 5 percent for the bank loans taken out by the company.
However, the leverage effect is limited by restricted borrowing possibilities, as well as
increasing interest rates with high indebtedness and due to lack of investment opportunities.
Calculation of the leverage effect
An example of return on equity is:
A company in the real estate industry has on its balance sheet on the asset side only one rented property worth 1 million euros. The company finances itself entirely with equity capital.
The balance sheet is based on pure equity financing
Assets side a fixed assets of 1.000.000 euros, on the liabilities side equity of 1.000.000 euros.
The property makes an annual profit of 80.000 euros, which is the balance of rental income of 100.000 euros results, as well as from the depreciation in the sum of 20.000 Euro.
This profit and loss statement is then as follows:
rental income of 100.000 Euro minus depreciation of 20.000 Euro results in a profit or annual surplus of 80.000 euros.
Leverage effect
Assuming that half of the equity capital, i.e. 500.000, by borrowed capital, for example a bank loan of 500.000 euros at an interest rate of 5 percent, is replaced and 500.000 euros goes to the owners, this results in a balance sheet with partial debt financing
Asset side fixed assets 1.000.000 euros and equity 500.000 Euro
Passivaseite Bank loan 500.000 Euro
The profit is reduced by 25.000 Euro, by 5 percent interest on the loan, from before 80.000 euros to 55.000 Euro:
Rental income 100.000 euros
– Depreciation -20.000 Euro
– Interest expense -25.000 euro
= profit or net profit for the year 55.000 euros
Since the equity is now limited to 500.If the inheritance is reduced to EUR 000, this results in the following formula for calculating the return on equity according to the leverage effect:
Return on equity = profit / equity = 55.000 Euro / 500.000 Euro results in 11 percent
Leverage effect and its limits
If you keep replacing equity with debt, you increase the return on equity.
More debt means higher interest rates and higher risk, and if there is more debt, the bank will no longer allow loans if the equity ratio drops and the return on investment is no longer above the borrowing rate.
The leverage effect only has a positive effect as long as the return on investment, i.e. the return on total capital, is much greater than the interest rate on borrowed capital,also known as the leverage opportunity.
In the above example, the return on investment of the property has 8%, but the interest on the loan is only 5%.
The leverage effect is therefore positive: money is borrowed at 5% and is increased with the company at 8% – the difference pleased the owner and his return on his equity increases. If the interest rate on the loan rises to 9%, for example, the leverage effect becomes negative, as it makes no sense to borrow money for 9% and invest it in the company in order to generate only 8% return on investment. The difference is a minus for the owner.
Investment opportunities also decrease, since a company cannot multiply its business size as often as it likes,too much competition or the market is saturated.