Leverage (finance) - Worked Example

Worked Example

Calculate equity return given:
5% Projected Return on Investment
4% Cost of Debt
8:1 Leverage Debt:Equity

LONG-FORM MATH

(I) Profit from investment = Investment * Return on investment = 9 * 5% = 0.45
(II) Interest on debt = Debt * Cost of debt = 8 * 4% = 0.32
(III) Net profit = (I) - (II) = 0.45 - 0.32 = 0.13
(IV) Return on Equity = (III) / Equity = 0.13 / 1 = 13%

SHORT-FORM GENERIC CALCULATION

Return on Debt = Return on Investment - Cost of Debt = 5% - 4% = 1%
Net Profit From Debt = Debt * Net Interest Rate = 8 * 1% = 0.08
Net Profit From Equity = Equity * Return on Investment = 1 * 5% = 0.05
Return on Equity = Total Return / Equity = (0.08+0.05) / 1 = 13%