Reading for Enrichment Leverage And the Cost of Borrowing

Many entrepreneurs use borrowed money to accomplish their goals. This is called leverage. Levers allow people to move much heavier weights than they could otherwise handle. In business, borrowed funds make it possible to increase the rate of return earned on an investment. Let’s look at an example.

Connie and Cal want to start a mountain bike rental business in a Colorado mountain town. They plan to pool their savings of $20,000 to buy bikes and cover other start-up costs. If all goes well, they expect the business to earn about 15 percent per year on their $20,000 investment.

15% * $20,000 = $3,000 earnings

Their bank offered to lend them $40,000 at 10-percent interest for the venture. (At that rate, the loan would cost Connie and Cal $4,000 in interest charges: 10% * $40,000 = $4,000.) On the other hand, the loan would allow Connie and Cal to buy more bikes and advertise their business throughout the community and in tourist magazines.

Leverage can magnify earnings. As long as interest payments on loans are less than earnings, leverage enables firms to magnify their gains. Suppose Connie and Cal accepted their bank'’ loan. Here’s how leverage could work for Connie and Cal.

Connie and Cal’s personal investment	$20,000
Bank loan	$40,000
Total funds available	$60,000

Connie and Cal predict that the use of the extra $40,000 for advertising and a better selection of bikes could result in more rentals. They hope to earn 15 percent on their investment. If their predictions come true…

$60,000 * 15% = $9,000 earnings

- interest charges = 4,000

net earnings = $5,000

The return on Connie and Cal’s personal investment will be even greater as a result of leverage!

$5,000/$20,000 = 25%

According to this scenario, by borrowing $40,000, Connie and Cal could increase the rate of return on their investment from 15 percent to 25 percent.

Leverage can magnify losses. Now suppose Connie and Cal accepted the loan, but the weather in the Rockies turned damp and cold that summer, and few people rented Connie and Cal’s bikes. As a result, none of their predictions come true, and they only receive a 5-percent return on their investment. How would this affect their earnings?

$60,000 * 5% = $3,000 earnings

- interest charges = 4,000

(net loss) = ($1,000)

The return on Connie and Cal’s personal investment was $3,000 – the same amount they had hoped to earn without borrowing extra cash. However, since they had interest to pay, their business actually experienced a loss as a result of leverage!

- $1,000/$20,000 = 5% loss

Remember, Connie and Cal planned to earn $3,000 without borrowing any money from the bank. What rate of return would Connie and Cal need to break even? Would you recommend they borrow the money? How about borrowing less? Why or why not?

In Connie and Cal had a good year, their bank would probably extend their loan, and even offer to lend them more money. On the other hand, after a bad year, the bank is likely to ask for its $40,000. Connie and Cal would be out of business.

Borrowing money to start or expand a business is common. It can improve chances for success, but it can also magnify the risks.

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