Here is the mainb question
Assume that you were going to explain good and bad uses of leverage to a person just about to buy a restaurant or other small business or to a home buyer. How would you explain this concept? If they were to finance 90% of the purchase, is that too much leverage? If they bought only what they could buy for cash, are they being too conservative on use of leverage?
respond to student 1 below
You would have to consider interest rates, forecast of potential mark up value, ensuring you have something considered to make money and lose money. You must ensure you are not paying more interest than bringing in a return. 90% of a purchase is not too much leverage dependant on the investment. Buying that home in that great up and coming neighborhood that has potential to bring in high equity or that new computer monitor application business that every ISP wants. You can purchase a large asset with little of your personal income. There is the motto, “You have to spend money to make money.” This is the case where you can lower capital in order to make a profit.
If they bought only what they could buy for cash, are they being too conservative on use of leverage?
Again, this is dependant what they could get. You also have to consider other factors such as credit score, responibilities like driver’s license status, employeement, and other background credentials. A bank is not going to go with a high risk investment, unless they know they are going to get something back like offer a high interest rate over course of time. However, if you are offered a low interest rate with little down and low payments, that means the bank justifies you are a low risk and know they will receive their loan w/ interest back.
respond to student 2 below
If the business owner is willing to finance 90% of the purchase I don’t think that is too much leverage depending if the business is foreseeing to make profit and have equity or assets that will be over the debt of 90% plus interest. I think financing the business is a great idea and there are many helpful tools out there for businesses. I don’t think this would work for a restaurant though since there is a lot of competition.
respond to student 3 below
The definition of leverage, according to Investopedia, is “The amount of debt used to finance a firm’s assets†(Investopedia US, 2013). In other words, an investor is financing an asset in the form of debt, with the hope that the financed debt will increase in value in the long term. Leverage is used by an investor to purchase property and investments that they would not normally be able to pay cash for.
A good example of leverage is financing a house or commercial property. Sharma explains that a pro of leverage is “You gain access to a larger amount of capital and invest to earn a return high enough to make a profit. If your investments perform well, the use of leverage can greatly magnify those returns†(Sharma, 2008). Similarly, Sharma states that the risk of leverage is “Just as gains are magnified, so are losses. As well, increases in loan interest rates may also cut into your profits or add to your losses†(Sharma, 2008).
The degree of leverage really depends on what risks the investor is willing to take in addition to what capitol the investor has. Mortgages are often financed with 10% down, which leaves the leveraged amount at 90%. However, depending on the interest rate and economy, the mortgage holder may a profit based on the property value rising. This rise in property values will help to cover the initial investment and interest rate fees. The other side of the coin is that the property value tanks. In this case the investor ends up owing more than what the investment is worth.
If an investor only bought what they could in cash, then this may be considered too conservative as paying only in cash means that the investor would not be able to invest in anything outside their means. This will work if the investor has a ton of money. If not, then it would take an investor considerable longer to own assets.
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