Individuals and companies purchase assets to fund projects using money from banks or private lenders. This form of lending is known as leveraged finance, which allows borrowers to acquire funds quickly to achieve their financial goals and repay later.
Learning about leveraged finance investment banking helps understand how companies and investors get funding for their projects, and the exact role leveraged finance plays in investment banking.
In the following sections, we will define leveraged finance, explain its importance, and describe a few benefits of this financial tool.
What is Leveraged Finance?
Leveraged finance, also known as trading on equity or leverage, is a financial practice where businesses or individuals use borrowed money to fund projects or acquire assets. After achieving the financial goal, the borrowers repay the loan interest and the principal amount to the lender.
The purpose of using leveraged finance may differ from firm to firm and individual to individual. Companies aim to increase shareholder value by acquiring equipment or property, while individual investors may use leveraged finance to increase return on investment.
When a company owner borrows leveraged finance for expansion, they aim at making more revenue than the principal and interest amount they have to repay. It allows the borrower to profit even after repaying what they owe. A store owner may borrow a loan to set up another storefront in a new area. If the store becomes successful, the owner can repay the loan quickly and continue making a profit from the new store.
Importance of Leveraged Finance
Leveraged finance investment banking allows organizations and private investors to benefit from the available investment opportunities beyond their cash reserves. Although the process carries risks, it enables companies to grow, increase their commercial activities and provide more employment. It allows non-profit organizations like universities and hospitals to serve more people.
A retail store owner might decide to establish a small manufacturing unit and begin producing its line of goods. Not having instant cash to purchase the equipment outright pushes them to borrow leveraged finance, helping the company grow and profit.
After establishing the manufacturing unit, the store owner will make minimum payments on the borrowed amount until it starts making money from selling the goods. The borrower can repay the remaining loan and interest amount and start making profits from the sales.
Benefits of Using Leveraged Finance
Leveraged finance is a useful financing tool for borrowers with predictable incomes. It helps predict how quickly you can repay the loan:
Below are a few benefits of using this form of financing:
- Leveraged finance allows borrowers to achieve their goals with a small upfront investment.
- Borrowers can purchase more equipment or assets through extra funds from leveraged finance.
- If conditions are favorable, leveraged finance leads to higher returns than the business or individual might have achieved otherwise.
Leveraged finance investment banking enables individuals and businesses to invest in hard-to-reach projects or equipment. It allows borrowers to use their current finance more efficiently. If a growing company requires cash for its regular operations, leveraged finance can help multiply its profits without disturbing its current financial health.
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