Question

13. Investing in residential income-producing property. Mallory Comer is thinking about investing in some residential income-producing property that she can purchase for $200,000. Mallory can either pay cash for the full amount of the property or put up $50,000 of her own money and bor-row the remaining $150,000 at 5 percent interest. The property is expected to generate $30,000 per year after all expenses but before interest and income taxes. Assume that Mallory is in the 28 percent tax bracket. Calculate her annual profit and return on investment, assuming that she (a) pays the full $200,000 from her own funds or (b) borrows $150,000 at 5 percent. Then discuss the effect, if any, of leverage on her rate of return.

Answer 1

Mallory Comer

a. Alternative 1: Pays the full $200,000 from her own funds:

Annual Earnings before interest

and taxes = $30,000

Tax (28%) 8,400

Annual after-tax earnings = $21,600

Return on investment = $21,600/$200,000 * 100 = 10.8%

b. Alternative 2: She borrows $150,000 at 5 percent:

Annual Earnings before interest

and taxes = $30,000

Interest expense (5% of $150,000) = 7,500

Earnings before tax = $22,500

Tax (28%) 6,300

Annual after-tax earnings = $16,200

Return on investment = $16,200/$50,000 * 100 = 32.4%

c) Effect of leverage on Mallory's rate of return: Leverage increases the rate of return, provided Mallory has an alternative investment vehicle to put her $150,000 idle capital. And the investment must be able to earn more than 10.8%, depending on her risk appetite.

Step-by-step explanation:

a) Data and Calculations:

Cost of investment in residential income-producing property = $200,000

Options:

a) Pay full amount from own funds (equity) $200,000 or

b) Contribute (equity) $50,000 and borrow (debts) $150,000

Cost of debt = 5% interest

Mallory's tax bracket = 28%