Why does the ROE increase with more borrowing?

Leverage effect

Leverage effect definition

The Leverage effect describes the Leverage of borrowed capital on the return on equity: through the use of borrowed capital (instead of equity), the return on equity can be increased for the owners.

Requirement for one positive leverage effect is that the company's return on investment (return on total capital) is greater than the interest rate on borrowed capital. This means: the company achieves a return (e.g. 10%) with its operational activity (e.g. automotive engineering) that is higher than the debt interest rate of e.g. 5% for the bank loans taken out by the company.

The leverage effect is limited by

  • limited borrowing options,
  • rising interest rates with higher indebtedness as well
  • lack of investment opportunities.

Alternative terms: financial leverage effect, leverage effect, leverage effect of debt capital, leverage effect, leverage effect (or short: leverage).

Leverage effect example

The leverage effect can be calculated:

Example: Calculating the leverage effect

The example of return on equity is taken up at this point:

A company in the real estate industry only shows a rented property worth € 1 million on the assets side of its balance sheet. The company is fully financed with equity:

The property produces an annual profit of € 80,000, which is the balance of rental income of € 100,000 and depreciation of € 20,000 (further costs and taxes are neglected at this point for the sake of simplicity).

The (abbreviated) profit and loss account then looks like this:

Rental income100.000 €
-Depreciation-20.000 €
=Profit / net income80.000 €

Calculation of the return on equity

The return on equity is calculated as follows:

Return on equity before leverage:

Return on equity = profit / equity = € 80,000 / € 1,000,000 = 8%.

Leverage effect

It is now assumed that half of the equity, i.e. € 500,000, is replaced by outside capital (a bank loan of € 500,000 with an interest rate of 5%) (e.g. by distributing € 500,000 to the owners):

This reduces the profit from the original € 80,000 by € 25,000 (5% interest on the loan of € 500,000) to € 55,000:

Rental income100.000 €
-Depreciation-20.000 €
-Interest expense-25.000 €
=Profit / net income55.000 €

Since the equity has now been reduced to € 500,000, the formula for calculating the return on equity is as follows:

Return on equity after leverage effect:

Return on equity = profit / equity = € 55,000 / € 500,000 = 11%.

The return on equity has thus increased from 8% to 11% through the use of outside capital. That is, the outside capital "leverages" the return on equity upwards.

Limits to the Leverage Effect

Theoretically, one could continue to replace equity with borrowed capital, thereby increasing the return on equity.

Increasing debt leads to higher interest rates

However, as the debt rises (due to the higher risk), the interest to be paid will initially rise and the bank will no longer provide any further loans if a certain level of debt is exceeded.

In the above example this is probably not a problem: the equity ratio is still 50%, a comparatively high value.

The return on investment must be higher than the interest rate on borrowed capital

In addition, the leverage effect only works (positively) as long as the return on investment (the return on total capital) is greater than the interest rate on borrowed capital - this is also referred to as the Leverage opportunity.

Positive leverage effect

In the example above, the property's return on investment is 8%, the loan interest is only 5%.

The leverage effect has a positive effect: you borrow 5% money and make 8% of it with your company - the difference benefits the owner; this increases its return on equity.

Negative leverage effect

For example, if the loan rate were to rise to 9%, the leverage effect would have a negative effect.

It doesn't make sense to borrow 9% of the money, to invest the borrowed money in the company, which only generates an 8% return on it. The owner would have to bear the difference.

Investment opportunities decrease

The investment opportunities are not unlimited either: a company cannot multiply its business volume as often as desired; this is ensured by the competition or the markets are saturated.