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 

It costs $100 to build this project. That is the cap X that’s going to be spent and the project will last exactly one year and at the end of the year we can sell that project and all of the benefit it has generated for $109. So there’s a $9 baked in profit, and let’s say that that project has been funded with an unlevered capital structure. It’s been funded with no debt, so it’s been funded with zero debt and $100 in equity. So on exit one year from now, when we sell that project, we receive a profit of $9 right? 109 minus 100 that was invested and we didn’t borrow any money and so how would we calculate the return on equity for that? We would look to the $9 profit as the numerator and the denominator, what do we divide it by? The total amount of equity that was invested,100.

So nine divided by a hundred tells us that there would be a 9% return on equity for this investment for an equity investor if the project is unlevered. By comparison, if the project was levered, let’s say we borrowed $60 in debt and funded this project with only 40 in equity to pay for the full 100 million or $100 in cap backs, this is what it might look like. We face that same $9 of profit on exit, and by that I mean after the debt has received its full repayment of it’s 60 and the equity has received its money back, it’s 40 we’ve got the same nine in profit. But at this point in time you got to remember we borrowed money. So let’s just say that the interest rate on that $60 was a 5% interest rate, meaning over the course of the year, we have $3 in interest expense that needs to be repaid.

So we got $9 in profit on exit, less $3 of interest expense gives us $6 that’s available to be distributed to equity. So what’s our return to equity? It’s the $6 that can be distributed divided by the amount of equity that was invested. 40. 6 divided by 40 is a 15% return on equity. So now can you see the power of leverage? I just took an investment that delivers a 9% return, and I borrowed some money at a relatively modest interest rate at 5% which meant I invested less of my own money and I was able to turn that 9% investment into a 15% return on equity, which is way higher than I would have received if there was no debt. So in the next module, what we’ll talk about is how to use Excel to quantify the financial returns to an equity investor from more complicated set of cash flows that doesn’t just last a single year. And we’ll be using concepts of net present value or NPV and internal rate of return or IRR.