Leverage

Leverage is a notion whose meaning has evolved as a result of financial innovation during recent decades. Traditionally, leverage related to the relative proportions of debt and equity funding a venture. The higher the proportion of debt, the more leverage. A leveraged venture entailed more risk and potential reward for equity holders.

Consider a stylized example. A corporation is established by ten investors. Each puts up USD 100 in equity. There is no debt. After one year, the corporation will be liquidated. At that time, if its net assets are worth USD 900, each equity investor will realize a –10% return. If assets are worth USD 1100, each investor will realize a 10% return.

Now consider the same corporation, but financed differently. The same ten investors each put up USD 100, but only five of them hold equity. The other five hold debt. Debt holders are guaranteed to receive USD 105. At the end of the year, if the corporation's assets are worth USD 900, there will be USD 375 left over after paying debt holders. Each equity investor will realize a –25% return. If, on the other hand, the corporation's assets are worth 1100 at year end, there will be USD 575 left over after paying debt holders. Each equity investor will realize a 15% return.

As the examples illustrate, debt financing magnifies the risk as well as the possible reward for equity holders. Traditionally, the word "leverage" referred to the use of debt financing. In recent decades, that meaning has shifted to encompass any technique that similarly magnifies risk and reward for an investor.