Principle of leverage, Financial Management

Leveraging can be described as an investing principle where funds are borrowed to invest in a part of the securities. The manager hopes to earn a return that is greater than the cost of funds obtained through borrowing. Leveraging can either magnify returns or losses from an investment for a given change in the price of that security.

Let us consider an investment of Rs.1 crore into a 10-year Treasury bond with a coupon rate of 9%. Here the investor is using his own funds; this strategy of not using borrowed funds is known as un-leveraged strategy. Table 1 shows what could the return realized from the investment would be at various yields six months from the date of investment. At the end of six months, the return on his investment would be the coupon payment plus the change in the value of the treasury bond. The annualized percent return is calculated by multiplying with 2 as the returns calculated are semi-annual returns.

Table 1: Annual Return from a Rs.1 crore Investment in a 10 year 9% 

Coupon Treasury Bond held for Six Months  

Assumed Yield  Six months from now (%)

Price per
Rs.100 Par Value

Market Value per Rs.1 crore Par Value

Semi-Annual Coupon Payment (Rs.)

Rupee Return at the end of Six Months

Annualized Percent Return%

10.00

88.64

88,64,000

4,50,000

-10,91,000

-21.8

9.50

95.23

95,23,000

4,50,000

 -2,70,000

-5.4

9.00

100.00

1,00,00,000

4,50,000

  4,50,000

9.00

8.50

106.11

1,06,11,000

4,50,000

1,061,000

21.2

8.00

113.61

1,13,61,000

4,50,000

18,11,000

36.2

Here we see that the annualized percent return based on assumed yield six months from now ranges from -21.8% to + 36.2%.

Now, let us consider that the investor also borrows Rs.1 crore @ 10% interest and invests in 10-year 9% treasury bonds. The treasury bonds purchased would be the collateral for this loan. Out of the Rs.2 crore investment, one crore is borrowed and one crore is from investor's equity. Therefore, the amount of leverage would be "2-to-1 leverage".

The investor would receive an interest of Rs.9,00,000 every six months, on his Rs.2 crore investment and has to make an interest payment of 5,00,000 every six months on the borrowed funds. The net rupee return on the investment at the end of six months would be interest received plus the change in the value of the bond minus the interest that is to be paid on the borrowed funds. Assuming same yield as in table 1, the annualized percent return would range from -37.44% to 62.4%. Therefore, we can conclude that the range for annualized percent return is wider than in the case where the investor uses his own funds to purchase the bonds.

Table 2: Annual Return from a Rs.2 crore Investment in a 10 year 9%

 Coupon Treasury Bond held for Six Months  

Assumed Yield  Six Months from now (%)

Price per Rs. 100 Par Value

Market value per Rs.2 crore Par Value (Rs.)

Semiannual Coupon Payment (Rs.)

Rupee Return at the End of Six Months (Rs.)

Annualized Percent Return (%)

10.00

88.64

1,77,28,000

9,00,000

-18,72,000

-37.44

9.50

95.23

1,90,46,000

9,00,000

-5,54,000

-11.08

9.00

100.00

2,00,00,000

9,00,000

4,00,000

8.00

8.50

106.11

2,12,22,000

9,00,000

16,22,000

32.4

8.00

11,3.61

2,27,22,000

9,00,000

31,22,000

62.4

Posted Date: 9/11/2012 1:38:24 AM | Location : United States







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