Leveraged finance is the use of an above-normal amount of debt, as opposed to equity or cash, to finance the purchase of investment assets. Leveraged finance is done with the goal of increasing an investment’s potential returns, assuming the investment increases in value.
Example of How Leveraged Finance Increases Returns
Here is a simple example of exactly how leveraged finance increases equity returns.
In the illustration below we show three examples:
- No Leverage – 100% equity-financed
- Moderate Leverage – 70% equity-financed (30% debt)
- High Leverage – 40% equity-financed (60% debt)
Notice how the internal rate of return to equity investors goes up over time as more leverage is added. We made the assumption that all debt is amortized into equal payments over 5 years.