Leveraging

Leveraging helps the company to reduce the cost of capital and increases net present value for specific projects but at the same time, too much of debt increases potential risk, which can lead to the possibility of bankruptcy (Howe 1988). Therefore, in a competitive environment, finding an appropriate level of leveraging is difficult but it can provide a competitive advantage for the company.

Leverage involved the use of various financial instruments and borrowed finances (such as margin) to increase the overall return on investment. When a company has much more debt than equity, it is considered to be highly leveraged. One of the most common uses of leverage is in real estate investments, and comes with mortgages for home purchases. (Petruecello 1988) Successful investments using leverage can lead to great returns, whereas losses for the same investment could potentially be devastating. With this in mind, managers need to be prudent with the level of leverage that is used in transactions.

Most companies use some amount of debt to finance its long-term goals. This equates to an increase in leverage as it allows investment in operations without an increase in equity levels. For example, if a company starts with $5 million, the company has $5 million as it total equity level for operations but if the company uses debt financing to raise another $30 million, the company controls $35 million to invest, which creates more of an opportunity to create value for investors.

Leverage can help or hurt the company and its investors to a potentially high degree. If the company uses leverage in an investment and the market moves negatively against the trade, the loss is much higher than it would be without leverage. Within a competitive industry, management can utilize debt leverage to create greater wealth for investors, but if this investment does not perform as planned, interest expenses and default risks will have the opposite effect and be extremely...