Leverage effect

Leverage means leverage and the leverage effect or financial leverage describes the fact that the expected return on equity will continue to rise if the company is increasingly financed with outside capital. However, leverage also increases the risks.

The return on equity is an uncertain figure for a future period, such as the coming year. It can therefore not be characterized as a number but only by a probability distribution, and this in turn can be described by distribution parameters such as expectation and variance.
When borrowing capital, the expected value of the return increases, a desirable phenomenon. At the same time, however, the variance (= square of the dispersion) of the return increases, and since equity investors are risk averse, this is undesirable. It is therefore unclear whether the equity investors want to raise outside capital at all, and if so, to what extent. Corresponding considerations can be found under the heading of capital structure.

Interessant ist, daß es auch einen Operational Leverage geben kann. Bei vielen Vorleistungen kann das Management entscheiden, ob die Vorleistungen über den Factor market bezogen werden sollen, oder ob sie in der Unternehmung selbst erstellt werden sollen.

When buying via the factor markets, a fee is usually to be paid that is proportional to the quantity (quantity). There is a unit price. The margin is therefore independent of the sales volume.

When increasing the vertical range of manufacture and in-house production, operating facilities are usually created for production, and these usually result in costs that vary only slightly with the quantity, there are fixed costs. If there are variations in sales volume, the revenue is proportional to the quantity, but the costs are not.

If the amount were a safe or easily predictable quantity, it can be calculated what is cheaper here. Often this is your own production. If the quantity is an uncertain quantity, however, there is a risk that the fixed costs will still arise if the quantity is smaller. Even with such operational decisions, it is therefore a matter of weighing up a lower expected return with a low risk and a higher expected return with a higher risk.

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Further explanations for the first letter L