Leverage is most commonly employed in real estate transactions via the use of mortgages to purchase a home. Leverage can be created via options, futures, margin and other financial instruments. For example, if you have $2,000 to invest. This amount could be invested in 40 shares of Microsoft stock, but to increase leverage, you could invest the $24000 in five options contracts. You would then control 2000 shares instead of just 40.
Most companies employ debt to finance operations. By doing so, a company increases its leverage due to it can invest in business operations without increasing its equity. For example, if a company formed with an investment of $20 million from investors, the equity in the company is $20 million, this is the money the company employs to operate. If the company employs debt financing by borrowing $40 million, the company now has $100 million to invest in business operations and more opportunity to increase value for shareholders.
Leverage helps both the investor and the business firm to operate or invest. On the other hand, it arrives with greater risk. If an investor employs leverage to make an investment and the investment moves against the investor, the loss is much bigger than it would have been if the investment had not been leveraged. Leverage exaggerates both losses and gains. In the business world, a company can use leverage to attempt to generate shareholder wealth, but if it fails to do this, thus the interest expense and credit risk of default destroys shareholder value.
In finance, leverage is a universal term for any technique to manifold losses and gains. Common ways to come upon leverage are taking over money, purchasing fixed assets and employing derivatives. Some of the essential examples are:
A public corporation may purchase its equity by taking over money. The more it takes over, the less equity capital it calls for, so any losses or profits are shared among a smaller base and are to a proportionate degree, larger as a result.
A business entity can leverage its revenue by purchasing fixed assets. This will increase the proportion of fixed, as opposed to variable, costs, entailing that a alteration in revenue will result in a larger alteration in operating income.
Hedge funds oftentimes leverage their assets by employing derivatives. A fund might get any gains or losses on $40 million worth of crude oil by posting $2 million of cash as margin.
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