Using debt to increase equity returns
Using debt to increase equity returns
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.
The effective cost of debt is lower than equity (since debt holders are always paid out before equity holders, and hence it’s lower risk).
Leverage, however, will also increase the volatility of a company’s earnings and cash flow, as well as the risk of lending to or owning said company. These risks will include factors such as (but not limited to) changes in the company’s liquidity, the stability of its industry, and shifts in the economy such as interest rates.
Analysts need to understand a company’s use of leverage to assess its risk and return characteristics. Understanding leverage can also help in forecasting cash flows, allowing the selection of an appropriate discount rate for finding a firm’s present value.
Here is a simple example of exactly how leveraged finance increases equity returns.
In the illustration below we show 3 examples:
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.
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Within a financial institution’s investment bank, a division in charge of Leveraged Finance is responsible for services related to a client’s leveraged buyouts. These services typically include structuring, managing, and advising upon debt financing for acquisitions.
For example, if a private equity firm is exploring various financing options in its efforts to acquire another company, the Leveraged Finance division would present different types of debt the client firm might raise (bank debt, high-yield debt, syndicated loans, etc.). It would subsequently help the client firm determine the best option based on their capital structure and operations.
Once the firm has raised the debt, the Leveraged Finance department markets the offering(s) to debt investors, helping the firm raise the capital needed for their acquisition.
To learn more, explore CFI’s Interactive Career Map.
The job of a Leveraged Finance Analyst is largely divided between analyzing credit and risk, structuring debt, and communicating with clients. Analysts are responsible for examining the credit profile of their clients and debt investors, analyzing the potential returns to their sponsors, as well as utilizing Excel models to determine the optimal capital structure, based on their client’s financial projections.
There are many areas of expertise employed within Leveraged Finance divisions, namely deal originating, capital market research, asset/portfolio management, and the sales and trading of debt instruments. As Leveraged Finance division typically deals with less-established firms, it offers a variety of opportunities to connect and collaborate with private equity firms, which can be attractive to people who have interests and ambition in private equity.
We hope this is been a helpful guide to leveraged finance and how leverage increases equity returns (and increases the corresponding risk). To keep learning, explore these relevant resources below:
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