Why would you use leverage when buying a company?

Why would you use leverage when buying a company?

• A. To leverage out their position.
• B. To increase return.
• C. To finance acquisitions with cash only.
• D. To diversify risk across deals.

Answer: (B)

Using leverage means funding part of the purchase with debt so you put less of your own money into the deal. The idea is that if the business can generate enough cash flow to cover debt service and still produce extra profit, the return earned on the smaller amount of equity is amplified. For example, buying a company for 100 with 60 funded by debt and 40 by equity, and the business generates enough cash flow to cover interest and leave, say, 12 for equity after debt service, gives an equity return of 12/40 = 30%. If you had bought with all cash, the same cash flow would yield 15/100 = 15% return. So leverage increases returns when the company’s returns exceed the cost of debt, though it also brings higher risk if cash flows weaken or debt costs rise.

Using leverage means funding part of the purchase with debt so you put less of your own money into the deal. The idea is that if the business can generate enough cash flow to cover debt service and still produce extra profit, the return earned on the smaller amount of equity is amplified. For example, buying a company for 100 with 60 funded by debt and 40 by equity, and the business generates enough cash flow to cover interest and leave, say, 12 for equity after debt service, gives an equity return of 12/40 = 30%. If you had bought with all cash, the same cash flow would yield 15/100 = 15% return. So leverage increases returns when the company’s returns exceed the cost of debt, though it also brings higher risk if cash flows weaken or debt costs rise.