August 19, 2008 Posted in Investing

Leverage normally designates a strategy in which borrowed capital, or any other debt, is invested with the expectation of hopefully yielding a higher return to equity. In essence, leverage strategies potentially offer a superior return prospective or hedging opportunities, although these strategies are mainly intended for investors with high risk tolerances.

To acquire financial leverage, an investor is presented with two possible solutions. Investors will either utilize funds obtained by means of a normal loan or through the contraction of debt, the process of which will be reinvested. This strategy, if proved successful, will produce a higher return than the total cost of the debt together with interest. In this case the return on equity will have presented comparable benefits to the firm and a clear financial gain over not borrowing the funds.

It is evident that this strategy is only lucrative when the return is equal or larger than the total cost of the funds borrowed. Even if the direct return only equals the interest charged on the loan, a firm still stands to benefit since the investments acquired will produce return over and over again further on down the road. Additionally, leverage can provide a direct line of funds if a good business opportunity arises in a time when the firm has no funds of its own available to invest.

The common risks associated with leverage strategies should be considered since there are plenty of things that can go wrong, llike dealing with the problems of remortgage and trying to find solutions for financial loans. Interest rates are the most significant dilemma attached to this type of investment, especially if they are very high. If the borrower is unable to cover the expenses or the profits presented by the assets is lower than the interest on the capital, the return on equity is lower than if the firm had not borrowed the money. Cash flow obligations can also create strain since the money borrowed will be reinvested and the firm is required to make repayments on the funds. If repayment schedules are not met as stipulated, the firm might be forced to sell the assets prematurely, eliminating any compensation initially thought possible.

In the end, when undertaking an investment, it is important to understand the risks associated especially given that the funds needed to complete the venture can comprise an enormous expenditure for the firm. Making sure the leverage investment doesn’t exceed investors adequate risk tolerance levels can be the first line of defense.

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