Next Up Previous Contents Index
Next: Technological leverage Up: Theme 2: Leverage Previous: Leverage through debt

Inherent leverage

  Debt leverage is but one kind of leverage. Let's return to the hole in the windblown soil of Idaho to examine another. Despite appearances, you have not been taken to the cleaners. Beneath the ground is a vein of silver ore reliably assayed as bearing at least two ounces of silver for every share of stock in the ``mine''. But wait, you say, visions of wealth swirling before your eyes, silver is $6 an ounce! I'd better buy more stock before this gets out!

Alas, as always, there is A Catch. The ore from the Bitter Luck Next Time Mine is a substance one could describe charitably as ``low grade ore'' or cynically as ``high grade dirt''. The total cost of extracting silver from the mine, including development, excavation, and refining, works out to about $9 an ounce. Now the stock price begins to make sense: what's the value of a mine which can produce tons of silver while losing $3 on every ounce?

But suppose the price of silver rises. As long as silver sells for much less than $9 an ounce, your shares will be close to worthless. But for every dollar silver rises above $9, your shares represent $2 of real value. If silver should rise to $50, as it did in 1980, and remain there, as it did not in 1980, then each share in your mine would be worth about $82 (2(50-9)). If you invested 1000 dollars in shares at $0.03 each, your investment would grow to a more than two and half million dollars. This is leverage: leverage without debt. Shares in the mine acquire value only when the price of silver crosses a specific threshold: the price of production. After that point, they track the price in a linear fashion. If you believe that the price of silver will rise at some time in the future, but you don't know when, you can place a bet on that belief by buying shares in a mine with production cost above the current price, sit back, and wait for the price to rise.

This is only one example of inherent leverage. Anybody with a stock option benefits from another. A stock option can never be worth less than zero at its strike price, but its upside gains are unbounded. Stock purchase warrants, rights offerings, options on commodity futures contracts, and convertible debt securities are all financial instruments which exhibit leverage without the assumption of debt.


Next Up Previous Contents Index
Next: Technological leverage Up: Theme 2: Leverage Previous: Leverage through debt

Editor: John Walker