An investment is called leveraged if some of the money is borrowed, e.g. via a loan from a bank. A good way to look at leveraged investments is as follows:
- Own capital (equity): This money comes out of your pocket, and once invested you earn the ROC (return on capital) on it.
- Borrowed capital (debt): The investment of this money earns the ROC, too, but you also have to pay interest on it. You effectively earn the difference of ROI and interest rate.
ROC and ROI
- ROC (return on capital) is the financial ratio obtained by dividing the net income by the total invested capital (debt+equity). It indicates how profitable an installation is.
- ROI (return on investment) is the financial ratio obtained by dividing the net income by the own capital only (equity).
Note that the return on capital (ROC) is fixed for different levels of leverage. But the return on investment (ROI) changes: As you increase leverage you borrow more and put down less of your own money (equity). If the ROC is larger than the interest rate your ROI goes up. If your installation is very productive at a low turnkey cost, the effect of leverage can be dramatic.
The Leverate Graph
The horizontal axis show the yield in kWh/kWp and the vertical axis show the ROI. You see the results for five leverage levels. For example, 10% leverage means you put down 10% of the capital and borrowd 90%.
The lines cross at the point where ROC is exactly equal to the effective interest rate. At this point, borrowing has no effect because the income from that part of the investment goes exactly into covering the interest rate payments. Clearly, financing an instalation at such a low ROC is a bad idea. You want a ROC that exceeds the prevailing interest rates by quite some margin. The higher the ROC compared to the interest rate the more effect does leverage have.
Note that your gross income throughout the years, whatever may come, must always suffice to pay interest. With an unlevereged investment, if something goes wrong, the worst case is that you sink all your monety. If you are leveraged, you can lose more than your investment!
► Higher Leverage always means higher risk.