Question

Q1.What is leverage ?. give an example.
Q2. Explain the Importance of leverage?

Answer 1

In view of the company, leverage is use of borrowed capital as a form of funding into the capital of company. By funding the company through borrowed funds, company will increase it's asset base and generates higher returns. Leveraging can be considered as investment strategy which will result in increasing the potential return on equity. We can conclude leverage is the amount of the borrowed funds used to finance the assets of the company.

Ex:- Company A and Company B is looking to finance their first Home. Company A would like to use 50% own funds and 50% of debt. Company B ll invest 100% of its own funds.

Company A might incur Interest cost additionally on its borrowed funds but residual return to equity holder is high.

Particulars	Company A	Company B
House Price	1,000,000	1,000,000
Own funds	500000	1,000,000
Borrowed @ 5% p.a	500000	0
Sold after 1 year	1,100,000	1,100,000
Net return to Owners(Sold-Cost- Interest)	75,000	100,000
Return on equity (Net return / Own fund)×100	15%	10%

Company A owners made return of 15% on their investment by leveraging 50% whereas company B made return of 10% without leveraging.

Importance of Leveraging

1. It helps management in taking best investment decisions.

2. Leverage gives more than one financing options to achieve the target returns.

3. To measure the financial risk of the company and designing the capital structure

4.To analyse the profitability and should eliminate the capital structure impacting the profits adversly.