Benefits of Leverage

Overview

Learn the real reason for debt in a transaction. In this extract from a Pivotal180 course, you will understand why equity returns increase with leverage.

Video

 

Video Transcript

Dan: We have a project that costs $100 to build; that is the capital expenditure (CapEx). And the project will last exactly one year. At the end of the year, we can sell that project along with its generated benefit for $109, so there’s a $9 baked in profit.

Let’s say we fund the project with an unlevered capital structure. That’s zero debt and $100 in equity. So on exit one year from now, when we sell that project, we receive a profit of $9. That is $109 minus the invested $100, and we didn’t borrow any money. So how would we calculate the return on equity? We would look to the $9 profit as the numerator. And what would be the denominator? What do we divide it by? The total amount of equity invested: $100.

So, $9 divided by $100 tells us there would be a 9% return on equity if the project is unlevered.

How to use the benefits of leverage in Project Finance

But what would happen if the project is levered? Let’s say we borrow $60 in debt and fund this project with only $40 in equity to cover the full $100 in CapEx. We face that same $9 of profit on exit, that is, after fully repaying the $60 debt and once equity has received its $40 back. Let’s suppose the interest rate on the $60 of debt was 5%. This means that, during the year, there are $3 in interest expense that we must repay.

We have $9 in profit on exit, less $3 of interest expense. This gives us $6 available for distribution. So what’s our return to equity? It’s $6 divided by the $40 of equity investment; this results in a 15% return on equity if the project is levered.

Can you see the power of leverage? First I took an investment that delivers a 9% return. Then I borrowed money with a modest interest rate of 5%, which means I invested less of my own money. This way I turned that 9% into a 15% return on equity, way higher than what I would have received with no debt.

In the next module, we’ll use Excel to quantify the financial returns on equity with a more complicated set of cash-flows, one which lasts more than a single year. And we’ll use the concepts of Net Present Value (NPV) and Internal Rate of Return (IRR).