the what and why of the leverage effect

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Okay, I know basic math and I see the numbers, but I’m an economic idiot because I fail to see how taking bigger loans cause higher profits. What is the leverage effect and why do I want to make use of it?

In: 1

Suppose you have $1000 to buy stock. Assume you make 5% per year, so at the end of the year you have $1050.

Now assume you have $1000 and you borrow $1000 for a year at 3%. You buy stock with it and make 5% and pay 3% on the loan, so you have $1070 after you pay off the loan.

The problem with leverage is it goes both ways, if you borrow money and then the stock goes below your purchase price, you owe money to the lender.

Loans are a means to an end. If the money obtained from the loan is wasted or used on bad investments, then there will not be increased profits. The underlying idea is that if the money obtained is used properly, then the increase in profits will exceed the cost of the loan (ie the interest payment).

An example. Say a farmer can make $1,000 profit from an acre of land per year. Each plot of land costs $10,000 to purchase. The interest rate is 5% so the cost of borrowing $10,000 is $500 a year. If the farmer can borrow $100,000 then they can purchase 10 acres of land and get $10,000 more profit. The cost of the loan is $5,000 – therefore the net additional gain to the farmer is $5,000 per year by borrowing $100,000.

Now if the farmer borrows $100,000 and uses it buy a vacation villa, that will clearly not increase their profit.

Loans are a business tool. Used wisely, it can increase profit; used badly, it won’t increase profits.

Let’s say I’m really really good at making lemonade. The best in fact. I can sell this stuff for $5 a bottle. But.. I have a problem. I don’t have the money to buy lemons.. or sugar..

So.. I go to the bank and ask the nice person at the bank for $100 so I can go buy some lemons and sugar so I can make that amazing lemonade. We agree that in a few months I’ll pay the bank back it’s $100, as well as a $10 fee since they were nice enough to loan me the money in the first place.

A few months go by, I bought the lemons and the sugar and got to selling. And it’s a hit! I completely sold out of lemonade almost immediately. I sold so much lemonade I made $1000! Holy crap!

I then go back to the bank with my $1000 and give them their $100 plus the $10 fee and pocket the rest. Such a good deal!

The thing is, in this situation because my lemonade was so popular, if I took out a $200 loan I could have bought more lemons and very likely could have made $2000 instead of $1000 and doubled my revenue.

That’s the basics of leverage. You borrow money and then use that to make more money by investing it into something else. In this case, I invested the money into my own skills into making lemonade. But that could be anything. A house, a business etc..

EDIT: I should point out that this isn’t risk free. If I happen to sell no lemonade, then, I owe the bank their $100 back along with their $10 fee. In this example the numbers are small but imagine this when you’re taking about borrowing millions of dollars and the risk becomes more apparent.