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Peter Drucker

Financial Leverage

Concept Briefing:

Financial Leverage or Gearing is the use of debt as a part of capital funds to invest in assets or projects with the hope to earn a greater rate of return than the interest rates. Leverage allows greater potential return to the investor than otherwise would have been available. The potential for loss is greater because if the investment becomes worthless, not only is that money lost, but the loan still needs to be repaid. Margin buying is a common way of utilizing the concept of leverage in investing. An unlevered firm can be seen as an all equity firm, whereas a levered firm is made up of ownership equity and debt. A firm's debt to equity ratio is therefore an indication of its leverage.

Utilizing leverage amplifies the potential gain from an investment or project, but also increases the potential loss. This increased risk may be perfectly acceptable or even necessary to reach the goals of the entity or person making the investment. In fact, precisely managing risk utilizing strategies including leverage and securities purchases, is the subject of a discipline known as financial engineering.

24 Jan 2007 08:22:01

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