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Occupational Health and Safety, Canadian Edition

15th Edition
by David L. Goetsch, University of West Florida and Oskaloosa-Walton Eugene Ozon, Algonquin College
1035 Solutions 49 Chapters 1386 Studied ISBN: 0133450244 Computer Science 5 (1)

Chapters 33: DQ 10

10. LAST WORD Does leverage increase the total size of the gain or loss from an investment, or just the percentage rate of return on the part of the investment amount that was not borrowed? How would lowering leverage make the financial system more stable?


Step-By-Step Solution

10. LAST WORD Does leverage increase the total size of the gain or loss from an investment, or just the percentage rate of return on the part of the investment amount that was not borrowed? How would lowering leverage make the financial system more stable?

Answer: The term leverage is used in finance to describe how the use of borrowed moneycan magnify both profits and losses. Leverage does not increase the total size of the gain or loss from an investment, because we can assume that a given investment will have the same gain or loss regardless of the source of the funds used for the investment. However, leverage can greatly increase the percentage rate of return on the part of the investment that was not borrowed. When things go well, the investor receives the profits from the investment. If the investor has borrowed a large percentage of the money to fund the investment, the percentage rate of return on the investor's own money will be much greater than if the investor had funded the entire project with her own money. If things go poorly, the percentage rate of loss is also magnified accordingly if borrowed money has been used to fund the investment.

Lowering the amount of leverage permitted in investing would make the financial system more stable because with high leverage, a relatively small loss is magnified greatly and can make a financial institution insolvent (unable to repay the funds it borrowed to finance its investments). If the leverage were reduced significantly, it would take much larger losses to push a financial firm into insolvency. However, decreasing leverage significantly reduces a financial firm's potential profits, so the banking industry has lobbied strongly and successfully against any legal attempts to require lower leverage levels.


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