Definition for : Leverage effect

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 Chapter 13 Return on capital employed and return on equity of the Vernimmen)

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