Positive leverage arises if a business or individual borrows funds and invests the funds at the consequences higher than the rate at which they were lent. The use regarding positive leverage can greatly increase the return from what will be possible if one were merely to invest using interior cash flows.
For instance, a person can borrow $1,000,000 at an interest rate of 8% and invest the funds at 10%. The 2% discrepancy is positive leverage that wills consequence in net income of $20,000 for the person, earlier to the effects of income taxes.
Although, leverage can rotate negative if the rate of return on invested funds turn down, or if the interest rate on borrowed funds raise. Therefore, the perception of positive leverage is least risky when both basics – the borrowing rate and investment rate – are fixed. The amount of leverage is mainly subject to inconsistency when both essentials are variable. In the latter case, an investor can find that investment returns swing wildly within a small period of time.
The finest time to take benefit of positive leverage is when both of the following factors are present:
- The borrowing rate is much lower than the investment rate; and
- It is relatively easy to borrow funds
When such a “lose money” situation exists, expect provisional investors to borrow huge amounts of cash. When the lending environment later tightens, expect increasing numbers of these investors to become insolvent as their positive leverage turns unconstructive and they cannot hold their liabilities. In a tighter lending environment, at slightest expect investors to sell off their investments and use the resulting funds to pay back their highest-interest loans.