I spent literally an hour trying to figure out the concept of leverage, I think I finally got it.
The financial equations is, Equity=assets-debt, so it follows that Assets=equity+debt
A company borrows $100 at 10% interest. And invests $100 of it's own money in a stock. (200=100+100) A year later the stock has appreciated in value 20% (debt=100, equity=100, assets=200) after one year 240=110+130, the ROE is 30% instead of 20%. The money they borrowed produced more money invested than the interest rate, which allowed a high return. So when they pay it back, they have 130 instead of 120, if they had just invested 100 of their own money with no borrowing.
The problem is
If the stock only appreciates in value at 2% the equation becomes 204=110(debt)+96(equity) so even though the stock appreciated in value, THEY LOST MONEY. It increases risk BOTH WAYS.
THIS IS HOW ALL OF MODERN FINANCE WORKS.
A company borrows $100 at 10% interest. And invests $100 of it's own money in a stock. (200=100+100) A year later the stock has appreciated in value 20% (debt=100, equity=100, assets=200) after one year 240=110+130, the ROE is 30% instead of 20%. The money they borrowed produced more money invested than the interest rate, which allowed a high return. So when they pay it back, they have 130 instead of 120, if they had just invested 100 of their own money with no borrowing.
The problem is
If the stock only appreciates in value at 2% the equation becomes 204=110(debt)+96(equity) so even though the stock appreciated in value, THEY LOST MONEY. It increases risk BOTH WAYS.
THIS IS HOW ALL OF MODERN FINANCE WORKS.