So let's demonstrate the impact of leverage on returns.
Firstly, let's consider your whole coffee business completely funded by equity.
There are 10,000 shares, each trading a $40 per share.
So the market capitalization, the market value of your equity is $400,000.
Let's also assume that there are three possible states of
the world that you face.
Let's first take our normal or our expected state of the world.
We expect to generate $100,000 of operating profit.
So our net income before tax is $100,000.
We pay tax at a corporate rate of 30%, leaving net income of $70,000.
So our return on equity in our expected state of the world is 17.5%
Simply, $70,000 divided by $400,000, being the market value of equity.
In the poor state of the world, we generate only $10,000 of operating profit,
implying a return on equity of only 1.75%.
And in the great state of the world, we generate $200,000 of profit,
generating a return on equity of 35%.
Now let's consider the down state of the world,
where operating profit is only $10,000.