The leverage effect describes the effect of debt on the return on equity: Additional debt can increase the return on equity for the owner. This applies as long as the total return on the project is higher than the cost of additional debt.
Example of a positive leverage effect:
If the project return is 5% and the interest on debt is 3%, it is worth raising even more debt capital: In this case, the company only has to pay 3% interest on the capital it obtains, but generates a total return of 5%. As less equity capital is required for the project, it is used more effectively and economically.This results in a higher return on equity.
Example of a negative leverage effect:
If the interest on debt exceeds the total return of the project, less money is generated with the help of debt financing. This reduces the return on equity. With a total return of 5% and an interest on debt of 6%, you pay more for the additional capital than you can earn with it.
To get more information about the different returns in greenmatch, read this article: What is the difference between Equity IRR, Project IRR and Payout IRR?
