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Thursday, May 26, 2016

How leveraging works

Leveraging (Other People’s Money) is one of the techniques, most used by billionaires to amass fortune. Sam Walton, Donald Trump, Aristotle Onassis, W. Clement Stone, Daniel Ludwig and number of other tycoons applied this principal to set up their empires.

Financial leverage is using borrowed funds to invest in an industry. Say, for example, an investor borrows 1000$ and invest it along with his own 1000$. Now, if the industry generates 20% returns he would be able to produce 33% return on equity as compared to 20% returns he would have generated without leveraging.

The most famous example of application is Aristotle Onassis who borrowed funds from banks, using future cash flow from his already owned ships as collateral, to build more ships. Although Daniel Ludwig was the founder of this technique but Aristotle Onassis is more famous for its application.

W. Clement Stone also used other people’s money to buy other insurance companies. E.g. he bought the Pennsylvania Casualty Company using funds borrowed from the Commercial Credit Company of Baltimore, which owned the company he was buying.

Financial leverage is a double edged sword. Using it can generate super normal profits in good days but it can play against you, as well, by generating extra losses during recession.

Leveraging may help you to be extra vigilant regarding your business expenses. The liability you have under taken in form of funds and interest would pressurize you to be extra careful in your expenditure and you would move towards cost cutting. It may provide impetus for you to work hard. Fed chairman Ben Bernanke, has compared, adding debt to firm’s capital structure, to putting a dagger to steering wheel of your car.   Dagger- which points towards your stomach- would motivate you to drive carefully but at the same time the risk of damaging yourself is very serious when someone else hits you- even if you are driving carefully.

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