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5.1 AN ILLUSTRATION OF FINANCIAL LEVERAGE

As the name suggests, since financial leverage reduces the equity contribution, it plays a pivotal role in either increasing or decreasing the returns generated by the investment. This definition may be illustrated through an example.

EXAMPLE 5.1

Suppose we analyse a real estate investment with an initial value of €10 million. The investor may choose whether to invest without financial leverage (an unlevered approach) or alternatively using borrowed capital to cover 50% of the overall investment (a levered approach). If the annual cash flow generated by rental payments for the real estate units (operating income) is equal to €800,000, assuming an interest rate applicable to the borrowed capital of 7%, the investor will receive net cash flows of €450,000 if it has opted for a levered approach. Net cash flow on the other hand will be €800,000 if the investor has invested according to an unlevered approach.

Now let's assume that the property's value increases by €100,000; the total return on the asset, subdivided into its two components of income return (the ratio between net cash flows and the equity made available for the investment) and appreciation return (the ratio between the increase in value over the period and the equity made available for the investment) will be equal to 11% for a levered investment and 9% for an unlevered investment. In this case, financial leverage has a virtuous effect, enabling the investor to increase the return on the investment.

Alternatively, let us assume that the same investment suffers a fall in value of €300,000. In this case, assuming that income return is the same as in the previous case, the appreciation return will fall by 3% for an unlevered investment, but by 6% if a debtfinancing approach is chosen. The net effect on the total return for the investor in the event that a levered financing approach is chosen will consequently be negative, moving from 5% for unlevered to 3% for levered. The above described effect is summarized in Figure 5.1.

Impact of financial leverage on investor returns

FIGURE 5.1 Impact of financial leverage on investor returns

What is the mechanism according to which financial leverage affects investor returns?

• Positive leverage: the impact of financial leverage is beneficial when the return on nondebt-funded investment (unlevered) exceeds the cost of debt financing. In the former case in the above example, the unlevered return on investment is equal to 9%, whilst debt servicing costs are 7%. With a financial leverage of 50%, the return on equity will increase to 11% (compared to a return which would otherwise be 9% without debt financing).

• Negative leverage: in contrast, the impact of leverage has a penalizing effect when the cost of debt financing exceeds the unlevered return on the investment. In the latter case in the above example, the unlevered return is equal to 5% whilst debt servicing costs remain unchanged at 7%. With leverage of 50%, the return on equity will fall to 3% (compared to a return which would otherwise be 5% in the absence of any debt financing).

Since it is generally not possible to ascertain the future return on investment when it is necessary to decide whether or not to adopt a levered approach, the choice is directly dependent on considerations over the greater or lesser certainty (volatility) in the future operational performance of the investment.

 
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