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Financial Leverage

 

A financial leverage is a use of borrowed money to achieve more efficient capital structure. A borrowed capital is cheaper than equity capital most of the times. So usage of loaned money makes weighted average capital cost (WACC) lower if done properly. 

 

Financial leverage is most common in two areas:

  • In corporate finance financial leverage is used for development of an activity or acquisitions. Most big companies are using borrowed money to grow larger. The bigger share of borrowed capital, the higher financial leverage (different operating leverage) and risk is. Usually such ratios as D/E (debt/equity) or D/EBITDA (debt/EBITDA) are used to measure company’s indebtedness level. 
  • In investment financial leverage mostly is used by hedge funds, also by some private investors. Repo contracts or margin trading are main instruments to use financial leverage in an investment portfolio. Financial leverage in investment may help to achieve faster results when market are growing, but it extremely risky in volatile markets and might burn all capital in several bad days… (You can read more about such risks in book about investing).

 






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