Leverage

Leverage is one of the most power ful concepts in finance,

and it corresponds roughly to our previous discussions of financing choices and capital structure. You may have friends

in finance who get weepy- eyed when they talk about lever-

age. Empires have been built and destroyed because of

leverage, and you’ll see why.

Why is it called “leverage”? The easiest way to under-

stand the power of leverage is to recall the power of a lever

in an engineering context. Imagine a big rock that you can’t

possibly move by yourself. A lever will allow you to move

that rock, seemingly magically, by multiplying the force

you apply to the task. And that’s a precise analogue for

what happens with leverage in finance. Just as a lever lets

you move a rock you couldn’t other wise move, leverage in

finance allows owners to control assets they couldn’t control

other wise.

Let’s consider your own personal balance sheet after you

buy a home. What if no mortgages were available for you to

buy a home? If you had $100, you could only buy a home that

was worth $100. With a mortgage market, you can borrow

money to buy a home that is worth, say, $500. Let’s see what

your balance sheet looks like under those two circumstances.