Leverage effect (See Chapter 13 of the Vernimmen) The leverage effect explains a company’s return on equity in terms of its return on capital employed and cost of debt. The leverage effect is the difference between return on equity and return on capital employed. Leverage effect explains how it is possible for a company to deliver a return on equity exceeding the rate of return on all the capital invested in the business, i.e. its return on capital employed. When a company raises debt and invests the funds it has borrowed in its industrial and commercial activities, it generates operating profit that normally exceeds the interest expense due on its borrowings. The company generates a surplus consisting of the difference between the return on capital employed and the cost of debt related to the borrowing. This surplus is attributable to shareholders and is added to shareholders’ equity. The leverage effect of debt thus increases the return on equity. If the return on capital employed falls below the cost of debt, then the leverage effect of debt shifts into reverse and reduces the return on equity, which in turn falls below return on capital employed. Leverage effect is expressed in the following formula: ROE = ROCE + (ROCE – i) ? D/E, where ROE is the return on equity, ROCE is the after-tax return on capital employed, i is the after-tax cost of debt, D- net debt, E – equity. The leverage effect itself is the (ROCE-i) x D/E. Leverage effect (See Chapter 13 of the Vernimmen) The leverage effect explains a company’s return on equity in terms of its return on capital employed and cost of debt. The leverage effect is the difference between return on equity and return on capital employed. Leverage effect explains how it is possible for a company to deliver a return on equity exceeding the rate of return on all the capital invested in the business, i.e. its return on capital employed. When a company raises debt and invests the funds it has borrowed in its industrial and commercial activities, it generates operating profit that normally exceeds the interest expense due on its borrowings. The company generates a surplus consisting of the difference between the return on capital employed and the cost of debt related to the borrowing. This surplus is attributable to shareholders and is added to shareholders’ equity. The leverage effect of debt thus increases the return on equity. If the return on capital employed falls below the cost of debt, then the leverage effect of debt shifts into reverse and reduces the return on equity, which in turn falls below return on capital employed. Leverage effect is expressed in the following formula: ROE = ROCE + (ROCE – i) ? D/E, where ROE is the return on equity, ROCE is the after-tax return on capital employed, i is the after-tax cost of debt, D- net debt, E – equity. The leverage effect itself is the (ROCE-i) x D/E. See all terms in the dictionary of finance To know more about it, look at what we have already written on this subject :

You get more than just a glossary on www.vernimmen.com: - A monthly newsletter with over 26,000 subscribers - 610,000 financial data for over 16,000 groups - A 279-question quiz with answers - A text book that has sold 70,000 copies - And all the rest

To find other words in the dictionary of finance, click on the first letter of the word you are looking for:

A B C D E F G H I J K L M N O P Q R S T U V W X Y Z

Definitions of terms begining with the same letter as "Leverage effect" :

L/C LBO LBU LIBOR, London Interbank Offered Rate LIFFE, Liffe LIFO, Last in, first out LMBO LOI LSP LYON, Liquid Yield Option Notes Large cap Last in, first out Lead Lead arranger Lead bank Lead manager Lease Leasing Legal merger Lending facility Lessee Lessor Letter of comfort

Letter of credit, L/C Letter of intent, LOI Level of control Level of ownership Leverage Leverage effect Leveraged build-up, LBU Leveraged buy-out, LBO Leveraged lease Leveraged management buy-out Leveraged recapitalisation Leveraged share buyback Levered beta Levered cost of equity Liabilities Life of the bond Life of the loan Lifecycle of financing sources Limited share partnerships, LSP Liquid Yield Option Notes Liquidity Liquidity - assets Liquidity - investments

Liquidity - liabilities Liquidity discount Liquidity preference theory Liquidity premium Liquidity ratios Liquidity risk - market Liquidity risk – company Liquidity – balance sheet Liquidity – security Listed security Listing Lock up period Lockbox system Locking in future prices or rates London Interbank Offered Rate Long (position) Lookback option Loss Ratio Loss rate Ltv, see Loan to value Ltv, see loan to value