What does 'using leverage by investment banks' exactly mean?

Leverage in an investment banking context almost always means the use of borrowed money (ie debt) to increase the return on an investment.

For example:

Lets imagine that you have the ability to buy as many lemonade stands as you want subject to your ability to pay for them.

You have $100 cash

Lemonade Stands are selling for $10

Annual profit to a lemonade stand owner = $1

Under this scenario you would be able to buy 10 lemonade stands for a total of $100 - exhausting all of your funds. You will receive $10 in profits each year. A 10% profit or 10% return on your equity.

Now imagine a bank offered to lend you up to 80% of the value of each lemonade stand and required you to pay 6% of the borrowed amount on a yearly basis. Incidentally, they would also require a full security interest in the stands and the revenue produced.

You still have a 100 dollars of your own money (equity). Heres how much you have to spend now:

We know that $100 = 20% of funds available to spend -given the banks offer to lend up to 80% of the lemonade stands - you can borrow $400.

You know have $500 to spend so..

you buy 50 lemonade stands, with earnings before interest of $50.

You do owe some money to the bank for your loan

6% interest on $400 = $24 payment

you know have $26 for yourself and your return on investment is 26%. You have more than doubled the rate of your return by using leverage.

This is a simplistic exercise so it ignores the commensurate rise in risk (among other things) to you as the equity holder when the relative proportion of debt increases.

Leveraged buy outs (LBOs) are often focused on leverage - appropriate amounts, credit deterioration, availability of debt funding etc- the analysis can be quite complex.

This is a total for all stands.

I know that 20% * Y = 100 (Equity)

So 100/20% = 500 (Y or total funds)

Total Funds - Equity = Debt or 500-100= 400

Hope that helps. Report It

Use of leverage involves borrowing money and using those funds to purchase more assets.

Example: An investment banker has $1,000 invested in Company A. He borrows $1,000 from you and invests those funds in Company A. He now has $2,000 invested in Company A, but only has $1,000 of equity in Company A.

Leverage is used by all the business around the world, and it is basically borrowings i.e. loans.